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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1984
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, AND URBAN
AFFAIRS
UNITED STATES SENATE
NINETY-EIGHTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF
1978
JULY 25 AND 31, 1984
Printed for the use of the Committee on Banking, Housing, and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON I 1984
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
MACK MATTINGLY, Georgia
ALAN J. DIXON, Illinois
CHIC HECHT, Nevada
JIM SASSER, Tennessee
PAUL TRIBLE, Virginia
FRANK R. LAUTENBERG, New Jersey
GORDON J. HUMPHREY, New Hampshire
M. DANNY WALL, Staff Director
KENNETH A. McLEAN, Minority Staff Director
W. LAMAR SMITH, Economist
(ID
CONTENTS
WEDNESDAY, JULY 25, 1984
Page
Opening statement of Chairman Garn
Opening statement of Senator Proxmire
Opening statement of Senator Riegle
1
1
2
WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Prepared statement
The overall economic performance
Imbalances and strains
Monetary policy
International and domestic banking markets
Conclusion
Table I: Economic projections for 1984 and 1985
Table II: Growth ranges reconfirmed for 1984 for money and debt
compared with actual growth through June 1984
Table III: Growth in domestic nonfinancial debt
"Midyear Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978"
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 1984
Charts:
RealGNP
Real gross domestic purchases
Interest rates
Real income and consumption
Total private housing starts
Real business fixed investment
Exchange value of the U.S. dollar
,
U.S. real merchandise trade volume
U.S. current account
Nonfarm payroll employment
Civilian unemployment rate
Hourly earnings index
Consumer Price Index
GNP prices
Ranges and actual money growth
Ranges and actual money and debt growth
Velocity
Table: Growth of money and credit
Strength of the economy
Some warning signals flashing
Caution and constraint needed
Nomination of Dr, Seger
Lower interest rates for farmers
No political comment
Fed s monetary targeting
Stretchout of international loans
Problem banks range near 700
Effects of deflation on the financial system
am
3
4
4
6
9
13
17
20
21
22
23
24
28
32
33
33
33
35
35
35
42
42
42
44
44
46
46
46
55
56
58
51
62
63
65
66
68
73
74
75
76
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Page
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve SystemContinued
Competition of banks for funds
Long-term investment lagging
Refundings involve a lot of new money
Need for quality loans by banks
Reduced standard of living avoidable
Effects of leveraged buyouts
Competitive equity in banking
Less growth in second half of the year
Lack of trust by financial community
$3.5 billion bailout loan
Higher interest rates dangerous
Debt of 30 developing countries at $400 billion
Trade imbalance leveling out at a high level
Paid $2 dividend in 1982 and 1983
Timing of Open Market Committee decisions
Lack of national treatment for U.S. banks abroad
Supervision of Continental Illinois questionable
Need to flag problems early
No new capital involved
Rise in interest rates could wipe out thrifts earnings
Concern for the structural strength of the financial system
Government spending more than it takes in for 40 years
Response to written questions of Senators Garn, Mattingly, and Trible
79
81
82
84
85
87
88
89
92
92
94
96
97
98
100
102
104
106
107
108
110
112
114
TUESDAY, JULY 31, 1984
Opening statement of Chairman Garn
139
WITNESSES
William Poole, member, Council of Economic Advisers
Present economic expansion
Rapidly rising to capacity
Lower inflation inspires confidence
Prepared statement
The economic expansion to date
The economic outlook
Concluding comment
Table 1: Sector contributions to GNP growth: Typical and current
recovery
Table 2: Capacity utilization and 1984 investment plans
Table 3: Short- and long-term inflation expectations
Weekly money supply data
Federal Reserve should have single target
Health of net fixed investment
Tax increase?
Deflation—possible concern
Greater external constraints needed
A. James Meigs, senior vice president and chief economist, First Interstate
Bank of California, Los Angeles, CA
High interest rates expected
Money growth's effect on inflation
Slowing of" money growth desirable
Prepared statement
The historical evidence
Some implications for monetary targeting strategy
The current situation
Credibility: The instructive case of Japan
Chart 1: GNP deflator
Chart 2: Money supply growth—Ml
Chart 3: Inflation versus Ml growth 2 years prior
Patrick Savin, vice president and capital markets analyst, Drexel Burnham
Lambert Inc., New York, NY
Premium put on low inflation
Fed has lost control of the curve
Tax system favors heavy debt
L39
139
141
142
145
145
149
156
157
158
159
160
161
162
165
167
168
170
170
172
174
177
179
183
184
186
189
190
191
192
192
193
195
Page
Patrick Savin, vice president and capital markets analyst, Drexel Burnham
Lambert Inc., New York, NY—Continued
Prepared statement
196
Panel discussion:
Proper procedure for monetary policy
210
Congress is responsible for uncertainty in the marketplace
Fed needs to be held accountable
Congress is scapegoat for the Fed
Beryl Sprinkel, Under Secretary for Monetary Affairs, U.S. Department of
the Treasury
Deleterious economic effects of inflation
Decline in inflation causes velocity to fall
Price stability is Government's economic function
Prepared statement
The outlook for inflation
The behavior of velocity
Implications for monetary policy
The importance of money growth targets
Concerns for the future
Conclusion
Chart 1: Money leads inflation by 2 years
Chart 2: Velocity and trend velocity, 1960 first quarter to 1984 second
quarter
Change in the definition of Ml
Real interest rates still high
Balanced budget amendment
211
212
214
215
216
217
219
222
223
224
225
227
228
230
231
232
233
234
236
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1984
WEDNESDAY, JULY 25, 1984
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS*
Washington, DC.
The committee met at 9:30 a.m., in room SDG-50, Dirksen
Senate Office Building, Senator Jake Garn (chairman of the committee) presiding.
Present: Senators Garn, Heinz, Gorton, Mattingly, Hecht, Proxmire, Riegle, Sasser, and Lautenberg.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. The Banking Committee will come to order.
Mr. Chairman, we are happy to have you with us for your semiannual report to the Senate Banking Committee. It appears for the
first time we have a room big enough to handle everyone. As a
matter of fact, there are empty seats, but I do think this is more
comfortable for everybody than our normal hearing room.
Although we are happy to have you before the committee today,
I wish I could say I was happy to be back in Washington, but as I
was just saying to my colleagues, it's the best recess that I have
ever had. We should have Presidential elections every year so the
Congress can get out of town. I can hardly wait until the Republicans have theirs so we can leave again. It's a delightful time in
Utah and the world still has both feet on the ground out there with
none of the panic we see in Washington.
In any event, I have been very pleased during the recess to see
from the economic indicators that the economy is still continuing
to grow and progress. So we are happy to have you before the committee again.
Senator Proxmire, do you have a statement you wish to make?
OPENING STATEMENT OF SENATOR PROXMIRE
Senator PROXMIRE. Thank you, Mr. Chairman.
Chairman Volcker, as the chairman of this committee has indicated, the economic news could hardly be better. Here we have the
biggest increase in jobs in America's history in the last IVfe years, 6
million. We have inflation behaving like a perfectly trained hunting dog, staying below 4 percent. We have exuberant economic
growth, 9.5 percent in the first quarter of the year and 7,5 percent
in the second quarter. Personal income is breaking all records.
(i)
Just this morning, the New York Times reported that auto sales
in mid-July broke a 6-year record for that period. We are beginning
to move into the classic framework for inflation to break out of its
remarkably gentlemanly like behavior. We are operating at well
above 80 percent of capacity. While overall unemployment is still
at 7 percent, it's below 4 percent in Massachusetts, below 5 percent
in a number of States. As we all know, unemployment is a lagging
indicator so we can expect it to fall for another 6 months or more.
This means labor shortages that will certainly tend to push up
wages and prices.
All this can be expected a few months into 1985, but not before
the election, of course. Our current account balance is at an annual
rate of minus $70 billion. The deficit account is at an annual rate
of $170 billion and the Nation's investors are so concerned that
they shoved the stock market down yesterday to the lowest level in
IVz years, in spite of all the great economic news.
It would be hard for this Senator to imagine a scenario that
would more emphatically call out for monetary restraint.
Now contrast this with the last Presidential election year, 1980.
For the first half of 1980, economic growth actually declined at an
annual rate of more than 3 percent compared to this year's exuberant growth. Unemployment was higher than it is now and rising
and the price level was substantially higher than it is today but it
was falling. Our current account balance for the first half of 1980
was bobbing along not at $70 billion but at an annual rate of minus
$5 billion on its way to actual favorable balance plus for the year;
and the deficit in the first half of 1980 was moving at an annual
rate of $50 billion, less than a third of the present level.
By and large, the 1980 economic situation seemed to have called
for a much easier monetary policy than the present 1984 economic
situation.
Now I know you don't think in political terms and you shouldn't,
but the big fact is that this is an election year and I hope you will
treat President Ronald Reagan with the same objective, arm's
length election year fairness, with the same meticulous disregard
for political consequences that you treated President Carter.
When Vince Lombard! was coach of the Green Bay Packers a reporter asked one of the players whether Lombardi showed any unfairness in the treatment of players. The player told the reporter,
"Listen, Coach Lombardi treats us all the same—like dogs."
Mr. Chairman, I hope you can show that same objectivity and
painstaking fairness in dealing with the Presidential candidates in
the 3 months before the election.
The CHAIRMAN. Senator Mattingly.
Senator MATTINGLY. I have no statement at this time.
The CHAIRMAN. Senator Riegle.
OPENING STATEMENT OF SENATOR RIEGLE
Senator RIEGLE. Mr. Chairman, I will make just one brief comment because I am interested to hear what Chairman Volcker has
to say to us today. I, too, am concerned with the structural problems that Senator Proxmire touched upon and what is obviously a
very substantial apprehension in the financial markets over the
contradictions that are out there—on the one hand the strong economic growth, while on the other hand we have rising interest
rates, and greater and greater pressure on financial institutions.
The bailout of Continental Illinois graphically illustrates this pressure, but we also have another 700 banks in trouble'and the savings and loan industry increasingly in trouble. Other problem
areas include the trade deficit, as was just noted, and the selloff
that's occurring in the stock market which seems to reflect the financial markets' view and apprehensions about the future. I would
hope that as you go through your statement you will elaborate on
areas that deal with the structural strengths of the system to
handle the problems that it now faces.
Thank you, Mr. Chairman.
The CHAIRMAN. Senator Hecht.
Senator HECHT. I have no statement, Mr. Chairman.
The CHAIRMAN. Senator Heinz.
Senator HEINZ. No statement.
The CHAIRMAN. Mr. Chairman, please proceed.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. VOLCKER. Thank you, Mr. Chairman and Senators. I think I
will touch upon matters that you raised in your opening comments
except for the delights of being in Salt Lake City, but you do have
some work to do here,
[The complete statement and the midyear monetary policy report
to Congress follow:]
Statement by
Paul A. Volcfcer
Chairman, Board of Governors of the Federal Reserve System
I appreciate the opportunity to appear once again Defore
this Commi ttee to review monetary policy in the context of our
overal 1 economic performance and problems.
In accordance
with the Humphrey-Hawk ins Act, the semi-annual report of the
Federal Reserve Board reviewing economic developments and the
decisions of the Federal Open Market Committee with respect to
monetary and credit targets for 1984 and 1985 was transmitted
to you this morning.
As indicated there, the FOMC reaffirmed
the target and monitoring ranges for the various monetary and
credit aggregates for 1984 and decided to reduce the top end
of the ranges for Ml antl M2 for 1985.
later in my testimony.
I will discuss that
First, I would like to summarize some
key poi nts about the economy and call your attention to particular
problems that present clear risks to an otherwise positive outlook,
The Overa 11_Eegngini_g Performan; ce
Measures of aggregate economic activity, employment,
costs, and prices have provided an almost unbroken string of
favorable news so far in 1984.
The process of recovery from
the deep and prolonged recession -- a recovery that began amid
widespread doubts about both its potential vigor and staying
power —
had proceeded strongly through 1983.
There were
widespread anticipations early this year that, as we moved
beyond recovery into a new expansion phase, the pace of growth
would slow.
But in fact growth actually accelerated as we moved
into this year.
During the second quarter of 1984, the economy
as a whole operated at a level more than four percent higher
than in the closing months of last year and 7-1/2 percent higher
than a year earlier.
Almost three million more people have been employed so far
this year, bringing the total gains over the past IB months clc=^
to 1 million.
percent.
The unemployment rate has dropped to about 1
Business investment has risen very rapidly this year,
while consumer spending has remained strong.
The forward momentum
of the economy still appears considerable.
At the same time, inflationary pressures have to this
poi nt remained subdued, with most summary price measures rising
little, if at all, faster than the sharply reduced rate of
1983.
In fact, a number of sensitive commodity prices have
dropped recently, following sizable cyclical increases.
Highly competitive domestic and international markets,
influenced by the strength of the dollar overseas and continued
strong efforts to discipline costs, have been key factors
contributing to greater price stability.
The net result has
been rising productivity and good gains in real incomes, even
while nominal wage and salary increases have remained moderate.
Looking only at these overall measures, this recovery
and expansion period has been atypical —
atypical in the sense
that such a rapid expansion has been maintained longer after the
recession trough than in any comparable cyclical period since
World War II, excepting only the Korean War episode.
period has been atypical in other ways as well —
But the
in ways that
potentially could have severely adverse impliest ions unless
dealt with by timely and effective policy actions.
Imbalances and S t r a i n s
In any period of recovery and expansion, some sectors
fare relatively better or worse than others, and in that g e n e r a l
respect this period has been no exrt>pt ion .
Some of our heavy
industries -- for instance, steel and other metals and heavy
machinery -- are still at operat ing rates well below earlier
experience.
Demand for our agricultural products from abroad
has not been buoyant, and many fanners —
particularly those
with large debts -- are being severely squeezed by high interest
rates and f a l l i n g land prices.
What is d i f f e r e n t , in degree and in kind, is that some
i n e v i t a b l e iinevenness in patterns of growth in particular sectors
has been aggravated by the massive arid related imbalances in both
our fiscal p o s i t i o n and our international trading accounts and
by some s t r a i n s in f i n a n c i a l markets .
As you know, rapid growth
has been reflected in some reduction in the budgetary d e f i c i t ,
estimated for fiscal 1984 in the neighborhood
of $170-5175
billion.
The Congress is in the process of enacting the
so-called
"downpayment" against future deficits, part of which
has already been signed by the President.
But the hard fact
is, as I am sure the Congress is fully aware, the deficit
remains huge in absolute and relative terms, and absent further
action little or no further decline now seems probable for 1985
and beyond, even assuming the economy continues to move to
"full employment" levels.
That circumstance has been reflected in continued large
Treasury borrowings, and expectations of indefinite continuation.
Meanwhj 3e, private c red it demands, responding tc and support in-;:
growth in consumption and investment, have accelerat&d.
Persona 1
savings rc-lati ve to incorae have remained in the lower range
c h a r a c t e r i s t i c of the late 1970s,, anc! destine growth in in terna 11;,
generated corporate cash f lows, the sources of oomest i c funds
have fallen far below cur demands.
In these circumstances,
interest rates -- already historically high -- tended to
move s t i l l higher during the spring.
Those h i g h interest
rates, combined with favorable economic conditions gene rally ir.
this country, h a v e attracted more and more c a p i t a l from ahroad
to help meet our domestic needs, and the dollar has appreciated
despite deterioration in our trade and current accounts.
The strong do]lar and the ample a v a i l a b i l i t y of goods
from abroad at a time when growth in most other developed
countries has been relatively sluggish have certainly been
potent forces helping to contain inflation.
The capital inflow,
supplement ing our net domest ic savings by a quarter, has been a
factor containing pressures on our own financial markets.
And,
the large rise in our imports has helped stimulate economic
activity among some of our leading trading partners and eased
somewhat the severe adjustment process underway
in Latin America.
But what is in quest!on is the s u s t a i n a b i l i t y of that
process, as the United States becomes more and more dependent
on foreign capital, as our export and import ing-competing
industries are damaged and seek protectionist relief, and as
interest rate pressures remain strong.
The only real quest ion is
whether the needed and inevitable adjustments will be f a c i l i t a t e d
and enccoraged by constructive public p o l i c i e s , consistent with
long-term growth and stability, or whether we are content,
despite all the strains and dangers, to let events simply take
their course.
Short-sighted relapses into lack of financial
discipline, widespread protectionism, and wage and pricing
excesses could only aggravate the situation.
It is, in the end, the choice between building on the
enormous progress of the past to achieve sustainej growth in a
framework of greater stability or a relapse into i nflat iorvary
economic malaise.
With that choice clear, I am confident that
the needed policies are well w i t h i n our collective grasp.
The continuing d i f f i c u l t i e s of some heavily indebted
developing countries in Latin America, and in some other places
as well, has been one point of uncertainty.
A sense o£ greater
concern has, ironically, come at a time when several of the
largest borrowers have more clearly made substantial progress
toward reducing external financing requirements and toward
carrying out the more fundamental adjustments that should
provide a firm base for their renewed growth.
But other
borrowing nations have made less progress, and the uncertainties
have been fed by signs of growi ng protect ion ism in industrialized
countries and by the increases in interest rates in the United
States which impact directly on debt service costs of countries
with large external dollar-denominated debt.
Within the United States, the relatively high level of
interest rates has aggravated financial pressures in the farm
sector.
Many thrift institut ions face the prospect of «eak
e a r n i n g s at a time when capital posit ions have been eroded by
losses earlier in the decade.
And, despite the rapid growth of
the economy and strong increases in business prof it ability
overall, more stable prices have exposed some weaknesses in
credit practices in the energy and other areas encouraged
by earlier inflationary expectations.
Monetary Pol icy
These developments have provided the setting for the
implementation of monetary policy thus far in 1984 and for the
review of monetary and credit objectives by the Federal Open
Market Committee for this year and next.
In reaching its policy judgments, the Committee members
shared the widespread view that the overall rate of economic
growth would moderate soon as resources become more fully
employed and would continue through 1985 at a sustainable
pace.
While the rate of price increase has been somewhat
slower than expected over the first half of 1984, that rate is
generally expected to rise by a percentage point or so next
year, assuming that the dollar remains in the same general
range as over the past year.
In making those projections,
which are detailed in Table I attached, Committee members also
noted that continued high budget deficits and other factors,
unless dealt with effectively, would pose substantial risks
of less sat is factory results with respect to economic act ivity
or prices or both.
The economic projections, of course, took account of the
decisions made on monetary policy.
Broadly, monetary policy
10
w i l ! repair? d i r e c t e d toward p r o v i d i n g enouqh money to support,
s u s t a i n a b l e growr h w h i l e c o n t i n u i n g to encourage greater price
s t a b i l i t y over ti.-ne.
As d e t a i l e d in the f u l l report, Comrittee
members t elt t h a t hruac objective was consistent w i t h the growth
ranges for money and credit specified in February for t h i s
year, and no chamjes were made .
For 1965, the tentative de^isirin
was reached to reduce the ranges slightly for both Ml and M2,
specifically by lowering the top end of the ranges specified
for this year by 1% and 1/2%, respectively.
The target range
for Ml and the monitoring range for domestic c r e d i t were left
unchanged.
These t e n t a t i v e decisions for 1985, reflected in
Table II attached, w i l l be carefully reviewed at the start of
next year.
in assess ing the appropriate ranges, and the relative
weight to be placed upon the various aggregates, the Committee
reviewed the evidence of more typical cyclical behavior of Ml
in recent quarters relative to Gf<P, following the unusual behavior
of velocity in 1582 and early 1983.
In the light of that exam-
i n a t i o n , it felt that roughly equal weight should be g i v e n each
of the monetary aggregates in implementing policy.
appraisals
However,
of their movements, and relationships among them,
w i l l cont iriue to be judged in the light of developments in
economic a c t i v i t y , inflationary pressures, financial market
conditions, and the rate of credit growth.
W h i l e both M l a n d M 2 have grown w i t h i n t h e i r t a r g e t e d
ranges Of t h i s year, 4 to B percent and 6 to 9 p e r c e n t r e s p e c t i v e l y ,
M3 a n d p a r t i c u l a r l y d o m e s t i c c r e d i t , have e x p a n d e d f a s t e r t h a n
11
ar.t ic : fa * ed .
Creai t growth has , in f a c t , continued to outpace
t r,a t of n o m i n a l GNp , as was the case last yf;ar but contrary
to longer-tern t rends.
Viewed in a mf-di urn-term or longer
jjers^f--11 ve , those growth rates for «3 ar.d domestic c r e d i t ar>=
h i g h e r t h a n consistent with S u s t a i n a b l e rates of growth in the
eccnor-y and progress toward price s t a b i l i t y .
For that reason ,
the Committee deciaed not to raise the target ranges for this
year, feeling that would provide an inappropriate benchmark for
measuring desired long-run growth, even though Coruni t tee members
reergr. i zed t h a t , as a p r a c t i c a l natter, growth in these
a g g r e g a t e s , at least for domestic c r e d i t , would likely exceed
the specified ranees.
In reach ir.y those judgments, the Committee recognized
t h a t the rate of business credit growth had been a m p l i f i e d by
an unusual spate of merger a c t i v i t y and corporate f i n a n c i a l
reorganizations -- so-called "leveraged buy-outs" —
the e f f e c t of substituting debt for equity.
that had
The implications
of those f i n a n c i n g s , w h i l e potentially adverse from the standpoint
of the overall f i n a n c i a l strength of p a r t i c u l a r businesses, are
relatively neutral from the standpoint of demands on real
resources and overall credit market conditions.
Estimated
adjustments for that a c t i v i t y on the rate of overall credit
growth would reduce the indicated expansion over the first half
of the year from n rate of about 13 percent to 12 percent,
closer to, but s t i l l above, the monitoring range.
That
growth, together v i t n the extraordinary rise in consumer and
Federal Government d e b t , is shown in Table III.
12
Typically, Federal deficits shrink substantially as
the economy moves into the second and third years of expansion -there was a day when ba lance or surplus was the reasonable objective,
That is not happening this time.
And in contrast to 1982 and
rnost of 1983, Treasury must compete strongly with accelerated
demands for consumer and business credit arid a continued high
level of mortgage borrowing.
With long-term markets unreceptive, much of the increase
in business and consumer borrowing is being done at banks.
Thrift institutions remain highly active in the mortgage markets.
These institut ions, in turn, rely increasingly on certificates
of deposit and other forms of market finance included in the M3
aggregate, account ing for its relative strength.
In implementing the policies reflected in the various
targets, steps were taken during the late winter and early
spring to increase somewhat pressures on bank reserve positions,
and the discount rate was raised once, from 8-1/2
to 9%.
Reserve
pressures have not changed appreciably since that time, as
reflected in relatively unchanged borrowings at the discount
window (apart from those by the troubled Continental Illinois
Bank).
With both Ml and K2 remaining within their target ranges,
and against the background of the economic, price, and financial
market developments reviewed earlier, stronger restraining
act ions on money and credit growth generally have not appeared
appropriate.
At the same time, the relatively rapid rates of
growth in M 3 and domestic credit are flashing cautionary signals.
13
while pressures on bank reserves did not increase further,
both long- and short-term
interest rates cose over the spring,
The continued heavy credit demands, expectations that those
demands would persist against the background of the huge federal
d e f i c i t and strong economic expansion, and fears of a resurgence
of inflationary pressures as both labor and capital are more
fully employed all played a part.
In more recent weeks, rates
have tended to stabilize at high levels, perhaps partly because
current price trends have, at least so far, not borne out more
extreme inflationary concerns expressed earlier.
Nonetheless,
markets remain volatile and apprehens ive.
International and Domestic Bank ing Markers
The atmosphere surrounding credit and banking markets at
times during recent months has been appreciably influenced by the
apparent d i f f i c u l t i e s of one of the nation's largest banks and by
continuing concerns over the ability of some developing countries
to service debts held mainly by large commercial banks around
the world.
As I have reported to the Committee before, orderly and
full resolution of the latter problem will require a strong
cooperative effort by borrowers and lenders alike over a
considerable period of time.
A few minutes ago, I noted there are,
in fact, encouraging signs that the difficult process of internal
and external adjustment is beginning to bear fruit in important
countries in Latin America, including Mexico, Venezuela and
Brazil.
Negotiations are currently underway by the first
two of those countri es wi th banks look ing toward a long-term
u
restructuring of their external debt at terms r e f l e c t i n g the
evidence Of prudent policies and improving credit-wort hi ness.
Provided that growth is m a i n t a i n e d in the industrialized countries
and markets for their products are not closed, prospects for
econoric recovery and growth on a sustainable basis in those
Lat in A m e r i c a n countries appear more favorable, helped to a
substantial extent by the growth in our own markets.
In other
countries the adjustment process is less advanced, but the progress of some, both in adjustment and f i n a n c i n g , can point the
way for others.
Vihile- the challenge for all remains substantial,
we need to view it r e a l i s t i c a l l y , as a situation that justifies
n e i t h e r neglect nor despair.
Rather, appropriate approaches
tailored to the needs of each country can bring results.
But
w i t h that effort on all sides, the problem is manageable.
The problems of Continental Bank essentially reflected
serious weaknesses in the domestic loan portfolio oE a bank
that had engaged in aggressive growth and lending practices
for some time, including heavy involvement in participations in
energy loans o£ the Penn Square Bank that failed two years ago.
As other cred it losses surfaced and earnings pressures continued,
market sources of funding were reduced and the bank became Heavily
dependent on discount window borrowings during the spring.
As
the atmosphere surrounding the bank deteriorated and threatened.
to disturb markets more generally, the supervisory authorities,
together with a group of other major banks, provided a massive
financial assistance program pending a more permanent solution.
I believe those more lasting arrangements will be announced shortly.
15
a'ic. w i "- i pr :.>v ide ,1 ; n. *-~ t?^f f ci a he-a 1 thy , Duf cnns ; tlfrat:! y
smaller ba: jk.
TKa t s 11 ..a*, i on is u n i q u e for a large bank, but
the
epi sot:e riciy be an object lesson about the importance of
looking anoad to anticipate problems.
In a period of rapid econorr i c and credit expansion,
there can be temptations to relax prudent credit standards in an
effort to maximize growth.
K i t h deposit markets deregulated,
there may De a percept ion by i n d i v i d u a l banks that added fundscan be raised as needed in donestic or foreign markets by b i d d i n g
rates higher to fund larger and larger loan portfolios -- and
that loan rates can be raised as fast as deposit rates.
But the
aggregate supply of funds is ultimately not really inexhaustible;
confidence must be m a i n t a i n e d , and h i g h and volatile interest
rates can undermine the credit-worthiness of weaker borrowers.
When e x t e r n a l economic developments and high interest
rates impair the a b i l i t y of otherwise credit-worthy borrowers
fully to m a i n t a i n scheduled debt service on loans made earlier
in a different economic environment, prudent banking may indeed
suggest fore bea ranee and renegotiation of outstanding loans.
We, for instance, have introduced supervisory procedures to
assure that examiners refrain from criticizing banks for exercising
forebearanee on agricultural cred its when consistent with safety
and soundness.
I also believe that, when heavily indebted countries
are moving aggressively to improve their credit-worthiness,
restructuring of foreign credits over a substantial period, and
the provision of new money as part of an appropriate adjustment
16
program under IMF auspices, may be indispensable parts of a
favorable resolution of the internalional debt problem over
time.
But clearly the need remains to anticipate new problems,
as well as to deal with old ones.
Recent credit-financed mergers
have attracted a great deal of attention, and some of those have
involved very large and strong companies.
But there is a dis-
turbing element in some mergers and in leveraged buy-out
activity viewed more generally; it reduces appreciably the
equity cushions of the resulting company.
For the economy as a whole, equity in U.S. corporations
(apart from retained earnings) was retired at an annual rate of
some $75 billion over the first half of 1984.
That seems anomalous
at a time of rising business activity and profits, and when
stronger corporate balance sheet ratios would be welcome.
in
evaluating prospective loans to support mergers or leveraged
buy-outs, bank managers need to appraise the risks prudently,
taking full account of the possibility of a more adverse economic
and interest rate environment.
That, of course, is and should
be customary policy of banks, and I sense some have reviewed
practices in that respect to make sure they are appropriate in
today's ci reurns tances,
Asset growth in any event needs to be supported by
adequate risk capital, and I am glad to report that capital
17
posit ions of the largest hanks and their holding companies have
generally improved over the past few years from the relatively
low levels reached during the 1970s.
The supervisory agencies
are in the process of developing guidelines for fuether improvement
for those banks and holding companies, and specific proposals
are now being tested against public comment.
The approaches we
are adopting are, I believe, fully consistent with the intent of
the International Lending Supervision Act sponsored by this
Commi t tee last year and, so far as holding companies are concerned,
with the spirit of the provisions touching upon capital in S. 2851.
In that connection, I would also emphasize that capital
adequacy and asset strength are only two of several important
tests of the strength of a banking organization.
Maintaining an
adequate liquidity cushion and opportunities for maintaining and
improving earnings without undue risk are also of critical
importance.
Conclusion
Indicators of overall economic performance have been
exceptionally favorable for more than a year.
So far, a strong
economic expansion has been consistent with better price performance
than we have enjoyed for many years.
At the same time, there are obvious strains, imbalances,
and risks that, unless dealt with forcefully, could undercut
much of what has been achieved.
High interest rates are plainly
a symptom of the excessive demands on our savings as well as
lingering (and related! concerns about inflation. Certainly,
18
there is no evidence, in the midst of rap id econorric e x p a n s i o n ,
high rates of growth in debt, and the -monetary trends 1 have
descri bed, that the economy has been starved for money and
credit.
Indeed, the challenge over t i m e w i l l remain to work
toward growth of money and credit consistent with lasting price
stability.
A n c! we need to do that in ways that r e l i e v e heavy
pressures on vulnerable sectors of the economy, make us less
dependent on foreign capital, and reduce strains on the international financial system.
None of these problems w i l l be cured by attempts to
drive interest rates down a r t i f i c i a l l y by excessive money
creation; the inflationary repercussions
the situation.
could only aggravate
Nor can. distortions arising from other sources
be dealt w i t h effectively by any general monetary measures.
Bat we are, as a country, by no means helpless in
dealing with the strains and risks.
Kith respect to the budget deficits, as things now
stand, d e f i c i t s next year w i l l remain in the same area as
currently, and unacceptably large thereafter.
The implicat ions for
f i n a n c i a l markets and the economy become more adverse precisely
as growth
in the private sector generates more need for credit
and capital.
That outlook must be changed in the only way it
constructively can be —
moving beyond the welcome "down payment"
to further substantive action on the budget as soon as feasible.
With respect to our exceedingly large trade d e f i c i t ,
protectionist pressures are understandable, but it is no less
important to avoid measures -- all too likely to be emulated abroad
19
t h a t would d r i v e up cc^ts, undermine the f a b r i c of trade, and
place r.ew barriers in the place of h e a v i l y burdened debtors
already s t r u g g l i n g to make necessary adjustments.
And industry
and lai^iir must c o n t i n u e to be s e n s i t i v e to the need to rerain
competitive in t h e i r own wage and price decisions.
W i t h respect to our f i n a n c i a l f a b r i c , p u b l i c policy
needs, at one and the same time, to respond strongly to threats
as they emerge, while undertaking supervisory approaches, such as
encouraging banks to increase c a p i t a l , to strengthen t h a t
fabric over time.
And, of course, the challenge remains to reach appropriate
judgments on growth in money and credit, with the object!ve of
encouraging sustainable growth at more stable prices.
I have
spoken of our plans, and I am prepared to address your questions
on that, matter today.
But I first want to emphasize the success of all those
approaches -- and they plainly are within, our capacity as a
nation -- are dependent on each other.
No monetary policy can
work without strains in the face of deficits that preempt so
much of our savings as the economy is more fully employed
—
and, of course, efforts in fiscal and trade policy must presume
a prudent monetary policy consistent with stability and growth.
In the areas of our responsibility —
both monetary and
supervisory policy -- we are working toward that end.
count on progress
in other directions as we 11,
We
The facts with
respect to growth and inflation for more than a year demonstrate
t h a t we all h a v e much upon w h i c h to b u i l d .
But there are also
clear signals that -- far from b a s k i n g in the warmth of past
and present progress -- the strongest kind of effort w i l l be
necessary to convert p o t e n t i a l Success into sustained growth
and s t a b i l i t y .
20
Table I
Economic Projections for 1984 and 1985*
FOMG Members and other FRB Presidents
Rang e
Central Tendency
Percent change, fourth quarter to fourth quarter:
Nominal GNP
Real GNP
Implicit deflator for GNP
9-1/2 to 11-1/2
6 to 7
3-1/4 to 4-1/2
10-1/2 to 11
6-1/4 to 6-3/4
4 to 4-1/2
Average level in the fourth
Unerapl oyment rate
6-1/2 to 7-1/4
6-3/4
6-3/4
to 9-1/2
2 to 4
3-1/2 to 6-1/2
6
3
5-1/4
to 9
to 3-1/4
to 5-1/2
6-1Ik to 7-1/4
6-1/2
to 7
to 7
Percent change, fourth quarter to fourth quarter:
Nominal GSP
Real GNP
Implicit d e f l a t o r for GNP
Average level in the fourth
quarter, percent:
Uneraployment rate
*The Administration has yet to publish its Mid-session Budget Review document,
and consequently the customary comparison of FOMC forecasts and Administration
economic goals Is not Included in this report.
21
Table II
Growth Ranges Reconfirmed for 1984 for Money and Debt
Compared with Actual Growth through June '84
Ranges
Actual Growth
QIV '83 to June '84
Ml
4 to 6
7.5
M2
6 to 9
7.0
M3
6 to 9
9.7
Debt"
6 to 11
e/
Note:
e/
13.2
Growth ranges pertain to period from QIV '83 to OIV '84,
Estimated.
Tentative Growth Ranges Adopted for 1985
Ml
4 to 7
M2
6 to 8-1/2
H3
6 to 9
I/
8 to 11
Debt
Note:
I/
Growth ranges pertain to period from OIV '84 to OIV '85,
Domestic nonfinancial sector debt.
22
Table III
GROWTH IN DOMESTIC NONFINANCIAL DEBT
(Seasonally adjusted annual rates, percent
—
"
'
—
'
Total
0
1
V : 1981
to QII: 1984 I/
13.1 y
Federal
14. 6
Other
12.6
Selected Categories
Home Mortgages
11.7
Consumer Credit
18.4
Short-term Business
Borrowing
15.6
_!/
Based on quarterly average flow of funds data.
partly estimated.
2/
Adjusted for the credit used in corporate mergers and
buyouts, it is estimated that growth in domestic nanfinancial debt would be about 12 percent (SAAR) over the
first half of 1964.
QII:
1984
23
FOR USE AT 9:30 A.M., E.D.T.
WEDNESDAY
JULY 25, 1984
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 25, 1984
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, O.C., July 25, 19&4
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its Midyear Monetary Policy Report lo the Congress pursuant
to the Full Employment and Balanced Growth Act of 1978.
Sincerely,
Paul A. Volcker, Chairman
24
Section 1:
The. Out look for Che Economy
As reviewed In later sections of this report, the nation's economy
In the f i r s t half of 1984 was characterized by marked strength in sales, production, and employment and by relatively low inflation.
Moreover, economic
activity still appeared to have substantial forward momentum at midyear,
and the strong growth of the U.S. economy was helping to encourage recovery
abroad as well.
Amid the favorable overall performance, However, some impor-
tant structural imbalances and financial strains were apparent that need
tention lest they Impair the sustalnability of orderly growth.
at-
In particular,
extraordinary increases In domestic demand have been accompanied by a further
d e t e r i o r a t i o n of our trade and current account deficits, which has contributed
to dangerous protectionist pressures.
The persistent strength of the dollar
in foreign exchange markets has helped to keep inflation quiescent, but that
strength has been dependent on a pattern of massive capital inflows.
Interest
rates, under pressure from the combined credit demands of the federal government and the rapidly growing private sector, have risen from what already
were high levels historically, adding to stresses on some sectors of the U.S.
economy and on heavily indebted foreign countries.
As labor and capital
re-
sources have become much more fully utilized, and as real growth has continued
exceptionally rapid, the possibility of demand pressures contributing to renewed Inflationary tendencies has become a concern to many.
For the near terra, the prospects for continuing good gains in
economic activity appear favorable.
Consumers seem to be willing to spend,
and they have the wherewithal to do so.
The rising trend of contracts and
25
orders points to further sizable increases in business plant and equipment
spending.
And Inflation should remain relatively subdued in the period
immediately ahead, given the recent behavior of labor and material costs.
However, as we Look beyond the near terra, the stresses and imbalances
in the economy give rise to significant uncertainties in assessing the economic
and price outlook—and pose substantial challenges for public policy.
The
members of the Federal Open Market Committee recognized this fact as they
prepared their economic projections for the remainder of 1984 and for 1985 at
their meeting earlier this month, emphasizing that the probability of maintaining
highly satisfactory performance could only be assured by timely decisions in
a number of public policy areas.
In formulating Its own policy plans, the
Committee agreed that, while flexibility and sensitivity might be required in
conducting monetary policy during this crucial period, Federal Reserve policy
would need to remain basically oriented toward encouraging growth in a context
of maintaining progress over time toward price stability.
The specific
monetary objectives outlined In the next section provided part of the assumptions
underlying the projections.
At this tine, the members of the FOMC (including those Reserve Bank
presidents who are not at present voting members) generally foresee appreciable
gains In economic activity over the remainder of 1984, but with growth of
real GHP less rapid than in the first half of the year.
While clear evidence
of substantial moderation in the pace of expansion la still limited, some
slowing seems likely in light of some softening of demand in the housing
market, some probable tendency for inventory investment to level off after a
sharp surge in the first h a l f , and other factors.
The central tendency of
26
Committee members' forecasts is for an increase In real o u t p u t of about
6-1/2 p e r c e n t for the year as a w h o l e .
The unemployment rare, which averaged
about 7-1/2 percent in the second q u a r t e r of 1984, is expected to fall further
in coming months, although much will depend on the highly uncertain behavior
of l a h o r force p a r t i c i p a t i o n rates and productivity growth, as well as on the
strength of demand in the economy.
The i m p l i c i t d e f l a t o r for gross national
Economic Projections for
1984 anfi 1985*
FOMC Members and other FR fl Presidents
Central Tendency
Range
Percent change, f o u r t h quartet to fourth q u a r t e r :
Nominal GNP
Real GNP
i m p l i c i t d e f l a t o r for GNP
9-1/2 to 11-1/2
6 to 7
3-1/4 to 4-1/2
10-1/2 to 11
6-1/4 to 6-3/4
4 to 4-1/2
Average level in the f o u r t h
quarter, percent:
Unempl oyrnent rate
6-1/2 to 7-1/4
6-3/4 to 7
Percent change, f o u r t h quarter to f o u r t h quarter:
Nominal CTiP
Real GNP
Implicit deflator for GNP
6-3/4 to 9-1/2
2 to 4
3-1/2 to 6-1/2
8
3
5-1/4
to 9
to 3-1/4
to 5-1/2
6-1/4 to 7-1/4
6-1/2
to 7
Average level in the f o u r t h
quarter, percent:
Unanployment r a t e
*The Administration has yet to publish its Mid-session Budget Review document,
and consequently the customary comparison of FOMC forecasts and Administration
economic goals la not included in this report.
product is expected to rise slightly f a s t e r than In the f i r s t half of 1984,
but even so, the central tendency of Committee members' i n f l a t i o n forecasts
shows an Increase for the year that—at around 4-1/4 percent—would be only
slightly above the 1983 rise and would be lower than generally expected at
the start of this year.
Members of the FOMC believe that growth in activity is likely to
continue in 1985, though at & slower pace.
factory to the extent It reflected
That slower pace would be satis-
the settling of the economy into a sus-
tainable pattern of longer-run expansion a f t e r a rebound from an exceptionally
deep recession.
Specifically, the central tendency of FOMC forecasts calls
for real growth of 3 to 3-1/4 percent next year and some f u r t h e r decline in
the unemployment rate.
The Committee expects price increases to be somewhat
larger in 1985 than this year, with the central tendency of members' forecasts
being 5-1/4 to 5-1/2 percent, on the assumption that the dollar remains in
the trading range of the past year or so; the expectation of some pickup in
price increases in fact reflects in part the assumption that the inflationdamping influence of dollar appreciation will abate, but on the basis of
past experience some cyclical pressures on wages and prices might also be
anticipated as a result of reduced slack, in labor and product markets.
The behavior of the dollar in foreign exchange markets is only one
of the uncertainties In the outlook for 1985.
Strains In financial markets
have been aggravated by the historically large current and prospective federal
budget d e f i c i t s , and international debt problems will continue to require
attention.
W i t h respect to the federal budget, Committee members are assuming
that Congress and the Administration will soon complete action on a series of
28
raaasures Chat represent an initial "dowi payiteftt" toward reducing current and
prospective federal budget d e f i c i t s .
Although no specific assumptions were
made regarding f u r t h e r deficit-reducing steps in 1985, it was recognized
that additional, substantial budgetary actions will be needed to enhance the
prospects for sustained, orderly economic growth.
Section 2:
The Federal Reserve's O b j e c t i v e s f o r G r o w t h o f Money and Credit
The Federal Open Market Committee has reviewed its
target ranges
for 1984 and established tentative ranges for 1985 in light of its
objective
of achieving sustained growth In the context of continuing progress toward
reasonable price stability over time.
The behavior of Ml and M2 In the first
half of 1984 was broadly consistent with the Committee's expectations and
objectives.
Although difficulties in anticipating demands for various measures
of money and credit under changing economic circumstances remained, partly
reflecting the new deposit accounts introduced in the recent period of deregulation and changing financial practices, no developments were foreseen that
would call for changes in the 1984 targets for Ml and M2.
Consequently, the
Committee reaffirmed the existing target ranges for 1984 for those aggregates.
M3 expanded above its target range and domestic nonfinancial sector
debt ran well above its n»nitoring range during the first half of the year.
The unexpectedly brisk expansion of spending appears to be a factor influencing credit expansion-
But in addition, this rapid growth is partly attribu-
table to the unusual amount of corporate mergers and buyouts, which also have
led to a sharp reduction in corporate equity shares outstanding.
Some of
this rapid debt expansion may have influenced M3, as banks issued CDs, for
example, to finance credit expansion, though it is always d i f f i c u l t to evaluate how institutions or depositors would have behaved If circumstances had
differed.
It appears that the factors that led to growth in M3 and debt above
the upper limits of their ranges in the first half could be less important
29
during the second h a l f .
Credit flows associated with corporate acquisition
activity should diminish, partly because of higher prevailing interest rates
and partly because of greater caution on the part of lenders In evaluating
the soundness of proposed transactions.
It also seems likely that growth of
household spending and consumer and mortgage credit demands will moderate
somewhat.
However, given the levels of the money and credit aggregates at
midyear, It is unlikely that H3 and debt will be within their ranges by
year-end, although I t is expected t h a t some deceleration toward the upper
limits of the ranges will occur.
Under the circumstances, the Committee considered the question of
whether Increases in the ranges for 1984 for M3 and domestic nonfInancial
sector debt would be appropriate.
On balance, the Committee was of the view
that the broad direction of policy would best be communicated by retaining
the current range for M3 and the associated monitoring range for domestic
nonflnancial sector debt.
While the Committee anticipated growth somewhat
above their ranges for the year as a whole, it was felt that higher "target"
ranges would provide an Improper benchmark for evaluating desired longer-term
trends In these aggregates.
The Committee also discussed the ranges for the aggregates to be
established on a tentative basis for 19B5.
The Committee reaffirmed
its
intention to lower over time growth of money and credit to rates appropriate
to progress toward price stability In an environment of sustainable economic
growth.
Consistent with these goals, the FOMC established tentative ranges
for Ml and M2 that were somewhat below those for 1984. For Ml, the upper
limit was lowered by one percentage point, and the range was set at 4 to 7
30
percent-
For H 2 , the upper limit was lowered by one-half point, and a t e n t a -
tive 6 to 8-1/2 percent range was established.
The width of the Ml range was brought more in line with the dimensions of the ranges for the other aggregates.
This reflected experience over
the past year in which the behavior of Ml has been more consistent with previous cyclical patterns than was the case in the recent recession.
Conse-
quently, the Committee felt that it would be appropriate to glue roughly
equal weight to all of the monetary aggregates in implementing policy.
Nonetheless, It was recognized that uncertainties remained about the behavior
of Ml, as well as of the other aggregates, In periods of changing market
conditions.
For instance, should market interest rates change considerably,
it is possible that funds would flow quickly into or out of such fixed interest
deposits as NOW accounts, leading to sizable movements in Ml—but, with
limited experience to date with tVie present account structure, the extent of
these movements cannot be projected with confidence.
of financial deregulation continues.
Moreover, the process
At the beginning of 1985, the minimum
denomination on Super-NOW accounts and MMDAs is scheduled to decline from
$2,500 to $1,000; it was assumed that this will have no more than a minimal
impact on Ml and M2.
Sliould legislative action permit Interest on reserves
or on demand deposits, this would tend to affect—perhaps significantly—the
demand for monetary aggregates, particularly Ml.
The Committee retained for 1985 the current target range for M3
and the current monitoring range for domestic nonfinancial sector debtAs noted above, these aggregates might be somewhat above their ranges in
1984.
Thus, growth next year within their ranges would represent an actual
31
slowing from this year's pace.
The Committee noted that some deceleration in
growth of these aggregates Is both desirable and likely, reflecting a slowing
in expansion of nominal GNP and a drop in corporate merger activity.
Sttll,
business demands for external finance are Likely to remain strong, and absent
a substantial Improvement in the stock and bond markets would tend to continue
to be concentrated at banks and in short-term credit markets generally.
Although household borrowing ie expected to moderate somewhat in 1985, state
and local government borrowing may be heavier than in 1984 and the federal
budget implies the continuation of exceptionally large Treasury borrowing.
In its discussion, the Committee noted that only limited progress
has been made recently in reducing federal
budget deficits, and that current
and prospective structural deficits remain huge.
The massive fiscal stimulus
and credit demands associated with these structural deficits will tend to
hold interest rates at high levels.
Further progress in lowering the d e f i c i t
would help to relieve credit market pressures.
The Committee f e l t that implementation of monetary policy would
require continuing appraisal of the progress of economic activity and prices
and of conditions in domestic and international financial markets—especially
in light of the sensitive state of these markets and of a number of economic
sectors.
The Committee emphasized, however, the importance of appropriate
restraint in monetary and credit growth.
A Rood start has been made In
reversing the debilitating trends of rising inflation and languishing product i v i t y that plagued our economy for so many years.
But monetary vigilance—
in combination with determined action to reduce the federal presence in the
credit markets—is essential to the achievement of durable reductions in
32
interest r a t e s , overall financial and economic stability, and sustained
growth of the economy.
Section _3_:__Th_e_^erifQrmanc_e of the jconoiny_ jj^jjie^Firgt Half of
The economic expansion gained f u r t h e r momentum in the f i r s t half
of 1984, as the growth of real gross national product accelerated to an
annual rate of almost 9 percent.
Employment also increased rapidly, and the
unemployment rate dropped to Its lowest level in mote than four years.
Price
Increases continued to be relatively moderate.
In 1983, the economy had followed a path that was fairly typical of
previous postwar recoveries; with the continued rapid growth of activity in
1984, the current expansion has proved stronger than during comparable cyclical
periods since World War II, the only exception being the period of the Korean
War buildup.
Real GNP has grown f a s t e r , and the levels of economic slack have
declined more rapidly, than in the usual expansion.
In addition, real gross
domestic spending rose even more rapidly than production during the first
half —about 10-1/4 percent at an annual rate — and was reflected In a surge in
the demand for imports as well as strong demands for the goods and services
being produced domestically.
cession.
These gains, of course, followed a deep re-
The civilian unemployment rate at midyear — at just over 7 percent —
had dropped about 3-3/4 percentage points from I t s peak, but is still above
"full employment" levels.
The capacity utilization rate in manufacturing
is slightly below the postwar average.
The strong growth, reduced unemployment, and more stable prices of
the past year and a half have been reflected in rising productivity and higher
real incomes for most Americans.
After the Immediate hardships associated with
the recession, progress toward our long range goals has been apparent.
Even
33
Real GNP
Change from end of previous period, annual rate, percent
Timr
1978
1980
1982
1984
Real Gross Domestic Purchases
Change from end of previous period, annual rate, percent
1978
1980
1982
1984
Interest Rates
Percent
N /\A.30-year Treasury
' \i
15
\
~ ~'~
V--/ "
3-month Treasury Bill
1978
1980
1982
1984
10
34
so, the economy still faces a number of serious problems and, in some respects,
these problems have grown more worrisome over time.
During the current expan-
sion, there has been an enormous increase in federal debt and an unprecedented
deterioration in o«r balance of trade.
A number of domestic producers have
not shared fully in the expansion, and many developing nations still are burdened by large external debts.
Concern about financial stress in both the
domestic and International economies has heightened this year as i n t e r e s t
rates have risen from levels that already were high by historical standards.
Widespread concern about the outlook for i n f l a t i o n also persists,
despite the continuation of favorable wage and price patterns through the f i r s t
half of 1984.
One cause for concern is that growth in the demands placed on
the economy could continue at a pace that, if maintained for Ions, would
damage the prospects for sustaining real growth, achieving better balance in
financial markets, and making f u r t h e r progress toward price stability—central
objectives of public policy.
Inflationary
pressures would be intensified
if
the exchange value of the U.S. dollar were to decline sharply from its current
high level in the face of unprecendentedly large current account deficits.
These concerns are importantly related to the strains on real and financial
markets stemming from federal
budget d e f i c i t s , actual and potential, which,
among Other implications, now complicate the conduct of monetary policy.
The Household Sector
Strength in the household sector continued to provide a strong impetus for expansion in the first half of 198*1.
Personal income, in nominal
terms, rose at about a 10-3/4 percent annual rate during the f i r a t half of the
35
Real Income and Consumption
Change from end of previous period, annual rate, percent
[[fl) Real Disposable Personal Income
|_jRea) Personal Consumption Expenditures
1978
iD
1980
Jffl1982
1984
Total Private Housing Starts
Annual rate, millions of units
— 1.0
—
1978
1980
1982
5
1984
Real Business Fixed Investment
Change from end of previous period, annual rate, percent
MB Producers' Durable Equipment
f~] Structures
15
1978
1980
1982
1984
36
year, and with Inflation low, most of that nominal gain translated directly
into sizable Increases in real purchasing power.
In addition, despite the
recent upswing in interest rates and some decline In stock market i«alth,
consumers remain generally optimistic about future business conditions.
Reflecting that optimism, they have continued to consume heavily oOt of current Income and have become increasingly willing to take on higher levels
of debt.
As a result, personal consumption expenditures, In real terms,
rose rapidly in the f i r s t half of 1984—at an annual rate of nearly 6
percent.
Consuioer sending for new cars was particularly robust in the f i r s t
half of 1984 as unit auto sales rose to the highest level since mid-1979.
With
quotas limiting the Imports o£ foreign models, most of the rise in spending was
channeled Into sharply higher purchases of domestically produced automobiles,
and in light of strong sales, many domestic auto plants operated near full
capacity in the first half of 1984.
Auto o u t p u t , In real terms, was about 50
percent above the depressed level of 1982.
Spending for housing also continued to advance in the f i r s t half of
1984, thereby maintaining the vigorous cyclical expansion that was apparent
during 1983.
Housing starts spurted to a six-year high in January and Feb-
ruary, and outlays for residential construction rose in both the first and
second quarters.
All told, the rebound in housing activity over the past
year and a half has been stronger than generally expected and has exceeded
the gains experienced during most previous housing recoveries.
During this
period, demographic Influences and relatively stable house prices provided
support for housing demand, and innovations in housing finance
37
helped Co soften the e f f e c t of high mortgage interest rates.
While home
sales appeared to be moving lower toward midyear, there should continue to
be a supporting Influence in housing markets from some of the same factors
that have helped to boost activity to a high level during the early phases
of the expansion.
Household balance sheets are no Longer strengthening as they dirt
during the recession and early phases of the recovery.
Some of the earlier
gains in stock market wealth have been reversed during this y e a r ' s decline In
stock prices, and household debt has been growing much more rapidly than In
1983.
In addition, there are troubling aspects to some of the recent patterns
of household credit gtowth.
Consumer credit has been rising much faaCer than
Income this year, and some of the recent Innovations in mortgage lending,
while supportive of current housing activity, also Increase the level of
borrower exposure to adverse movements In Interest rates or unexpected shortfalls in f u t u r e household Incomes.
The Business Sector
Economic conditions In the business sector have strengthened during
the past year and a h a l f .
Output, sales, profits, productivity, and investment
spending have all been rising throughout the expansion.
By the f i r s t quarter
of 1984, after-tax profits in the domestic nonfinancial corporate sector were
about twice the levels of late 1982.
Fixed investment spending, in real
terras, has risen roughly 25 percent during the first year and a half of the
recovery.
The rise In business investment spending during the current expansion
has been much stronger than generally expected.
Unused capacity was at a
particularly high level when the expansion began and appeared likely to inhibit
new capital outlays for some time.
However, as the economic expansion started
to look more durable during the course of 1983, businesses began rushing to
modernize old units or to add to capacity.
In addition, other factors, such
as the 1982-83 stock market boom and changes in tax laws, contributed to the
ebullience in investment spending.
The widespread adoption of new computer-
based technologies, which was evident even during the recession, also has
continued to provide an element of strong support in the capital goods sector,
and, more generally, businesses have recognized a need to invest in new technologies in order to remain competitive w i t h foreign producers.
Reflecting
these Influences, spending for new capital equipment recorded p a r t i c u l a r l y
strong gains during the past year and a h a l f , and spending for
structures
also has strengthened markedly in recent q u a r t e r s .
Inventory accumulation during 1983 was less rapid than in the early
phases of many previous recoveries, but, In light of lengthening delivery times
and the sustained strength of sales, businesses appear to have become more
willing to rebuild stocks in the f i r s t half of 198i.
In real terms, business
inventories rose at more than a $30 billion annual rate in the first quarter
of the year, and a further sizable accumulation was apparent in the second
quarter.
Even so, stocks in most industries still appear lean relative to
the recent pace of sales.
Despite the impressive improvement In activity over the past year
and a h a l f , businesses have not restored their financial ratios to positions
comparable to pre-inflation and pre-recession levels.
As Is typical in the
early phases of economic expansions, many businesses began moving to strengthen
39
their balance sheets In 1983, but the period of balance sheet restructuring
in the current expansion appears to have been unusually brief.
A downturn in
stock prices this year has made equity financing less a t t r a c t i v e , and rising
long-term interest rates have inhibited bond financing.
Mergers and so-called
"leveraged buyouts" have resulted in a disturbing net retirement of equity
so far this year.
The business sector has remained heavily reliant on short-
term credit as its source of finance and is still relatively vulnerable to
adverse Interest-rate developments.
Financial problems of a more severe nature are evident in particular
sectors of the-economy.
In farming, for example, export developments have
continued to be discouraging, land prices are falling In important agricultural
areas, and many farmers that had accumulated large volumes of debt during the
more inflationary years are,, at present, facing severe financial strains.
The Government Sector^
With the cyclical strengthening in economic a c t i v i t y , federal tax
revenues have increased and the rate of growth In federal spending for income
support programs has slowed markedly.
Nevertheless, federal debt has continued
to accumulate at an enormous rate, reflecting both an underlying uptrend in
federal outlays and the series of tax reductions that took e f f e c t during the
past three years.
Federal debt outstanding has risen mare than 80 percent
stnce the end of 1979.
Net interest payments on the debt have nore than
doubled over than same period, rising to an annual rate of about $110 billion
by the first half of 1984.
Current prospects are for further sizable increases
in bath outstanding debt and net interest payments in coming years.
40
These spending and revenue policies of the federal government
have provided an extraordinary stimulus to aggregate demand for goods and
services, but they also have contributed to high interest rates, unsettled
conditions in financial
of trade.
markets, and a startling deterioration In our balance
Recognizing the dangers posed by current policies, Congress and the
Administration have sought appropriate ways to reduce federal budget deficits,
but the actions taken to date are only a limited beginning toward dealing with
the full itiagnltude of the problem.
The underlying thrust toward higher federal spending has been
obscured In some of the recent data.
For example, In real terms, federal
purchases of goods and services in the f i r s t half of 1984 were slightly
below year-earlier levels as outlays early In the year were depressed by an
unusually rapid liquidation of the farm inventories held by the governm e n t ' s Commodity Credit Corporation.
For othec goods and services, federal
purchases in the f l r g t half were nearly 4 percent above a year earlier,
a f t e r adjustment for inflation.
Real outlays for defense were up about 5-1/4
percent from a year earlier.
The financial situation of state and local governments has Improved
markedly during the expansion*
In real terms, state and local outlays, though
up moderately in the first half of 1984, still have shown only a small real
gain over the past three years as a whole; these cautious spending patterns,
coupled with increased tax revenues associated with the expansion, have
resulted In large operating surpluses for state and local governing units as
a whole.
41
The Foreign Sector
After falling sharply In 1981 and 1982, the volume of U.S. exports
rose moderately during 1983 and increased f u r t h e r in the early part of this
year.
However, imports have grown ranch f a s t e r , and as a result the trade
deficit Increased from an annual rate of roughly $40 billion in the first
quarter of 1983 to a rate of more than $100 billion In the first q u a r t e r of
1984.
The V.S, current account deficit registered a corresponding s h i f t during
this period, with the f i r s t quarter deficit reaching an annual rate of nearly
$80 billion.
Data through May indicate that the trade balance remained weak
Into the second quarter.
The magnitudes of these trade and current account
deficits are without historical precedent.
While the gains in exports in recent quarters have not fully reversed
the declines that occurred during the last recession, imparts have surged far
above their pre-recession peak.
A major influence on Chese trade patterns
has been the tremendous appreciation in the exchange value of the U . S . dollar
In rscerit years.
Buoyed by high U.S. interest rates and an eagerness of
foreigners to invest in dollar-denominated assets, the dollar rose by about
45 percent against other currencies from late 1980 to late 1983 and, a f t e r
turning down temporarily in early 1984, rose to new highs around midyear.
This appreciation, through its impact on relative prices, has been both a
depressant of exports and a strong stimulant to Import growth.
Recent trade developments also reflect the sharply divergent growth
patterns In the world economy.
The exceptional strength of the U.S. economy
over the past year and a half has been manifested partly in a surge of import
buying.
In contrast, the economic recovery in other Industrial nations has
42
Exchange Value of the U.S. Dollar
Index, March 1973=100
Trade Weighted Average
130
— 110
90
1978
1980
1982
1984
U.S. Real Merchandise Trade Volume*
Annual rate, billions ot 1972 dollars
100
Exports
80
Imports
1978
60
1982
1980
1984
U.S. Current Account
Billions of dollars
firm
25
50
75
1978
1980
* 1984 02 is average of April and May
1982
1984
43
been substantially less rapid than in Che United S t a t e s , and exports to those
nations have lagged.
Many developing countries that are burdened with huge
external debts have, necessarily, sharply constrained Imports, Including
Chose from the United SCaCes.
Labor Market Developments
Labor market developments In the f i r s t half of 1984 were shaped both
by the vigorous expansion in economic activity and by widespread restraint on
increases in nominal wages and salaries.
Employment rose r a p i d l y , work sched-
ules l e n g t h e n e d , and unemployment declined.
Thus far in the current expansion,
payroll employment has risen a l i t t l e more r a p i d l y than in most previous postwar recoveries; the average workweek, another indicator of labor demand, has
increased much f a s t e r than usual.
The slack economic conditions during the recession and the early
phases of Che recovery may have discouraged many persons f r o m seeking new
jobs, but as the expansion has lengthened into 1984, new jobseekers started
e n t e r i n g Che labor force at a f a s t e r pace.
However, employment opportunities
rose even f a s t e r and, as a result, unemployment races continued to f a l l .
June the c i v i l i a n unemployment rate had dropped to nearly 7 percent,
By
its
lowest level since April 1980.
Notwithstanding the general improvement in labor market conditions,
there are wide disparities in the job situations across d i f f e r e n t regions.
Unemployment is still q u i t e high in many of the t r a d i t i o n a l
Industrial states,
and problems of longer-term unemployment remain especially acute in communities
In which plants were permanently closed during the recession.
for blacks and teenagers also remain exceptionally high.
Jobless rates
44
Nonfarm Payroll Employment
Millions of persons
90
85
1978
I960
1982
1984
Civilian Unemployment Rate
Quarterly average, percent
1978
1980
1982
1984
45
Recent wage developments appear to have been affected both by changes
In behavior that f i r s t were evident during the recession period and by the
moderation of price Increases.
Nominal wage increases, vhlch were running
close to 10 percent per year at the start of the decade, f e l l sharply in 198Z
as unemployment rose to nearly I t percent of the labor force.
As the economy
has expanded, the rate of wage increase has remained close to those lower
levels.
Year-to-year increases in the employment cost Index, a fairly compre-
hensive neaaure of wage and benefit change, held at about the 5-3/4 percent
mark from September 1983 through March 1984; the hourly earnings index, a
measure of wage change for production and nonsupervlsory workers, has slowed
a little further In the f i r s t half of this year to an annual rate of about
3-1/4 percent.
By the 1970s, large annual Increases in nominal wages had become
almost automatic In a number of Industries, thereby imparting strong momentum
to the inflationary process.
However, as labor markets weakened In the early
1980s and price expectations moderated, there were marked changes In patterns
of vage determination.
Outright declines In wages occurred in many troubled
Industries, and workers in general became more concerned about job security
than about automatic vage increases.
Workers and managers alike took new
Interest In measures to Improve productivity ond to enhance competitiveness
in foreign markets.
With labor markets now tightening, a key question in the outlook
Is whether the recent conservative patterns of wage determination &tH be
maintained, or alternatively, whether there will be a reversion Co the more
Inflationary patterns of the previous decade.
Important signs regarding the
46
Hourly Earnings Index
Change Irom end o! previous period, annual rate, percent
10
1978
1980
1982
1964
Consumer Price Index
Change from end of previous period, annual rate, percent
15
10
1978
1980
1982
1984
GNP Prices
Change from end of previous period, annual rate, percent
Implicit Deflator for GNP
10
1978
1980
1982
*Consumd once change for 1 984 HI is based on December (o May period.
1984
47
outlook for wages should emerge l a t e r this year, as new collective bargaining
negotiations get under way, including soise In industries In which economic
conditions have s t r e n g t h e n e d markedly during the expansion.
PTics d e ve 1 opinents
I n f l a t i o n rates fell dramatically d u r i n g 1982 and—by the standards
of the past decade—have remained relatively moderate through the f i r s t year
and a h a l f of the expansion.
The consumer price index rose at an annual rate
of about 4-1/2 percent during the f i r s t
five months of 1984; the price d e f l a t o r
for gross national product was up at a rate of only 3-3/4 percent in the f i r s t
half.
The rate of increase in the CPI was slightly above the pace experienced
d u r i n g 1983; the GNP d e f l a t o r has risen at the same r a t e this year as in
1933.
Producer prices, a f t e r rising only fractionally in 1983, Increased at
close to a 3 percent rate in the f i r s t half of this y e a r ; basic commodity
prices have been declining In recent weeks, r e v e r s i n g some of the sharp
advances that occurred earlier in the expansion.
Taken together, these and other price data suggest that i n f l a t i o n
in the f i r s t half remained in the range that has generally prevailed since
early 1982 and is running at l i t t l e more than one-third of the peak i n f l a t i o n
rates of the 1979 to 1981 period.
Price behavior over the past year and a
half has been constrained by highly cootpetitive markets, as well as by the
ample plant capacity and labor resources generally available during the
recovery period.
In addition, because of the sharp rise of the dollar in
exchange markets, the dollar prices of Imported goods have Increased only
slightly thus far in the expansion and have been a greater restraining influence on domestic prices than in past expansions.
48
Imbalances between supply and demand have been an important influence
on price developments in food and energy markets, sectors in which Inflationary
pressures had been particularly acute in the 1970s.
Because of spate capacity
in world oil markets, a protracted war in the Persian Gulf has, to date, had
little e f f e c t on the prices of oil or petroleum products; consumer energy
prices, in relative terms, have continued to decline this year.
Similarly,
the slack export demand for U.S. farm products has helped to damp price pressures in the food sector; despite the severe drought of last summer and a
damaging freeze this past winter, the rise in consumer food prices in the f i r s t
half of the year was not much d i f f e r e n t than the general rate of inflation.
All told, the nation is enjoying a better price performance than for
any sustained period in more than a decade.
The fact that inflation rates and
underlying wage trends have remained moderate during a particularly robust
expansion is an encouraging development.
However, there typically has been
little price acceleration in the first two years of business expansions; the
dangers have become greater in the later stages of expansion.
Moreover, while
the foreign sector has provided an important restraining Influence on domestic
prices thus far in the current expansion, that influence lias been dependent
on an exceptionally strong dollar and a high level of capital inflows from
abroad.
Thus, although current price trends are favorable, Important tests
of progress toward greater price stability remain ahead.
49
S.get 1 on 4 :_ _ Mein _e y , _Cr e dl t , _an d F i n a n cl a1 H a rke t s i n t he First Ha1f of 1984
E a r l i e r this year, the Federal Open Market Committee established
s p c i f i c growth objectives for the monetary and credit aggregates for 1984.
These o b j e c t i v e s were A to 8 percent for Ml, 6 to 9 percent for both M2 and
M3, and 8 to 11 percent for domestic nonfinanclal sector debt.
were set
The ranges
1 / 2 or a f u l l percentage point below the ranges for 1983, to be
consistent w i t h continued r e s t r a i n t on i n f l a t i o n a r y pressures while encouraging sustainable expansion in economic a c t i v i t y *
Tn setting these objectives, the FOMC assumed that special factors
that had c o n t r i b u t e d to strong demands for money in 1982 and 1983 would not
be nearly so important in 1984.
The massive s h i f t s of f u n d s brought about
by the introduction of the new deposit accounts were largely completed last
year.
The continuing strength of the economic rebound and the size of federal
budget d e f i c i t s made It appear that further substantial declines in interest
rates, such as those that had accompanied the recession in 1982 and had
contributed to sharp declines in monetary velocity, were unlikely over the
near term.
Moreover, greatly improved prospects for employment and Incomes
seerned to be reducing the uncertainties that earlier had swelled demands for
precautionary balances.
Consequently, the relationships of the monetary
aggregates to income and interest rates were expected to f a l l more Into line
with historical norms.
Even though, as 1984 began, there was some evidence that the velocity of Ml was behaving more In accord with past patterns, the Committee
decided that it would not yet be appropriate to place f u l l weight on that
50
aggregate as a policy guide and that I t s growth would need to be Interpreted
In light of growth in the other aggregates.
Moreover, growth of all
the
aggregates needed to be appraised In the context of the outlook for economic
activity and prices, and over-all credit market developments.
In the first part of the year, credit demands proved to be exceptionally strong, reflecting the continued rapid expansion In private sectors of
the economy, coupled with sustained, large federal borrowing needs.
Indeed,
growth in the debt of domestic nonftnanclal sectors accelerated in the f i r s t
quarter and remained at an advanced pace of around 13 percent at annual rate
through the f i r s t half, significantly above the range set by the FOMC at the
beginning of the year.
The debt of private sectors Increased at about 12-1/2
percent annual rate in the f i r s t half of the year—some 4-1/2 percentage
points more than last year—while federal debt expansion remained strong at
around a 14-3/4 percent annual rate.
In appraising credit growth over the f i r s t half of the year, account
needs to be taken of an unusually large voluae of merger activity.
Several
large mergers and many smaller ones were financed largely w i t h debt, and led
to liquidation of a sizable amount of equity.
Siich mergers are estimated to
have accounted for roughly one percentage point of the annual growth rate of
domestic nonfinancial sector debt In the first half of the year.
Much of the debt expansion was concentrated In short-term markets.
Bank credit growth accelerated
to a 14 percent annual rate in the first
quarter of the year, though growth slowed somewhat in the spring as banks
liquidated securities to a greater extent in accommodating loan demands.
Large amounts of credit alao were raised In the commercial paper market.
51
GROWTH OF MONEY AND CREDIT
Percentage changes
Domestic
Period
Fourth quarter to
June 1984
Fourth quarter to
second q u a r t e r 1984
nonf inanclal
sector debt
Ml
M2
M3
7.5
7.0
9.7
13. le
6.7
6.9
9.7
13. ie
8.0
8.2
8.}
7.5
7.4
9.0
1
9.3
5.1 ( 2 . 5 )
8.7
9.5
12.1
10.0
11,8
10.3
9.6
12.3
10.5
9.7
U.3
12.1
9.6
9.9
9.0
10.8
12.8
11.6
9,5
4.8
20.5
10.6
6.9
8.5
10.8
9.3
7.4
9.8
8.9
10.4
11.8
10.3
7.2
6.1
7.0
6.8
9.0
L0.2
12.5
13. 3e
Fourth quarter
to fourth quarter
1978
1979
1980
1981
1982
1983
Quarterly growth rates
1983— q i
Q2
Q3
Q4
1984—<}l
Q2
e—estimated.
1. Ml figure In parentheses Is adjusted for shifts Co NOW accounts In 1981.
52
Corporate borrowers—^£ii eh as a group had not had any significant
need for
net external financing in the previous two years—this year began to experience
a else In the financing gap, as spending for inventories and plant and equipment came to outpace internally generated funds.
While borrowing in short-terra markets p a r t i c u l a r l y strengthened,
the demand for funds in longer-term debt markets remained large relative to
the supply of savings into those instruments.
Mortgage borrowing by households
rose sharply, and corporate bond issuance picked Lip somewhat from Its pace of
the second half of last year.
Meanwhile, the federal government continued to
market a. sizable amount of longer-term debt obligations to meet its
large cash needs and to roll over maturing debt.
continuing
On the other hand, a c t i v i t y
in che municipal bond market was subdued during the f i r s t h a l f , at least by
comparison with the past two years, reflecting a lapse In authority to issue
mortgage revenue bonds and anticipated legislative limits on Industrial development and student loan bonds retroactive to January.
The strength of total credit demands exerted, upward pressures on
interest rates.
These pressures were reflected in about a 1 to 2 percentage
point rise In short-term rates over the f i r s t half of the year.
Long-term
rates also rose by about that amount, reflecting in part the weight of Treasury financing and uncertainties about the budgetary and economic outlook
generally, whereas they normally rise by much less Chan short-term rates.
The Federal Reserve in implementation of monetary policy added
nwdetately to pressures on the reserves of the banking system around the-end
of the f i r s t quarter to maintain appropriate growth of money and credit.
To
meet credit demand and deposit growth, institutions had to turn somewhat more
to the discount window; borrowing for adjustment and seasonal purposes at
the
window rose to around SI billion In Match and April a f t e r averaging only about
$640 million during the f i r s t two nonths o£ the year.
The narrower monetary
aggregates—Ml and M2—have remained within their ranges.
However, under the
pressure of strong public and private credit demands both M3 and total domestic
c r e d i t have been expanding at n more rapid rate than anticipated.
As reserve pressures increased, growth of total reserves and the
monetary base slowed s u b s c a n c t a l l y during the early spring.
Part of the slow-
ing in growth of total reserves reflected the return of eKceas reserves to
more usual levels a f t e r they had expanded sharply in February, at the time
of the i n t r o d u c t i o n of contemporaneous reserve accounting.
tn May and June,
growth in the reserve aggregates accelerated, partly reflecting the upward
impact on required reserves of s h i f t s in the deposit mix as banks relied relatively more heavily on large time deposits and as government and interbank
deposits also rose.
The large borrowing by Continental
Illinois Bank over
this period was o f f s e t in open market operations by reduced holdings of U.S.
Government securities, so that borrowing by depository institutions apart
from t h a t bank remained close to the level reached in early spring.
The federal funds rate rose from about 9-1/2 percent in the early
part of the year to the 10 percent area In early spring and to around 11 percent in June and early July.
The Federal Reserve discount rate was raised
from 8-1/2 to 9 percent in April.
While the rise in the funds rate—which is
sensitive to banks' day~to-day demands for reserves relative to supply—In part
reflected somewhat greater restraint by the Federal. Reserve in provision of reserves through open market operations during the spring, it also reflected the
54
Increased willingness of banks to pay more for federal funds as credit demands
remained strong, and as other sources of funds became relatively expensive.
The loss of confidence In the Continental Illinois Bank and wellpublicized problems related to ongoing international debt negotiations in May
led to a widening in the spread of yields on certificates of deposit Issued
by depository institutions over Treasury securities of similar maturity.
Indeed, investors seened to show an increase In preference for government
securities relative to private credit instruments generally.
More recently,
yield spreads have narrowed, ae progress has been made in debt questions and
the Continental Illinois situation has remained unique and contained.
Ml has grown generally in the upper half of the 4 to 8 percent
range adopted by the Committee.
From the f o u r t h quarter of 1983 through June
of this year, that aggregate grew at a 7-1/2 percent annual rate, close to
the rate of growth during the second half of 1983, but s i g n i f i c a n t l y lower
than during 1983 as a whole.
Growth in currency, demand deposits, and travel-
ers checks (essentially the narrow measure of money used before 1980) has
remained near laat year's 5-1/4 percent pace.
However, other checkable
deposits (OCDs) have decelerated sharply from the nearly 30 percent rate of
growth of 1983 to around 14 percent this year.
OCOs—primarily consisting of
NOW accounts—are interest-earning, and tend to be used not onLy for transactions but also as A repository for liquid savings.
This y e a r ' s slowing
apparently reflects a waning of the motives that led to heavy demands for
liquid assets in 1982 and 1983, as well as recent increases in the o p p o r t u n i t y
cost of holding such balances as interest rates on other instruments have
risen.
56
Ranges and Actual Money Growth
Billions of delta's
Annual lates of growth
19B3 Q4 to 1981 Q2
6 7 fjercenl
1983 Q4 to June 1984
7 5 percent
1983
Annual rates of gio
Range adopted Dy FOMC for
1983 Q4 to 1984 Q4
1983 G-f to 19S4 Q2
6.9 percent
1963 Q4 to June 1984
7 0 percent
1963
56
Ranges and Actual Money and Debt Growth
M3
Billions of dollars
Annual rales of growth
— Range adopted by FOMC
tor 1983 O4 lo 1984 Q4
1983 Q4 to 1984 Q2
9 7 percenl
1983Q<ilo June 1984
9.7 percent
2800
2700
1983
Domestic Nonfinancial Sector Dobl
Billions of dollars
Annual rales Of growth
Range adopted by FOMC
tor 1983 Q4 to 1984 Q4
1983 04 to 1984 Q2
1 3 1 percent
560O
1983 Qd W June 19S4
13. 1 percenf
57
W h i l e Ml growth has slowed relative to last y e a r , its
income veloc-
ity—measured by the ratio of gross national product to noney—Increased
r a p i d l y , given the strength of the economy and associated demands for money
and credit.
Over the first half of the year the Income velocity of Ml has
Increased at about a 5-1/2 percent annual rate, a l i t t l e more rapid than
u s u a l l y has occurred in the second year of an expansion.
Nonetheless, the
level of Ml v e l o c i t y still rematis about 3 percent below the peak reached
during 1981, and about 10 percent below an extrapolation of Its pre-1982
trend—suggesting that at least some relatively permanent, sizable Increase
in demand for Ml may have stemmed f r o m the Impact on the p u b l i c ' s money
preferences of the sharp drop of market Interest rates in 1982 as
inflation
a b a t e d , given the c o m p a r a t i v e l y low o p p o r t u n i t y cost of holding Ml that
developed with the larger role of interest-bearing transactions accounts in
t h a t aggregate.
Growth in M2 also has been well below that of GNP over the f i r s t
half of 1984.
To sorae degree, expansion in M2 appears to have been restrained
by heavy inflows to individual retirement accounts (IRAs) and Keogh accounts,
which are excluded from money stock measures.
Inflows to IRA and Keogh
accounts at depository Institutions alone surged by more than $20 billion
over the f i r s t half of the year, much of which likely Is not yet taken Into
account by seasonal adjustment factors.
The composition of growth in the
nontransactions component of M2 has tended In recent months to shift toward
small time deposits, perhaps reflecting a willingness of Investors to s a c r i f i c e
l i q u i d i t y In order to receive higher yield.
At the sane time, the fact that
depository Institutions have lagged in raising their o f f e r i n g rates on time
58
Velocity'
Halio scale
7.0
Velocity of M1
Velocity of M2
59
deposits relative to market interest rates probably has encouraged some
savers to invest In market instruments instead.
However, M3 growth—like growth In cotal debt—has pushed above the
upper end of its
range.
This aggregate comprises, in addition to all of the
assets In M2, large CDs and certain other borrowings by depository Institutions.
Thrift Institutions have continued to issue large CDs at a rapid pace, owing to
heavy acquisitions of mortgages and mortgage-backed securities and moderate
core deposit growth.
Loan growth at commercial banks strengthened f u r t h e r In
the f i r s t half of 1984. Commercial banks, which last year ran off about $40
billion of large CDs In response to the flood of money market deposit account
money and sluggish loan demand, Increased outstatidlngs by $25 billion in the
first six months of the year to fund the surge in loan demand.
Growth in M3
would probably have been even aore rapid had not commercial banks supplemented
deposit funds by heavy borrowing from foreign o f f i c e s , amounting ti> $15 billion over the first half of 1984.
In general, the rapid further expansion of the economy in the first
half of 1984 has been financed by an accelerated rise In velocity of money
and by large-scale extensions of credit, all accompanied by further increases
In interest rates and by an unusually large share of credit raised from abroad.
In the process, greater stresses, or their potential, have been evident this
year In the financial position of some economic sectors.
Depository institutions as a group have not been under pressure from
disintermediatton as they often have In the past when Interest rates rose, as
regulatory ceilings on yields payable by depository institutions have Largely
been removed.
Thus, deposit flows have been well maintained.
Still the prof-
60
its
of banks and t h r i f t s deteriorated in the first half of 1984—in the case of
banks partly because of continuing problem loans, and, in the case of t h r i f t s ,
mainly because of rising interest rates.
With regard to the corporate business sector, the reduction in equity
shares outstanding thus far this year, together with the concentration of overall
borrowing in short-term market sectors, has in some degree reversed the
progress made last year toward stronger balance sheet positions.
In the house-
hold sector, rapid growth in consumer credit and in mortgage debt, especially
adjustable rate mortgages, has increased the actual and potential share of
income devoted to debt service.
There has been a sharp upswing in use of adjustable-rate mortgages,
looat of which are made at initial rates well below the cost of fixed-rate
financing, that has tended to support housing activity and mortgage lending.
Nearly two-thirds of conventional mortgages originated by savings and loan
institutions in early 1984 were of the adjustable-rate variety.
Thrifts also
have been originating and holding a growing volume of consumer loans.
Both
of these types of assets carry yields that more closely track current market
yields than do long-term fixed rate mortgages.
Despite the shift away from
origination of fixed-rate mortgages, however, the asset stocks of t h r i f t
iflstitutiona remain heavily concentrated in such instruments, leaving industry
earnings vulnerable to rising Interest rates.
The foreign exchange value of Che dollar on a trade-weighted basis
declined somewhat during the first few months of the year, but since has
retraced all of its decline and more, establishing bilateral record highs
against several currencies.
The dollar's rebound appears partly related to
61
Increases in dollar interest rates relative to yields on assets denominated
(n foreign currencies.
Demand for the dollar may have been spurred also by
the favorable inflation performance in the United States and a perception that
monetary policy will continue to resist inflationary pressures.
In addition,
part of the dollar's strength may~reflect labor relations problems that have
affected European currencies, as well as military conflicts in the Mideast.
Reports of a widening trade deficit may have weakened the dollar, but on
balance the forces mentioned above more than o f f s e t the e f f e c t s of the d e f i c i t .
The large net inflow of funds that foreigners have been willing to
place in the United States has been an tnportant factor enabling credit markets to finance the faster rise in private borrowing needs, while still accommodating to the unusually large and continuing federal credit demands.
Thus,
the imbalance, at current interest rates, between doraestic savings and domestic
demands on that saving f r o m the federal budgetary d e f i c i t and private spending
for investment has been accommodated by a large f u r t h e r rise in debt owed to
foreigners.
62
The CHAIRMAN. Thank you very much, Mr. Chairman.
As you well know, over the past several years I have shared your
concerns about the deficits and we have talked about those over
and over again and their impact on the economy, on credit markets, and I still share those concerns and certainly hope that Congress means what they say when they talk about coming back after
the election and taking much stronger actions than the so-called
downpayment,
STRENGTH OF THE ECONOMY
On the other hand, though, I continue to be surprised at the
strength of the economy. Certainly it has grown much more rapidly with less inflation than I anticipated 1 year ago or 6 months ago,
and I think that is true of most economists.
The Commerce Department figures show an annual growth rate
of 7.5 percent in the second quarter after having grown 10.1 percent in the first quarter. Commerce also announced that inflation
in the economy fell to 3.2 percent annual rate in the second quarter from 4.4 percent in the first quarter. Yesterday it announced
that consumer prices rose at an annual rate of only 2.4 percent in
June.
The New York Times reported that economists say the economy
is growing faster with less inflation than it has in two decades and
also the New York Times noted yesterday that for the last 18
months the boom in capital investment has been the strongest
since World War II. The Times went on to say that economists attribute much of that capital spending boom to the tax cuts of 1981.
Your statement today notes that this recovery and expansion
period has been atypical in the sense that such a rapid expansion
has been maintained longer after the recession trough than any
comparable cyclical period since World War II, excepting only the
Korean war period of time.
Would you agree with these economists that the tax cuts of 1981
at least deserve a good portion of the credit for the ongoing boom
in capital investment and the strength and duration of the recovery and expansion?
Mr. VOLCKER. I think the tax cuts provided incentives for business investment. High interest rates theoretically work in the opposite direction, but we see a rapid expansion in business investment. Business investment level is still not exceptionally high relative to the GNP, but the rate of growth has indeed been very rapid.
Let me say that I think there has probably been, in terms of
what most economists expected earlier and in terms of your own
expectations, more thrust from the budget deficit as well as from
the particular tax measures than was anticipated; the other side of
that coin, on the inflation front, has been, in part, that the competitive pressures related to our foreign trade position have been
strong and salutory in the immediate sense.
The dollar has been strong. Goods are readily available from
abroad. That has been a powerful competitive force.
I think as we look ahead and against the background of those
very favorable developments, we have to ask ourselves, of course,
what we need to do to keep the process going effectively at a sus-
63
tainable rate and to keep that price situation under control. There
is a source for concern, because I do think that some policy adjustments are necessary.
The CHAIRMAN. Again, I stated that I agree with you. I share
those concerns. But every time we come back we express those concerns again. I guess what I'm trying to get at is why? Why does it
continue to grow at this rate with such low levels of inflation, continuing reducing unemployment? In other words, the question I'm
getting to, we continue to talk about this and, again, I haven't
changed my mind on the impact of the deficits and what they can
do in the future, but 6 months from now, we are going to come
back here again and we're going to talk about owr concerns with
the economy still booming, inflation is still down and so on, and
why? Why, Mr. Chairman? Are we all wrong in our projections?
Mr. VOLCKER. I don't think we can repeal economics. I do think
the inflation situation—I'm repeating myself now—has benefited
greatly from the foreign trade situation and the dollar. But you
have to ask yourself: Is that sustainable? Is it sustainable for us to
supplement our domestic savings by one-quarter from abroad? We
are becoming a debtor country. We are borrowing abroad at the
rate of $80 billion and $90 billion a year. Is that possible? That is
related to that budget deficit that concerns you and concerns me.
We are directly or indirectly financing the budget deficit from
abroad. That's something you can do for a year or two; I don't
know how long you can do it, but I'm certain you can't do it forever, so we've got to make that adjustment.
SOME WARNING SIGNAL FLASHING
The risk in the inflation outlook is frankly what happens to the
dollar. We have had an appreciating dollar during this period. We
also have a widening trade deficit. Are those things consistent over
a period of time? I think warning signals are clearly flashing in
that area.
Then, finally, I don't think you referred to interest rates that are
on a lot of people's minds. Interest rates have risen somewhat
during this period. They started at a very high level. That produces
strains and distortions and imbalances both in our economy and
throughout the world, and I think that's not something to be taken
lightly. You have to ask what's the source of these interest rate
pressures. And given everything else that's happening—including
what analysis of monetary policy you want to make and the growth
in money and the growth in credit, which doesn't seem to me to be
starving the economy in and of itself—you have to look at what is
causing those high-interest rates and what kinds of strains and distortions that's creating in the economy. Again, I think you come
back to legitimatizing your concern and your continuing concern
about the deficit.
The CHAIRMAN. Mr. Chairman, I don't disagree with what you
said. I guess the only shade of difference we would have is that I
would attribute a great deal more of the growth and continuing
strong economy to the tax cuts. If we start looking at the level of
taxation compared to even financing World War II, we are still
being taxed at a very, very high level of gross national product,
64
and there is a difference in how you achieve budget deficit reductions. There is a big difference between whether you take more
money out of the economy. If you've got a $200 billion deficit and
you decide that you're going to reduce it by $50 billion with $50
billion in tax increases you have reduced the amount of interest
paid on that deficit, but you're still removing $200 billion from the
private sector, $150 billion from the borrowing and $50 billion more
from taxation; compared to reducing it by expenditure reductions
by $50 billion, you're only taking $150 billion out of the private
sector and removing pressure from those credit markets for higher
interest rates.
So I think the tax cuts are very, very helpful. If I had my way,
which I obviously don't, I would go for additional tax reductions
with expenditure reductions, rather than continuing to talk in a
political year about who's going to raise taxes after the election. I
think it's a bad way to go, the wrong way to go, in the economy we
have been describing with either party or whoever gets elected,
rather than talking about expenditure reductions.
According to data from the St. Louis Federal Reserve Bank,
growth in the adjusted monetary base has been highly erratic in
recent months. The March 14-May 23 adjusted base declined at an
annual rate of 4.7 percent. From May 23-July 18 the base grew at
a 20-percent rate. The monetary base is the aggregate over which
the Federal Reserve has the most direct control.
Why has the growth been so erratic? Doesn't this lead to uncertainty in financial markets that put upward pressure on interest
rates?
Mr. VOLCKER. I should say first of all, I don't look at the St.
Louis calculation of the monetary base which has some conceptual
questions attached to it. The monetary base is what we directly influence, but we influence that for other purposes. We don't aim, in
the first instance, at creating stability in the monetary base itself.
What we are interested in is what effects that has on the monetary
aggregates that we do target and, in turn, judging those in the context of overall economic activity.
Bank reserves have been moving quite erratically recently, and
they are a component, the most volatile component in the monetary base, however it's calculated, partly because of variations in
behavior of banks with respect to holding excess reserves that have
been influenced by a variety of uncertainties in financial markets.
We have had periods of several weeks where excess reserves have
moved quite erratically judged against any trend when the money
supply has not. We're interested in the money supply.
I think for quite a while currency, which is the biggest component of the monetary base, has shown some odd fluctuations, too.
We do not attempt, for perhaps obvious reasons, to control the
amount of currency in circulation specifically, but it's very heavily
weighted in the monetary base.
The CHAIRMAN. Thank you, Mr. Chairman. My time is up.
Senator Proxmire.
65
CAUTION AND CONSTRAINT NEEDED
Senator PROXMIRE. Chairman Volcker, in my opening statement
I said that the economy's rapid growth suggested this seems to be a
time when monetary policy should be cautious and constrained.
Would you agree with that?
Mr. VOLCKER. Yes.
Senator PROXMIRE. Now Treasury Under Secretary Beryl Sprinkle told this committee a few months ago that any policy changes
by the Fed with respect to monetary aggregates would affect inflation with a 2-year lag. He presented an elaborate graph that
showed a remarkable consistency between changes in Ml and the
rate of inflation with a consistent 2-year lag.
If that's true for inflation, it seems to me that the consequence of
monetary policy changes on unemployment would also have a very
long lag. Since inflation and unemployment are the two big political enchiladas, since the election is less than 3% months away, is
there any economic role of the Fed in the coming election? With
the economic powerhouse agency you have, are you all finished as
far as contributions you could make to the outcome of the 1984 congressional and Presidential elections?
Mr. VOLCKER. If you assume some lags, I think that's correct.
Senator PROXMIRE. Are the lags right?
Mr. VOLCKER. I think there are long and variable lags. That's the
whole problem with monetary policy and other economic policy
measures. If there were no lags, if we could move today and affect
everything tomorrow in some predictable way, you could have an
automaton run the Federal Reserve. I don't think that is the experience and I do not share the confidence of some that these lags—
for instance, the 2-year lag that you mentioned from monetary
growth to prices—is nearly as consistent in the historical record as
we would like to have it.
Senator PROXMIRE. Let me ask you this. Is there any economic
indices—say, interest rates—which could be affected by the Federal
Reserve policy now or next month that would have an effect before
the November election?
Mr. VOLCKER. If very strong actions were taken one way or another, I'm sure, yes. You will recall the episode—this wasn't exactly monetary policy in the ordinary sense—in early 1980 when the
decision was made to adopt some relatively mild controls on consumer credit, and the psychological reaction was such that the
economy almost instantaneously reacted, contrary to everyone's expectations. Now that, I think, was almost entirely because of the
psychological impact of a measure announced by the President.
Senator PROXMIRE, That psychological reaction is very tricky,
isn't it?
Mr. VOLCKER. Yes.
Senator PROXMIRE. In other words, if you follow a policy of trying
to hold down interest rates as some have suggested by increasing
Ml, the investors may interpret that as inflationary and therefore
interest rates may rise?
Mr. VOLCKER. Yes, I agree with that.
Senator PROXMIRE. On page 8 you have told us that:
66
Viewed in a medium-term or longer perspective, those growth rates for M3 and
domestic credit are higher than consistent with sustainable rates of growth in the
economy and progress toward price stability.
In other words, you are telling us that that growth is inflationary and for that reason you say the Committee decided not to raise
the target ranges for this year.
Well, can't you do more than that? Are there any policies you
can follow that would reduce the rate of growth in M3 so that it
would be more sustainable and less inflationary?
Mr. VOLCKER. Presumably, yes, if we put more pressure on bank
reserve positions and in that sense had a more restraining policy,
over time the growth in M3 and debt would be reduced. We would
also have a reduced growth in Ml and M2, maybe more promptly
than in the others.
Senator PROXMIRE. Why shouldn't you do that then?
Mr. VOLCKER. This is what you have to reach a judgment on and
that has been debated.
Senator PROXMIRE. But you decided not to change Ml and M2.
Mr. VOLCKER. We decided, looking at everything that's going on,
including Ml and M2 which are within their ranges—in fact, M2,1
think, is at or below the midpoint of the range while Ml is relatively high in its range—and looking at the rest of the economy and
looking at indications of price pressures and looking at conditions
in financial markets, we did not take, as I reported, additional restraining measures. Interest rates have continued to go up during
most of this period, except for the last couple of weeks, when
there's been a lot of volatility.
Senator PROXMIRE. Now there's been a lot of criticism of Jesse
Jackson for what he did in Cuba and in Nicaragua, but he's not
under the discipline of the administration or of the executive
branch. Recently, the U.S. Ambassador to France held a press conference in Paris where he declared that the Federal Reserve should
reduce short-term interest rates. The purpose of the press conference apparently was to affect monetary policy.
I wonder if you have any comment on the state of our diplomatic
relations with France and how we could improve them?
Mr. VOLCKER. No, sir. I found the source of those comments a
little odd in terms of history, and I must say I found the analysis a
little curious as I looked at it.
Senator PROXMIRE. I have never seen that happen before. It
seems to me if we have any diplomat who is qualified to make this
kind of judgment it would be Arthur Burns, our Ambassador to
Germany, who is eminently qualified but who has the sense not to
butt in.
NOMINATION OF DR. SEGER
On July 2, the President nominated Martha Seger to the Board
of Governors. I felt this was extraordinary. It was extraordinary because this was a very controversial appointment. Martha Seger was
opposed by every Democrat on the committee. The nomination now
comes to the floor. I didn't see that it was an emergency kind of
situation. Perhaps it was, but that case hasn't been made.
Did you ask the President for a recess appointment?
67
Mr. VOLCKER. No.
Senator PROXMIRE. Were you consulted on the President's decision to make a recess appointment?
Mr. VOLCKEH. No.
Senator PROXMIRE. Is there any evidence that the Board or the
Open Market Committee would have difficulty performing their responsibilities had they waited for Dr. Seger to be confirmed
through the normal processes of the Senate?
Mr. VOLCKER. Not from my particular point of view, but I suppose other opinions may differ on that.
Senator PROXMIRE. Why do you suppose the President used his
recess appointment authority in this case?
Mr. VOLCKER. I don't know.
Senator PROXMIRE. I understand the Secretary of the Treasury
was consulted on Dr. Seger's initial nomination. I understand Dr.
Seger was interviewed at some length by the Vice Chairman of the
Federal Reserve Board, Mr. Martin. Were you involved in this selection?
Mr. VOLCKER. Yes; I was aware of the process and had opportunities to comment upon it, but this appointment process is the President's and the Congress.
Senator PROXMIRE. Are you aware of any other controversial appointment to the Federal Reserve Board that's ever been made on
a recess basis? It seems to me that this agency is so importantly
independent of the executive branch that to have this appointment
made under these circumstances is an extraordinary precedent and
I think perhaps a dangerous precedent.
Mr. VOLCKEK. I don't recall any, Senator, of this kind.
Senator PROXMIRE. Now, some people argue that the Reagan administration seems to have shifted from Fed bashing to big bank
bashing in their effort to explain why interest rates remain so
high. Are banks responsible for keeping interest rates artificially
high?
Mr. VOLCKER. Are bankers responsible?
Senator PROXMIRE. Yes, sir.
Mr. VOLCKER. I would not describe bankers as responsible for
keeping interest rates artificially high. As I indicated in my statement, in this deregulated banking environment, a period of economic expansion particularly, I think there is a sense among bankers that they don't have constraints on their ability to raise money.
To overstate it a bit, you make the loan and then you finance it,
and as credit expansion proceeds. It does have to be financed; the
bidding for funds proceeds, and that raises rates in the market.
That's the way the market process works.
I wouldn't call it exactly artificial. I wouldn't call it artificial at
all. My concern about the process would be whether, in the end,
from the perspective of the entire economy, the credit expansion
doesn't proceed faster than is healthy in aggregate terms, which we
have to look at in terms of our policy, but also importantly in
terms of individual banks retaining appropriate prudence in their
lending process.
Senator PROXMIRE. Now let me move quickly to another subject.
My time is almost up.
68
LOWER INTEREST RATES FOR FARMERS
Senator Exon, a Senator whom I especially admire and like, is a
neighbor right across the street and a good friend, has introduced a
resolution. You referred to the same concern that he had on page 5
of your statement when you talked about the effect of high interest
rates on farmers. His resolution, S. 130, expresses the sense of the
Senate that the President should cooperate with the Fed to exercise appropriate authority to ensure that an adequate flow of credit
is available to American farmers at reasonable rates and that
American farmers be treated not less favorably than foreign borrowers with comparable levels of risk.
What about this? Is there anything the Fed can do to lower interest rates paid by farmers? As you know, they are in terrible
straits. Prices are down now. Foreclosures are very common. It's
almost a depression that many people aren't aware of because they
now constitute a relatively small percent of the population, but it's
a real crisis out there.
Mr. VOLCKER. There's no question that there are strong financial
strains on farmers who are at all heavily indebted, and many of
them are, as you know. I think there are real problems out there
created by the general interest rate situation. I think our ability to
deal with that on a selective basis is extremely limited. It's basically nil.
My concern about resolutions of that type are that they imply
that we have got more power than we do to deal with the situation.
What we have tried to do, as I indicated in my statement, is something which I suppose is broadly analogous to the kind of comments we made about the international debt situation. In the case
of farmers who are in a position, basically, where over time they
should be creditworthy, but are in a debt squeeze right now and
can't keep up with their payments, and when the bank appropriately thinks that forebearance ought to be shown, we have said we
don't want the bank examiners classifying those loans when they
also have the judgment that that farmer can be basically creditworthy. We try to make sure that the appropriate reaction of a
banker in being tolerant, understanding, and forebearing in these
situations is not discouraged by the bank examiners, and I think
we have done that.
Senator PROXMIRE. Thank you, Mr. Chairman. My time is up.
The CHAIRMAN. Before I turn to Senator Mattingly, I would just
respond to the Senator from Wisconsin and the Chairman that Mr.
Eccles was a recess appointment, for whatever that is worth, and I
can't say that from personal knowledge because that was so long
ago that I was in a period when I had no hair. In between I had
hair. I have gone from that period through the hair period and
back to the bald state where I was a 1 year old when Mr. Eccles
was a recess appointment to the Fed.
Senator PROXMIRE. If the chairman would yield on that, I think
bald states are controversial and I've tried to do my best to improve my status. But Mr. Eccles was not a controversial appointment. I don't know of any Senators who were against him.
Mr. VOLCKER. My counsel has given me the same note that Mr.
Eccles' first appointment was made during recess.
69
The CHAIRMAN. At my age at that time I don't know whether it was
controversial or uncontroversial and I can't afford the kind of surgeon
that Senator Proxmire had.
Senator RIEGLE. Mr. Chairman, just for the record, I wonder if
the same historian is here to tell us whether that occurred in the
midst of the session or at the end of the session.
Mr. VOLCKER. We will provide the circumstances for the record,
Senator.
Senator RIEGLE. I would be very surprised if it occurred in the
midst of the session.
Mr. VOLCKER. Let us research the issue and provide the answer
for the committee.
The CHAIRMAN. I'm not sure that it's too important one way or
another.
Mr. VOLCKER. Somebody else had a very temporary appointment,
but I will provide the circumstances to you for the record. I was 8
years old at that time.
The CHAIRMAN. Senator Mattingly.
[The information was supplied for the record:]
BOARD OF G O V E R N O R S
FEDERAL R E S E R V E SYSTEM
WASHINGTON, D. C. 2 D S S I
HJL A. V O L C K E B
CHAIRMAN
August 6,1984
The Honorable Jake Garn
Chairman
Committee on Banking, Housing
and Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
During the Committee's hearing on the conduct of
monetary policy on July 25, 1984, Senator Proxmire raised the
question of whether there had been any recess appointments of
Federal Reserve Board Governors by Presidents prior to the
recess appointment of Governor Seger.
During the subsequent
discussion, you pointed out that Chairman Eccles had received a
recess appointment, and Senator Riegle requested information on
whether there were any other recess appointments and whether
any of those appointments had been made prior to the
adjournment of the Senate sine die. I said that I would supply
the information for the record.
The enclosed memorandum notes that there have been
three recess appointments made to the Board; Adolph C. Miller
on August 21, 1934; Marriner S. Eccles on November 15, 1934;
and John E. Sheehan on December 23, 1971. The Miller and
Eccles appointments were made after the adjournment sine die of
the First Session of the 73rd Congress and the Sheehan
appointment was made after the adjournment sine die of the
First Session of the 92nd Congress.
With best wishes.
Enclosure
cc:
Senator Proxmire
Senator Riegle
71
August 6, 1984
MEMORANDUM
SUBJECT:
Previous Recess Appointments to the Board
Prior to jovernor Seger's appointment to the Board of
Governors, there had been three recess appointments made to the
Board:
Adolph C. Miller, on August 21, 1934; Marriner S.
Eccles, on November 15, 1934; and John E. Sheehan, on
December 23, 1971.
All three of the previous appointments were made when
Congress had adjourned sine die between sessions.
Both
Mr. Miller and Mr. Eccles were appointed during the adjournment
between the 73rd Congress and the 74th Congress, which lasted
from June 18, 1934 to January 3, 1935.
Mr. Sheehan was
appointed during the intersession recess from December 17, 1971
to January 18, 1972, between the first and second session of
the 92nd Congress. In all three cases, the nominations were
submitted to the Senate arter it reconvened from the
recess during which the appointments were made.
The
relevant dates
for each
appointment
were as
follows:
Adolph C. Millerj./
Adjournment of Senate (73rd Cong.)
Recess Appointment
Oath of Office
Senate Reconvenes (74th Cong,)
Nomination Submitted to Senate
Favorable Report from Committee
Confirmation by Senate
Permanent Appointment
Oath of Office
June 18, 1934
August 21, 1934
August 21, 1934
January 3, 1935
January 10, 1935
January 22, 1935
January 23, 1935
January 26, 1935
February 1, 1935
!./ Mr. Miller was one of the original members of the Board.
was first appointed in 1914 and reappointed in 1924.
He
72
Marriner^ S. Eccles
Adjourninent of Senate (73rd Cong.)
Recess Appointment
Oath of Office
Senate Reconvenes (74th Cong.)
Nomination Submitted to Senate
Hearings Before Committee
Favorable Report from Committee
Confirmation by Senate
Permanent Appointment
Oath of Office
June 18, 1934
November 10, 1934
November 15, 1934
January 3, 1935
January 10, 1935
April 15 and 19, 1935
April 23, 1935
April 24, 1935
April 25, 1935
April 27, 1935
E. Sheehan
Adjournment of Senate (1st Sess
92nd Cong. }
Recess Appointment
Oath of Office
Senate Reconvenes(2d Sess.,
92nd Cong. }
Nomination Submitted to Senate
Hearings Before Committee
Favorable Report from Committee
Confirmation by Senate
Permanent Appointment
Oath of Office
December 17, 1971
December 23, 1971
January 4, 1972
January 18,
January 24,
January 27,
January 27,
February 7,
February 7,
February 8,
1972
1972
1972
1972
1972
1972
1972
73
Senator MATTINGLY, Thank you, Mr. Chairman. I'm not sure
whether anybody who's got to borrow money in the private sector
is too worried about that appointment.
We now go to the haired members of the committee to ask questions. I thought I'd throw that in. [Laughter.]
Let's return to the original question of Senator Gam. I think he
was trying to get you to say you were supporting the President's
policies. On page 5, you made the comment that it is in the end a
choice between building on the enormous progress of the past to
achieve sustained growth in a framework of greater stability—I
assume you're endorsing the Reagan policies of the last 3Vz years—
"or a relapse into inflationary economic malaise," which sounds
like the 4 years of the Carter administration.
In order to treat all us dogs equally, are you saying that the policies of the last 3l/z years
NO POLITICAL COMMENT
Mr. VOLCKER. I am making no political comment whatsoever. I
am somewhat aware that this is the period for debating these
issues, but I don't want to entertain debate in that context.
Senator MATTINGLY. Well, are you saying the policies—taking
the candidates out—the policies of the last 3V2 years have made a
lot of economic progress?
Mr. VOLCKER. I have said this repeatedly—and I recall saying it
18 months ago in my comparable statement—that I thought we
had succeeded in laying the foundation for the possibility of a long
period of sustained growth with greater stability, and I think those
things have to go together. Indeed, I think a lot of what's going on
has been very favorable, not only in the immediate sense but also
reflecting changes in attitudes, changes in behavior, changes reflected in restraint on pricing, restraint on wages, high productivity, signs of increased business investment; that all augurs very
well. But there are some very real shoals out there that simply
must be dealt with and, indeed, the events of the economy make it
more urgent to deal with them.
Senator MATTINGLY. But the policies of 1979 and 1980 in that era
which gave us 21 percent prime and 13 percent inflation, and the
policies that we have now
Mr. VOLCKER. Maybe I'd better just say that I was here in 1979
and 1980, so as far as the Federal Reserve was concerned, I would
like to think those policies were part of laying a sound base, too.
Senator MATTINGLY. Right. But generally speaking, you think
the tax cuts and the reductions in Federal spending is healthy for
our economy?
Mr. VOLCKER. I'm not sure I have any difference at all with Senator Garn. I said—the words may sound familiar to you because I
repeated them in earlier testimony—that clearly the ratio of Federal spending to GNP is above historical relationships; taxes are
about as high as they have ever been relative to the GNP. From a
strictly economic point of view, I believe that the more that spending can be reduced to close this gap, the better.
I have also said that, as a practical matter—and that's what the
political process is all about—if it can't be done on the spending
side, you've got to look at the revenue side.
Senator MATTINGLY. You're still recommending spending cuts
first?
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Mr, VOLCKER. The more you can do on spending, the better.
Senator MATTINGLY. Right. You're still endorsing spending cuts
first?
Mr. VOLCKER. Right,
Senator MATTINGLY. Thank you. I guess we've come a long way
in 3:/2 years.
FED'S MONETARY TARGETING
It's been reported that the views of a number of analysts feel
that money supply targeting has always been a secondary objective
of the Federal Reserve to interest rate manipulation. The implication is that monetary stability will be abandoned whenever the
Federal Open Market Committee feels that interest rates should be
higher or lower.
How would you respond to that?
Mr. VOLCKER. I think the monetary targeting is designed to and
does give us a substantial element of discipline, and it's a kind of
point of departure in assessing policy. It's a strong point of departure; there's a strong presumption we'll follow these targets.
If you ask me whether there are particular situations when you
would follow a target and not take account of judgments about
whether the relationship between money and other forms of economic activity were changing, we obviously do use an element of
judgment. You will recall that in the second half of 1982, for instance, where we thought some of the monetary numbers were
giving misleading signals, when we assessed the overall economic
situation, we permitted monetary growth to exceed the targets,
particularly Ml growth. But that was done on the basis of a general analysis and not done in an effort to seek a particular level of
interest rates, which I think would be a mistake; we are not doing
that.
As you know, interest rates have gone up somewhat in recent
months when the money supply has been rather equitable.
Senator MATTINGLY. Suppose that the Federal Reserve revealed
the nature of its policy decisions shortly after they were formulated. What effect would this have on the markets? Wouldn't the
public be able to make more efficient decisions regarding employment, savings, investment, production, and consumption?
Mr. VOLCKER. No. I think the opposite actually, Senator. Some
decisions clearly can be announced that would have no impact at
all. You announce we're not doing anything different, say. When
we change the discount rate, we do announce that. But many of
our decisions are conditional by their nature. The Committee meets
at intervals and decides what to do today and what to do some
weeks later if something else happens.
Let me give you one example of that, one rather clear example.
In December, the Committee reached a decision and said in effect—
and this has long since been published—that we don't want to do
anything at the moment, but we really are directing the open
market desk in New York, the operating arm, to tighten up a bit if
the money supply shows signs of rising more rapidly than we now
expect or if certain things happen in the economy.
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Those things never happened and there wasn't any additional restraint put on the economy at that time. But if we had announced
that at the time of the meeting, the market would have reacted, I
assure you. I can almost guarantee that because the market reacted a little bit a month later when we announced the decision, even
though by that time it was no longer applicable. The market
always wants to know, and the real problem is not what we did
yesterday or what we are doing today, but that they want to know
what we're going to do tomorrow or next month, and that's an unanswerable question in its details.
Senator MATTINGLY. But I think a lot of people feel the public
would just spend a lot less time and money trying to discover the
intent of the policy if they knew what the decisions were immediately.
Mr. VOLCKER. There's a debate on this subject and all I can give
you is my strong feeling, based upon 20 or 30 years of experience in
this business, that it would make things worse.
Senator MATTINGLY. We won't pursue that any further. I do have
a bill, Senate bill 2620, which is the Federal Reserve Reform Act,
which I'm sure you're familiar with, to require such disclosures,
We will debate that at a later time because I think, as you well
know, that there is a need for greater disclosure.
Mr. VOLCKER. I know people come to differing views. All I can
tell you is that, based upon all my experience in this business, I
think it would turn out to be a mistake.
Senator MATTINGLY. I think there are parts of that legislation
that you would agree with now from some of your testimony.
Mr. VOLCKER. If I may just say one further word on this, I think
we should make a distinction between policy and implementing
policy. We're discussing policy here today in terms of these targets
and the background for them. These decisions about precisely when
you increase pressure on bank reserves are all within the context
of an announced policy. If the policy changes, I agree that we
should announce it. What the argument is about, in my terms, is
whether you announce all the implementing decisions.
STRETCHOUT OF INTERNATIONAL LOANS
Senator MATTINGLY. One last question. With reference to the
international loans which you spoke about. Recent financial publications continue to report that a lot of the major banks are writing
down many of those international loans because they are of questionable quality. At some point in the future these institutions are
going to have to face reality and stretch out these loans if they
ever hope to be paid.
Dp you, as a regulator, currently have the authority to require
such a stretchout of those loans?
Mr. VOLCKER. We don't have any regulatory authority to require
a stretchout. We do have authority to
Senator MATTINGLY. Does current authority allow you to require
such action?
Mr. VOLCKER. No.
Senator MATTINGLY. Would you like such authority?
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Mr. VOLCKER. I don't think I want to get into the banking business to that degree, I express opinions about it publicly. In that
sense, we get involved in the process. The International Lending
Supervision Act last year had specific words of congressional endorsement of that approach, but it's not a specific regulatory authority that we have.
Senator MATTINGLY. But you and I agree that a lot of those loans
can't be repaid in that timespan that they've currently scheduled.
Mr. VOLCKER. That is correct. I think the bankers understand
that, too.
Senator MATTINGLY. Right. But the banks have got to take such
action voluntarily or else somebody is going to have to require it of
them.
Mr. VOLCKER. You get into obvious negotiating arguments. If you
take the other side for the moment, they say, "That's right; we've
got to look toward repayment over a longer period of time, but I'd
rather make that decision about just how long and what the interest rate is when the loan comes due rather than in advance."
That's got the disadvantage of leaving a great deal of uncertainty
surrounding the situation, but it can be argued that this is the way
of maintaining discipline on the borrower.
I think there are legitimate matters of banking practice that are
involved here, but I do think it is important—to repeat what I already said in my statement—that where countries are making real
progress, and they've taken very tough measures, and their external position is improving but they clearly can't repay the pileup of
short-term debt, there may be a mutual interest in stabilizing the
situation and stabilizing the psychology by providing now for a
more orderly repayment schedule.
Senator MATTINGLY, My time is up. I'm glad you agree with me
that some of these loans will need to be stretched out. Thank you.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Mr. Chairman, approximately how many banks
are on the problem list at the moment?
Mr. VOLCKER. I haven't got that.
Senator RIEGLE. Would any of the staff present have that information? I see the figure at roughly 700. Is that correct?
Mr. VOLCKER. I don't think we have announced such a figure;
other agencies may be different. We only directly supervise State
member banks. I certainly don't have that information with me.
PROBLEM BANKS RANGE NEAR 700
Senator RIEGLE. Well, let me tell you what I'm reading and I
assume you're reading the same things in the financial journals,
and that is that there are very substantial numbers of banks on
the problem list. The general number that is used today is in the
range of 700. In talking with savings and loan people, I find they
are increasingly being squeezed into an adverse position. As you
well know, more and more of the savings and loans, despite the legislation we passed 3 years ago, are being pushed back into an enlarging problem category, and I assume the same is true for credit
unions. This is raising a lot of justifiable apprehension about the
overall structural soundness of that sector of the financial system.
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Now there's more and more talk about certain areas of the economy that are experiencing a kind of deflation, a relatively new experience. Our main concern has been inflation for a long time, but
now, as you know, there are a number of people that are starting
to focus on sectors that are witnessing a rather sharp deflation.
We're seeing that with respect to the value of farm land, its collateralized behind a lot of loans. We saw it a couple years ago with
energy loans which is a major factor in the problems experienced
by Penn Square and Continental Illinois. I recognize the fact that
the economy is uneven; that there are areas of strength and there
are areas of weakness—but how do you view the areas which are
now experiencing deflation and what observations could you make
about that?
Mr. VOLCKER. Undoubtedly, there are areas that are under heavy
pressure, as you indicated. I think you mentioned the two leading
sectors within the U.S. economy. When one looks around the world,
you've got countries that are under very heavy pressure. The way I
would size that up is that I think it has some dangers; it should be
addressed. There is too much unevenness and to a considerable
degree that unevenness is a reflection of a particular mix of public
policies. And I come back to the root of this—not all of it but some
of it—which is the fact that we are forced to finance a very large
budget deficit at the same time the strong sectors of the economy
are borrowing a lot of money and that puts pressure on interest
rates and aggravates some of those sectoral strains without question, The whole imbalance in foreign trade is fundamentally related to this, which is perhaps the most serious manifestation of the
kind of imbalances that you describe.
I take it extremely seriously and it's another way of stating some
of the concerns I talked about in my statement. The relevant question is: How do you deal with that? I think the answer to that is
pretty straightforward. We have the tools for dealing with it in a
way that's constructive, in a way that deals with that without
losing all the gains that Senator Mattingly and others have spoken
about here.
EFFECTS OF DEFLATION ON THE FINANCIAL SYSTEM
Senator RIEGLE. I'd like to try to connect the two factors. I'd like
to try to connect the unevenness of the economy and the deflationary problem areas to the structural soundness of the financial
system, and there are a lot of variables which bring this in focus.
Obviously, the problems experienced by Continental Illinois are
very much front page news and that stems principally from energy
loans but one assumes other factors as well, keeping in mind that
we have a long list of other financial institutions which are presently experiencing difficulties as well.
What I'm concerned about is, if you go back to the 1920's, there
were really two periods where we began to experience substantial
deflation in certain sectors. We were able to weather that deflation
in the early and mid-1920's. But when it extended into the late
1920's and early 1930's we found ourselves in a rather rapid deflation because the bottom fell out of a lot of price levels in different
sectors, from land, across the board, to other kinds of assets.
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The concern I have here is: How much margin have we left in
terms of the overall structural soundness of the banking system to
be able to take another set of shocks here on the margin?
I talked the other day to the head of a major money center bank
who pointed out to me that the agricultural loan problem has now
grown to an entirely new dimension for that particular institution,
and he expressed a rising level of concern about what is happening
in terms of those collateralized farm loans. I thought to myself, this
is likely to be one of the next stories that we will be reading about
that hasn't really received front page treatment today.
I'm wondering, has the Fed done any analysis yet on the pockets
of deflationary pressure, including commodity prices as they would
feed back through to additional pressures on the banking structure
and the financial structure at this point?
Mr. VOLCKEB. We try to evaluate all these things, but if you
think that somebody can come to a simple timing of or mathematical answer to just what the problems will be in the agricultural
sector next year in this respect and how they might have repercussions on agricultural banks around the country, I think you're
asking something that is beyond any analytic capability. I would
simply say
Senator RIKGLE. I'm not trying to just limit it to agriculture. I
would include foreign loans and other kinds of loans.
Mr. VOLCKER. The foreign loan situation is as I tried to describe
it. I think there are signs of progress in some countries, some important countries, and in some sense fundamental progress is being
made, but sentiment has not been very buoyant surrounding that
problem recently for perhaps understandable reasons, because
there are other countries not making progress, and there is a real
concern about these protectionist measures and interest rates.
That's as much psychological as real.
I would simply respond to this whole line of inquiry, Senator, by
saying if you are concerned about these things—and I recognize
that you are; I reflected my degree of concern in my statement—
that there is just no reason not to begin to take the measures that
will clearly relieve those pressures then these kinds of questions
won't arise.
I don't think it's very useful to make a calculation that if this
went on for 2 years it's going to be a problem, or if this goes on for
18 months it's going to be a problem, or maybe we can wait another 9 months. Do it now; go ahead.
Senator RIEGLE. Well, I agree on the need for action now and the
sense of some considerable need of urgency and in fact you use language in your statement that I thought made it quite clear that
you have a genuine sense of concern. On page 2, you say that if we
don't act we potentially face severely adverse implications. I think
that's pretty blunt language and I agree with it.
But this is what I think we need to do at this point. I think it
isn't just the deflation that we're seeing with respect to farm land
values and commodity prices and certain other areas that are
working their way back through the collateralized loans and just
the ability of certain creditors to even pay their bills, but in a
broader sense, we have seen a kind of devaluation of the quality of
the foreign loans. A lot of them had to be written, down in the
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sense that they're nonperforming. I'm not saying they are exactly
the same thing. What I am saying is that the collateral base of a
large number of financial institutions in this country is under
rather substantial pressure and that's why I asked the question at
the outset of how many banks and financial institutions are on the
problem list. And the answer is, a very substantial number and the
list is growing. It's not receding.
We are about to nationalize one of the biggest money center
banks in the country because it just basically failed, and I don't
know how many more might be right behind it. I hope no others.
Mr. VOLCKER. I think that situation is unique. But let me point
out, in terms of this concern that you're expressing, we have—and
perhaps that incident reflects it—a very strong safety net, a very
strong apparatus in this country to deal with problems of that sort
when they do arise unexpectedly.
Senator RIEGLE, You also mentioned another area that I want to
discuss and I hope to do so on the second round. That's your concern about leveraged buyouts. I have a similar concern because
what we're seeing is the subtraction of equity and the replacement
of it with debt and to a rather substantial degree, and in a sense it
seems to me that's applying still a further kind of strain on financial institutions.
So I would hope that the Fed would conduct a study on this. I
think the time has come for the Fed to take a look at the question
to which the unevenness in the economy is hitting sectors, such as
the energy sector which was hit before, that may be causing an aggregate pileup of new strain on financial institutions that may
press us out to the outer edge of what our system is capable of handling. I do have an apprehension about it and I'd like you to take a
look at it and let us know what you think.
Mr. VOLCKER. We try to take a look at this kind of thing all the
time, and I would simply repeat myself by saying if you have this
kind of concern I hope you will press for those obvious policies that
deal with it
Senator RIEGLE. I intend to.
Mr. VOLCKER [continuing]. In the only effective way they can be
dealt with.
COMPETITION OF BANKS FOR FUNDS
Senator RIEGLE. I just want to conclude by mentioning the ads
that are running today in the New York Times which you have
probably seen. They began running this week under the headline
"Rate Alert." This happens to be an ad for Manufacturers Hanover
but Chase Manhattan is running similar ads, where they are now
offering for a 6-month certificate an effective annual interest rate
of 13.34 percent for any amount over $500. Now this seems to me to
be an extremely high rate of interest to be offering at this stage of
the game on accounts for a 6-month term that go up from the
lowest level of $500.
I'm wondering how are we to make sense out of that? We may
conclude that a number of these banks, not just one, but the big
money center banks in New York are doing this because they're
anticipating higher interest rates in the future so they are willing
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to commit themselves to pay a higher rate for deposits because
they expect rates to go up, but it also makes, me wonder if there
isn't a kind of churning going on here where they feel the need to
bring in. immediate deposits for whatever the reasons. Presumably
they need them and they are willing to put out their rather high
rate of interest in order to meet whatever their immediate cash requirements are. How are we to interpret this?
Mr. VOLCKER. I think you are using today's paper to illustrate a
point I made and alluded to generally in my statement, that in this
banking environment we have now, during a period of rapid credit
expansion—and a lot of that credit expansion has converged on
banks—they need the loan demand, may even seek out the loan
demand, and then finance themselves by bidding in the market aggressively for money. If the cost of their money goes up as a result,
the thought is the interest rate on the loan will go up. You get a
kind of ratcheting process—it's a market process—in the midst of a
strong economic advance, a strong credit demand. Ten years ago it
wouldn't have happened that way, because you had these interest
rate ceilings and banks would have been forced to constrain the
loans, but we now are living in a different banking environment.
You don't get restraint on bank lending any more from an inability
to raise money because banks are up against ceiling rates. We have
taken off the ceiling rates and this is the market response that you
see during a period of this kind.
Senator RIEGLE. I'll conclude with the predicament Continental
Illinois now finds itself in. Continental Illinois got into a situation
where suddenly its cash requirements were so severe that it had to
resort to virtually every expedient, including borrowing institutionally, to meet its overnight reserve requirements, and I'm wondering if there's any suggestion in the case of the big New York
money center banks that this sudden ratcheting up in rates is because they need to suddenly increase their reserves to the point of
going with extraordinarily high rates to do it.
Mr. VOLCKER. Continental Illinois, after a passage of time, was
excluded from the markets because of the confidence problem. But
I think banks should be careful about keeping their funding up
where they are ahead of their asset growth. The point I'm making
is, there isn't any restraint on the asset growth of the kind that
there used to be except by the interest rate itself, because the interest rate rises in this process.
Senator RIEGLE. Well, I will come back. My time is up.
The CHAIRMAN. Senator Heinz.
Senator HEINZ. Thank you, Mr. Chairman. I just want to make
one serious comment before I get to the questions here. I just
wanted to ask Chairman Volcker if he kind of agreed with the
notion that you and Senator Mattingly touched on earlier, which is
that a lack of hair inhibits fuzzy thinking. [Laughter.]
Mr. VOLCKER. No comment.
Senator HEINZ. We'll put you down on the yes column on that.
Senator MATTINGLY. I'll get him on the second round.
Senator HETNZ. Chairman Volcker, in your statement you
touched on some of the costs that we are paying as a result of high
interest rates and as a result of high deficits and as a result of
combined with a lot of borrowing in the private credit markets,
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and you indicated that the farmers have been particularly hard
hit, that thrifts have been hard hit, that those businesses that tend
to be undercapitalized, mainly small business, those that don't
have as easy access to equity markets have been hard hit, and you
sounded some alarm, as I understood your testimony, about what
further rises in interest rates would do to less developed countries
[LDC] already heavily burdened with debt.
That's a pretty grim scenario in and of itself, but I'm wondering
if there's still more to it. Chairman Garn mentioned that capital
spending had been healthy, very healthy, but as I recollect from
our hearing in June, there are some holes in that capital spending
picture that are not as rosy as the superficial analysis of the New
York Times would point out. Would you care to elaborate on that?
Mr. VOLCKER. I think you're probably referring to a point that I
may have made
Senator HEINZ. Nothing personal.
Mr. VOLCKER [continuing]. In an earlier hearing. It may be in the
process of some change, but investments have been very heavily
concentrated on rather short-lived investment, electronics, data
processing, computers, and all the rest. There has been less in machinery plant expansion and so forth. I think the most recent evidence suggests that that area is certainly improving as well, but it
has lagged behind some of the other forms of business investment,
which you could expect with interest rates so high. The high-interest rates are a much greater inhibition on long-term investment
than short-term investment.
LONG-TERM INVESTMENT LAGGING
Senator HEINZ. Is it your understanding that long-term investment year to date is still lagging?
Mr. VOLCKER. It's rising. I don't have the figures in mind.
Senator HEINZ. All investment is rising. The question is whether
it is lagging.
Mr. VOLCKER. It is lagging relative to some other forms of investment. Long-term investment interpreted to include office buildings
and commercial construction is rising quite rapidly. I'm focusing on
the manufacturing industries.
Senator HEINZ. If you left the commercial structures, office buildings out, which tend to correlate more with service functions as opposed to industrial activity, you would say that there is a definite
lag, even though there is a rise, there is a definite lag in industrial
investment long term?
Mr. VOLCKER. Yes; relative to earlier levels.
Senator HEINZ. Now I certainly agree with you that the Federal
deficit is one of the causes of the high-interest rates. There is some
disagreement on that. The Treasury Department says there's no
correlation between high-interest rates and large deficits.
Can you rebut the testimony of Mr. McNamar and others before
our committee which says there is no correlation?
Mr. VOLCKER. Let me say, first of all, there is no correlation in
the superficial sense of correlation. If you look back in history, deficits tend to be big in recessions, and interest rates tend to be lower
in recessions, and you would say there is an inverse correlation.
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There's an obvious explanation for that. Interest rates are low in
recessions because business demand is low, and the tendency for
Government deficits to rise in recessions doesn't offset those other
forces pushing interest rates down.
What you're really looking at is, other things equal, what do Federal deficits do? I know of no refutation to the argument that,
other things equal, if you superimpose a Federal deficit on the
credit markets and on the economy, you will get an expansionary
force and an additional demand on the credit markets; with monetary policy and private incentives the same, you're going to get
rising interest rates.
Senator HEINZ. There are two scenarios. One is overexpansion of
the economy and inflationary pressures. The other is an increase in
interest rates and deflationary pressures as economic expansion
comes to a halt. And I worry as much about the latter as the
former.
One of the reasons I worry is that it's very difficult to predict
what future Treasury borrowings are going to do in the financial
markets.
Now I seem to recollect that the Treasury Department will be
doing only a modest amount, relatively speaking, of financing and
refinancing over the next several months. When is the next major
Treasury Department effort due?
REFUNDINGS INVOLVE A LOT OF NEW MONEY
Mr. VOLCKER. I think they've got a major operation at the end of
this month. This is their normal quarterly, what is euphemistically
called a refunding. The refundings involve a lot of new money
these days. I may have their schedule of financing with me.
Senator HEINZ. My recollection, Mr. Chairman, is that they just
did their refinancing 2 or 3 weeks ago.
Mr. VOLCKER. These days they do it every 2 or 3 weeks.
Senator HEINZ. They do it every Tuesday, but—so your information is that there is no particularly large Treasury operation
planned other than monthly for the rest of this year?
Mr. VOLCKER. They have a large quarterly refunding and they
have what they call minirefunding now that also add in many billions these days, too.
Senator HEINZ. The reason I ask, I seem to recollect that there is
a big one due in November, but you don't happen to have that information.
Mr. VOLCKER. November would be a normal month, too. November is a normal month for a big refunding, as are August, February, May. In between, they have these so-called minirefundings
which are bigger than the regular refundings.
Senator HEINZ. Did you say the minirefundings are bigger?
Mr. VOLCKER. Than the regular refundings we used to have.
Senator HEINZ. I take little comfort from that. So you do not see
any particularly unusually heavy refunding, just a series of backbreaking ones?
Mr. VOLCKER. That's right. These are not unusually heavy by the
standards of the past year; they are maintained roughly in the
area of the past year.
83
Senator HEINZ. So you see continuing pressure on the financial
markets and very little end in sight absent additional action by the
Congress?
Mr. VOLCKER. That is correct. I make a basic point: We are going
to have a deficit next year as big as this year, and maybe bigger.
Senator HEINZ. I think we agree on the fact that—at least you
and I—I can't speak for the Treasury Department—both financing
and refinancing in the market do drive up interest rates. But
having settled that issue perhaps as the major cause of high real
interest rates, I'd like to explore with you the area that Senator
Riegle touched on, which has to do with bank performance in this
area.
Do you agree or disagree with the notion that the quality of bank
assets, the loans that they have held, has, notwithstanding the
period of economic expansion, continued to decline in quality?
Mr. VOLCKER. I doubt that it's continued to decline in quality. I
think we are still seeing asset problems, which were generated essentially earlier, reflected in the statistics.
Senator HEINZ. Regardless of when they were generated, would
you say that the quality of bank assets, regardless of when they
were purchased, are stronger today than 1 year ago, weaker today
than 1 year ago, or about the same?
Mr. VOLCKER. About the same.
Senator HEINZ. And that's in spite of an economic expansion, in
spite of record earnings by auto companies, for example.
Mr. VOLCKER. Yes.
Senator HEINZ. That seems very odd.
Mr. VOLCKER. You might have seen more improvement by this
time in the recovery against the background that you described. I
think it is a reflection of the unevenness of the recovery.
Senator HEINZ. And where are those weaknesses concentrated?
Mr. VOLCKER. I think without question in the energy area domestically.
Senator HEINZ. Exclusively?
Mr. VOLCKER. No, but a big sector that was affected, not across
the board, but broadly, I think you would certainly say the energy
area. A lot of exploration was done, as you know, on expectation of
sharply higher oil prices and when the oil price trend changed and
those
Senator HEINZ. What other areas in addition to energy?
Mr. VOLCKER. I wouldn't put my finger on any other particular
area.
Senator HEINZ. In your statement you fingered leveraged
buyouts.
Mr. VOLCKER. I don't think they've been a source of great difficulty yet. I was looking ahead; I don't want them or merger activity more generally to be the next source of difficulty. In the real
estate area, we don't have the dramatic change that we had in
energy, but I certainly think things are going on as part of the leveling off of prices that properly dictate caution in that area.
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NEED FOR QUALITY LOANS BY BANKS
Senator HEINZ. So you would disagree with the proposition that
currently banks are making less high-quality loans than they were
at previous stages in other economic expansions?
Mr. VOLCKER. I certainly hope that it is true that the quality is
not deteriorating in that sense,
Senator HEINZ. Well, it's an important question.
Mr. VOLCKER. It is an important question and certainly in our supervisory responsibilities and those of other agencies we should be
encouraging prudent credit practices during this period. We are in
the midst of a recovery. Let me also say that I don't want to suggest that I think the situation is such that everybody moves to the
other side of the boat and becomes so cautious that they don't lend
on anything. What we need is steady prudence in this area.
Senator HEINZ. Mr. Chairman, I sense from your comments that
it would take a considerable amount of time and probably some research, certainly on my part—perhaps on yours, I don't know—to
become more specific about the quality of bank assets and I
wouldn't want to pursue it any further because I am out of time. I
would appreciate it, though, if you could answer hypothetically for
me a question, and I stress it is hypothetical.
If it were true that the loans that banks were making were of
less high quality this year than last or this quarter versus two
quarters ago, would it not also be true that they would be seeking
higher interest rates on those loans in order to compensate for the
lesser quality or higher risk, and would that also not make it true
that they would be willing to go out and bid for deposits more aggressively and thereby drive up interest rates by bidding for those
deposits?
Mr. VOLCKER. Yes, but I don't want to accept the initial premise.
Senator HEINZ. I'm not trying to get you to accept the initial
premise.
Mr. VOLCKER. That could go on without the quality of the loan
deteriorating. That process could go on with perfectly sound and
prudent loans. If there are any temptations to weaken loan standards I want to guard against them. If that danger exists—and I alluded to it—I want to guard against it.
Senator HEINZ. Do you think that there is any danger of it happening? Do you think that banks are trying to sustain the growth
of their earnings on volume, as it were?
Mr. VOLCKER. I think there can be temptations that we should
guard against. I don't want to suggest, on the other hand, that everybody crawl into a hole.
Senator HEINZ. Mr. Chairman, my time has expired. I thank the
members of the committee. What this leads me to conclude is that
we need an oversight hearing sooner rather than later on the oversight capabilities and practices of the supervisory agencies—the
Fed, the Comptroller, the FDIC. I have been troubled, of course, by
the fact that there have been some reports that there were a lot of
warning signs with respect to Continental Illinois in its annual
report. I'm not an expert on bank examination, but I also wonder
about the larger policy question which is whether in fact we are
seeing, with leveraged buyouts being kind of the obvious tip of the
85
iceberg, a a deterioration in the quality of bank loan portfolios in a
time of economic expansion, and what the implications of that are
for interest rates. I do not mean to suggest that that's going to be
the major cause of high interest rates. I think the Federal deficit is
going to remain that.
It would seem to me that we might want to have such an oversight hearing, Mr. Chairman. We can discuss that at another occasion, but I do believe that we have some major questions in this
area both in terms of supervisory capability and, second, in terms
of the effect of present practices in the banking industry on what
in fact they are doing that might impact interest rates adversely.
Thank you.
Senator RIEGLE, I'd like to, if I may, join in expressing a concern
with the Senator from Pennsylvania and join in the request for
such an oversight hearing because I think it would be useful for us
to take a look at that.
The CHAIRMAN. Senator Lautenberg.
Senator LAUTENBERG. Thank you, Mr. Chairman.
Welcome, Chairman Volcker. I'm sorry that I wasn't here to
greet you at the opening of your testimony.
I'd like to start off by reading a quote here from the Brookings
Institution report, "Economic Choices for 1984." It says:
The United States is indulging in a. boom of public and private consumption of
assets both foreign and domestic. Future generations will experience a reduced
standard of living, smaller capital stock and the burden of repaying that foreign
debt.
Would you agree with that?
Mr. VOLCKER. I certainly think we are liquidating our net asset
position, our investment position overseas, yes.
Senator LAUTENBERG. How about the reduced standard of living?
REDUCED STANDARD OF LIVING AVOIDABLE
Mr. VOLCKER. That depends upon a lot of other things happening
between now and then. That refers to a very long-term process and
I would say that is avoidable if we attack the problem now.
Senator LAUTENBERG. It's avoidable you say?
Mr. VOLCKER. Yes. It's avoidable if we take the right actions.
Senator LAUTENBERG. But you believe that it is an avoidable condition, that we can continue to maintain the same essential standard of living that we have now?
Mr. VOLCKER. We are talking about the rate of growth in the
standard of living in all probability, and I think that is a direct
long-term analysis that we're going to continue running budget
deficits of this size, for instance.
Senator LAUTENBERG. So the focus then gets us back to budget
deficits and how we deal with that. The President has indicated
that he wants to reduce the deficit primarily through further cuts
in Federal spending. Last night he effectively ruled out increases
in taxes and I take him at his word. Perhaps you can help me understand what the implication there is. Take the 1985 budget approved by the Senate, endorsed by the administration. The deficit
is $182 billion, total spending is $926 billion. It has 29 percent of
that total coming from defense, nondiscretionary is 17 percent, en-
86
titlements is 46 percent, net interest is 13 percent, and a couple
others offsetting receipts are $49 billion.
Assuming $10 billion in interest savings results from other reductions, it still leaves us $172 billion deficit.
Now where are we going to get the $172 billion without resorting
to further taxes? Do you see any places that we can further cut
spending that you'd like to point to particularly?
Mr. VOLCKER. No, Senator. I think this period, above all periods,
is part of the political process. These are decisions that you gentlemen and the President are going to have to make; you're in the
midst of debating them and I think that's entirely appropriate. All
I would say is that I hope you act as forcefully and as soon as you
can and resolve those differences about the particular approach to
be taken. I expressed a general preference on economic grounds
earlier.
Senator LAUTENBERG. OK. Just to make sure that we're clear on
your recommendation, you want us to act quickly and forcefully. Is
that taking the total picture? Does that include some tax increases?
Mr. VOLCKER. I think arithmetically that depends on what you
can do with the spending.
Senator LAUTENBERG. I guess it's fair to say that we can't save it
totally from spending. You said something earlier in your remarks,
Mr. Chairman, about the fact that taxes as a percentage of GNP
were—did you say at an all-time high or very high?
Mr. VOLCKER. They are fluctuating around the highest levels
they have been. I don't know that they are precisely at an all-time
high now, but they are running now, as I recall, 18 or 19 percent of
GNP, which in peacetime at least, is as high as they have been.
Senator LAUTENBERG. Is there room for more?
Mr. VOLCKER. There's always
Senator LAUTENBERG. Without destroying our economic growth
or substantially impairing the living standards for the coming
years?
Mr. VOLCKER. I can't say that some increase in taxes is going to
destroy living standards. It depends on how you do it. I might just
say—and I don't want to get into the pros and cons of particular
measures—that the possibility of changing the way we go about
collecting taxes, I take it, has been raised as a political issue and
that's another dimension of this thing.
Senator LAUTENBERG. I notice in the report that I read recently
that families in America who have an income of $1 million or more
a year pay an average tax of 17.7 percent. I don't know how many
families there are that make $1 million. I guess there are not a lot,
but it certainly suggests some inequity there when the basic tax
rate is something substantially higher.
Mr. VOLCKER. Total budget receipts, essentially taxes and other
receipts, ran about 18.6 percent last year, 20.2 percent the year
before. The highest figure I see on this table, which runs back to
1964 is 20.8 percent in 1981; it was 20.5 percent in 1969, got down
in the low 18's. We're now estimating about 19 percent this year, so
we're running in that range.
Senator LAUTENBERG. Is that a pure measure by itself? I mean, is
that something that to you indicates we ought not to go any fur-
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ther, that that's as high as it's been and therefore it's plenty to
take out of the economy?
Mr, VOLCKER. All that I've said is that, in general terms, from
the economic standpoint, with expenditures that last year ran 20.7
percent of GNP—a high on this table by a considerable margin—
from the standpoint of the functioning of the private sector in the
economy, you would be better off doing it on the spending side. But
now you have the question of how much you can do on the spending side. That gets into issues that 1 have no competence in. They
are both technical and political issues, and properly so. If you can't
dp it on the spending side, then you've got to look at the revenue
side.
EFFECTS OF LEVERAGED BUYOUTS
Senator LAUTENBERG. You said in your remarks that there is essentially no effect on capital markets of leveraged buyouts and I
think you termed it neutral from the standpoint of real resources
and genera) credit market conditions. Is that right?
Mr. VOLCKER. Looked at very broadly over a period of time, I
think that's correct, yes. It does affect the structure of industry if
there are enough of them.
Senator LAUTENBERG. You said that it affects the structure of individual businesses.
Mr. VOLCKER. If there are enough of them, it can affect the
whole economy.
Senator LAUTENBERG. Well, it seems to me that there are enough
of them to make a big difference. We saw huge investments made
in acquisitions out of capital from the marketplace.
Mr. VOLCKEH. I think that's correct. The figure I cited in my
statement of a reduction in equity at an annual rate of $75 billion
is a startling figure; that we are going down in equity or at least
retiring equity at a time of great economic advance.
Senator LAUTENBERG. So that's a real warning sign, certainly in
terms of the ability of companies and business generally to be able
to finance themselves in the future?
Mr. VOLCKER. That is my concern; yes, sir.
Senator LAUTENBERG. And you also say in your statement that
the supply of funds is not really inexhaustible. Would you think
that there ought to be legislation restraining or restricting some of
these leveraged buyouts in terms of the needs or the interest of the
capital marketplace?
Mr. VOLCKER. I don't think a legislative solution is practical or
desirable from what I see going on now. My major emphasis is that
people should, in loaning the money, appreciate the risks. I think
you can find leveraged buyouts that probably improve the effectiveness and efficiency of the particular unit that's at work; for instance, if you take out part of a big conglomerate or a big company
and from the managers that are actively working on that part of
the company as an independent organization with their own
equity, there may be a particular reward for conducting that portion of the business independently, maybe it will work better. But I
don't think that obviates the need to be cautious about this extremely high degree of leveraging that is involved.
Senator LAUTENBERG. Since there's a discount on the time expiration I noticed by my colleagues, I will take the discount for just 1
minute more.
COMPETITIVE EQUITY IN BANKING
Mention was made here of the deregulation phase that's going on
in terms of banking, and the Continental Illinois problem is one
that's highlighted the worst of the problem, I think, the worst of
the possibilities. There are suggestions of other big institutions
being shaky or in jeopardy and I wonder whether you would want
to comment—or I'd like you to comment—you may not want to—in
terms of whether or not the banking industry would just like to get
out of the loan business and invest in other types of business and
kind of feather their nests that way. I mean, when I see the ad
that Senator Riegle pulled out and I see the suggested return is
higher than the prime rate, I know that there's—I don't know how
many borrowers borrow at prime rate, but there's certainly a problem trying to manage the spread between those to leave enough
left over for the shareholders and the continuing expansion of the
operation. I wonder whether in fact we are not inviting a further
disaster and further problems by permitting the banks to move further. We have made decisions in this committee, a decision I supported, but we ought to be monitoring this situation pretty closely
because I think we may be encouraging the banks who provide an
essential service in our communities to get out of the business and
get into other businesses that look for the moment like easier businesses. Any comment?
Mr. VOLCKER. I think most bankers want to be bankers, and I
think that's healthy and that involves making loans. I think you
find some people in the banking business—maybe I should state it
that way—who see the future lying in other lines of activity.
As you know, the basic philosophy that I have expressed in connection with the legislation is that there is something special about
banking and we can't have a complete mixture of banking and nonbanking business, although I think bank holding companies can legitimately somewhat expand their areas of activity. To the extent
they can do that profitably, it may make for better banks as well
by avoiding or relieving some earning pressure on the bank per se
or an organization more broadly construed. I think that there are
many more competitive pressures on banks today than there were
10 or 20 years ago, and that this leads to the reaction that they
want to get in other areas.
Senator LAUTENBERG. Or abandon some.
Mr. VOLCKER. Or even to abandon them, if you took it in the extreme. Or it might encourage the kind of credit practices that Senator Heinz was concerned about in an effort to make money. In
considering banking legislation, considering banking regulation, we
certainly want to encourage them to do a good job in banking, but
there are lessons for how their competitive position is legitimately
protected, if I may put it that way. There are limits to what nonbanks should be able to do that really is banking, and there should
be a demarcation competitively. That's what this nonbank bank argument is all about essentially; we ought to make a line of demar-
89
cation between the banking sector—with certain functions and
with a strong governmental safety net—and other kinds of business.
Technology advances and those distinctions aren't easy to make,
but there are ways they can be made. The committee is going some
distance toward that in the bill you're dealing with. I still have
some qualms, I must say, as to whether that could not be improved
in some technical aspects in drawing those lines of distinction. For
instance, there's some question just about the definition of a bank.
I fear that the so-called thrift test in that bill may be so loose that
in fact nonbanks could do a banking business in the guise of a
thrift. There's a test in there and I welcome that; I just raise the
question whether the test is set at a level that protects against the
very danger that you may be referring to.
Senator LAUTENBERG. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gorton.
Senator GORTON. Thank you, Mr. Chairman.
Senator Mattingly asked me to ask a question which I find to be
an interesting one and I will start with that.
Chairman Volcker, in your opinion, can the Board maintain
money growth stability within target ranges for the rest of this
year without significant adjustments in bank reserve growth that
could have a substantial impact on interest rates?
Mr. VOLCKER. That depends entirely upon what happens in the
rest of the economy, Senator.
Senator GORTON. What factors?
Mr. VOLCKER. You've got a supply and a demand, so to speak,
and we influence the supply factors. What's left unknown is the
demand factor. We have been aiming to be in those targets. Now if
the demand increases very rapidly because, let's say—a most obvious way is the economy expands very rapidly—you could well get
pressures on interest rates, as we got during the first part of the
year when that happened in terms of money growth and economic
growth. If the economy slows down, you've got quite a different picture.
Senator GORTON. Do you expect a more rapid growth in the economy than we have had in the last 6 months?
Mr. VOLCKER. No.
Senator GORTON. You don't expect that at this point, do you?
LESS GROWTH IN SECOND HALF OF THE YKAH
Mr. VOLCKER. Our anticipation is for less growth in the economy
and I believe that that is likely. I must say that most people believed that was likely 6 months ago too, but I do think that the
probabilities are that the rate of economic growth will be slower in
the second half of the year.
Senator GORTON. On another aspect of the supply and demand of
money, you have expressed a concern, as have many others, with
what can conceivably happen if foreign investors lessened the
amount of money which they are investing in the United States on
the value of the dollar. Obviously some reduction on the dollar's
value may very well be desirable, but I presume that it would tend
to cause inflation or be reflected in inflation, and that reduced cap-
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ital inflows might tend to raise interest rates, partly depending on
how the Board reacted.
If any serious flight from the dollar begins or if foreign inflows
simply slow down considerably, which are you likely to view as the
most serious potential problem—an increase in interest rates or an
increase in inflation?
Mr. VOLCKER. The tendency, as you suggest, would be in both directions; they would be interrelated. There are no easy options for
monetary policy in that kind of a situation.
Nobody is going to worry about fluctuations in the dollar within
the range of the past 6 months or 1 year, but you raise a vulnerability that I just want to emphasize as strongly as I can; the only
way I know of dealing with that vulnerability, constructively, in
terms of what we want to achieve over time, is not have to do so
much financing from abroad. If we reduce that source of pressure,
and if we don't get so much capital inflow
Senator GORTON. By reducing our own budget deficit?
Mr. VOLCKER. Yes, by reducing the budget deficit; I know of no
other way. I think the best way to state the problem of the budget
deficit is by pointing out that vulnerability.
To put it another way, we have succeeded in financing this deficit at quite high interest rates, in an easier way than we otherwise
would have, because we are drawing on foreigners for capital at a
rate of $80 or $90 billion a year. What you're raising is the hypothesis that that's no longer possible at some point. There's no signs of
it diminishing at the moment, and I am not in any way forecasting
it's going to diminish in the near term time horizon. But you have
to ask yourselves whether it can go on forever. We'd better get prepared because it's not healthy in terms of our longer term economic growth and vulnerability.
Senator GORTON. Let me ask you a subsidiary question to that
one. Is inflation divisible in any respect whatsoever. If an increase
in the consumer price index over a period of several months were
due solely to the fact that the value of the dollar was going down
and therefore the cost of imported goods was rising without any accompanying increase in the price of domestically produced goods or
inflationary wage increases, would you view that rather narrowly
caused inflation over a few months differently and less alarmingly
than you would regard an inflation in which there was a very substantial domestic component?
Mr. VOLCKER. If you can make that distinction, I think there
would be grounds for viewing it differently. If you could say that
this is a temporary, once and for all adjustment, I think you would
view it differently. But, of course, the practical problem will be
that in the end you don't divide it up so neatly. You can measure
the import costs and it will certainly affect prices of things directly
competitive with imports; then you get into how that affects pricing more generally, wage trends throughout the economy, and all
the rest.
If you could distinguish and say this is a once and for all adjustment, we've just got to swallow it because the dollar is going to a
new level but from then on the trend is going to be exactly the
same, you would have a much easier problem to handle than if it's
a dynamic process.
91
Senator GORTON, But you don't think that that's easily distinguishable?
Mr, VOLCKER. No. There is something to what you say, but, of
course, it is a dynamic process, where the thread is that one thing
affects another.
The CHAIRMAN. Mr. Chairman, if I could interrupt for a moment,
there is a vote going on and to expedite as rapidly as possible, Senator Gorton will continue and I will leave and go vote so I can get
back as quickly as possible. So when you are completed with your
questions, we'll just recess until we get back.
Senator GORTON. Fine. I do want to ask you one question or
maybe a couple related questions about Continental Illinois. Obviously, at least a significant part of that bank's problem was its
heavy reliance on purchased deposits greater than the $100,000
limit on nominally insured accounts or what we might call scared
money. Can you tell me, or can you find for me if it's not at the tip
of your fingers, how many among our 20 or 25 largest banks have a
significant portion or a portion as large as Continental Illinois of
that kind of assets?
Mr. VOLCKER. The way we kind of arbitrarily measure these
things, purchase money against other money, I think I can tell you
Continental had the largest portion of any major bank, but there is
a spectrum to this, obviously. A few other banks are relatively
close; others are further away. My recollection is Continental was
absolutely at the top of the list.
Senator GORTON. Does this indicate that our deposit insurance
system might be equally ineffective at stopping runs on some of
these other banks which are close to the Continental condition
should they take place and, in turn, does that call for a significant
overhaul of the Federal deposit insurance system in your view?
Mr. VOLCKER. I think there are conceptual problems, practical
problems with the deposit insurance system, simply because of the
passage of time and different attitudes over time—different kinds
of bank financing, as you point out—that will deserve review and
should be reviewed. I don't, myself, think this is the time to introduce significant changes in the deposit insurance system. I think
basically it works pretty well and I would like to think this Continental episode shows that the deposit insurance system interacting
with the Federal Reserve and vice versa is capable of dealing with
these problems and containing them. But there are some issues
that are spotlighted by this situation, spotlighted by some others,
as to what the appropriate guaranteed insurance limits are, and
how failing banks should be dealt with. I think they all are very
relevant questions that should be looked at, and I know that Congress has done at least a little thinking in that area, but I would
also say this is a very sensitive area in terms of psychology so
changes should be introduced with due deliberation. People are familiar with the way the system works now and there's a certain
benefit to familiarity.
Senator GORTON. Thank you. Why don't you take a break. I will
go vote now so we will be in recess until the chairman returns.
[Recess.]
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LACK OP TRUST BY FINANCIAL COMMUNITY
Senator SASSER. The committee will come to order.
Mr. Chairman, last night I watched the President's press conference and he was asked why interest rates were so high and in
effect he said that the financial markets fear a revival of inflation,
and the President indicated that he felt such fears were unjustified
and that they were, if I could quote him, based on a lack of trust on
the part of the financial community.
Mr. Chairman, I'd like to ask you this morning what your experts at the Federal Reserve say about this. What do they think
are the real reasons for the high interest rates?
Mr. VOLCKER. I think that kind of anticipation and concern—I
will speak for myself
Senator SASSER. Well, you are the expert at the Federal Reserve.
Mr. VOLCKER. But I'm not alone in this. The concern about a rebirth of inflation, if I could word it that way, is a factor in markets
and there is concern about reaching capacity levels, so to speak, in
economic growth. There is certainly concern about budgets and the
budget concern is dual. First, there is an immediate impact on the
market obviously. There is also the expectation of a continuing
impact in the market just from the weight of the budget deficit.
Then, there is a great deal of concern—and now I'm getting into an
overlapping factor—that those kinds of budget deficits in a period
of prosperity will themselves have inflationary repercussions and
make it difficult for monetary policy and so forth. There are concerns about the risks involved with the dollar that I was speaking
about with Senator Gorton earlier.
Those combination of factors I think lie behind the uncertainty,
the nervousness, and lack of faith, if you will, that you referred to.
Senator SASSER. So the President is right, then, when he says
there is a lack of trust in the financial community and this arises
because of a fear of inflation that's fueled primarily by a very large
budget deficit. Would that be a fair statement, Mr. Chairman?
Mr. VOLCKER. It is certainly one of the factors in that concern.
Senator SASSER. Let me get into another area that's of some interest I think to the committee. I know it is to this Senator and
you reflected on it briefly here earlier this morning. It was reported yesterday that there will be a $4.5 billion bailout for Continental Illinois, and that this is being concluded between the Federal
Deposit Insurance Corporation and other affected parties.
$3.5 BILLION BAILOUT LOAN
Now central to this bailout is a $3.5 billion loan from the Federal
Reserve Board to the Federal Deposit Insurance Corporation for
the purpose of purchasing the problem loans at Continental.
Now I'd like to have further details about the loan, Mr. Chairman, for the record. Could you spell out the terms of this loan to
the Federal Deposit Insurance Corporation?
Mr. VOLCKER. I think it would be inappropriate for me to describe arrangements that haven't been announced yet and, indeed,
I cannot be sure of until they are finalized.
93
Let me simply say on that particular aspect there is a possibility,
technically, of an assumption by the FDIC of loans that the Federal
Reserve has already made to Continental Illinois.
Senator SASSER. Well, one of the concerns that's been raised, that
I think this is without precedent to my knowledge
Mr. VOLCKER. No, this has been done before.
Senator SASSER. Is it not?
Mr. VOLCKER. No. In several cases where the FDIC has assisted,
either commercial banks or savings banks, the FDIC has assumed a
loan that the Federal Reserve had made before to the institution.
Senator SASSER. In other words, then, in times past the Federal
Reserve Board has loaned the FDIC money with which to purchase
Mr. VOLCKER. I am just going to have to use different words than
you're using. There have been times in the past when the FDIC has
assumed the loan that the Federal Reserve had made to the assisted institution.
Senator SASSEH. But never in this magnitude?
Mr. VOLCKER. No. I don't remember the size of the other ones off
hand.
Senator SASSER. And you're making, if my memory serves me
correctly, a loan to the FDIC that's roughly half the value of the
insurance fund itself?
Mr. VOLCKER. No, no.
Senator SASSER. What is the value of the insurance fund?
Mr. VOLCKER. The figure that sticks in my mind is $16 billion,
something in that neighborhood.
Senator SASSER. I had in mind $6 billion, so I dropped a digit.
Mr. VOLCKER. $6 billion may be the FSLIC, but the FDIC fund is
in the neighborhood of $16 billion.
Senator SASSER. Well, it's been speculated that, reading here
from the New York Times, it says the loan from the Federal Reserve has set a precedent that could point the way in which the
two deposit insurance agencies, the FDIC and the FSLIC, could replenish their strained resources without an act of Congress, without substantially increasing the insurance premiums that they
charge hard-pressed financial institutions.
To your knowledge, does that logic figure in this proposed arrangement, Mr. Chairman?
Mr. VOLCKER. If that kind of arrangement were adopted, it follows a practice that has a number of precedents, as I indicated, and
fairly sizable precedents I'm reminded.
Senator SASSER. Can you recall off the top of your head the previous largest sized transaction of this kind?
Mr. VOLCKER. I can recall because somebody put a note in front
of me. Franklin National Bank, about $1.75 billion when they were
being assisted by the FDIC; Greenwich Savings Bank, a little less
than $'/2 billion; First National of Midland, $600 million.
Senator SASSER. Mr. Chairman, I know that what goes on in the
Federal Open Market Committee is not for public consumption.
Mr. VOLCKER. Let me say that it is for public consumption in the
sense that, with a short delay, we do publish the policy record.
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Senator SASSER. Let me just ask you this question. During the
most recent meeting, was the vote of the Federal Open Market
Committee on monetary policy unanimous?
Mr. VOLCKER. The vote on these long-term targets, yes.
Senator SASSER. So there was no dissension at all on the question
of long-term targets?
Mr. VOLCKER. That's correct.
Senator SASSER. Mr. Chairman, your projections for a rising inflation in 1985 assume no major change in the value of the dollar.
What would happen to inflation if the value of the dollar fell by 20
percent? Would such an outcome be unacceptable to the Federal
Reserve?
Mr. VOLCKER. It's not up to the Federal Reserve to accept or not
accept. We had to make some kind of uniform assumptions for
these projections, and I didn't mean to imply that fluctuations
within the general range of the last 6 months or so, which I think
may have been more than 5 and less than 10 percent between ups
and downs over that period, would be terribly significant. When
you get into the range you're talking about, the kind of question
that Senator Gorton was raising is relevant. It moves in a direction
of increasing inflationary pressures. I don't think there's any question about that.
Senator SASSER. Is it fair to say that the Federal Reserve's
present plans don't assume or allow for a depreciating dollar?
Mr. VOLCKER. I can't say they don't allow for it. We don't plan on
it.
Senator SASSER. You don't plan on it, but you don't close the door
that this could occur?
Mr. VOLCKER. There's a big market out there. We didn't plan on
it appreciating either.
HIGHER INTEREST RATES DANGEROUS
Senator SASSER. Mr. Chairman, yesterday John Fall, the chief
economist of Morgan & Stanley testified before the House on monetary policy and interest rates, and I suspect you have seen the
quote. If you haven't, I will read it.
He said:
The LDC debt problem and the liquidity problems of the U.S. banking system
imply that sole reliance an monetary policy to slow the growth of demand in the
U.S. economy could be dangerous. Pushing interest rates higher in such an environment conceivably could fracture the system and lead to a worldwide recession.
And Mr. Alan Sinai, a vice president of Shearson-American Express, said at the same House hearing:
Numerous LDC's are under pressure. Large U.S. banks are under pressure as well
because the loan repayment and interest burdens are insurmountable for some
LDC's except perhaps through agreement to austerity programs that are politically
unacceptable. Another cyclical rise in interest rates would run the risk of setting off
an international financial crisis.
Well, I know you're concerned about this, Mr. Chairman, and I
might ask you how much weight is given to the problem of the less
developed countries' debt problem in the Fed's discussion of monetary policy?
Mr, VOLCKER. We discuss and evaluate that kind of problem, domestic problems of various sorts. Naturally, one considers all these
kinds of factors and their interrelationship with interest rates. In
terms of the general comments that those gentlemen are making,
in this general line of questioning, there is no doubt in my mind
that working with a different kind of fiscal policy would relieve the
problems faced by monetary policy and make a better overall economic policy, a policy that would deal with some of these sources of
strain and pressure in the only way I believe they can be dealt
with effectively.
Senator SASSER. Is the State Department consulted for its views
on political effects in various less developed countries if there are
further interest rate increases by the Federal Reserve?
Mr. VOLCKER. They are consulted about conditions in those countries. I don't think they are particularly consulted about the specific interest rate question.
Senator SASSER. Mr. Chairman, I'm supposed to hold the fort
here until the chairman gets back. Let me ask one other question.
Mr. Chairman, it's my understanding that a 1-percentage point
increase in U.S. interest rates raises the developing nations' debt
service .by approximately $3 billion. How have recent interest rate
increases affected the ability of the less developed countries to
pay off their debts? Which ones are most adversely affected?
Mr. VOLCKER. The ones that are most adversely affected, quite
obviously, are the ones with the most dollar debt. Of course, those
also happen to be the biggest countries, by and large, so in relative
terms it may look differently. But I would make one comment. It is
a serious problem in terms of the additional cost involved. I think
it's been more important recently psychologically rather than actually. I don't want to minimize the actual impact, but fears of further increases enter into the picture, too, in terms of the psychology of the situation.
I do want to point out the other side of the equation. Our growth
has also been much more rapid than anticipated and that growth
has direct favorable implications for these same countries in improving their export markets and a very healthy influence in terms
of improving that part of the equation.
Senator SASSER. You mean our economic growth in this country?
Mr. VOLCKER. We bring in imports; that directly helps both their
external situation and equally important has helped domestic business.
Senator SASSEH. It doesn't help our deficit problem.
Mr. VOLCKER. It doesn't help our deficit problem. In a sense, it's
part of our deficit problem, but it helps our inflation problem and
it is enormously constructive, both in terms of the external position
of those countries and, as I said, the expansion of export oriented
industries in those countries that have to be part of the fundamental solution.
Looked at in that light, one has to also view the possible impact
of very strong protectionist measures taken here, and whether
we're not undercutting the ability of these countries to undertake
what they have to do over a period of time to have a healthy economy.
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DEBT OF 30 DEVELOPING COUNTRIES AT $400 BILLION
Senator SASSER. According to the International Monetary Fund,
during 1983, about 30 developing countries had *a total debt of approximately $400 billion at the end of 1983. Do you have any projection, Mr. Chairman, of what that debt might be at the end of
1984 and 1985? Would we see it increasing?
Mr. VOLCKER. Increasing at a much slower rate of speed than it
has been increasing. Many of the major borrowers, I suspect, will
not have any increase at all. I think that's quite possible in the
case of Mexico. There may be a decline as some portions of debt get
repaid in the short run.
Senator SASSER. How about Argentina?
Mr. VOLCKER. It should be true of Venezuela. It would not be
true of Argentina as far as I can see. I think it's likely to be true of
Brazil, although that's a country where the rate of debt increase
ought to be significantly lower. Brazil had a great deal of discussion at the time a new money lending package was put together for
that country 6 or 8 months ago—saying it wouldn't last, it was designed to last through the end of this year. Well, all indications are
that it will last. Their external position has been improving faster
than projected. Their current cash position is stronger than was assumed and indeed there are indications of some revival of some
sectors of the economy.
Overall, when you consider at the kind of global figure that
you're looking at, I would expect an increasing amount of debt outstanding—I don't have the figure in mind—but clearly at a slower
rate of speed than those rapid years of the 1970's and early 1980's
when debt was rising too fast to be sustained. The rise for most of
these countries should be consistent with lower relative debt service burdens and less exposure of international banks relative to
their own capital.
If that holds steady, and the bank grows and the country grows
in nominal terms, the debt burden becomes less. We are beginning
to see that process. It's slow so far, but if we are successful and if
countries are successful, it will happen more rapidly over a period
of time. Without an actual decline in the debt or even with some
increases in the debt you will get a relative decline in the debt
burden. If you can combine that with very sizable decline in interest rates, you would have a much different picture.
Senator SASSER. That same argument could be made or that
same rationale could be advanced, could it not, Mr. Chairman, with
regard to our budget deficit here?
Mr. VOLCKER. Obviously.
Senator SASSER. If GNP grows, then our deficit declines.
Mr. VOLCKER. That's right. It could be advanced if it conformed
with the facts, but it doesn't. The debt is rising faster than the
GNP and we are using up external assets and we're turning into a
net debtor, so it doesn't fit the facts.
Senator SASSER. You said earlier that we're liquidating our net
asset position abroad.
Mr. VOLCKER. Yes.
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Senator SASSER. By bringing in foreign capital essentially to finance this deficit. And also our balance-of-payments situation deteriorates even further as we purchase more goods abroad.
Mr. VOLCKER. That is right. I hope that the balance-of-payments
situation does not deteriorate further. There are some signs that it
may be leveling out, but it's leveling out at a very large deficit. The
balance-of-payments situation in part reflects the fact that our
growth is much more rapid than other industrialized countries. It
certainly reflects these problems in the developing countries as you
mentioned. If their growth picked up some abroad, that would be a
factor helping our balance-of-payments situation, but it has indeed
reached a very large deficit.
Senator SASSER. Thank you, Mr, Chairman.
Senator RIEGLE. Could you yield just on that point?
Senator SASSER. I will yield, yes.
Senator RIEGLE. Thank you.
Senator SASSER. I'm going to yield right out the door.
TRADE IMBALANCE LEVELING OUT AT A HIGH LEVEL
Senator RIEGLE. Just to follow through on the point my colleague
from Tennessee was making concerning the trade imbalance, which
you say is leveling out—it may be leveling out, but at a very high
level. It seems to me that with interest rates continuing to rise and
the value of the dollar continuing to go up, putting greater strain
on the underdeveloped countries in terms of paying their bills and
so forth, that they in a sense are being squeezed into a tighter and
tighter corner and they have to maintain their exports which
become imports for us.
It seems to me that we may be caught in a situation here where
if needs be they will have to lower their prices in order to continue
to make the import penetration here simply because they can't
afford to have that item disappear at this point. So I don't know
that anybody has taken the cycle of actions and reactions far
enough out here, but it seems to me that the countries that are
sending in a lot of their goods really can't afford to have our trade
deficit disappear any time soon because it's desperately important
to them.
Mr. VOLCKER. They can't afford to have our import market disappear. We can get more competitive where most of our trade is,
which is with the developed world. But you're right, they can't
afford to have their import markets cut off. You talk about their
pricing. The pricing that's relevant here is in dollars. That does not
suggest that they have to run unprofitable industries at home in
their own currency. They have had large devaluations, so in terms
of their competitive position, it may be good. It does not necessarily
imply that they have to engage in practices of great subsidization
of their internal industry. In fact, we obviously would like to see
that they get that internal industry on a sustainable competitive
basis without a lot of subsidies.
But the declines in the exchange rate make them very competitive. It doesn't mean that the industry is unprofitable at home
when it's attractive in the United States.
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Senator RIEGLE. I'll just leave you with the thought that I'm concerned that the countries that are running the trade surpluses
with us at this point are going to need to maintain those and therefore you could find a whole new element of deflation which we
were talking about earlier in the sense that those trade differentials are ones that other countries would be very reluctant to surrender and I don't know that it's realistic to assume that somehow
magically the whole trade deficit is either going to level off nice
and neatly or work its way down. I'm frank to say I don't see how
that's going to happen.
Mr. VOLCKER. Having the trade deficit level off at this level is
not a wonderful projection; it is a very large deficit.
Senator RIEGLE. That's exactly right.
Mr. VOLCKER. Whether or not the trade balance of particular
LDC's will become bigger or smaller depends upon where they are
now. Mexico and Brazil went through a very sharp cutting of imports; they are going to have to increase their imports as they grow
and they will have appreciable increases in imports. Currently
Mexico is having an increase—not as big as they expected, but a
sizable increase in imports—and I expect that will continue for a
while. But they have got themselves in a position currently of
having a sizable balance-of-payments surplus so they can absorb
some increase in imports and, of course, they are our next door
neighbor and a lot of the imports come from us.
Just to complete the circle—or get out of the vicious part of the
circle that you're referring to—it would be an enormous help to
have lower interest rates.
Senator HECHT. Mr. Chairman, I understand many of the questions that I have have been asked.
Many people say that the Continental failure is the tip of the iceberg reversing the Fed's deflationary course. Specifically, what
impact will the Continental bailout have on the Fed's policy?
Mr. VOLCKER. I don't think it has any basic influence. In a technical sense, when we lend as much as we have lent to Continental
Illinois, it puts reserves into the system and you may get some unevenness in our reserve position, but over time we have the capacity to take back with another hand what we put forward with the
first hand. If you look at that as an isolated incident, it doesn't
have any basic influence on our policy.
Senator HECHT. During one of our previous meetings, I stated
that the feeling of the American people was that the FDIC was
backed up by American taxpayers. You countered that the insurance fund was industry supported and did not represent tax support. When FDIC Chairman Isaac pledged to back up all depositors
regardless of size of their account, didn't this go beyond the reach
of the FDIC's fund and place the U.S. taxpayers in a risk position?
Mr. VOLCKER. One would have to assume that the fund was not
big enough to handle the situation, which I think is contrary to
fact.
PAID $2 DIVIDEND IN 1982 AND 1983
Senator HECHT. I'd like your comments on the Continental Illinois statement of roughly around 1979 or 1980 it became well
99
known that the Penn Square failure in Oklahoma. In 1982 their
earnings per share were $2.12 and they paid out $2 in dividends. In
1983, their earnings were $2.46 per share and they paid out $2 in
dividends.
Do you consider this prudent banking?
Mr. VOLCKER. This is Continental Illinois?
Senator HECHT. Yes.
Mr. VOLCKER. You must be right about 'the figures if you have
them in front of you. I didn't remember them just that way. But,
over time, you obviously can't pay the dividends if you're not earning them.
If the bank or any other company feels that it has a temporary
curtailment of earnings, it might choose to continue the dividend.
Certainly Continental did continue their dividends quite late in the
game here. It turned out it was based on their misapprehension of
how serious the situation was.
Senator HECHT. Shouldn't it have become apparent, though,
when the Penn Square Bank folded up that many of these loans
would be tied into Continental?
Mr. VOLCKER. It was apparent at the time when the Penn Square
thing broke. It was discovered at that time that there was a very
large involvement by Continental and one could argue—and the argument becomes even better with hindsight—that it would have
been better to look at the dividends right then, I think, with hindsight, that's an unassailable argument.
Senator HECHT. I have mentioned to you a couple other times at
our hearings that I felt there was a double standard on banking
where if the small bank had a problem the FDIC would walk in
and curtail dividends. Do you think they were negligent in this
particular case?
Mr. VOLCKER. No, and I don't want there to be any pointing of
the finger at the FDIC. We supervise that holding company and
the question was raised upon a number of occasions.
Senator HECHT. And you did not want to interfere?
Mr. VOLCKER. I think you could conclude from events we did not
feel that we wanted to take an order, an official legal action.
Senator HECHT. Do you regret that now?
Mr. VOLCKER. I don't know. It's a judgment call. Basically, we
don't want to get involved unless we have to in this kind of business decision. As I say, these things are easy to do in retrospect.
You could have easily argued, and they would certainly argue, if
their problems had turned out not to be so serious it would have
been a great mistake, because it would have raised unnecessary
questions; that's what the debate is.
Senator HECHT. If the assets of Continental Illinois would have
been $100 million, do you think the FDIC would have walked in
and stopped the dividend policy on the basis of problem loans?
Mr. VOLCKER. I think you would have to ask them, but I don't
have any particular feeling that they would have necessarily had a
legal order to require that.
Let me say I think there is some misapprehension. The FDIC can
speak for itself, but speaking from the Federal Reserve standpoint—and I suspect it's true of the FDIC—there is a great effort
when a bank gets in difficulty, whether it's big or small, to work
100
with that bank and work in such ways that if it's possible that
bank and banking service is maintained. In some cases that isn't
possible, but very, very few banks—small banks I'm talking about
now—have been closed in a way that the depositors lost money.
This happened in a few instances. In most cases, the amount of
large, uninsured deposits is very small in small banks. That's the
way small banks are. The great bulk of their deposits are legally
insured and in that sense guaranteed. Typically, we don't close
banks at all, but a bank is not closed unless it's insolvent, unless
its assets don't add up to its liabilities. That has not been the case
in Continental Illinois. Typically, when that is the case, there is an
effort to merge that bank into another one, often with FDIC assistance, so the banking services are not interrupted. That has been
the typical way of handling these situations in small banks. Sometimes it's not possible. Penn Square was a case where it was not
possible. It was not a small bank, but it was not possible in that
instance.
Senator HECHT. Many people have accused you of believing that
prosperity causes inflation. Would you comment on this?
Mr. VOLCKER. I don't think prosperity causes inflation. I think
you could have excesses of demand and a relatively fully employed
economy could clearly cause inflation.
Senator HECHT. Mr. Chairman, no further questions.
The CHAIRMAN. Mr. Chairman, back to some more technical type
questions. We discussed earlier the uncertainties in the marketplace and many people have argued that a lot of this uncertainty is
increased by the fact it takes 45 to 60 days for the results or public
release of decisions by the Federal Open Market Committee.
TIMING OF OPEN MARKET COMMITTEE DECISIONS
Why can't the Open Market Committee at least give out to the
public an immediate or relatively immediate summary of its decisions? Do you believe if you did that this could reduce some of the
uncertainties and the speculation that goes on during that 6 weeks
or 2-month period when everybody is trying to guess what you're
doing and making decisions on the basis of their guesses?
Mr. VOLCKER. I think basically—and this is just a judgment I
reach on the basis of my own experience in this area over many
years—it would increase the uncertainty, increase the guessing
about what we are going to do.
The CHAIRMAN. To have a summary of what you've done would
increase the uncertainty about what you have done?
Mr. VOLCKER. Yes, because if that summary is going to be fair
and honest—of course, it might increase the pressure to have a different kind of summary or have them much more frequently—it's
going to discuss various contingencies. It's going to discuss various
considerations that the committee had in mind, and people will
speculate about that and say are these contingencies going to come
about. There's much less confusion in the market about what we're
doing currently. What they really want to know is what we're
going to do next week, or next month, or 3 months from now. By
definition, we can't tell them that. You might have the difficulty
that they think they know more than they do. If we get out there
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and announce things aren't going to change, and then something
changes 2 weeks from now and we draw up another announcement
for the market 2 weeks later saying that things suddenly changed,
they would say, "Well, you double-crossed us. Two weeks ago you
said we haven't changed anything and we bought all these bonds
because you promised things hadn't changed." We don't promise
them a thing, except this is what we're doing until next notice;
that's basically what we do now.
You can go back and look at the old reports and see which ones
would have led to speculation in the market and which ones
wouldn't.
The CHAIRMAN. What's magic about 45 or 60 days?
Mr. VOLCKER. Nothing.
The CHAIRMAN. If you want to play that kind of game, make it
90 days.
Mr. VOLCKER. There's nothing magic about 45 days or 60 days,
and sometimes if we really want to change something we say so.
We say it right then. When we change the discount rate, we say it.
When we change what I would call policy in any basic sense, we
tell them. When we change these targets, we tell them. What we
are not telling them right away is what our tactical changes are—
and I think they are tactical because they are within the context of
the long-range policy that's announced—until we have had another
meeting. There s nothing magic about 45, or 50 days, or 60 days, or
whatever. They are released after the next meeting, so they lose
the speculative interest they would otherwise have because we
have had another meeting in between. It could be a shorter time
period between meetings; the timing is just the vagaries of when
the next meeting is.
The CHAIRMAN. Well, I don't suppose I will ever be here long
enough to understand what I have just heard in context of what
you and I have talked about about releasing weekly aggregates
which everybody agrees cannot be accurate and yet people make
financial decisions based on them.
Mr. VOLCKER. I think you and I agree that we might be better off
not doing that. There are a lot of people who disagree with me. I'm
giving you a rather technical response, I suppose, although I would
argue that it's based on a lot of experience. But to put the other
side of the coin forward, I have no problem when we're changing
what I think of as policy, which obviously is done quite infrequently. We announce policy changes. In October 1979, we announced
one before the market opened, a very large change. We made a special announcement in the fall of 1982 when we deemphasized Ml.
When we announce these targets, we announce them as soon as we
can mechanically and surround them with an explanation, fitting
in with your own schedule.
I think a change in policy, a change in approach, should be announced as soon as it can be explained in context.
The CHAIRMAN. What I'm driving at is—and I have often asked
questions of a technical nature—lag reserve accounting and all
those sorts of things because in the years I've been on this committee I have found that psychology and perception have such an enormous impact on what is going on out there.
Mr. VOLCKER. I agree with you.
102
The CHAIRMAN. And I have not been one who has been critical of
your overall policy. As you well know, I have supported it over and
over again, but I have been highly critical of the technical implementation of that policy. So again, as I continue to hear from a lot
of different people and hear the weekly figures released that
nobody agrees are accurate and people base decisions on them, and
then we have 45 to 60 days in which we wait and have people
making decisions on their speculation, I guess neither one of us
will fully understand the other one on this point. In other words, I
agree with you. I supported your policy. I've supported your reconfirmation, but I still think technically speaking and mechanically
speaking, we could do a better job.
Mr. VOLCKER. I'm not so sure we have any disagreement on the
money supply figures. I think the trouble with your position and
my position on the money supply figures is we can't convince
enough other people.
I would be perfectly happy to publish them less frequently
myself. We do have a technical problem there—technical may not
be the right word. If we are collecting the numbers and people
have all that interest in them, I don't like to sit on them for a few
weeks, simply because there's just too much risk of the figure getting out anyway. We try to maintain confidentiality of these things
and I think our record is very good, but I don't want to put that
kind of a strain on the system.
The CHAIRMAN. Let me change to another subject. Time is fleeting and I apologize for the length of your testimony today, but I
can't control the Senate floor or votes and I believe when I'm finished Senator Riegle is the last questioner, but let me turn to another subject.
LACK OF NATIONAL TREATMENT FOR U.S. BANKS ABROAD
Last fall I introduced legislation that would attempt to secure
more national treatment for U.S. banks operating abroad. I have
not pushed that legislation particularly hard because I wanted
some of these foreign countries who were being particularly discriminatory to our banks while operating in our country with national treatment to see if they would get the message. Some of
them have a little bit. There have been some tokenism out there
with Australia and some of the other countries. But the Treasury
recently released a report on 16 foreign markets indicating a continuing lack of national treatment for U.S. banks in those areas.
So I'm getting to the point where if not enough action is taking
place, I think not only should I push that bill but maybe make it
tougher because of the very unequal treatment by foreign governments of our banks.
What's your opinion of the importance of pushing for national
treatment for U.S. banks abroad?
Mr. VOLCKER. You were thinking in terms of your bill, as I
recall, which puts in reciprocity.
The CHAIRMAN. It would simply require the Comptroller of the
Currency to consider when looking or when about to rule on an application by a foreign bank to consider treatment of U.S. banks in
that country. So, yes; you are correct, it's reciprocity. How do they
103
treat us and if they're not treating us well, maybe we will treat
them the same way.
Mr. VOLCKER. I have some sympathy—and I thought we had
some correspondence on this earlier—with what you're driving at.
The other side of the issue that's pressed upon me is that this
involves very difficult judgments in particular instances; whatever
foreign countries do, it is basically good policy for us to allow
others in to compete on an equal basis with us and, as a practical
matter, you get into a contentious series of questions that are very
hard to evaluate.
I come down on the side of saying I think it is reasonable for this
to be a consideration that should be looked at.
The CHAIRMAN. Well, some of the lines are not hard to draw.
You look at Australia. They have had two reports—a Martin &
Campbell report down there and they've decided to open it up to a
few foreign banks. They have had none. Yet there are Australian
banks that operate in as many as five States that end up having
superior privileges to our own domestic banks which cannot operate across State lines. That is very, very clear and there are other
countries that are doing the same sort of thing, and I see no reason
to grant an Australian bank a permit to operate in five States in
the United States when they allow no retail banking yet of U.S.
banks in Australia.
Mr. VOLCKER. Let me just suggest one kind of problem. We allow
them freedom. In fact, you can argue, in some respects, that foreign banks have more privileges than American banks in the
American market, in terms of interstate banking. We are a very
large market. You can at least raise a question as to whether a
country with a very small banking system, in absolute size, may
wonder whether permitting the full degree of access in their country that we have, let's say, with our very large market, would leave
them with a banking system; we've only got to buy a couple of institutions. Is there any point at which a country in that kind of a
situation might legitimately feel that permitting some foreign competition is one thing, but having foreign banks dominate in the
economy is another? Simply because of absolute size that question
doesn't arise in the same way here, but it does arise in those countries, and that's a difficult issue for me.
The CHAIRMAN. Well, I understand what you're saying, but some
of the cases are so discriminatory.
Mr. VOLCKER. I agree with that.
The CHAIRMAN. We could go a long, long way before we ever
reach any point of dominating there.
Mr. VOLCKER. That's why I've expressed a degree of sympathy for
what you're saying, but I do, in conscience, want to report the arguments that many others have against it.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman. I'm going to shortly
get back into an issue that Senator Hecht was raising a minute
ago, and I want to preface my remarks by saying to Chairman
Volcker that, as you well know, I have great respect for you and
have expressed that many times in many forums and it continues
today. So, when I take exception to something you say, it ought to
104
be against that background of very positive feeling toward you and
the professional way in which you exercise your duties,
But I must say that when I asked earlier the question about how
many banks and S&L's are on the problem list you bypassed that
because that data was not immediately familiar. But I am concerned, as I put that together with some of the responses to Senator Hecht, about the structure of the financial system right now,
both in this country and abroad. I think there are all kinds of red
lights flashing and I think we ought to deal with it with the degree
of seriousness that it deserves. Perhaps we have a stark difference
of opinion on these financial signals and if we do, fair enough. I
want to get that on the record. But I don't want us to, in a sense,
make it appear as if those structural problems are less than they
are.
SUPERVISION OF CONTINENTAL ILLINOIS QUESTIONABLE
I don't think the supervisory job that was done in Continental
Illinois was very good. I think there was an incredible failure of
the supervisory procedure and when I read today, as I do in the
Wall Street Journal, that the Continental Illinois shareholders—
and obviously they must take the major part of the beating here—
that's the nature of common stock holdings—but when I read that
they could receive as little as one-thousandth of a cent for each of
their shares under a Federal plan to bail out the bank, I ask myself
where were the regulators earlier in the game when this kind of
fiasco was developing. It seems to me the oversight procedures
were not at all adequate and the schedule of dividends paid out by
that institution when it was sinking into deeper and deeper difficulty, only increased the problem. It seems to me we need a better
answer for where the supervisors were when this situation was developing because now we find ourselves today with the fact that
the Fed is about to come up with $3.5 billion. I don't know where
that money is coming from, but obviously it's coming from somewhere. It's real money or make-believe money. It's money that's
not going to be available, capital that's not going to be available to
somebody else because it's going to be used in this situation. So,
this is not a cost-free exercise that we are undertaking here by any
means. We've had to suspend the laws again on deposits over
$100,000 and basically hold everybody harmless while setting up a
sort of double standard where somebody invested in the big money
center banks are in trouble, they're treated and protected one way
under the law whereas other people across the country presently
with deposits in excess of $100,000 in smaller institutions presumably are under the same written laws that exist at the moment and
they are not protected. This type of reaction on the part of Federal
regulators creates uncertainty in our financial system to say the
least.
Mr. VOLCKER. Wait a minute, Senator. As I indicated earlier,
with a small bank or large bank, if it's possible, there is an effort
to merge that institution to render assistance and keep the bank
open. In some cases, that's not possible, but it's been done with a
great many small banks as well.
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Senator RIEGLE. Let me ask you this, though. Have there not
been instances in the last couple years where there's been bank
failures where depositors with deposits in excess of $100,000 have
had to take the loss above that figure?
Mr. VOLCKER. There have been some instances of that kind.
Senator RIEGLE. So, we have had on the face of it in a contemporary timeframe that kind of unequal application of the law, have
we not?
The CHAIRMAN. Would the Senator yield?
Senator RIEGLE. Well, I will, but I don't want to digress.
The CHAIRMAN. I have heard this as chairman of this committee,
I get it every place I go from the small banks. Now whatever the
case is, the regulatory failure or nonfailure, with Continental Illinois, let me put it bluntly. That is just a phony charge that we
have singled out one. I get a little bit tired of hearing it. I'm not
singling out you. I'm talking about over and over again because I
sat through as chairman of this committee when there were more
on the trouble list and the S&L's from 1981, and 1982, and 1983
and the vast majority of those were handled exactly the same way
with assisted mergers which not only preserved those over
$100,000, dozens and dozens of them. Dick Pratt, of the Federal
Home Loan Bank Board, he handled more failures in 1982 than in
the entire history of the Federal Home Loan Bank Board combined, and most of them were handled on an assisted basis where
all the depositors, without regard to the $100,000 limit.
So, yes, there are examples, Senator Riegle, where there were
some that were not, but the vast majority were handled on an assisted merger basis, because, believe me, I heard about every one of
them. Every day I would come to work and look at the ones that
Dick Pratt and Bill Isaac were handling on an assisted basis, day
after day after day, and it not only solved all those depositors'
problems, but it saved the FDIC and the FSLIC a great deal of
money. It costs a lot less to go into those assisted mergers than if
they had just gone in and simply said, OK, we bail out everybody
with $100,000 and everybody else loses. The cost of those insurance
funds would have been incredibly more than through the assisted
mergers.
So, pardon me for interrupting, but I don't think it's fair to constantly use Continental Illinois to say that the small guys weren't
protected when the factual record shows that dozens—and dozens—
hundreds were handled on an assisted merger in S&L's and banks
through that period of time.
Mr. VOLCKER. I have some figures in front of me that reflect the
point you're making.
The CHAIRMAN. Before you go on, the clerk will not take that
time from Senator Riegle. Do not deduct my time from Senator
Riegle.
Mr. VOLCKER. There were 10 bank failures in 1980. In seven of
those, deposits amounted to $200 million and were handled by purchase and assumption, in the jargon; three of them with the total
deposit amount of $16 million were closed. I don't know what the
loss was to the depositors but I would guess there wasn't any. The
banks were so small they probably didn't have uninsured deposits
which may be the reason they were closed. In 1981 there were
106
eight purchase and assumptions for a total amount of almost $4 billion; there were two banks closed with a total amount of $48 million. Again, this was total deposits, not uninsured deposits. They
were very small banks. In 1982, 27 purchase and assumptions;
there were 7 closed and that included over $500 million in deposits
because Penn Square was in there. We looked for a way to keep
Penn Square open. The bank, in that case, was much too far gone;
you couldn't do it. That gives you some sense of the situation.
Senator RIEGLE. The point I'm making, although I don't want to
get into a debate on the issue that the chairman of the committee
is raising, is that I think there's a clear failure on the oversight
procedures of the regulatory agencies with respect to Continental
Illinois, and you may disagree, but basically to have to step up with
$3.5 billion right now as part of the rather tortured workout of this
situation, which may or may not succeed over a period of time, represents this type of failure I'm referring to. If proper foresight were
exercised early on—and I'm not speaking of crystal ball-type predictions, just proper regulatory oversight—then we would not now
be forced to come up with such a staggering amount of capital in
order to bail out Continental Illinois. In this sense, I'm concerned
about how many more there may be coming behind it.
Mr. VOLCKER. Nobody is patting themselves on the back. I mentioned earlier that we are the supervisor of the Continental Illinois
holding company, which is fairly small outside the bank. We are
not the primary bank supervisor and I don't intend to direct
my
Senator RIEGLE. I wasn't saying you are.
Mr. VOLCKER. I don't want to direct myself to that question, but I
just want to make a general comment that banking supervision has
a large job to do to keep the system safe and sound. I don't think
you can have a system that's going to guarantee with the kind of
enormous and complex banking system we have—proof against
failure. If you had that kind of system you would smother it absolutely. That's the only way you could get that kind of system.
NEED TO FLAG PROBLEMS EARLY
Senator RIEGLE. You should run a supervisory system to try to
flag these problems before they end up as a disaster as they surely
failed in this case.
Mr. VOLCKER. I agree, we want to look at these problems in the
future. I just want to remind you that I have urged this committee
again and again to consider new banking legislation and the types
of activities, from the safety and soundness standpoint, that banks
and their holding companies should be permitted to engage in.
Senator RIEGLE. I think that's a very important statement and I
share that concern exactly as I've heard you express it before.
Now I think we need to know where the $3.5 billion is going to
come from to bail out Continental Illinois.
Mr. VOLCKER. The $3.5 billion does not disappear from the
system.
Senator RIEGLE. But where does it come from?
Mr. VOLCKER. You're going on a newspaper report which describes a transaction which is certainly under consideration, where
107
a loan of the equivalent amount of $3.5 billion that we already
have made to Continental Illinois would be assumed by the FDIC.
It doesn't involve any new money. It's already been lent.
Senator RIEGLE. Where does that money come from? You take
that money from where in order to allocate it to this purpose
which you have already done?
Mr. VOLCKER. In effect, if we keep our balance sheet in total unchanged upon making that loan, like any other loan we make or
any other discount we make, whether to a commercial bank or
others in very rare instances, the offset in an unchanged monetary
policy would typically be in reduced holdings of Government securities on our balance sheet.
Senator RIEGLE. Take me a step further then. In other words,
where in a sense does the $3.5 billion or so, where has that been
displaced? In other words, somebody else presumably would have
gotten it.
Mr. VOLCKER. If somebody withdrew a deposit from Continental
Illinois, they couldn't replace it. A lot of people withdrew deposits.
We replaced those deposits. At the same time, we sold Government
securities. To simplify the process, the people who take the deposits
out of Continental Illinois buy the Government securities, so
there's no real capital used. There is a reshuffling of different
assets among different holders, but the deposit that was in Continental Illinois in effect ends up in the assets that we sell indirectly;
the deposit is replaced by borrowing from us.
Senator RIEGLE. Well, I guess what I'm trying to understand and
I want to get is an the explanation so that a lay person can understand it.
NO NEW CAPITAL INVOLVED
Mr. VOLCKER. There's no new capital involved here.
Senator RIEGLE. But what I'm asking is this. If we did this, say,
in 10 instances at once so we were not talking about $3.5 billion
but $35 billion, presumably we're not just inventing money that
doesn't really exist. Presumably, that, in a sense is a credit or a
credit equivalent that's being established and used that takes away
from something else.
Mr. VOLCKER. No.
Senator RIEGLE. So you're saying presumably we could get as
many of these as we want without any consequences?
Mr. VOLCKER. It changes the composition of our balance sheet
and it changes the composition of the rest of the world's balance
sheet. Somebody has borrowed from the Federal Reserve; somebody
holds more Government securities; they offset each other.
Senator RIEGLE. So you can make any number of these loans and
basically it's just an accounting transaction and nothing is really
altered?
Mr. VOLCKER. The limits on our ability to make such loans are
very broad, obviously, and by design. The system was designed to
do precisely this. The real limit is only the amount of money we
put on our balance sheet in accordance with the needs of monetary
policy. It's the same money; we just put it out in different form.
108
But we have the concern about the overall amount of money that
goes out.
Senator RIEGLE. Well, it seems to me that one of the many problems here, in addition to bad supervision, is that it appears to me
you're sort of going in two directions at once. On the one hand,
there's some concern about outstanding credit at the present time,
and in this transaction in effect you're giving credit.
Mr. VOLCKER. That's why we pull it back with the other hand.
Senator RIEGLE. I guess what I'm trying to understand is the
degree to which you can continue to do that, the degree to which
you can continue to add these one on top of the other and go in two
different directions at the same time and in a sense say, "don't
worry about it, everything is fine."
Mr. VOLCKER. Let me get to that point in a second, but let me
just try to pin something down here. The operation that we are engaged in in lending to these banks—Continental Illinois in this
case—is the most basic function of the Federal Reserve. It was why
it was founded, to serve as a lender of last resort in times of liquidity pressures of this sort, so that they don't spread through the rest
of the system to innocent parties not involved in Continental Illinois at all; we were founded so that there should be that elasticity
in the system. That's what a central bank is all about, to provide
liquidity in those circumstances. We are just carrying out the most
classic function of a central bank.
To deal with your other question, one could imagine situations in
which the amount of liquidity assistance was great enough, in disturbed enough market situations, that you didn't pull all the
money back. In those circumstances you presumably wouldn't want
to pull all the money back, and that's a difficult judgment to make.
If you have a more generalized kind of liquidity problem, you ought
to be providing more money to the economy. Just how, when and
how much is a difficult concern, but that is again the job of the
central bank.
Senator RIEGLE. It sounds to me, though, as you yourself acknowledged a minute ago, this sort of has you going in two different directions at once.
Mr. VOLCKER. There's no doubt in the immediate sense it has you
going in two different directions at once. In the technical operations you're going in two different directions at once.
Senator RIEGLE. I want to relate this to one other point here and
I'll finish quite quickly. That is, the thrift industry—I asked the
question before as to how many thrifts we have in trouble and how
rapidly that problem is growing, and the sense that I have is we've
got a developing problem there, in addition to the problem of banks
that are in difficulty,
RISE IN INTEREST RATES COULD WIPE OUT THRIFTS EARNINGS
But the thrift industry estimates that for each percentage point
rise in interest rates that it reduces thrift income nationwide at
the level of about $1.2 billion a year, which means that if you take
the 2-percentage point increase in rates that we have had since the
beginning of the year, and if that continues, it will wipe out, if you
will, almost $2.5 billion in thrift earnings that otherwise might
109
occur. If we continue on that track, that's going to more than
eliminate the $310 billion in pretax operating and earnings that
was earned by all the savings and loans in the country last year. In
other words, their aggregate margins are very small to begin with
as they labor back out of the last calamity that they were in.
I'm wondering, as you look at this situation, can you put me at
ease and tell me I ought not to be worrying about this problem
with respect to the thrifts, or do we have a problem developing
here of size and consequence that we'd better pay attention to
rather quickly?
Mr. VOLCKER. I certainly think that is a problem. I mentioned it
in my statement. It follows directly from increases in interest
rates. I think the only question you're left with is how constructively do we deal with that problem? Again, I think the answer is obvious.
Senator RIEGLE. Well, the one thing that I think we need to get
from the Fed and I'd like to ask that this be done, recognizing that
there are a lot of different players in the act, I think we have to
take a look at the financial system and the credit system, the
banks directly involved, the S&L's, and credit unions. I also think
we have to take a look now at the degree to which you have a
rising number of institutions in difficulty, not to the Continental
Illinois degree yet and hopefully not to that degree any time soon,
but the statistics that I have seen show an alarming increase in
problem situations. It seems to me that one thing the Fed ought to
be doing is tracking that, adding it up and trying to in a sense be
able to make some interpretative comment to us about it as to how
big the problem is, the rate at which it's changing, and what steps,
if any, are needed to correct the situation. We need to look at the
deposit insurance system, as well as other factors in addition to
just macroeconomic policy recommendations which obviously need
our careful scrutinization.
Mr. VOLCKER. I agree with you in general. I made some comments about deposit insurance earlier. I just think this piece of legislation before you is a very constructive piece of legislation and I
think it's in the general framework that we talked about in
common. I just repeat that one of my concerns about that legislation is that it recognize precisely the kind of concerns that you're
expressing now, that it gives us the structure in the banking
system that is inherently safe and continues to be safe. I think we
have such a structure, and I think we have a very strong safety net
under it, but the kind of things that you raise should be constantly
reviewed. We do it. I don't think that the number of problem banks
that has already become evident to you is in itself of great significance and I don't keep it on the top of my mind. But we do track
and should track developments in this area.
You cite some trends that I don't think are evident, certainly not
in the degree to which you seem to think. There are more nonperforming loans reported than was the case several years ago, but
they are not on any sharp upward trend, and you wouldn't expect
them to be at this stage of the cycle.
Senator RIEGLE. Well, am I incorrect in believing and being told
that there are roughly 700 banks on the problem list?
Mr. VOLCKER. I don't remember the number on the problem list.
110
Senator RIEGLE. Therefore I infer from your comments that the
figure of 700 is way off the mark.
Mr. VOLCKER. I don't want to infer that. We've got 14,000 banks
in the country. A very small bank on the problem list obviously
doesn't have the same significance as another bank, and the problem list does not imply by any means failure. It doesn't imply they
are on the edge of failure. I don't want to leave that implication at
all.
Senator RIEGLE. Well, the concern I want to express to you is
that we are all focused on Continental Illinois because that's not a
small bank. It's a major bank.
Mr. VOLCKER. There's no question about that.
Senator RIEGLE. It's right in front of us and we're in the process
of the largest bank bailout that I'm aware of in the history of the
country. I am concerned as to how many more may be following
behind it. I see interest rates rising and I see the thrift industry
which has been laboring so hard to keep afloat for the last 3 years
now pushed back to the point where they're coming in for help—I
don't know if they're coming to you or not, but they are certainly
coming to me. There is, in effect a great deal of apprehension from
the thrift industry about the erosion of the small profit margins
they are presently working under and many of them are going
back into problem situations.
Mr. VOLCKER. I am fully conscious of that and all I can say is
that there is a constructive way to deal with this situation, not just
for the thrifts, but for the farmers, for the LDC's, and other sources
of strain in the system. I don't know how you deal with the situation constructively without relieving the borrowing pressure on the
total market that comes from the Federal Government.
CONCERN FOR THE STRUCTURAL STRENGTH OF THE FINANCIAL SYSTEM
Senator RIEGLE. We agree on that. My question is in a different
vein. That is, I think we need to have an analysis of the degree to
which we are pressing against the structural limits that are there
and I don't sense that that work is being done and I'd like to have
it done, I'd like to have somebody at the Fed take a look at the
aggregate problem of bank difficulties, savings and loan difficulties,
and as you say everything is dynamic. We are looking forward. We
are projecting where things are presently taking us. I think a large
part of the apprehension in the financial markets and in the stock
market right now concerns the structural strength of the financial
system, touching on many of the things we've talked about, including the foreign loans and a whole host of other things.
Mr. VOLCKER. We keep all these things under review. We don't
have a nice, neat little report that's going to give you some trend
lines converging at sometime. I don't think that's the nature of the
problem. But if you're telling me we're agreeing upon two things or
three things, I'm perfectly happy to agree. I think we ought to deal
with this general problem that we are talking about, which certainly lies at the source of the interest rate problem which aggravates
all the other problems you referred to.
I don't think there should be any misapprehension out of the
Continental Illinois situation or anything else that we don't have
Ill
the capability of dealing with these particular incidents if and as
they arise. One can always review these situations and we always
try to learn and should learn lessons for the future out of any of
these situations. I would be glad to review what lessons there may
be in this for banking supervision or regulation in the future. I'm
repeating myself, but those lessons are not irrelevant for the legislation before you.
Senator RIEGLE. We might get faster'action on the macroeconomic policy adjustments which you and I agree are needed and needed
now in a major dimension, but if there is a feeling that the structural system is fine and dandy and can take these stresses and
strains and we don't have to worry about that, then that diminishes the likelihood we're going to see the policy actions that we
need to take.
My sense is that the structural problem is now more severe than
it was 6 months ago or 1 year ago.
Mr. VOLCKER. My sense is, if you're that concerned—and your
concern seems to be somewhat exaggerated in my view—you ought
to be out there leading a parade for a budgetary action right now
without worrying about any report from me.
Senator RIEGLE. Well, we're doing that, Mr. Chairman, but what
I'm trying to do today is to ascertain the degree to which you think
there's a structural problem and I basically get the sense that you
don't really have much apprehension in this area and you're certainly entitled to that view. What I still don't have is that I've
asked if the Fed could take a look at this and give us some data so
it isn't just an impressionistic response by either myself or anybody
else.
Mr. VOLCKER. We can give you some data. I'm not sure all that
data is terribly enlightening. You could have wonderful data about
Continental Illinois bank until about June 29, 1982. Apparently
with the benefit of hindsight, it was not very reflective of the situation. The management of that bank won some prizes for being the
best managed bank in the United States.
Senator RIEGLE. I trust they had to give the prizes back.
Mr. VOLCKER. I just suggest that there are intangibles here that
are not susceptible to easy statistical analysis and I don't want to
leave out the intangible of the strength of the safety net that we
have to deal with things of this sort that can arise inevitably and
without much warning.
Senator RIEGLE. I just hope that we don't leave the impression
that the safety net is infinite in size and we can take any number
of failures at once, because I don't think you believe that and I
know I don't believe that and that's what I'm trying to get at.
That's the question: The degree to which we are finding ourselves
with an overall buildup of pressures on the structure which we'd
better pay attention to and we would be well advised to eliminate
rather than just gloss over them.
Mr. VOLCKER. To the best of my knowledge, there were characteristics of the Continental Illinois Bank that were unique. I mentioned that earlier. My memory is about a statistical analysis of reliance of borrowed funds; they were at the top of the list.
The CHAIRMAN. Mr. Chairman, we appreciate your patience. Let
me just say in conclusion that I don't think there is anybody in the
112
regulatory agencies, or on this committee, or in the Congress who
glosses over the problems. My experience is that this is being
tracked on a daily basis and I believe that there needs to be structural changes in the regulatory system for the banks and savings
and loans in this country. That will come. It cannot come until we
decide who's going to be doing what and whether we go to functional regulation or what. That will have to be done over a period of
years. But I think you made a very significant point. We in Congress can point fingers at the regulatory structure. I don't care
what we do with the regulatory structure, the FDIC, the Fed or
anything else, even when you've made some mistakes, even when
hindsight shows maybe in Penn Square the FDIC should have been
there and closed them down earlier.
GOVERNMENT SPENDING MORE THAN IT TAKES IN FOR 40 YEARS
I'm talking about overall regulation. Until Congress gets their
act together, until we come up with some figures, I don't care what
we do with the structure. I don't care what we do with the powers.
The fundamental problem is spending more for the last 40 years
and continuing to do so than we take in. The economy, the savings
and loans, the thrift industry, the banks—how can you tolerate
borrowing more than 70 percent of the net domestic savings of this
country? The problem lies here, among those of us who are elected
to be Senators and Congressmen, no matter how much we may try
to blame somebody else—and I agree with the Senator from Michigan—there is blame to go around other places, but there are some
structural changes we ought to be aware of. We ought not always
be dealing with hindsight. We ought to have more foresight before
these things occur, whether it's Continental, Penn Square, whether
it's the Jake Butcher situation in Tennessee. We can all look back
and we ought to learn from that. So there's a lot of fingers in the
pie that causes these problems, but I just have to state once again
that the fundamental problem—until that is cured—and that is the
matter of this inordinate amount of spending as a percentage of
gross national product, the inordinate buildup of deficits. When
you look at the deficits, what are we carrying—whatever the deficit
is—$180 billion, $125 billion of it is interest on past excessive
spending by the Congress of the United States. You notice I'm not
mentioning Democrats, or Republicans, or Presidents, or anything
else. I'm talking about Congress as an institution. It simply will not
discipline itself. When I go home and spend 3 weeks at home, I try
to get that message across to my people—quit looking for scapegoats everyplace else, just look at your elected representatives,
without regard to their political party, without regard to what they
are running for, and look at their voting record and see if they vote
the way they talk. If they talk about balanced budgets and deficit
reduction and so on, but their voting record doesn't match that,
then get somebody else, regardless of political party. We are the
ones that are responsible basically, with others aggravating the situation.
I think it's fundamental that before we get into the structural
changes which we should do. I agree with the Senator from Michigan. There are a lot of other things we should do. But interestingly
113
enough, who does that relate back to—whether it's the deficit,
whether it's making structural changes, whether it's trying to set
some policy—it's Congress. We're the only ones by the Constitution
given the power to pass laws in this country. No one else is. Others
can interpret them. The Supreme Court can decide whether we are
constitutional or not. But ultimately it lies with us. I don't know
that I ever had any hope for 535 prima donnas, each thinking they
have the individual answers to all the problems of this country if
they could only be a dictator for a few days we would solve it all. I
don't know whether we are institutionally capable, 535 people that
put out press releases, get on TV, and so on—I don't know that we
are capable of coming to grips with some of these problems. It's
much easier to look elsewhere rather than looking inward to the
only body that's given the power to appropriate money and the
power to pass laws in this country.
I appreciate your patience this morning and we will look forward
to 6 months from now. Hopefully, things will continue to improve
and we will have no more Continental Illinois situations.
Senator Mattingly has some additional questions for the record.
Senator Trible was not able to be here and he has some questions.
And I have some additional questions but due to the length of time
I will also submit these for your response for the record. Thank you
very much, Mr. Chairman.
[Response to written questions of Senators Garn, Mattingly, and
Trible:]
[Whereupon, at 12:15 p.m., the hearing was adjourned.]
114
QUESTIONS SUBMITTED BY CHAIRMAN GARN
RE CONTINENTAL ILLINOIS
July 27, 1984
Understanding the delicacy of the current negotiations and
deliberations about Continental Illinois Bank, the press
reports, particularly the New York Times, indicate that
Continental Illinois Corporation creditors may be made
whole by the Government. Is that really true?
2.
Can you give the Committee assurances that the FDIC and Fed
will only be assisting the insured bank and not the holding
company shareholders or creditors?
Answer:
There is apparently some misunderstanding about the
effect of the FDIC transaction on the creditors of Continental
Illinois Corporation
£ "CIC").
The
creditors of
Continental
Bank's holding company are not insured by the FDIC and the FDIC
assurances against loss for depositors and general creditors of
the Continental Bank do not apply to the creditors of CIC.
After the adoption of. the proposed assistance package,
and under the hypothetical circumstance where the Bank would be
closed,
its
assets liquidated,
and
the
holding
company
insolvent, the CIC noteholders could be more senior to that of
the
FDIC
as
stockholder.
a
result
of
the
position of
a preferred
In that hypothetical situation, to the extent
that there is any recovery from the assets of the Bank and the
holding company, these assets
would probably be di stributed
first to the noteholders and
only
preferred stockholder.
then to the FDIC as a
115
In view of the commitments of support to the Bank made
by the FDIC and the Federal
situation
that
practical benefits
capital
to the Bank
to the approach of
through
the holding
providing
company.
Indeed, adopting a different, less effective, capital
could
this
was more hypothetical than real, while there were
substantial
equity
Reserve, it seemed
well
have
hastened
the
result
regulators have sought to avoid.
fact that any successful
incidental
beneficial
on
the
banking
We also took into account the
assistance
effect
which
structure
program
the
CIC
would have
noteholders
some
by
strengthening the Bank.
Nonetheless,
careful consideration was given to the
structuring of the assistance to Continental Bank in the form
of a stock investment in the Bank, rather than through the
intermediary of the holding company which cculd have avoided
even the hypothetical situation described above.
provision
in the indenture governing
However, a
CIC' s long-term
debt,
requiring that the holding company hold at least 80 percent of
the capital
stock of the Bank, made
this course of
impossible in an open bank transaction.
action
All of those involved
on the government side in thi s transact ion concurred
in the
view that an open bank transaction was important in order
to
maximize the possibilities for a successful rehabili tation of
the Bank, minimize the cost to the FDIC, and maintain general
market confidence.
As noted above, we also recognized that no
116
matter how an open bank transaction was structured, CIC's
noteholders would obtain some benefit, if only because the
major asset backing the holding company1s debt to them —
Bank —
the
would be benefited by the FDIC assistance, whatever its
form.
Consideration was also given to making a subordinated
debt investment in the Bank, but with warrants to holding
company
stock, instead
of Bank
stock, thus
limitations of the covenant described
above.
avoiding the
However, this
alternative was also rejected by the FDIC because it could not
be considered as the full equivalent of capital for either
regulatory or market purposes.
The FDIC came to the conclusion that the capital
infusion portion of the assistance to the Bank through the
preferred stock
investment in the holding company providing
rights to 80 percent of the common stock, when combined with
the other elements of the package that gave the FDIC important
management rights and the ability to recoup losses by acquiring
additional stock, was the best way of meeting these twin goals
of protecting the insurance fund while providing the best
opportunity for putting the Bank on a self-sustaining basis.
The Board concurred in this judgment.
In reaching this judgment, careful consideration was
given to the legal issues.
After a full analysis, the FDIC
concluded that it had the authority to take preferred stock in
117
the holding
company and downstream
Reserve board counsel
it to the Bank.
Federal
agreed with this position, as did the
Office of Legal Counsel of the Justice Department.
We are concerned
about
bank holding
company debt
covenants which have the result in this case of circumscribing
the ability of the FDIC to make a direct capital investment in
the Bank.
We are looking
into whether
these covenants are
widespread and what their effect is with a view to taking
appropriate regulatory action to limit their scope
future.
in the
In any event, the assistance program for Continental
Illinois Bank
is not
indicative of a policy
of extending
protection to holding company creditors.
As far as the Federal Reserve assistance is concerned,
the only lending by the Federal Reserve that has occurred has
been with the Bank and not at the bank holding company level.
3.
Why did the FDIC "guarantee" all depositors, whether
insured or not, in the original assistance package?
Answer:
In May, Continental Bank, following a series of events
including
substantial
loan
losses,
confidence in the national and
experienced a
international money
loss
of
markets
where it was obtaining the preponderance of its funding.
Based
on all facts known then and now, the capital of the Bank was
adequate to meet these losses.
appropriate and necessary
Action to sustain the Bank was
to avoid disruption of the banking
118
and financial
system.
This was done
with both liquidity
support and by an injection of capital by the FDIC and certain
banks on a subordinated basis.
PDIC had a clear
operating
interest
Having taken this step, the
in maintaining the Bank
entity by providing
an assurance
of
as an
continuing
operations for depositors and general creditors of the Bank.
In this connection, the FDIC stated:
"In view of all the
circumstances surrounding Continental Illinois Bank, the FDIC
provides assurance
that, in any arrangements that may be
necessary to achieve a permanent solution, all depositors and
other general creditors of the bank will be fully protected and
service to the bank's customers will not be interrupted."
1.
Who else is being guaranteed in this bank that no one wants
to buy?
Answer:
Other than the announced FDIC assistance package and
the liquidity support being provided by the Federal Reserve,
there is no other government assistance for Continental.
D.
Are the Continental Illinois shareholders getting options
in case the stock appreciates while the FDIC takes all the
bad loans?
Answer:
The FDIC assistance package was carefully structured
to provide substantial protection for the FDIC against losses
and to enable it to participate in any increase in value of the
Bank.
The FDIC would take rights to 80 percent of the common
119
stock of the CIC and the remaining 20 percent stake in the
common stock of Continental
Illinois Corporation that would be
held by existing shareholders
would be subject to a so-called
"make whole" agreement, whereby these shares would, in effect,
be turned over to the FDIC under a formula based on the amount
of
losses
the FDIC
Continental Bank.
incurs
on
the loans purchased
from
Under the arrangement, if the FDIC loses
$800 million on the loan
purchase, all of
interest in CIC held by existing shareholders
the
ownership
would be conveyed
to the FDIC, at its option, at the nominal price of $0.00001
per share.
Moreover, any dividends paid by the Bank or CIC
will be held subject to the make whole agreement.
The assistance package proposal also provides existing
shareholders with rights to buy new stock in the Bank at an
initial price of $4.50 per share -- a cost equal to the price
of the FDIC's stock investment —
for a period of 60 days, or
$6.00 per share during the subsequent 22 months.
It should be
noted, however, that these rights, if fully exercised by the
shareholders, would
add an additional $240 million to the
common equity of CIC.
Moreover, in order for the stockholders
to gain on their remaining holdings of CIC stock, the FDIC
would also have a gain on its much larger holdings, thus
helping to offset the risk of loss borne by that agency.
In
this situation, it would be unlikely for the shareholders to
benefit from their rights while the FDIC would be incurring
losses.
120
6.
Do you 3o that in small banks you close?
Answers
Banks
exception
are
only
when
closed
and
liquidated
they
are
insolvent —
almost
without
when
their
liabilities exceed their assets and when circumstances combine
with other severe problems, such as a very high
level of
contingent liabilities due to mismanagement and fraud, so as to
make a purchase and assumption
impossible.
Considered over the
history of the FDIC, bank liquidations with losses to insured
depositors and creditors have not been the normal procedure for
dealing with problem banks.
Normally, a high value is placed
on maintaining banking services regardless of the size of the
bank, consistent with minimizing the cost
fund.
Continental, however,
was
not
to the insurance
insolvent
and
the
shareholders maintain an equity investment with a book value of
about $800 million.
Consequently, the closed bank-liquidation
analogy is not appropriate and the regulators have attempted in
this case to take action which is functionally equivalent to a
purchase and assumption with the same emphasis on
maintaining
banking services while minimizing the cost to the FDIC.
When a bank is closed, small or large, any recovery to
the
shareholders
depends
on whether
remaining after claims have been
package
arrangement whereby
settled.
is any
The
value
assistance
the FDIC obtains rights to 80
percent of the banking organization
there
with the further provision
121
that existing shareholders would, depending on FDIC1s losses,
lose an amount up to their entire
sustained
losses, was
designed
investment if the FDIC
to ensure,
to the extent
practicable, an equitable distribution of risk between
shareholders
and the FDIC.
the
In the Continental case, the
analogy to a closed bank purchase and assumption transaction is
relevant
in the
situation
where
the
FDIC
would
suffer
$800 million of losses on the basket of loans acquired, and the
assistance package deals with this situation in a
manner
similar to that applicable to closed banks in as much as the
shareholders would lose all of their existing investment in CIC.
7.
Are the Continental Illinois Corporation commercial paper
holders getting an FDIC guarantee?
Answer;
No.
of
All of the commercial paper of CIC, from a peak
approximately
$2 billion on
June 30, 1982
(except
for
$20.3 million) has been repaid from the resources of CIC.
Moreover, the FDIC has made it quite clear that its assurances
do not extend to the bank
holding company or any of its
subsidiaries.
8.
Is the FDIC or the Federal Reserve guaranteeing that all of
the bondholders of Continental Illinois get paid?
Answer;
See response to Question 1,
122
9.
If they are, why did the Federal Government cesist
providing these types of guarantees to electric utility
bondholders on Long Island or in New Hampshire? Is this
consistent?
Ans we r_;
As you know, a safety net protecting the liquidity of
depository institutions has long been an established element of
public
policy.
Federal
assistance
Continental Bank; any benefits
has
been
directed
to
for its holding company
were
incident to, and inherent in, protecting the Bank.
10. Critics of granting new powers to depository institution
holding companies continue to assert that the problems of
Continental Illinois Bank argue against the granting of new
securities powers and/or other new powers.
What is your
opinion of these arguments?
An s we r;
The problems of Continental Bank essentially reflect
serious weaknesses in the domestic loan portfolio of a bank
that had engaged in aggressive growth and ler.iing practices for
some
time,
including heavy involvement and participation in
energy loans of the Penn Square bank that failed
ago.
in
two years
These problems, and other credit losses, were reflected
earnings
confidence.
pressures
and
consequent
less
of
market
The problems of" the Bank clearly did not arise
from the nonbanking activities of the holding company and, in
fact, the holding company
was
able to assist the banking
enterprise as a whole in meeting its problems.
We do not believe the problems
Illinois
Bank
argues against
of the Continental
granting new powers
to bank
123
holding companies that can be exercised in a safe and sound
manner
while
providing
consumers
with
competitive and convenient services.
the
benefits
of
We would be concerned if
the additional powers added substantial
risk to the banking
structure as a whole, and this has been a major concern of the
Board during the long
legislation.
and careful review of the
proposed
The new powers that are provided —
revenue bond
underwriting, discount brokerage, underwriting and dealing in
commercial
paper
and
in
residential
mortgage-backed
securities -- are comfortably within the scope of risks that
can be appropriately
taken by bank holding companies.
The
legislation now before the Senate provides a framework which
will help assure that these activities are conducted within the
bounds
of
particular
safe and
sound
emphasis on
financial
the
emphasizes capital adequacy
practices.
structure
of
the
We
put
bill which
and provides the
Board with
sufficient authority to establish the terir<s, conditions and
limitations on which these activities may be conducted.
Because of the close links between the fortunes of a
bank
holding company
demonstrated
in the
and
its
subsidiary
banks
Continental situation,
we
that
are
would
be
concerned about any weakening of these safeguards.
fact,
concerned
about
the
increasing
We are, in
authorization
of
activities for banks by the states that would not, at the
federal level, appear to be suitable for these institutions on
124
safety and soundness grounds and would not be authorized
by
Congress for this reason.
The
Continental
experience also
demonstrates
the
importance of adhering to time tested prudent principles of
banking, and that the inherent risks in this vital business
must
be protected
against
with
adequate
liquidity and diversification of risk.
capital,
ample
125
Responses by Chairman Volcker to the written questions
from Senator Hattingly in connection with the hearing
on July 25, 1984.
1. Chairman Volcker, I agree with your view that we
should expect and encourage adjustment in our external accounts
in the future. However, I am concerned that you might leave the
wrong impressions that we are attracting vast new sums of
capital from abroad. Isn't it actually true that the improvement in our capital accounts is the result of reduced bank
lending, rather than more funds from abroad? Therefore, we
aren't attracting new foreign capital.
Answer:
The growth of the U.S. current account deficit
since 1982 has been accompanied by a sharp reversal in the net
flow of funds from U.S. banks to foreigners.
In a fundamental
sense, the substantial current account deficit indicates that we
are consuming and investing more than we are producing.
The
financial counterpart to this deficit is a net capital inflow
from the rest of the world.
This inflow takes a variety of
forms, both recorded and unrecorded.
It is important, but from
the overall points of view secondary, whether this net capital
inflow is the result of an increase in U.S. liabilities to
foreigners or a reduction in U.S. claims on foreigners.
Looking
simply at the amount of credit available to U.S. residents, a
shift in U.S. banks' lending from foreign to U.S. residents has
close to the same impact as an inflow of new foreign capital
accompanied by no change in bank lending to foreigners.
126
From other standpoints —
including the question of
cause and sustainability -- I agree the composition can be
important.
tiously —
While data in this area must be interpreted cauthere is, for example, a large statistical
discrepancy —
you are right in attributing much of the swing to
reduced bank lending (or depositing) abroad, presumably in
response to changes in relative demands as well as the LDC
problem.
However, there also appears to be sizable continuing
inflows of funds originating abroad.
127
2. The Fed's economic projections in Table I of your
testimony have economic growth settling down to about 3* in 1985
with about 5-1/2% inflation.
However/ the economy has the potential to grow faster
than the long-run trend until full employment is reachedi
perhaps not until 1987.
If the economy grows faster than 3% without inflation
pressure, will the FOMC tend to restrict money growth to slow
the economy? Isn't it true that long-run economic growth is
determined by factors other than monetary policy?
Answer.
No one can be certain how much unused capacity
remains in our economy and how much longer rapid economic expansion can persist before we encounter a resurgence of inflationary pressures.
The forecasts presented in my testimony
represent the best judgments of FOMC members as to economic
growth and price movements next year, given underlying economic
conditions, the likely stance of fiscal policy, and their
decision on monetary policy.
A more favorable outcome, in which
our economy proved capable of sustaining more rapid economic
expansion for some time without generating a pick up of inflation, would be most welcome.
Such an outcome could be
accommodated comfortably within the monetary growth ranges
announced for next year, and the economy then would not only
reach a higher potential sooner, but the price performance would
be a favorable harbinger for sustaining orderly growth.
I do
believe it important that we approach our potential without
generating a renewed inflationary process —
and. indeed with the
128
possibility of making further progress toward our longer-term
objective of stable prices —
so that we can enjoy a prolonged
period of stable growth at full employment.
I agree that monetary policy does not itself determine
the long-run growth of the economy.
Rather, the growth of
potential output depends on expansion of the labor force and
capital stock/ and on gains in the efficiency with which labor
and capital work together —
that is, productivity.
The prin-
ciple role of monetary policy is to foster stable financial and
economic conditions conducive to sustained growth at a high
level.
However, the long-run growth of the economy can be
affected by the way monetary and fiscal policy interact in
pursuit of this objective.
One of my principle concerns with
our current and prospective federal budget stance is that by
absorbing a large proportion of the supply of private saving and
keeping interest rates relatively high, the deficits will tend
to discourage capital investment and thereby constrain the
long-run growth of the economy.
129
ANSWERS TO QUESTIONS SUBMITTED BY
SENATOR TRIBLE
L.
As the primary regulator of bank holding companies, what
role is the Fed playing in the rescue of Continental
Illinois?
As a matter of general background, problems arose out
of the loan losses of the Continental
holding company —
Illinois Bank and its
Continental Illinois Corporation ("CIC") —
was able to provide some assistance to the banking organization
as a whole
in meeting the problems resulting from the Bank.
From its perspective as holding company supervisor, the Federal
Reserve has monitored the condition of the CIC and the role it
has played in assisting the Bank.
In particular, beginning in
July 1982, the Federal Reserve Board staff, as well as the
staff of the Federal Reserve Bank of Chicago
("FRBC")
very
closely monitored the operations of CIC and its subsidiaries,
as well as the progress of the Bank.
The Board obtained periodic reports (either weekly or
daily) regarding the funding of CIC,
the maturity of its
liabilities, major sources of funds, asset composition, trends
in
stock
market prices.
interbank activity.
Federal
Reserve
borrowing, and
The Board and the Reserve Bank staff also
consulted periodically on numerous occasions with the national
bank examiners for the Bank.
In addition, during this period,
the Federal Reserve conducted two full inspections of CIC.
The
130
Federal Reserve in Washington and in Chicago held
numerous
meetings with the senior management and directors of CIC to
discuss their situation and funding needs and obtain frequent
progress reports regarding their operating results and success
in meeting projections.
assets
between
subsidiaries.
CIC
and
The Fed also monitored transfers of
its
banking
and
nonbanking
Prior to May 9 of this year, the Federal Reserve
assisted the Office of the Comptroller of the Currency in the
final examination of the Bank
analysis
and conducted
of the value of CIC's assets.
assistance package, the Federal
an independent
As part of the
Reserve has entered into a
written' agreement with CIC requiring it to establish a plan to
reduce the consolidated assets at Continental to a level that
can be funded on a sustainable basis.
Since the problems of the Bank became apparent, the
Federal Reserve has counseled with other federal agencies on
dealing with the Bank's problems and has participated in the
formulation o£ the Hay 17, 1984
temporary assistance package
and in the arrangements for permanent assistance announced on
July 26, 1984.
In addition, the Federal Reserve has
been
called upon for substantial discount window assistance by the
Bank, and in this connection,
Bank's
activities,
again
Comptroller and the FDIC.
in
has carefully monitored the
full
cooperation
with
the
131
2.
The Chicago Federal Reserve Bank is malting
Continental through the "discount window."
a.
loans' to
"~ •-,
How large ate these loans?
Discount borrowing by all depository
institutions are
disclosed weekly by the Board and borrowings by Federal Reserve
Districts are announced weekly for each Wednesday which is the
end of the statement
week.
Total borrowings
for the week
ending on August 8, 1984 were 47.3 billion, and for the Chicago
District, discount window loans amounted to $6.8 billion.
The
Chicago District amount very closely approximates the discount
window borrowing by Continental Illinois Bank.
The amount has
varied from time to time, but the August 8 figure is the
highest
weekly
amount that has been outstanding for this
institution.
b.
What interest rates do they carry?
The discount window loan by the Federal Reserve Bank
of Chicago to Continental Illinois Bank now carries an interest
rate of 11 percent.
Under regulations established by the
Board, the extended credit borrowing by the Bank normally
carries an interest rate based on the discour.t rate, now at 9
percent, plus Ji gradually increasing surcharge that raises the
applicable interest rate by a total of two percent at the end
of five months.
accelerated.
In the case of Continental, this schedule was
The initial nine percent rate was increased to 10
percent within thirty days, and to 11 percent within another
132
thirty days.
It is intended that this rate will be adjusted
from time to time so that it remains in line with isarket rates.
c.
How do these interest rates compare to rates which
private lenders would charge for the same loans?
The comparable interest rate would be the rate paid by
depository institutions of comparable size for certificates of
deposit.
The 3-month CD rate on August 3, 1984 as compiled by
the Federal Reserve Bank of New York was 11.3 percent.
The
federal funds rate, a measure of cost of funds for overnight
borrowing by large banks, was around 11.5 percent on that date.
d.
What subsidy is being conveyed to Continental by these
loans?
As noted above, the rate being applied to this loan is
based on the discount rate which is now nine percent to which a
2 percent surcharge is applied.
Also as noted above, this
11 percent rate is reasonably close to the prevailing CD rate,
and it is intended that the surcharge would be adjusted from
time to time to maintain a close approximation of the rate
charged on the discount window loan to market rates.
3.
The Fed apparently will lend money to the FDIC to allow
that agency to purchase "troubled loans" from Continental.
a.
What terms will these loans carry?
In an arrangement that is similar to three prior
cases, as part of the fundamental restructuring of Continental
SanJc, the FDIC is assuming Continental's obligation to repay a
portion
of
the discount
window assistance
by the Federal
133
Reserve.
Similar arrangements were adopted in the case of-the
Franklin national Bank in 1974, the Greenwich Ravings Bank in
1981, and the First National Bank of Midland in 1983.
Under
the
agreement,
the
FDIC
would
$3.5 billion of the indebtedness of Continental
Federal Reserve Bank of Chicago.
Bank to the
The FDIC would be required to
make quarterly interest payments.
required to use collections
assume
The FDIC would
also be
(net of the cost of collection}
from the loans and claims acquired
payments of interest and principal.
from the Bank to make
Any remaining principal
would be paid by the FDIC at the end of five years.
The interest rate applicable to $2 billion of the
indebtedness would be the three-month Treasury bill rate plus
25 basis points.
The interest rate applicable to the remaining
$1.5 billion of indebtedness would be the rate determined by
the FRBC to be applicable to advances from the FRBC to the
Bank.
As the Bank exercises its option ever time to transfer
additional loans to the FDIC, the amount of FDIC indebtedness
subject to the former interest rate would be increased by the
amount of loans sold, and the amount of FDIC
indebtedness
subject to the latter interest rate would decrease by the same
amount.
b.
What is the expected budgetary cost of the FDIC loan
purchases?
The budgetary aspects of the loan purchases are a
matter within the particular expertise of the FDIC and would be
most appropriately addressed by that agency.
134
Will these costs be reflected in the unified federal
budget, or will they be "off-budget"?
'"•>
The
same referral
to the
FDIC
would
also be
appropriate for this question,
d.
What subsidy will Continental get from selling its
loans to the FDIC (rather than to the market)? That
is, what will it cost the government to buy "troubled
loans" at book value, rather than at (discounted)
market value?
A portion of the loans to be purchased by the FDIC
will be marked-down substantially from their book value.
The
FDIC intends to purchase loans with a May 31, 1984 book value
of $3.0 billion (face value of over $3.6 billion) for s price
of
$2 billion --
45 percent.
an
initial
discount
In addition, the Bank
has
of
the
approximately
right for a
three-year period to select other loans outstanding on May 31,
1984 with a book value of $1,5 billion and sell them to the
FDIC for $1.5 billion.
If the PDIC purchases the full amount
of loans provided for under the agreement, the discount will
amount to approximately 32 percent.
so-called
This arrangement, plus the
"make whole" provisions of the arrangement which
allows the FDIC to recoup up to an additional $800 million of
any losses on these loans, is calculated to minimize the
possibility of losses to the FDIC as a result of the loan
purchases.
135
4.
The Fed was represented on the Chrysler loan Guarantee
Board. One of the elements of the Chrysler bailout was--Mie
government's receipt of warrants to buy Chrysler stock,
which ultimately reduced the cost of the rescue.
Have any federal regulators considered similar warrants
from Continental in exchange for federal assistance?
The
FDIC
will
receive,
subject
to
shareholder
approval, preferred stock which is convertible into 160 million
shares or approximately
80 percent of Continental
Corporation's common stock.
Illinois
In addition, as noted above, the
PDIC, if it suffers losses on the purchased
loans, would have
the right to the remaining 20 percent of the stock of the
Corporation.
It should also be noted that the government more
than covered the costs of its participation in the Chrysler
loan guarantee program.
As
in the case of Chrysler,
the
government is in a position to benefit from any increase in the
value of the shares of the Corporation.
Would the Fed recommend such warrants?
not?
The
Federal
Reserve
strongly
If net, why
supported
the
arrangements which provided convertible preferred stock to the
FDIC so that it could participate in any gair.s in value of the
corporation to compensate for the risks taken in the assistance
package.
5.
What steps are being taken to minimize the cost of the
Continental rescue to government and taxpayers?
The
arrangements
substantial protections
described
above
indicate
the
that the government has obtained
to
136
protect
increase
its position and to allow it to participate
in value
of
the
corporation.
The
in any
convertible
preferred stock, the "make whole," and the various covenants,
including those which provide the FDIC with certain essential
management rights, assure that the costs of this assistance
package
are minimized, and provide
financial gains.
for the possibility of
It is also important to note that to the
extent there are any costs to the FDIC of the assistance
package, they are borne by the insurance fund, which is made up
of insurance premiums paid by insured banks.
6,
The proposed Continental rescue has been described as
"effective nationalization" of the bank. Do you think that
is an accurate description? If not, why not?
It
is the intention of the agencies to create a
viable, independent bank positioned to continue providing the
full range of services to its customers, particularly those
throughout the midwest.
The FDIC has stated that it will not
interfere with or control the bank's day-to-day operations and
that
it will not
officers, lending
business decisions.
control
or
the hiring
or compensation of
investment policies or other normal
For these reasons, the assistance package
is not an "effective nationalization" and it is not intended
that it should be.
Rather, as soon as practicable, the FDIC
has stated that it intends to dispose of its stock interest in
CIC through the sale to a private investor group, to one or
more banking organizations or to the public in an underwritten
137
offering.
It should
be
emphasized,
of course, that
Continental Illinois banking organization
the.
will be subject
to
supervision and regulation by the Comptroller of the Currency
and the Federal Reserve.
FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1984
TUESDAY, JULY 31, 1984
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
Washington, DC.
The committee met at 9:30 a.m., in room SD-538, Dirksen Senate
Office Building, Senator Jake Garn (chairman of the committee)
presiding.
Present: Senators Garn, Heinz, Hecht, and Humphrey.
OPENING STATEMENT OF CHAIRMAN GARN
The CHAIRMAN. The committee will come to order.
We're continuing today our semiannual hearings on the conduct
of monetary policy.
Last week we had the pleasure of hearing the Chairman of the
Federal Reserve Board, Paul Volcker. This morning, we have the
pleasure of hearing outside witnesses and witnesses from the administration.
First, we're very happy to have William Poole before us this
morning. He'll be the first witness.
Before you start, Senators, do you have any comments you wish
to make?
[No response.]
The CHAIRMAN. Mr. Poole, please go ahead.
STATEMENT OF WILLIAM POOLE, MEMBER, COUNCIL OF
ECONOMIC ADVISERS
Mr. POOLE. Senator Garn, thank you very much. I am certainly
pleased to be here this morning to testify before this committee on
the midyear review of monetary policy.
My statement—and I'll read parts of it—is divided into two
major sections. The first, is on the economic expansion to date, and
the second is on the economic outlook.
My primary purpose is to examine the economic setting within
which present monetary policy decisions must be made rather than
to examine the details of monetary policy itself. The policy details
are very important, but many will fall into place rather naturally
if the underlying policy setting is properly conceived.
PRESENT ECONOMIC EXPANSION
Let's look at the economic expansion so far. The principal facts
of the vigorous recovery following the recession trough in the
(139)
140
fourth quarter of 1982 are well known. In short, we have enjoyed
rapid output growth, declining unemployment, and declining inflation. The controversial topic is not what has happened but why it
happened. The explanation most often offered is that the economic
expansion has been driven by "massive"—in quotes—Federal deficits. But others have expressed the view that the deficit will abort
the recovery. In my opinion Federal fiscal policy has played a very
important role, but the deficit per se has not been especially important in either driving or restraining this expansion.
Before turning to monetary policy I'll begin with comments on
fiscal policy, A key starting point to the analysis of fiscal policy is
that while the budget deficit is important for many purposes, it is
an inadequate summary measure of the impact of fiscal policy on
the economy. The source of the deficit and of changes in it can
make an enormous difference. Changes in Government spending
have different effects from changes in taxes, and the nature of any
spending or tax changes affects the final result.
In the present circumstances, the importance of these general
considerations can be seen quite easily.
Suppose this administration in 1981 had embarked on a program
involving a major expansion of a wide range of spending programs
instead of pursuing a program of tax reductions and expenditure
restraint. Suppose also that the budget deficits in this alternative
fiscal policy had turned out to be about the same as the budget
deficits actually realized so far. Would the economy's performance
been the same as that actually realized?
A negative answer is unambiguously the correct one. The investment boom we are now enjoying would not have occurred. The size
and importance of this investment boom are insufficiently appreciated by many analysts. Since the recession trough, real business
fixed investment has increased by an unusually large magnitude, a
magnitude more than double the typical contribution of business
fixed investment to real GNP growth over the first six quarters of
recovery. Indeed, in the second quarter of this year, real business
fixed investment as a share of real GNP was higher than for any
other quarter for which we have quarterly data since World War
II.
Table I, attached at the end of my statement, provides some additional detail on the composition of output during this expansion.
The first line of the table shows the growth of real GNP at a percent annual rate from 1982 fourth quarter to 1984 second quarter.
In this expansion real GNP has grown at a 7.2-percent annual rate
compared to a 5.9-percent annual rate over a comparable period for
a typical expansion. The importance of business fixed investment
to the present expansion shows up in line 3 of the table. This component has contributed 1.8 percentage points to real GNP growth
this time compared to 0.7 percentage point in a typical expansion.
Rates of return and investment opportunities in the United
States have improved dramatically over the last 4 years, and the
result is not only the investment boom at home but also an inflow
of capital from abroad and a strong dollar. Neither would have occurred without confidence in the future of the U.S. economy.
So far I have said nothing about monetary policy, which is the
focus of these hearings. Monetary policy has made an important
141
contribution to the results we are observing. Without monetary restraint from 1979 to mid-1982 the rate of inflation would not have
declined significantly. The Federal Reserve and the administration
have both emphasized that a disciplined monetary policy is essential to achieving the goal of full price stability, a goal all of us
share.
Now let me examine the outlook over the next few years and
longer. When all the evidence is in we may find that money growth
from mid-1982 to mid-1983 was too high. The future course of the
economy will depend partly on how the economic processes already
underway work themselves out, but future monetary and fiscal
policies will be more important. As for fiscal policy, no one disputes
the necessity of bringing the budget deficit down over time; however the outlook depends very importantly on how the deficit is reduced. The emphasis in deficit reduction should be on controlling
Federal spending. Tax increases rolling back the incentives for the
private economy to invest and grow would not be constructive.
The present investment boom is highly relevant to assessing the
feeling—I emphasize that it's a feeling—of numerous analysts that
this business cycle expansion is too good to last. Some analysts believe that our economy's good news is really bad news.
Before digging into this good news is bad news feeling, let me say
that I know that the time will come when some or many of the incoming economic statistics may appear less favorable. A few bad
numbers will trigger stories that the bad news is arriving, but I
want to emphasize the need for a sense of historical perspective
and for attention to the economic fundamentals that lie behind the
monthly outpouring of economic statistics.
The investment boom and its determinants are one of the fundamentals that must be emphasized when analyzing the good news is
bad news argument.
RAPIDLY RISING TO CAPACITY
Part of that argument is that we are rapidly pressing up to capacity in certain industries and that these industries will soon
become bottlenecks setting off a new round of inflation. Certain industries will, indeed, become bottlenecks unless they add additional
capacity to produce the goods rising in demand.
Table 2 at the end of my statement suggests that investment is,
in fact, being put in place in industries operating at relatively high
capacity utilization rates. For example, for durable manufacturing
as a whole, firms presently plan a 18.6-percent increase in investment expenditures in 1984 compared to 1983. But within the durable manufacturing category, the electrical machinery industry has
planned 1984 investment that is 23V2 percent greater than in 1983,
reflecting the fact that the industry is now operating at a capacity
utilization rate above its 1978-80 peak. Conversely, the steel, stone,
clay, and glass industries expect 1984 investment spending to be
about 9Va percent above the previous year, reflecting the fact that
in these industries the present level of capacity utilization is well
below prior peaks.
In addition to the protection from bottlenecks afforded by the investment boom, the U.S. economy at present can call on idle capac-
142
ity abroad. The economic recovery in Europe has been less vigorous
than ours. Substantial excess capacity exists in many industries.
One reason that maintaining open markets internationally is important to all of us is that International trade provides a mechanism for relieving bottleneck and inflation pressures, should they
arise. And the efficiencies can be enormous. It obviously makes no
sense to build capacity in the United States behind artificial trade
barriers when there is idle capacity abroad, just as it would make
no sense to build more capacity in a particular industry located in
California because some artificial trade barrier prevented idle capacity in New York from being put back to work.
This argument, of course, is completely symmetrical. As can be
seen from line 5(a) in table 1, U.S. exports have been rising since
the recession trough. This fact is a surprise to many who have assumed that the strong dollar is pricing U.S. goods out of foreign
markets. As the recovery abroad picks up momentum, U.S. exports
should grow even more rapidly, promoting additional employment
in the United States and continued growth in U.S. labor productivity.
As with my earlier discussion, this analysis may seem to ignore
monetary policy. Let me now emphasize that our excellent investment climate depends as much on monetary policy as on fiscal
policy. The spur to investment from the Economic Recovery Tax
Act of 1981 [ERTA], depends importantly on low inflation. The real
value of depreciation allowances in the tax law depends on the rate
of inflation which, in turn, depends primarily on monetary policy.
It is no accident that in the late 1970's investment tended to flow
in directions other than to business fixed investment. With higher
inflation, the use of original cost depreciation in the tax laws made
business investment less profitable than it had been in the 1960's.
In the late 1970's, our investment increasingly went abroad, into
land and housing, into precious metals, collectibles, and so forth.
The combination of lower inflation and ERTA has restored the incentive for business investment.
LOWER INFLATION INSPIRES CONFIDENCE
As important as is the measurable effect of lower inflation, a
much less tangible effect, rising confidence, is also at work. Inflation engenders a climate of uncertainty, fears of abrupt changes in
monetary and fiscal policy and of wage, price, and credit controls.
Monetary policy, and expectations about future monetary policy,
play the key role here. Today's investment boom is a vote of confidence that inflation will remain low in the immediate future.
Table 3 provides survey evidence on inflation expectations in the
United States. The top part of the table reports near-term inflation
expectations in the fourth quarter of each year from 1968 through
1977. The bottom part of the table reports both near-term and
longer term expectations for most quarters since 1978, picking up
data on 10-year inflation expectations from a survey started in
1978.
Since 1980, the one-quarter and 1-year inflation expectations
have declined dramatically, more or less in line with the decline in
the actual inflation rate, but the average annual rate of inflation
143
expected over 10 years has not declined nearly as much. Despite
the dramatic decline in actual inflation over the last few years, the
deep 1981-82 recession, and the vigorous recovery accompanied by
further declines in inflation, the 10-year inflation expectation only
fell from about 8V2 percent to about 6% percent. That means that
as of today the price level is expected to almost double over the
next decade.
Why should investors fear an average inflation rate of this magnitude? A little history is needed for perspective here. The rising
inflation from 1965-80 was interrupted by several unsuccessful control efforts. Comprehensive wage and price controls introduced in
1971 failed. Tighter monetary and fiscal policies and the 1973-75
recession had no lasting effect. After these episodes and others,
why should investors believe that the inflation battle is now won,
just because the present rate of inflation is low?
Previous efforts to control inflation failed principally because
monetary policy discipline was relaxed. The problem was not that
monetary policy failed to work as advertised, but that it worked all
too well. Inflationary expansions of money growth did, in fact,
cause inflation.
It would be foolish of me to say that it could never happen again.
With the wrong policies, of course it could happen again. Given the
false starts over the 1965-80 period it is not surprising that the
market is skeptical; however, no one should underestimate the determination of the administration and the Federal Reserve to
pursue noninflationary policies.
What precisely is a noninflationary monetary policy? In my view,
the policy announced by the Federal Reserve in its midyear report
is appropriate. I am pleased to see the renewed emphasis on Ml as
a monetary policy target. I am pleased to see the Ml target range
for next year have an upper limit of 7 percent growth, reduced
from this year's 8 percent upper limit. And I am pleased to see a
more narrow range for Ml growth for next year, a 3-percentagepoint range from 4 to 7 percent growth. I hope that in future years
the Federal Reserve will go even further in the same direction in
each of these policy dimensions.
A monetary policy emphasizing maintenance of steady money
growth within gradually declining money growth targets and a
fiscal policy emphasizing incentives for saving, investment, and
growth will work. As these policies are continued, a time will eventually come when market participants will realize that inflation
will not average 6 percent over the next decade. When that happens, market interest rates will fall, perhaps dramatically.
Now a brief concluding comment. I have sought to emphasize
that the vigorous expansion now in progress should not be greeted
with a good news is bad news reaction. Although intuition should
not be ignored, a vague feeling that there's trouble ahead is not a
good reason to change monetary and fiscal policy. There should be
no attempt to fine tune policy in response to wiggles in monthly
and quarterly data. Concentration on policy fundamentals is what
is needed: A progrowth fiscal policy with a declining budget deficit
and a disciplined monetary policy characterized by gradually declining money growth.
144
If we, in Government do our job, private economy will take care
of itself very nicely, indeed.
Thank you.
[The complete statement follows:]
145
STATEMENT
OF
WILLIAM POOLE
KEfioER
COUNCIL OF ECONCMIC ADVISERS
I am very pleased to have this opportunity to testify
before this Committee on the Midyear Review of Monetary Policy.
My statement is divided into two major sections, the first
on the economic expansion to date, and the second on the
economic outlook.
My primary purpose is to examine the
economic setting within which present monetary policy
decisions
must be made rather than to examine the details of monetary
policy itself.
The policy details are extremely important, but
many will fall into place rather naturally if the underlying
policy setting is properly conceived.
THE ECONOMIC EXPANSION TO DATE
The principal facts of the vigorous recovery following the
recession trough in the fourth quarter of 1982 are well known.
In short, we have enjoyed rapid output growth, declining
unemployment, and declining inflation.
The controversial topic
is not what has happened but why it happened.
The explanation
most often offered is that the economic expansion has been
driven by "massive" Federal deficits.
But others have
expressed the view that the deficit will abort the recovery.
In my opinion, Federal fiscal policy has played a very
important role, but the deficit per se has not been especially
important
in either driving or restraining this expansion.
Before turning to monetary policy I'll begin with some
comments on fiscal policy.
A key starting point to the
analysis of fiscal policy is that while the budget deficit is
146
important for many purposes it is an inadequate summary measure
of the impact of fiscal policy on the economy. The
source of the deficit and of changes in it can make an enormous
difference.
Changes in government spending have different
effects from changes in taxes, and the nature of any spending
or tax change affects the final result.
In the present circumstances the importance of these
general considerations can be seen quite easily.
Suppose this
Administration in 1981 had embarked on a program involving a
major expansion of a wide range of spending programs instead of
pursuing a program of tax reductions and expenditure
restraint.
Suppose also that the budget deficit from this
alternative fiscal policy had turned out to be about the same
as the budget deficit actually realized so far.
Would the
economy's performance have been the same as that actually
realized?
A negative answer is unambiguously the correct one.
The
investment boom we are now enjoying would not have occurred.
The size and importance of this investment boom are
insufficiently appreciated by many analysts.
Since the
recession trough in 1982:IV real business fixed investment has
increased by an unusually large magnitude—a magnitude
more than double the typical contribution of business fixed
investment to real GNP growth over the first six quarters o£
recovery.
Indeed, in the second quarter of this year real
147
business fixed investment as a share of real GNP was higher
than for any other quarter for which we have quarterly data
since World War II.
Table 1 provides some additional detail on the composition
of output during this expansion.
The first line of the table
shows the growth of real GHP at a percent annual rate from
1982:IV to 1984:11.
In this expansion real GNP has grown at a
7.2 percent annual rate compared to a 5.9 percent annual rate
over a comparable period for a typical expansion.
components of real GNP are reported
Six major
in the table; the entries
on lines numbered (1) through (6) add up to total real GNP
growth.
Selected subcomponents are also reported.
The
importance of business fixed investment to the present
expansion shows up in line (3) of the table; this component has
contributed 1.8 percentage points to real GNP growth this time
compared
to 0.7 percentage points in a typical expansion.
Another striking feature of this expansion is the net
export balance.
Many analysts have interpreted the decline in
net exports as a troublesome aspect of this recovery.
While it
is certainly true that the rapid gtowth of imports has produced
some dislocations in import-competing industries, the rising
capital flow to the United States—the counterpart to the
declining net export balance—is a clear sign that investors
have tremendous confidence in the U.S. economy.
dollar is another sign of this confidence.
The strong
148
In short, rates of return and Investment opportunities In
the United States have improved dramatically over the last four
years, and the results include an investment boom at home, an
inflow of capital from abroad, and a strong dollar.
None of
these would have occurred without confidence in the future of
the U. S. economy.
So far I have said nothing about monetary policy, which is
the focus of these hearings.
Monetary policy
has made an
important contribution to the results we are observing.
Without monetary restraint from late 1979 to mid 1982 the rate
of inflation would not have declined significantly.
The
Federal Reserve and the Administration have both emphasized
that a disciplined monetary policy is essential to achieving
the goal of full price stability—a goal all of us share.
I would be remiss, however,
if I did not point out that
the high rate of money growth from the summer of 1982 to the
summer of 1983 was important in propelling the economy forward
over the last six quarters.
But policy-makers in the Federal
Reserve and the Administration recognized that Ml money growth
from mid 1982 to mid 1983 was unsustainably high.
In response,
money growth was reduced in the second half of 1983 and Ml has
remained within its 4 to 8 percent target range in 1984.
Also, Ml growth has been reasonably steady.
constructive developments.
These are
149
THE ECONOMIC OUTLOOK
When all the evidence is in we may well find that money
growth from mid 1982 to mid 1933 was too high; the future
course of the economy will depend partly on how the economic
processes already underway work themselves out. But future
monetary and fiscal policies will be more important than the
lagged effects of past policy actions.
As foe fiscal policy,
no one disputes the necessity of bringing the budget deficit
down over time.
However, the outlook depends very importantly
on how the deficit is reduced.
The emphasis in deficit
reduction should be on controlling
Federal spending; tax
increases rolling back the incentives for the private economy
to invest and grow would not be constructive.
Private investment spending is important not primarily as
a direct stimulus to job creation—jobs can also be created in
industries producing consumption goods—but rather as a
necessary
ingredient to the economic growth process.
In the
long run the economy cannot grow without more productive
capacity.
Moreover, the application of new technology
from the
lab requires that new kinds of capital goods actually be built
and placed in service.
The end result is growing output,
growing labor skills and productivity, and a higher standard of
living.
The present investment boom is highly relevant to
assessing the feel ing--and it is a "feeling"--of numerous
analysts that this business cycle expansion is too good to
last.
Some analysts believe that our economy's good news is
really bad news.
150
Before digging into this "good news is bad news" feeling
let me say that I know that the time will come when some or
many of the incoming economic statistics may appear less
favorable.
A few bad numbers will trigger stories that the bad
news is arriving.
But I want to emphasize the need for a sense
of historical perspective and for attention to the economic
fundamentals that lie behind the monthly outpouring of economic
statistics.
The investment boom and its determinents are one of the
fundamentals that must be emphasized when analyzing the "good
news is bad news" argument.
Part of that argument is that we
are rapidly pressing up to capacity in certain industries, and
that these industries will soon become bottlenecks setting off
a new round of inflation.
Certain industries will indeed become bottlenecks
unless
they add additional capacity to produce the goods rising in
demand.
Table 2 suggests that investment is in fact being put
in place in industries operating at relatively high capacity
utilization rates.
For example, for durable manufacturing as a
whole firms presently plan an 18.6 percent increase in
investment expenditures in 19C4 compared to 1983.
But within
the durable manufacturing category the electrical machinery
industry has planned 1984 investment that is 23.5 percent
greater than in 1983 reflecting the fact that the industry is
now operating at a capacity utilization rate above its 1978-80
peak.
Conversely, the steel and the stone, clay, and glass
151
industries expect 1984 investment spending to be 9.6 percent
and 9.5 percent, respectively, above 1983 levels, reflecting
the fact that in these industries the present level of capacity
utilization is well below prior peaks.
A careful study of this table reveals some apparent
anomolies.
Some of these may be
considerations.
explained, in part, by other
Planned 1984 investment in the motor vehicles
industry is up sharply over 1983 even though present capacity
utilization does not appear especially high.
However,
production facilities for large cars are presently working at
capacity.
Looking farther down the table, utilities investment
appears weak even though capacity utilization at present, at
85.8 percent, is only slightly below the 1970-80 peak of 86.8
percent.
This apparent anomaly is explained by the fact that
there has been excess capacity in this industry ever since the
first oil shock raised energy prices and reduced energy
consumption.
The present utilities industry capacity
utilization rate is far below the 94.9 percent peak in 1973.
In addition to the protection from bottlenecks afforded by
the investment boom, the U. S, economy at present can call on
idle capacity abroad.
The economic recovery in Europe has been
less vigorous than ours; substantial excess capacity exists in
many industries.
One reason that maintaining open markets
internationally is important to all of us is that international
trade provides a mechanism for relieving bottleneck and
152
inflation pressures should they arise.
can be enormous.
And the efficiencies
It obviously makes no sense to build capacity
in the United States behind artificial trade barriers when
there is idle capacity abroad just as it would make no sense to
build more capacity in a particular industry located California
because some artificial trade barrier prevented idle capacity
in New York from being put back to work.
This argument is, of course, completely symmetrical.
As
can be seen from line (5a) in Table 1, U.S. exports have been
rising since the recession trough in 1982:IV.
This fact is a
surprise to many who have assumed that the strong dollar is
pricing U.S. goods out of foreign markets.
As recovery abroad
picks up momentum, U.S. exports should grow even more rapidly,
promoting additional employment in the United States and
continued growth in U.S. labor productivity.
As with my earlier discussion this analysis may seem to
ignore monetary policy.
Let me now emphasize that our
excellent investment climate depends as much on monetary policy
as on fiscal policy.
The spur to investment from the Economic
Recovery Tax Act of 1981 (ERTA) depends importantly on low
inflation.
The real value of depreciation allowances in the
tax law depends on the rate of inflation which, in turn,
depends primarily on monetary policy.
It is no accident that
in the late 1970s investment tended to flow in directions other
than to business fixed investment.
With higher inflation the
use of original cost depreciation in the tax law made business
153
investment less profitable than it had been in the 1960s.
In
the late 1970s, our investment increasingly went abroad, into
land and housing, into precious metals, collectables, etc.
The
combination of lower inflation and ERTA has restored the
incentive for business investment.
As important as is the measurable effect of lower
inflation, a much less tangible effect—rising
confidence--is also at work.
Inflation engenders a climate of
uncertainty—fears of abrupt changes in monetary and fiscal
policy and of wage, price, and credit controls.
Monetary
policy, and expectations about future monetary policy, play the
key role here.
Today's investment boom is a vote of confidence
that inflation will remain low in the immediate future.
I have emphasized the importance of inflation control in
maintaining an environment conducive to stable real growth.
That is, general price stability is not only desirable in its
own right but also because it is so important to growth in real
output and employment.
Unfortunately, the evidence suggests
that the market does not believe that the inflation battle has
been won permanently.
Table 3 provides survey evidence on inflation expectations
in the United States.
The top part of the table reports
near-term inflation expectations in the fourth quarter of each
year from 1968 through 1977.
The bottom part of the table
154
reports both near-term and longer-terra expectations for most
quarters since 1978, picking up data on ten-year i n f l a t i o n
expectations from a survey started in 1978.
As a digression, I might point out that survey evidence is
generally less reliable than evidence derived from a c t u a l
market trading.
M a r k e t evidence on i n f l a t i o n expectations is
available in the U n i t e d Kingdom from the t r a d i n g of
i n f l a t i o n - i n d e x e d government bonds.
No such m a r k e t evidence is
a v a i l a b l e in the Li. S. and so we must rely i n s t e a d on survey
evidence.
Since 1980 the one-quarter
and one-year
inflation
expectations have declined dramatically, more or less in line
w i t h the decline in the actual i n f l a t i o n rate.
But the average
a n n u a l rate of i n f l a t i o n
expected over ten years has not
declined neatly as much.
( U n f o r t u n a t e l y , this survey of
ten-year i n f l a t i o n expectations only started in 1978 and so it
is not possible to compare the recent decline w i t h the decline
in ten-year expectations that must have occurred in the mid
1970s.)
Despite the d r a m a t i c decline in actual i n f l a t i o n over
the last few y e a r s , the deep 1981-02 recession, and the
vigorous recovery accompanied by further declines in i n f l a t i o n ,
the ten-year i n f l a t i o n
expectation only f e l l from about 8.5
percent to about 6.5 percent.
That means that as of today the
price level is expected to almost double over the next decade.
Why should investors f e a r an average i n f l a t i o n
magnitude?
rate of this
155
A little history is needed for perspective here.
The
rising inflation from 1965 to 1980 was Interrupted by several
unsuccessful control efforts.
Comprehensive wage and price
controls, introduced in 1971, failed. Tighter monetary and
fiscal policies and the 1973-75 recession had no lasting
effect.
After these episodes, and others, why should
investors
believe that the inflation battle is now won, just because the
present rate of inflation is low?
Previous efforts to control Inflation failed principally
because monetary policy discipline was relaxed.
The problem
was not that monetary policy failed to work as advertised, but
that it worked all too well.
Inflationary expansions of money
growth did in fact cause inflation.
It would be foolish of me to say that it could never
happen again,
with the wrong policies of course it could
happen again.
Given the false starts over the 1965-SO period
it is not surprising that the market is skeptical.
However, no
one should underestimate the determination of the
Administration and Federal Reserve to pursue noninflationary
policies.
What precisely is a "non-inflationary monetary policy"?
In my view the policy announced by the Federal Reserve in its
Midyear Report is appropriate.
I am pleased to see the renewed
emphasis on Ml as a monetary policy target.
I am pleased to
see the Ml target range for next year have an upper limit of
156
7 percent growth, reduced from this year's 8 percent upper
limit.
And I am pleased to see a more narrow range for ML
growth for next year--a three percentage
percent growth.
point range of 4 to 7
I hope that in future years the Federal
Reserve will go even further in the same direction in each of
these policy dimensions.
A monetary policy emphasizing maintenance of steady money
growth within gradually declining money growth targets and a
fiscal policy emphasizing incentives for saving, investment,
and growth will work.
As these policies are continued a time
will eventually come when market participants will realize that
inflation will not average 6 percent over the next decade.
When that happens market interest rates will fall, perhaps
dramatically.
_Con_clut3ina Comment
I have sought to emphasize that the vigorous economic
expansion now in progress should not be greeted with a "good
news is bad news" reaction.
Although intuition should not be
ignored, a "feeling" that there is trouble ahead is not a good
reason to change monetary and fiscal policy.
There should be
no attempt to fine-tune policy in response to wiggles in
monthly and quarterly data.
Concentration on policy
fundamentals is what is needed: a pro-growth fiscal policy with
a declining budget deficit and a disciplined monetary policy
characterized by gradually declining money growth.
If we in
government do our job the private economy will take care of
itself very nicely indeed.
157
Table 1
Sector^ Contributions to GNP G trow th;_" Typical^ and[Current Recovery
First 6 Quarters
2
Typ teal1 Current
5.9
7.2
3.3
1.0
3 .8
1.4
.7
.9
.7
.1
.5
1.3
.3
1.6
1,2
2 .0
(5) Net Exports
Exports
(5a)
Imports(3)
(5b)
-.2
.3
.5
-1 .5
.5
2.0
(6) Government
(6a) Federal
(6b) Federal Excl. CCC Purchases
(6c) State and Local
.3
-.1
-.2
.4
Real GNP (percent annual rate)
Contributions,
in percentage points:
(1) Personal Consumption Expend.
Durables
(la)
(2)
Residential Structures
(31 Nonresidential Fixed Investment
(3a)
Nonresidential Structures
Producers' Durable Equip,
(3b)
(4)
Change in Business Inventories
.1
-0 .0
.4
.1
Final Sales (percent annual rate)
4.7
5.1
Final Sales adjusted for CCC
Purchases(4) (percent annual rate)
4.6
5.5
(1)
(2)
(3)
(4)
Average of recoveries from 1954II, 1958II, 19611, 1970IV and
19751 recession troughs.
Calculated from 1982IV recession trough.
negative contribution to GNP.
CCC purchases removed because they are inversely related to the
change in business inventories with dollar for dollar offset
for PIK programs.
158
Table 2
Capacity U t i l i z a t i o n and i'JBA Investment Plans
V
ton
June 1984 1978-80 Peak
M anu facturing
Durable m a n u f a c t u r i n g
Steel
Nonferrous
Fabricated M e t a l s
Electrical Machinery
Won elect. M a c h i n e r y
Motor Vehicles
Aircraft
Stone, Clay a.ncl Glass
Nondurable M a n u f a c t u r i n g
Food
Textiles
Paper
Chemicals
Petroleum
Rubber
1984
81..0
87.,5
15.5
81., 3
89.,4
18.6
71.,0 (May)
93,.4 (May)
76.,7
9L.,6
76.,7
85.,1
74.,7
79..1 (May)
97,,5
98,,2
90,,0
90,,6
83..1
94..5
93,,9
90,,4
9.6
10.5
13.9
23.5
12.8
38.9
10.8
9.5
82.,4
67..2
12.7
85.,2
91,,3
95,,1
83,,6
93..0
91,.5
7.5
24.4
16.0
13.5
10.4
17.5
79.,3
85.,7
95..4
72.,6
81,,1
94.,8
(ftpril)
(May)
(May)
(May)
(May)
M i n i ng
75,,9
90,,4
18.1
Utilities
85.,8
86,,8
7.1
Electric
84,, 4
87..0
2_/
Planned I n v e s t m e n t
Pla
Pe r c er^t_Change__
P
V FRB Capacity U t i l i z a t i o n - Release d a t e July 16, 1984
2/ Commerce ( B E A ) Capital Spending Survey - Release date June 11,
1984. Hojninal investment plans reported by business In April ana
May 1984.
159
Table 3
Short and Long-Terin I n f l a t i o n Expectations
(Expre"ssecr as~ AhnuaT~~RaTe~6f ~ C h a n g e 1 '
Average Change over:
Survey
Quarter
One Quarter1
3. 3
3. 1
5. 1
4 Quarters^
10 Years
3. 3
3- 1
1968;IV
1969:IV
1970:IV
1971:IV
1972:IV
1973:IV
1974:IV
1975JIV
1976:IV
1977:IV
3.4
4. 1
6.0
8. 9
5. 8
5. 7
5. 4
3. 6
3. 3
3. 6
5. 2
7. 7
6.0
5. 7
5- 7
1978:111
1978fIV
6. 3
7.4
6. 6
7.0
6, 2
1979:11
1979:IV
8.3
8. 2
7,9
a. 2
6. 8
1980:II
19SO:IV
9. 7
11.6
8. 8
9.6
a. 6
1981:1
1981:11
1981:111
1981:17
9. 7
8.6
8. 7
7. 6
9. 1
8. 8
7. 8
7. 4
8. 3
7. 9
7. 6
7. 7
1982:1
1982:11
1982:III
1982:IV
6. 2
6.2
6. 1
5. 5
7. 1
6.3
5. 9
5.6
7. 2
6.a
6. 7
6. 6
1983:1
1983:II
1983:111
1983:IV
4. 6
4. 3
4. 7
5. 6
5.0
4. a
4.9
5. 4
6. 3
6,6
6. 6
6. 6
1984:1
1984:11
4. 6
5. 5
4. 8
5. 4
6.a
6. 7
8. 8
1
Quarterly National Bureau of Economic Research/American
Statistical Association Survey of Economic Forecasters.
I n f l a t i o n m e a s u r e is the implicit GNP d e f l a t o r .
2
Decision Makers Poll by A. G. Becker Paribus, Inc. Final
survey month shown for indicated quarter if more than one
I n f l a t i o n m e a s u r e is
survey was conducted w i t h i n the q u a r t e r ,
the CPI.
160
The CHAIRMAN. Thank you, Dr. Poole. Last week when Chairman
Volcker was here I discussed some of the mechanics of handling
monetary policy or at least reporting it, as I have done many
times. I spoke to him about two things.
First of all, the weekly release of Ml figures and how everyone
agreed that they were inaccurate yet people based decisions on
them and shouldn't we do away with the weekly reporting and at
least go to monthly. Second, on the delay of 45 to 60 days in releasing of the Federal Open Market Committee's [FOMC] summaries of
their actions, he indicated that there would be too much uncertainty if the summaries were released. I fail to understand that.
All the guessing that goes on during that period of time. It seems
to me that there is a great more uncertainty with people trying to
anticipate what the Fed is doing rather than being told what they
are doing.
What's your feeling about the situation? The weekly reporting,
and then the other side of the coin, that we, at least what I feel,
are inordinate delays and what the FOMC is doing?
Mr. POOLE. Let me preface my remarks by saying that my comments are, of course, personal comments. This is an issue for the
Federal Reserve and Congress. So, my comments are more those of
an academic from Brown University than they are a member of
the administration.
WEEKLY MONEY SUPPLY DATA
First, a comment on weekly money supply data. I do not believe
that the data should be eliminated as long as the data are collected
and calculated by the Federal Reserve and as long as the Federal
Reserve pays some attention to the numbers. Then it is inevitable
that the market would be interested in what those numbers are.
If the data are calculated and used internally but not released,
there would be two kinds of problems. One would be leaks and a
second would be speculation on exactly what the numbers are.
Even putting the leaks aside, there will be many who will try to
calculate from available data what the weekly numbers are. It
would be much better for the Federal Reserve, if it is calculating
them internally, to release them as they do now so that the market
is not making guesses about what the Fed's numbers are.
Second, in terms of reporting FOMC decisions, in my view the essential distinction here is between, on the one hand the FOMC decisions and the reporting of the decisions and, on the other hand
the reporting of the FOMC debate and internal discussions. I think
there is good reason to report decisions promptly. And I mean by
that as quickly as practical after the decisions are reached.
I think there is good reason to delay reporting on internal debates. In fact, the old memorandum of discussion—the detailed
FOMC minutes that were maintained for many, many years and
were released with about a 5-year delay—provides a very accurate
record of FOMC deliberations that has been extremely important
to scholars in their understanding the process. But these discussions may involve a lot of, "what if this happens, what if that happens," and so forth. It's sort of trying out ideas. It's a natural thing
for people to do.
161
If all of that is going to be on the public record immediately,
then, of course, you hold those very important discussions in private rather than in the public meeting. So, I believe that the debates should be reported but with lag. I believe that the actual decisions that are reached should be announced quickly.
The CHAIRMAN. I would agree with that. I certainly didn't mean
to indicate that I thought a detailed reporting of their discussions—I just thought a summary of their decision should be released much earlier than the 45-60 day lag.
The Federal Reserve publishing target growth range is for three
aggregates and monitoring the range of growth in a fourth aggregate. How do we in Congress evaluate the Fed's performance?
There's been a great deal of discussion. Some of their targets sometimes are within, sometimes they're out. In other words, it's a
mixed bag.
There are four aggregates. How should we try and evaluate what
the Fed is doing?
Mr. POOLE. Here, again, let me give you an answer that is an
academic's answer from someone who has followed monetary policy
for many years.
FEDERAL RESERVE SHOULD HAVE SINGLE TARGET
In my view it would be desirable for the Federal Reserve to have
one monetary target, not multiple targets. There is nothing that
would prevent the Federal Reserve, given one target—and, of
course, I would prefer Ml—there is nothing that would prevent the
Federal Reserve from saying that because of other developments,
including the other M's, credit, anything else they want to look at,
that there is reason for departure from the announced target.
That is, all the arguments that the Federal Reserve now uses for
having multiple targets could be used with a single target. But
with a single target the accountability issue would be much more
clear and the Fed's direction of policy would be much more clear.
So, I would favor a single target but with the understanding, of
course, that other considerations might be brought in to explain
why Ml growth is on the upper side or lower side of the target
range, or even under special circumstances departs from the target
range.
The CHAIRMAN. Mr. Savin, who will testify later this morning,
said in his testimony neither the 1982 nor this year's deficit reduction package had any kind of the desired impact as anticipated on
the bond market. Would you agree with him?
Mr. POOLE. The debates here have to do with, of course, first the
size of the interest rate impact of the deficit and, second, the effects on the deficits of those legislative actions which you mentioned.
Let's talk about the most recent example, the Deficit Reduction
Act. I think that the main thing that has happened this year—the
main surprise or unanticipated event—is that the economy has
been much stronger in the first half of this year than people had
estimated or forecast at the beginning of the year.
Fiscal policy has come out more or less as had been anticipated
at the end of last year. Earlier this year I think most betting was
162
that there would be a Deficit Reduction Act of relatively modest
magnitude compared to the size of the deficit, but a real contribution—a downpayment, a step forward. All that was already discounted or included in interest rates at the beginning of the year
and so there was no reason to anticipate that the actual passage of
the act would have a large effect on interest rates.
The big surprise was the very strong economy with very strong
credit demands. I think that's most of the reason why interest
rates are rising this year.
The CHAIRMAN. Senator Exon has introduced a concurrent resolution on monetary policy. The Senate may consider it today or
later this week. It's very brief. I'll just read it to you.
The President in cooperation with the Board of Governors of the Federal Reserve
System, should exercise appropriate authority to ensure that an adequate flow of
credit be available to American farmers at a reasonable rate. American farmers
should be treated no less favorably than foreign borrowers with parallel levels of
risk and through the present cooperation of the Board of Governors, the Federal Reserve System should take noninflationary actions necessary to reduce interest rates
which are currently at levels abnormally above the real cost of money.
Well, this is not unusual. We get several resolutions a year on
the floor of the Senate concerning the Fed and or the President or
both, which I think are usually political statements.
First of all, I don't know how the President does either one of
those because I think there is a glaring omission which the Congress usually leaves out of these resolutions and that's Congress. I
don't know any other body under the Constitution given the authority to appropriate money other than Congress. No President of
the United States ever spent a dime not appropriated by Congress,
Not this President or any other.
So, when I hear about the President's deficit I think we're ignoring the Constitution which specifies where appropriation bills start.
But I suppose we'll pass this overwhelmingly. There may be one or
two or three of us who will vote against a political statement
during an election year, but would you agree there is rather a glaring omission of the Congress of the United States, the only body to
appropriate money, has been left out of this resolution.
It usually is and it apparently has nothing to do with inflationary pressure, or spending, or anything else.
Mr. POOLS, Senator Garn, I don't often disagree with you.
The CHAIRMAN, Thank you. Senator Heinz.
Senator HEINZ. Senator Garn, thank you.
Chairman Poole, I'm going to be rather brief in my questions and
I hope you can oblige in your answers because I have a markup at
10 o clock on the Senate Finance Committee.
In your testimony you cited with some encouraging words that
there seemed to be increases in nonresidential fixed investment
where businesses were investing, and if you want to put my line of
inquiry down as looking for bad news along with good, you're right.
HEALTH OF NET FIXED INVESTMENT
Is it your view notwithstanding the sunny statistics in your
report that net fixed investment is healthy in the United States at
this stage of the recovery? The net fixed investment?
163
Mr. POOLE. It's clear that gross fixed investment is doing very
well,
Senator HEINZ. I understand that.
Mr. POOLE. And that's what's in my tables. Net investment subtracts from gross investment an estimate of the depreciation allowances on the capital stock. Obviously, if we can maintain the strong
gross investment then the capital stock will rise and the economy
will continue to grow so that all of that will show in net investment in a relatively short space of time.
The problem with looking at net investment in the short run is
that there is a cyclical adjustment that is required. That is, we
have some idle capital at present because we're not back to full capacity utilization, just as we're not back to full employment in the
labor market. So, we have idle capital that is still being depreciated but is not now producing.
So, when we put that idle capacity back to work and the idle
labor back to work and we continue to have strong gross investment as a percent of a higher total output, then net investment
will behave very well.
Senator HEINZ. I didn't get the answer to my question. I heard a
lot of discussion and a lot of hypothetical. If, if, if. But, now, would
you please respond to my question?
Mr. POOLE. I believe that the environment is very, very good
right now. Obviously, we can make policy mistakes that will cut
short this expansion.
Senator HEINZ. I guess, let me restate the question specifically as
I asked it.
Is net fixed investment healthy right now? And all you're telling
me that the climate is nice out there and that's not an answer to
my question.
Mr. POOLE. If you look at the net investment number, let's say
for last year, it is lower than the postwar average for net investment. But I believe that it is insufficient to look at that number
alone in a situation such as last year. We don't have these numbers
except on an annual basis. To look at that number for a period like
last year when the economy was operating at a level well below
that justified by the size of the capital stock can be misleading.
Senator HEINZ. You're saying that operating rates should DC influenced by the amount of capital available for investment?
Mr. POOLE. No; I am saying that to judge whether we are making
progress on this dimension of capital formation, the net investment
number—which measures the accumulation of capital, as you correctly point out—needs to be adjusted for the stage of the business
cycle.
Net investment is always low in the recession and early recovery
period. That's no different now. And net investment is always high
in boom times.
Senator HEINZ. Are we having a boom time right now?
Mr. POOLE. I think the economy is doing very, very well.
Senator HEINZ. Most people would say we're having a boom time.
Is it not a fact that the ratio of net investment by business to U.S.
national product right now is low, relative to any other similar
stage of any other recovery we've every had? As a matter of
fact
164
Mr. POOLE. In 1983.
Senator HEINZ. How about through the first quarter of 1984?
Mr. POOLE. We don't really have many detailed numbers by industry for the first quarter.
Senator HEINZ. From what you know about the first quarter or
two?
Mr. POOLE. We know real gross' investment as a share of real
GNP is at a postwar high in the second quarter and that investment has been rising very rapidly.
Senator HEINZ. Let's hope it does. But let me just ask you. You
attempted to answer the question the first time by stipulating that
there were certain areas where operating rates were not as high as
they might have been. And you imply that had operating rates
been higher that net investment would have been higher and
would have been very healthy.
Now, what about net investment in those durable manufacturing
industries you talk about on table 2 which have experienced pretty
healthy operating rates such as electrical machinery. How are we
doing in that investment in the electrical machinery?
Mr. POOLE. Senator, I don't have net investment details in front
of me. All I have are the gross numbers.
Senator HEINZ. Let me try a hypothetical question for you. If it
were true that net investment were lacking, and that the reason it
were lagging is that people were investing in relatively short-lag,
quick fixes with relatively quick paybacks and being rather adverse
to putting any money into any long-term investments in truly new
plant that would get genuine modernization, you have, for all attempts and purposes, to either totally rehabilitate a plant or start
all over again.
You cannot put in computer controls or all the other kinds of
modernization techniques you need without really almost starting
from scratch. If in fact we knew that that was a trend, would you
worry about it?
Mr. POOLE. Of course. But I think that is not the trend.
Senator HEINZ. I understand. I'm not trying to put words into
your mouth. Would that trend suggest to you that we might risk
what some people would probably call deindustrialization. If that
trend which, for the record, I know you do not believe exists were
in fact to exist?
Mr. POOLE. I guess I'm not a fan of that phrase.
Senator HEINZ. Well, you understand it's common language
meaning, nonetheless. It means that we would have less basic industry rather than more. Would you agree with that?
Mr. POOLE. If that's what it is defined to mean, of course.
Senator HEINZ. I would define that as deindustrialization, even
though I understand that you are adverse to the use of the term.
What do we need to do to make sure that that trend which I worry
about and fear exists and which you hope doesn't exist, doesn t
either to the extent that it is defeated and to the extent that it's
here to continue. What do we need to do?
Mr. POOLE. I think the essential thing we need to do is to continue with a fiscal policy and a monetary policy as I emphasized in
my statement, that maintains the incentive to invest which is tied
up with inflation as well, as I emphasized. I would hate to see defi-
165
cit reduction take the form of tax increases that destroy the incentive to invest.
I think that it is particularly for those long lead-time large
projects where utilization might see the biggest impact. In table 1
where we look at the composition of the recovery, you can see in
lines 3a and 3b we've divided the fixed investment into the structures and durable equipment components. The strength in structures investment has been coming along.
Senator HEINZ. This is a pretty odd table, let me tell you. Sector
contribution to growth in real GNP. I don't quite know what that
is. It's an interesting measure and we can figure out what it means
in the real world sometime. I don't know what it means. Except
that there's been some improvement in gross investment which
we've already gone over. That's what it means, doesn't it? It says
very little about net investment.
Mr. POOLE. It's all in gross terms, that's correct.
Senator HEINZ. We know what it means. My time has expired.
But I just want to ask you one question.
TAX INCREASE?
The Democratic Presidential nominee, Mr. Mondale, has said
that he's going to raise taxes as soon as he becomes President, if he
becomes President.
President Reagan has been accused by him of having a tax surprise. Are you going to fight tooth and nail anybody else in the administration who might propose to the President a tax surprise?
Can we count on the Council of Economic Advisers to hang tough
against any tax increase at all next year, is that the position that
you're going to take?
Mr. POOLE. I think that from my statement, it's pretty clear
what my own views are. These are views that I do express within
the administration.
Senator HEINZ. And that is no tax increases?
Mr. POOLE. It seems to me that it would be a mistake to say that
under no circumstances never, never, never will we ever raise
taxes. It seems to me everyone knows that it might be necessary to
raise taxes.
The President has said very clearly that if the day comes when it
is clear that we cannot meet the national priorities that are required to be met through Government, when we cannot meet those
by raising revenues through the process of economic growth, and
we cannot bring the budget into balance or near balance by controlling expenditures, then we will have to raise taxes.
Senator HEINZ. Well, as you look at the budget, the President is
clearly not going to go lower than 5 percent real growth in defense.
That's between interest on the national debt and defense. You're
talking about a very significant proportion of the budget, maybe 45
percent of it.
The appropriated programs have been pretty much cut by the
Appropriations Committee, and when I say cut, I don't mean their
growth has been restrained, I mean they have been cut. And most
people say they can't go any lower on that.
166
So you're up to about 55 percent of the budget. Which leaves 45
percent of entitlements and all those other kinds of programs.
We've got some pretty sensitive kinds of programs in there. How
much would we have to reduce the rate of growth on those entitlement programs for a tax increase not to be necessary?
Mr. POOLE. That, of course, is going to depend also on how far
the economic expansion goes.
Senator HEINZ. Let's be optimistic and say that the forecast of
the Council of Economic Advisers, which is what—3 or 4 percent
real growth over the next several years?
Mr. POOLE. The administration forecast is basically for a 4-percent trend.
Senator HEINZ. Fine. Let's say that 4 percent real growth forever
is a reality. How much are we going to have to slow the growth of
those programs? By what percentage?
Mr. POOLE. I suppose over the span of the next 5 years, if you can
take—I don't have all the arithmetic in my head—but if you can
take—obviously if you can reduce total expenditures by something
in the neighborhood of 5 percent, along with economic growth, you
would be going pretty definitely in the right direction.
Senator HEINZ. If you could reduce the rate of growth.
Mr. POOLE. By 1990, if you could bring those programs in—all
the programs, now, taken together—in the neighborhood of 5 percent less than they are now estimated.
Senator HEINZ. Then they would have been?
Mr. POOLE. That's right.
Senator HEINZ, When you say those programs, you mean the
entire general budget?
Mr. POOLE. Yes.
Senator HEINZ. We all know that most of the budget—when I say
most, I mean more than 50 percent is pretty much untouchable for
the reasons described, so that means you ve got to bring things
about 10 percent less than that part of the budget that previously
was thought to be untouchable. The entitlement programs, is that
right?
Mr. POOLE. If I may make a comment on this argument about
part of the budget being untouchable, let me tell you a little story
if I may.
I had a visit some time ago from an Ambassador from an European country whose government expenditures are up in the neighborhood of 60 percent of the GNP. After we talked about whatever it
was he came to see me about, I said:
Mr. Ambassador, excuse me but let me tell you that from time to time I use your
country as an example of the problems we're going to get into if we do not find a
way of bringing our Government expenditures under control.
He said,
Oh, yes, we're getting things well under control now. If only we could get our
budget down to about 55 percent of GNP by cutting to the bone, we'd be all right.
And I said:
Well, what you call cutting to the bone at 55 percent of GNP would be an extraordinary expansion of Government for us. What is called cutting to the bone depends
entirely on what people have become used to and what the political process has accumulated over a period of many, many years.
167
Senator HEINZ. Just for the record, what is the total portion of
GNP taken by Government and quasi-Government in this country?
Mr. POOLE. Federal, and State, and local together, in the neighborhood of 35 percent, roughly speaking, of which about 25 percent
is Federal.
Senator HEINZ. Thank you. Thank you, Mr. Chairman.
Mr. GARN. Senator Humphrey.
DEFLATION—POSSIBLE CONCERN
Senator HUMPHREY. Thank you, Mr. Chairman. I popped in because I was hoping I would hear something new in the area of
monetary policy. Perhaps I missed some of it but in any case, Mr.
Poole, are you at all concerned, or do you share the concern that
some have that we are entering a period of deflation?
Mr. POOLE. No. I think that that's quite unlikely.
Senator HUMPHREY. But isn't it so that prices of commodities
have been retreating broadly. Is that not something new and significant?
Mr. POOLE. I think it's significant but I don't think it's something
new. For example, we had falling commodity prices in 1967-68 as
the general rate of inflation climbed. Remember that the inflation
that lasted over this whole period after 1965 was really getting
built into the economy in the late 1960's.
What people fear about deflation is generalized deflation accompanied by widespread bankruptcies and unemployment. That's why
the word "deflation" calls up such a nasty image in people's minds.
I just don't see evidence of things moving in that direction.
Senator HUMPHREY. Apart from the personalities involved, what
do you think of the means by which we in this country regulate the
money supply. How would you evaluate it. Is it a good system, is it
working well. What are your thoughts on that subject?
Mr. POOLE. There is ample room for technical improvements to
the Federal Reserve's mechanism of controlling money growth. It's
a subject on which I have written over many years. It's a technical
subject with a wide variety of nitty-gritty features to it.
One problem that the Federal Reserve took care of recently was
the transition from lagged reserve accounting to contemporaneous
reserve accounting. There are other technical issues of about the
same degree of excitement. And I think I should not get started on
that.
Senator HUMPHREY. You say there's ample room for improvement. Do you mean beyond the unexciting little technical changes
that have been made or are you saying there are some more sweeping improvements that you might make?
Mr. POOLE. The main technical change that's been made so far is
the move to contemporaneous reserve accounting. There's been
some improvement in the structure of reserve requirements, movement toward equilization of reserve requirements for different
banks. And that's also helpful.
Senator HUMPHREY. If you were starting up a country from
scratch, what kind of a system would you set up to regulate the
supply of money?
168
Mr. POOLE. I would enter a strong plea for—how shall we put
it—having a somewhat constitutional approach concerning the
monetary powers of the central bank—for finding a way to have
more constraints on the activity of the central bank than we have
now in the Federal Reserve Act.
I think it is worth noting that over our entire history until 1971
it was understood that we would maintain the gold standard. The
view was that the Federal Reserve was committed—the Treasury,
the Government—committed to maintaining the price of gold.
I'm not in favor of the gold standard, but that was an extremely
important external constraint on the powers of Government to control money creation. I believe we need more constraints put back
in, but they have to be well-designed for our modern era.
Senator HUMPHREY. I'm not trying to sharpshoot you here. I'm
just trying to improve my knowledge on this score.
GREATER EXTERNAL CONSTRAINTS NEEDED
You mentioned external constraints. One of the things that bothers me about the way the Federal Reserve works today with respect to monetary policy is that essentially you've got a group of
individual human beings making judgments, groping around in the
fog, using highly imperfect indicators and forecasters. It just seems
illogical to me.
I agree with you that there ought to be, to use your words, external constraints of some kind to replace what is essentially today a
system wholly based on human judgment. Is that not correct? That
in this important and central function we're relying wholly upon a
group of human beings to exercise their judgment. Is that not a
fair statement?
Mr. POOLE. But, let me emphasize that we have been moving—
much less rapidly than I would like—but still there has been some
progress in the right direction. Through the present system of monetary targets announced in advance and reviewed in hearings of
this type, the Federal Reserve is now by law required to announce
monetary targets and to provide an explanation to the Congress
when it departs from those targets.
I believe that if that system became more thoroughly established
in our institutional framework—in the expectations that we have
about central bank behavior—if the Congress would ask harder
questions of the Federal Reserve about departures from its own announced targets, that we would then move in the direction I'm
talking about.
Senator HUMPHREY. Is money a commodity? And, if so, why
should the regulation of money be placed in the hands of a few individuals and removed from the laws of supply and demand, if you
will, or the equilibrium that is usually established by those laws? If
money is a commodity why should it be removed from that process?
Mr. POOLE. Of course, the approach of this administration is to
move as far as we can in the direction of market regulation of the
credit activities of the financial sector as opposed to regulatory
agencies providing the discipline of regulation. The basic reason
why money, in terms of your question, differs from a commodity is
169
that a commodity has a cost of production. Money has a cost of production, quite literally, that involves the cost of printing paper and
it therefore requires some external control.
There is a tremendous incentive for private counterfeiting, for
example.
Senator HUMPHREY. Will you let me interrupt you there. If
money were tied to a commodity then it would lose that distinction
which you just cited. Namely, that the only cost of production is
ink and paper. If it were the counterpart, and exchangeable for
some commodity that had a true cost of production, then would not
that problem be obviated?
Mr. POOLE. That would take care of that problem but would
create other problems, which was the historical experience with
the gold standard. What we're interested in is stabilizing the general level of prices for all goods and services produced in the economy.
If there are significant changes in the relative prices of a particular commodity, caused, for example by discoveries of new gold deposits, then tying money to a particular commodity or even a group
or basket of commodities runs the danger of causing a generalized
price instability because there is nothing that says a particular
commodity is perfectly correlated with all prices in general.
Senator HUMPHREY. I can understand that argument if it's based
upon one commodity or a small number, but if it were based upon
a large basket, would not that problem be largely eliminated?
Mr. POOLE. Historically, and let me again use the gold standard
as an example, historically the relation of paper money to gold was
maintained by central banks and treasuries committing themselves
to buy and sell gold at the fixed price, actually maintaining a store
or hoard of this metal.
Now, when we talk about tying money to a broad basket of commodities, we have a different problem because presumably we are
not going to maintain storehouses full of each of these commodities
so they can be purchased and sold in order to maintain these fixed
relationships.
Senator HUMPHREY. There's got to be a better way. What we
practice today in the way of monetary policy seems to me something akin to witchcraft, sorcery and I just think— I'm hardly an
expert on the subject, as you can tell, but I've just got to believe
that there has to be a better way to do it and one that relies less
upon human judgment and more upon the realities of the marketplace.
I take it your answer to my earlier question, if you were starting
a country from scratch, how would you regulate the supply money?
I take it your answer is essentially the way we are with some fine
tuning or would you do something basically different?
Mr. POOLE. Again, your asking very much a hypothetical question that ignores all traditions and inheritances. But I would try to
put in some kind of a constitutional constraint on the creation of
fiat money, paper money.
Senator HUMPHREY. What would that be?
Mr. POOLE. We could have a directive that would say that the
central bank cannot create fiat money more than 2 or 3 percent a
year or something like that.
170
Senator HUMPHREY. So you're a Milton Friedman?
Mr. POOLE. Actually I was a student of his.
Senator HUMPHREY. Thank you. I see. OK, my time's up.
The CHAIRMAN. Dr. Poole, we thank you for your testimony this
morning and appreciate your willingness to be here.
Next I'd like to call to the witness table Patrick Savin, vice president and capital markets analyst, Drexel Burnham Lambert Inc. of
New York and Dr. A. James Meigs, senior vice president and chief
economist of the First Interstate Bank of California.
Good morning, gentlemen. Dr. Meigs, if you would like to begin.
STATEMENT OF A. JAMES MEIGS, SENIOR VICE PRESIDENT
AND CHIEF ECONOMIST, FIRST INTERSTATE BANK OF CALIFORNIA, LOS ANGELES, CA
Mr. MEIGS. I'm A. James Meigs, senior vice president and chief
economist of First Interstate Bank. I'm also a member of the economic policy committee of the Chamber of Commerce of the United
States.
It's a privilege to appear before you while you're considering
matters of such crucial importance. I'd like to submit a written
statement for the record. It has charts at the end of the statement,
which I hope you will follow along with when I get to them.
HIGH INTEREST RATES EXPECTED
It seems to me that one of the key issues is what the level of interest rates today tells us about expectations in financial markets.
Interest rates are behaving as though investors and borrowers
expect inflation in the future to be high and to stay there for a
long time. This expectation of high inflation persists in the face of
an actual fall in inflation rates.
Mr. Poole referred to this in his testimony.
If people in the markets believed the statements from the leaders
of both political parties, the Senate, the House, the Treasury, and
the Federal Reserve abdut their determination to control inflation—if those were taken at face value—interest rates would be a
lot lower and more stable than they are. So the question is: Why
this behavior? Why are interest rates behaving the way they are?
The second issue, it seems to me, is the risk to financial institutions and other businesses which is imposed by alternating waves
of inflation and disinflation.
The cost of underestimating these risks in the 1970's can be
clearly seen in the recent rise in failures and near failures of
banks, savings institutions, securities firms, and many other nonfinancial corporations. The efforts of investors and borrowers to protect themselves against such risks make it increasingly difficult to
finance long-term investment projects which we need for the
growth and security of this Nation.
The third issue is the Federal budget. We hear a lot about the
problems that Fiscal policy causes for monetary policy. I would just
remind you it's a two-way relationship, and that both fiscal and
monetary policy would be more effective if instability in the other
was to be reduced.
171
So, for your budget problems, monetary policy can make it's
greatest contribution simply by reducing inflation and holding it
down. That would directly reduce the cost of carrying the public
debt. It would help all units of Government to estimate the costs of
programs and to predict revenues.
Now I want to look at and review some of the historical evidence
on these points. Most of this has been before you at other times,
but I think it's interesting nevertheless. So the first chart is on inflation. We show here the percent change of the GNP deflator from
year to year from 1948 through 1984. The narrow bars of the chart
mark recession periods. And the projections for 1985 through 1989 I
put on just to illustrate some possibilities. Those are not forecasts.
What stand out in the chart are three phases. The first phase
from the end of World War II to the early 1960's, was a downward
trend in inflation, with some wide swings. Then, starting in the
1960's, about 1964, we have this upward rollercoaster of inflation
rates. So that's the second phase. Then the third phase is the fall of
inflation that we've just seen, which is a sharp fall, the biggest one
in many years. This phase has been very brief.
Now, many people are tempted to conclude that inflation has
been vanquished for all time, judging by what has happened in the
last couple of years. So, many economists and some officials are annoyed and surprised that financial markets do not believe that inflation is no longer a problem.
I would suggest to you that one of the reasons for this is that
people in financial markets look for repetitive patterns in market
behavior. We can certainly see a repetitive pattern in this chart,
the upward rollercoaster. Most financial managers in business
today have never seen anything except that upward rollercoaster.
So it would be natural for them .to think that this is going to continue.
They really have two fears. One is the direct fear of inflation, of
what inflation does to corporations and consumers. Second, they
fear the effects of Federal Reserve efforts to control inflation,
which many people expect would mean a recession, and higher interest rates for a time because on that chart each time that inflation came down, it was accompanied by a recession.
So, I think the question we should address is this: Is inflation
still on the upward rollercoaster, which would mean we have just
had a brief respite, or is it on a downward trend, as in the 1950's?
That would be a highly desirable development for the future of the
world.
Then, if we look for ways to break that upward trending cycle of
inflation and interest rates, it seems to me the use of monetary targets as required by the Humphrey-Hawkins Act, is the principal
candidate, the one thing that would really work. So, I think that is
where this committee has a responsibility and an opportunity,
through your power of oversight, to ask the hard questions that
Mr. Poole mentioned a minute ago.
Then we look at chart 2, showing what monetary policy has been
doing for many years, starting from the war, and see the ups and
downs. What we plot here are fourth-quarter-to-fourth-quarter
changes, as though we had been using the monetary target system
since 1946.
172
What immediately stands out in this chart is a pattern that is
very similar to the inflation pattern. There were two phases, the
downward trending phase and the upward trending phase, with
lots of big swings.
Swings in the money growth rate did not become smaller after
the Humphrey-Hawkins Act of 1978. We have had some of the largest swings on record just since 1978, which seems to be a contradiction of the purpose of the act. But I would say we have not yet had
a conclusive test of monetary targeting, because for most of the
time covered in this long history the Federal Reserve has been pursuing other targets, such as interest rates, and other money market
conditions.
MONEY GROWTH'S EFFECT ON INFLATION
Another point to notice is that every time there was a major
slowdown in money growth, there was a recession. This suggests
that it is dangerous to cut the money supply growth vote too
abruptly and too much in a short time.
Fourth, money growth strangely was lowest during recessions
and highest during expansion periods, which seems to be just opposite to what you would expect of a countercyclical monetary policy.
I believe this procyclical behavior of money supply really comes
from the Federal Reserve's longstanding practice of trying to stabilize interest rates, rather than controlling the money supply. It
means a procyclical policy.
Now chart 3 brings the two together, money growth and inflation. Because changes in the money supply affect prices with about
a 2-year lag, we moved the money supply line 2 years to the right.
Then if we look at, say, the year 1980, the inflation rate plotted for
1980 is plotted with growth of the money supply for 1978, 2 years
earlier. So this shows you what are the effects of that.
Now, some points to notice. First, each surge of inflation since
1964 was preceded by a monetary acceleration 2 years earlier. This
is very clear. I think it's rare in economics that we find such a
close association, which is, of course, what would have been predicted from many years of study of money and prices.
Second, it s obvious that when money growth was running
around 1 to 2 percent a year, we had inflation of about 1 to 2 percent a year. When money growth got up to about 8 percent or so a
year, so did inflation. Third, when money growth hit a peak of 8
and 9 percent in the 1970's, inflation was even higher than the
money growth rates, probably because there were associated with
that period some effects of oil price changes. The one apparent discrepancy on the chart is in 1950-51, when we had a spike in inflation without any apparent monetary acceleration. That came when
the Korean war broke out—consumers and businesses remembered
World War II price controls, and rationing, and so there was a
burst of stocking up on goods. This drove prices up briefly, but inflation fell back quickly.
I would remind you that the upswing of money growth that we
have plotted for 1984 and 1985 has already happened, that is not a
projection. That has, therefore, implications for future inflation. I
173
do expect inflation to be higher in 1985 and 1986 than it is this
year.
So this review of evidence suggests to me some strategies for
monetary targeting of a sort that you might want to consider. The
first point is obvious. It will be necessary to reduce money growth
rates from current levels, in order to reduce inflation permanently.
But we can't expect to see results within less than a 2-year period.
Second, if money growth is cut back sharply to get quick results,
then that raises the risk of recession, and that has been a common
mistake in the past. It suggests that policy should seek a gradual
slowing. If, on the other hand, we use short run, money growth
changes to stimulate higher output or reduce interest rates, these
raise the risk of inflation later. This was the mistake made in
1976-78. Chairman Volcker made this same point in his statement.
So the best strategy is a long-term program of reducing money
growth by about 1 percentage point per year until we reach a level
that gives us zero price change. That could be a zero change in the
money supply. But we don't know that yet.
So what to do now?
The policy dilemma facing the Federal Reserve, this committee
and the administration, I think was caused by an upsurge in
money growth from 5.1 percent annual growth in 1981, to 8.7 in
1982, to 10 percent in 1983. That has happened, and that is why we
would expect some effect on inflation to come in the future. Now
unless there has been a big change in the relationship between
money growth and inflation, this increase in money growth that
has already happened could add roughly 5 percentage points to the
inflation rate. If we are lucky, we'll get less than that as I implied
with the moderate projections shown on the chart.
When I came before your committee last year, money growth
had been very rapid, and I recommended immediately cutting back
to a 8-percent annual rate. Since then, the Federal Reserve has not
done much different than that. So I'm pleased to report, I think
that has been a move in the right direction, as Mr. Poole said too,
even though that slowing of money growth was too late to avert
some rise in inflation in 1985 and 1986.
Last year, as you remember, some Federal Reserve economists
and other economists said not to worry about inflation from this
big money growth. They argued that the demand for money had increased for various reasons, and that the increase in supply which
we saw that the Federal Reserve permitted, merely accommodated
an increase in the demand. They showed there had been a fall in
velocity, and that made it safe to increase the money supply and,
in fact, desirable.
Well, I think that argument is wearing out now, because obviously the economy is booming along, which to me shows that that big
injection of money had a powerful stimulative effect on spending
and economic activity. Now a standard monetarist analysis would
predict that a large injection of money in a short time would drive
velocity down, and that is exactly what Secretary Sprinkel said in
his testimony on the same day last year. He proved to be a good
prophet. That is, income velocity was down only temporarily, and
has been growing for the last four quarters at a 4.2-percent annual
rate.
174
SLOWING OF MONEY GROWTH DESIRABLE
The slowing of money growth since last year is highly desirable,
and so I believe this committee should support the Federal Reserve's announcement of reducing the money targets by another
percentage point for next year, the year ending in the fourth quarter of 1985. But I also believe the committee should caution the
Federal Reserve monetary authorities against overreacting to the
current strength of the economic activity. There probably will be
an inflation bulge sometime next year or the year after that, but
that cannot be helped now. It was built into the economy by the
Open Market Committee's decision to tolerate Ml growth, way outside of their target bands in 1982 and 1983. So now we have a problem of containing this inflation bulge without either letting it get
bigger, as in the case of the expansionary projections in chart 1 or
pushing the economy into a downturn by overreacting.
It would be far better to set a long-term course of gradual reductions in monetary expansion and adhere to this course, whatever
the temptations to respond to transient developments in the economy.
Now the big issue here is credibility. Financial managers of all
kinds are desperate for any clues as to Federal Reserve intentions.
Security traders leap like startled gazelles anytime something happens that makes them think the Fed may respond with a change in
policy.
Judging by their statements and by your questions, Senator, Federal Reserve officials evidently believe that they have to limit the
amount of information they provide regarding their future policies,
in order to protect their discretion and respond to emergencies. So
announcing the Federal Reserve's monetary targets has done less
to stabilize expectations in financial markets than some monetarists had hoped.
I think the problem is with using multiple targets, Ml, M2t M3,
and other aggregates, simultaneously. That is tantamount to
having no targets. So the financial market is continually confused
by that.
The width of the target bands also greatly limits the amount of
information provided to the public. Worst of all, I think, from the
standpoint of providing market information, the monetary authorities have not demonstrated the ability or the willingness to achieve
the announced monetary targets for any period long enough to convince the public that they are really serious. That is the basis for
the market's skepticism, I believe.
Gov. Henry Wallich made a very good statement about the value
of transmitting information to the market through performance.
He said in a recent paper, and I quote:
Setting and adhering to a target informs the public that an effort is being made
to control inflation. Reducing the target over time creates a desirable and persuasive expectation of secularly diminishing inflation.
I think your committee would perform a very great service if you
insist that the Federal Reserve do that. Some people argue about
whether it's possible or not. I would just recommend looking at the
case of Japan. I cite a recent study by an economist in Hong Kong,
John Greenwood, a very capable man. The points he makes are
175
much like those that Mr. Poole made and I made about what the
Bank of Japan does. They announce an expected year-to-year
growth rate for one aggregate. They pick one, rather than announcing multiple targets. They make this announcement without
fanfare at the end of each quarter for the following quarter. And
they have never deviated from the preannounced figure for the expected monetary growth rate by more than 1 percentage point
since 1974. They have delivered on promises.
So the Japanese financial community has become so accustomed
to this, they hardly pay attention when a new announcement is
made, because they expect the Bank of Japan to follow through.
Now the results of this strategy of gradual reduction of money
growth over time, preannounced and gradual, are very instructive.
Lower monetary growth sustained over several years has reduced
inflation from double-digit rates to less than 2 percent per year.
More stable money growth has also stabilized economic growth.
Japan did not have the two recessions that we had in 1980 and
1982.
A more tentative finding is that the Japanese monetary strategy
also has had a major effect in stabilizing capital markets. Japanese
stock prices, in particular, have become much more stable than
they were before the beginning of the Japanese monetarist experiment in 1974.
So I would suggest if the Japanese can do it, why can't we?
[The complete statement follows:]
176
Chamber or Commerce or the United Stales or America
Washington
U . S . CHAMBER CALLS FOR STABLE AND
MODERATE GROWTH IN MONEY SUPPLY
WASHINGTON, July 31 — I n t e r e s t rates in this country are now behaving
as though i n v e s t o r s and b o r r o w e r s expect U . S . i n f l a t i o n to rise to
double-digit annual r a t e s and to stay there for a long time, the U.S. Chamber
of Commerce told the Senate Banking, Housing and Urban A f f a i r s Committee
today.
Speaking for the Chamber, A. James Meigs, senior vice president and
chief economist of the F i r s t I n t e r s t a t e Bank of C a l i f o r n i a , said t h a t if
government's expressions of d e t e r m i n a t i o n to control inflation were accepted
at face value in f i n a n c i a l m a r k e t s , i n t e r e s t r a t e s would be much lower and
less v o l a t i l e than they are t o d a y . W h e t h e r or not the m a r k e t ' s implied
i n f l a t i o n f o r e c a s t e v e n t u a l l y proves correct, its contribution to high and
volatile i n t e r e s t r a t e s and to extreme u n c e r t a i n t y iii f i n a n c i a l markets today
must be viewed with great concern.
"The s a f e s t s t r a t e g y for reducing i n f l a t i o n , while minimizing the risk
of recession," Meigs said, "would be a long-term program of g r a d u a l l y
reducing money supply targets until a monetary e*pansion rate is found that
would yield a roughly s t a b l e price l e v e l - " B u t , he warned, an a t t e m p t to
speed up the process by r e d u c i n g monetary growth sharply would raise the risk
of recession.
"~
Meigs also noted t h a t p r e d i c t a b i l i t y and stability are key components of
any s u c c e s s f u l monetary policy, and argued that Federal Reserve behavior
between 1980 and J983 were inconsistent with t h i s prescription. Had monetary
policy followed the path laid out in the P r e s i d e n t ' s Program for Economic
Recovery, we could have avoided much of the economic d e t e r i o r a t i o n that
c h a r a c t e r i z e d t h e f i r s t f e w y e a r s o f t h i s decade.
177
IN THE SOS
Statement
of the
Chamber of Commerce
of the
United States
ON: MONETARY POLICY
TO; SENATE BANKING, HOUSING AND URBAN AFFAIRS
COMMITTEE
BY: A. JAMES MEIGS
DATE: JULY 31, 1984
178
STATEMENT
on
MDNETftKf POLIOT
before the
SENATE COMMITTEE CH BANKING, HOUSING AND URBAN AFFAIBS
for the
CHSMBER CP COtWERCE OF THE UNITED STATES
by
A. Janes migs
July 31, 1984
I am A. James Meigs, Senior Vice President and Chief Economist of the
First Interstate Bank of California. I also am a member of the Committee on
Economic Policy of the Chanter of Converce of the United states. It is a
privilege for me to appear before this committee when you are considering
matters of such crucial inportance to the future stability and prosperity of
the U.S. and world economies.
As Chief Economist of a bank operating all
over the viorld, I see effects of U.S. fiscal and monetary policies in world
financial markets every day.
Intecest rates in this country are now behaving as though investors
and borrowers expect U.S. inflation to rise to double-digit annual rates and
to stay there for a very long time.
U.S. financial markets are forecasting
irc>re inflation in the face of a fall in actual inflation rates. If the many
statements from the leaders of both major political parties, the senate, the
Ftouse,
the Treasury/ and the Federal Reserve System expressing
determination to control
their
inflation were accepted at face value in financial
markets, interest rates would be much lower and less volatile than they are
today.
179
Whether or not the markets'
implied
inflation forecast eventually
proves to be correct, its contribution to high and volatile interest rates
and to extreme uncertainty in financial markets today must be viewed with
great concern by the members of this Committee and by other policymakers in
the Government.
Alternating waves of
severe risks on financial
inflation and disinflation impose
institutions, other businesses, and consumers.
Costs of under-estimating these risks in the 1970s can be seen in the recent
rise in failures and near-failures of banks, savings institutions, securities
firms,
and
borrowers
difficult
non-financial corporations.
The efforts of
investors and
to protect themselves from such risks make it
increasingly
to finance long-term investment projects needed for the future
growth and security of this nation.
He hear a lot about the difficulties the Federal Budget causes for the
monetary
authorities.
monetary policy
But the relationship between fiscal policy and
is two-way; each would be made more effective by a reduction
in the instability of the other. Monetary policy could make its greatest
contribution
to the budget process by reducing inflation and keeping it down.
That would contribute directly to expenditure reduction by reducing interest
costs on the public debt.
price
And, even more important, maintaining a stable
level vould greatly improve the ability of all units of government to
estimate
businesses
future costs of programs and to predict revenues.
Government, like
and households, needs a stable monetary framework and a stable
price level in order to maximize productivity and efficiency in delivering
services.
The Historical Evidence
The charts at
the end of my statement should help to explain why
180
people
in financial markets have such a cynical, skeptical view of government
promises
since
to
control inflation.
Chart 1 shows annual average inflation rates
1948. The narrow bars identify recessions.
through
1989 in
plausible
the
future
shaded
areas
courses
for
at
The projections for 1985
the end of the chart illustrate two
inflation
under
alternative
assumptions
stand out in the inflation record.
In the first
regarding monetary policy; these are not forecasts.
Three
phase,
from
reached
in
major
phases
1948 to
World
1961,
War II
inflation
and
the
came
down
Korean
Vter.
in stages from the peaks
This downward movement in
inflation was accompanied by four business recessions.
In
coaster
the
second phase, inflation rose again on an upward sloping roller
track
from
1964 through
1981.
Each peak was higher than the one
before it and the inflation troughs were also progressively higher.
In
than
the
third
phase,
from
1981 through 1983, inflation fell farther
in any other comparable period shown on the chart except 1948-1949. For
the
first
time
preceded
it.
anti-inflation
inflation
costly
since
1961, an inflation trough was lower than the one that
Both
the
program,
one of
campaign.
Carter
and
the
Administration,
which
began
the new
Reagan Administration, which made reducing
its primary objectives, had hoped for a more gradual, less
Nevertheless,
bringing
inflation down to such a low level
within four years was a stunning achievement.
It
would
be tempting
vanquished
for
people
financial markets
high
to
in
levels
looking
business
in
of
for
time.
Same
economists
are
inflation
has
been
annoyed or surprised that
are unwilling to believe that, as shown by the
interest rates.
repetitive
conclude now that
Financial managers, however, are accustomed
patterns
in
market behavior.
Many of those in
today have never seen anything but the upward roller coaster pattern
inflation
all
to
rates
and interest
rates.
It
would be natural Cor them to
181
suspect
that something in our political-economic system made the U.S. economy
increasingly unstable and inflation-prone after the early 1960s. What many
of
them fear perhaps raore than the next wave of inflation itself is the
eventual effort of the Federal Reserve to suppress it.
fear,
They have reason to
from recent experience, that a new anti-inflation campaign could mean
higher interest rates for a time and another recession.
For reasons
to be explained in a moment, I believe inflation will be
higher in 1985 and 1986 than it is row. That is a dismaying prospect. The
question we must ask is whether inflation is still on the upward roller
coaster of
the 1960s and 1970s or whether it is now on a downward trend
toward price stability, as in the 1950s. The 1985-1989 projections on Chart
1 illustrate both possibilities.
If
we look for
institutional
developments that might break
the
upward-trending cyclical pattern in inflation and interest rates, the use of
monetary
tangets
by the Federal Reserve System, as required by the
Humphrey-Hawkins Act of
1978, is the most likely candidate. That brings me
to the second chart. Chart 2 plots fourth-quarter-to-fourth-quarter changes
in Ml as though monetary policy had been guided by a series of annual Ml
targets since 1946.
The first point to notice is that the pattern of annual changes in Ml
growth rates
Chart 1.
is very similar
to the pattern of inflation changes shown on
First, HI qrowth trended generally downward until the early 1960s,
although there were wide oscillations
from year to year. Then Ml growth
moved upward in big steps to a new peace-time peak in 1983. The year-to-year
swings
of
in money-growth rates did not become noticeably smaller after passage
the Humphrey-Hawkins Act in 1978 and the change in Federal Reserve
procedures
in 1979 than they were before. Ffowever, there has not yet been a
conclusive test of monetary targeting in the United States. Ftor most of the
182
years covered by the chart, and at times since 1978, the Federal Reserve has
placed more emphas is on other operating targets, such as free or net borrowed
reserves, federal funds rates, and other money-market conditions, than on the
monetary aggregates.
Another striking
feature of the chart is that every substantial
slowing in money growth was followed by a recession. This suggests that
lowering Ml growth targets by more than one or two percentage points from one
year to the next would raise the risk of a recession.
It
is also curious that Ml growth rates have been lowest during
recessions and highest during the expansion periods
between recessions,
although the Federal Reserve has been viewed as pursuing contra-cyclical
policies
s ince the Treasury-Federal Reserve Accord of
1951.
Textbook
discussions of well-timed contra-cyclical monetary policies would have led us
to expect just
the opposite pattern: higher money growth during recessions
and lower money growth during expansion periods, when inflation was more
likely to threaten. I believe the pro-cyclical behavior of Ml resulted rrom
the Federal Reserve's use of interest rates or net borrowed reserves as
operating targets over most of the period covered.
The final chart. Chart 3, illustrates the historical relationship
between
money-growth
rates and inflation.
Because monetary expansion
influences prices with about a two-year lag, we shifted the money growth line
two years to the right when drawing this chart.
rate for
Consequently, the inflation
1980, for example, coincides with the rroney growth rate for 1978,
two years earlier.
It
can easily be seen that each upsurge of inflation after 1964 was
preceded by a nonetary acceleration two years earlier. Each fall in the
inflation rate after
1964 was preceded by a fall in the rate of monetary
expansion two years earlier.
The ore apparent major discrepancy in the
183
pattern was in 1950 and 1951, when inflation leaped upward and then fell
back.
The contraction of the money supply two years earlier should have been
strongly deflationary.
In this case, consumers and business managers, with
roertories of hbrld War II price controls and rationing still Eresh, embarked
on a buying spree when the Korean frfer broke out.
Soros Implications for tonetary Targeting Strategy
This brief
review of the historical record of Ml growth, inflation,
and recessions has, I believe, some clear implications for monetary targeting
that you may want to consider in your oversight responsibility for nonetary
policy:
1. To reduce inflation, it clearly will be necessary to reduce money-growth
rates from current levels. However, visible results should not be expected
until a year or two later, because of. the two^ear lag between changes in
money-growth rates and changes in inflation rates.
2. If
the authorities reduce money growth sharply, in an attempt to get
pronpt results, the risk of recession rises.
3. If
the monetary authorities use short-run increases in money-growth rates
in an attempt to hold interest rates down or to stimulate store rapid growth
in real output, they risk raising inflation rates (and interest rates) later.
That was the mistake made in 1976 and 1977, when a lull in the 1970s
inflation appeared to offer
an opportunity for using expansive monetary
policies to increase output and to reduce unemployment.
4. The safest strategy for reducing inflation, while minimizing the risk of
recession,
therefore, would be a long-term program of reducing Ml targets by
about one percentage point per year until a monetary expansion rate is found
that would yield a roughly stable price level.
184
One criticism of a long-term gradualist strategy in monetary targeting
is
that
the
to
the
in
prices
progress in reducing inflation might be too slow to be credible
public.
shock
That would increase adjustment costs by delaying adjustments
and wages.
treatment,
one step.
serious,
Credibility
The recession
however,
inflation;
the
might
be established more rapidly by a
such as reducing money growth to a non-inflationary
that
cure
it
rate in
induced by a monetary shock treatment could be so
could
undermine public support for controlling
might be worse than the disease.
I have more to say on
the credibility issue later.
The Current Situation
Today's
results
policy
from
the
dilemma
for
this
Committee
and the Federal Reserve
upsurge in Ml growth from a 5.1% annual rate in 1981 to an
8.7%
annual
been
a major change in the relationship of Ml to national income and prices,
this
acceleration in monetary expansion could add roughly 5 percentage paints
to
the
rate.
are
rate
in
1982 and a 10% annual rate in 1983.
Unless there has
1983 inflation rate of 4.2% by 1985, bringing it to about a 9% annual
The actual
lucky,
as
increase in inflation by 1985 may be less than that, if we
implied
in the "Moderate Case" projections for 1984 and 1985
shown on Chart 3.
When
I
recommended
growth
nore
a
before
there
available
12% annual
Committee on July 21 of last year, I
be
through
reduced iimediately to an 8% annual
the
second
half
of
the year. The
at that time indicated that Ml had been growing at
rate since
the
middle of 1982.
Although it may
have been too late to avert some reacceleration of inflation for late
and 1985,
it
seemed high time to start moderating that reacceleration
before it could get out of hand.
this
Ml growth should
and held
data
than
already
1984
that
rate
unrevised
appeared
185
Seme Federal Reserve and other economists argued last year that there
was little need to worry about an inflation threat arising from the
extraordinary growth of
Ml.
The demand for Ml had increased for various
reasons, bhey argued, and so the
Federal Reserve
Increase in the supply permitted by the
from mid-1982 through mid-1983 merely accommodated
increase in demand.
cited as evidence
A fall
in
the
(Ml) income velocity over that period has
that the demand for Ml had increased, makir>g it safe,
indeed desirable, to increase the supply. That argument is wearing thin now,
as economic activity and spending boom along at far higher rates than the
money-demand-shift argument implied.
A standard monetarist analysis nould predict
instead that a large
injection of new Ml in a short time vould cause income velocity to fall for a
while, offsetting
part of
spending and income.
the impact of the faster money growth on current
Monetarists
would attribute the observed fall in
velocity more to the sudden increase in supply than to an increase in demand.
Furthermore,
velocity growth vould rebound later on toward or above its trend
rate of 3% or so per year. Dr. Beryl Sprinkel presented that argument in his
appearance
before this Committee a year ago.
income velocity has grown at
He proved to be a good prophet,-
a 4.2% average annual rate for the last four
calendar quarters.
The slowing of Ml growth since this time last year to about a 6.7%
annual rate through June was a highly desirable development. It certainly
has not yet put a danper on economic expansion, as the increase in velocity I
have just cited offset most or all of its downward influence on total GKP in
current dollars. I believe this Committee should support the Federal Reserve
in reducing
Ml growth by another percentage point in the target for the year
ending in fourth quarter 1985.
markets at
This may not be a popular move in financial
first, because some analysts will expect it to mean high interest
186
rates
and seme may
however,
forecast
a
recession.
After
they think it through,
many people in financial markets should be reassured by the evidence
that the Federal Reserve is serious in its determination to resist inflation.
I
also
against
believe this Committee should caution the monetary authorities
overreacting
to
the
current
strength in economic activity.
There
indeed
probably will be a bulge in the inflation rate late this year and next
year.
But that
can't
be helped now; it was built into the economy by the
Open
Market
Committee's
1983
target
bands.
without
either
decision
The problem
to
tolerate Ml growth above the 1982 and
now is to contain the new inflation bulge
letting it get bigger, as in the "Expansive Case" projections
in
Chart 1, or pushing the economy into a downturn by overreacting.
be
Car better
expansion
to
and
set
It would
a long-term course of gradual reductions in monetary
adhere to it, whatever the temptations bo respond to transient
developments in the economy.
Credibility: The Instructive Case of Japan
Realizing
near-term
that
and long-term
investors,
the Federal Reserve does will have jjiportant
effects on the wirld economy and financial markets,
borrowers, and financial managers of all kinds are desperate these
days
for
any clues
like
startled
to Federal Reserve intentions.
Securities traders leap
gazelles at any development they suspect may trigger a Federal
Reserve
response.
on
days
the
anything
The crowds of people trying to get into this hearing room
that Chairman \folcker announces new Federal Reserve targets are
evidence of the thirst for information on future monetary policies.
Judging
officials
they
of
evidently
provide
discretion
by their statements in hearings such as these. Federal Reserve
believe
that
they must limit the amount of information
regarding their future policies in order to protect their range
for
responding to unforeseen conditions and emergencies. But
187
that leaves the public uncertain about the future purchasing power of money
and makes it difficult for managers, investors, and consumers to plan.
Announcing the Federal Reserve's monetary targets has done less to
stabilize expectations in financial markets than monetarists had hoped.
This
is because announcing multiple tarqets for Ml, M2, H3, and other aggregates
simultaneously is tantamount to announcing no targets. Outsiders have no way
of
knowing which target the Open Market Committee is emphasizing at any given
time.
The width of
the target bands also greatly limits the amount of
information provided to the public.
Worst of all,
from the standpoint of providing market information, the
monetary authorities have not demonstrated the ability or the willingness to
achieve announced monetary targets for any period long enough to convince the
public that they are really serious. In the absence of such a demonstration,
much market energy
is used trying to find out what else the authorities are
trying to do.
Governor Henry Wallich expressed the value of transmitting information
on monetary policy through performance
when he said
in a recent paper,
"Setting (and adhering to) a target informs the public that an effort is
being made to control inflation.
Reducing the target over time creates a
desirable and persuasive expectation of secularly diminishing inflation."!
The Bank of Japan has done just that. In a recent study in the Asian
fonetary
Monitor, Hong Kbng, John G. Greenwood says that the Bank of Japan
announces only the expected year-to-year growth rate for one aggregate,
M2+CCB, rather than announcing multiple targets.^ The Bank also sidesteps
ideological controversy by calling the announced growth rate an expected
growth rate, rather than a "target." An announcement is made without fanfare
at the end of each quarter for the following quarter.
"The net effect,"
Greenwood says, "is
that the Bank of Japan has
188
compiled a remarkable record o£ never having deviated from its pre-anriounced
figure
for
point.
the expected monetary growth rate by more than one percentage
The
Japanese financial conroanity has become so used to
predictability of the Bank of Japan's announcement and its
achieving the predicted outcome that as an item of
the
success in
financial news the
announced monetary growth rate is treated as no rrore than a minor formality."
The results of the strategy of reducing and stabilizing monetary
growth in Japan are
instructive.
Lower nonetary growth, sustained over
several years, has reduced inflation from double-digit rates to less than 2%
per year.
escaped
(tore stable money growth has stabilized economic growth. Japan
recession during the two U.S. recessions in 1980 and 1981-82. A wore
tentative finding of Greenwood's study is that more stable monetary growth
also has produced more stable capital markets. Japanese stock prices, in
particular, have become much more stable than they were before the beginning
of the Japanese monetarist experiment in 1974.
If the Japanese can do it, why can't we?
* * *Note:
I want to express my appreciation to Moreen toyas, Lillian
McCalman, and Rodney Swanson for their help in preparing this statement.
Fcotnotes:
1.
Henry C. Wallich,
"Recent
Technigues of Monetary Policy," Economic
Review, Federal Reserve Kink of Kansas City, May 1984, pp. 21-30.
2.
John
G.
Greenvood,
"The Japanese Experiment in Monetarism", 1974 to
1984, Asian Monetary Monitor, March-April, 1984, pp. 2-8.
CHART 1
GNP DEFLATOR
* CWM3E OVER YEflR AGO
EXPANSI\€
oo
48 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82
86 S3 9D
First Interstate Bank
CHART 2
MONEY SUPPLY GROWTH - Ml
4TH QLWftTCR TO 4TH QUARTER % CWGE
to
o
46
5D
62
66
70
78
82
66
39
First Interstate Bank
CHART 3
DELATION VS Ml GROWTH TWO YEARS PRIOR
\
48
52
56
CHANGE OVER YEftR AGO; 4TH Q TO 4TH Q FOR HI
60
68
72
76
80
88
First Interstate Bank
91
192
The CHAIRMAN. Thank you, Dr. Meigs. Mr. Savin.
STATEMENT OF PATRICK SAVIN, VICE PRESIDENT AND CAPITAL
MARKETS ANALYST, DREXEL BURNHAM LAMBERT INC., NEW
YORK, NY
Mr. SAVIN. Thank you very much, Mr. Chairman.
Mr. Chairman, prior to any discussion of details on Federal Reserve policy, I should point out that we are returning to financial
stability, and the market is putting a premium on that journey.
There are two policemen on that journey. One policeman, of
course, is the bond market in this country, which is no longer subject to manipulation by rhetoric or Federal Reserve Board action.
The other policeman, of course, is the currency market. It's a
rather remarkable time, really, inasmuch as we're having asymmetric information from various markets. The commodity markets
seem to feel that high inflation is not likely in the near or distant
future. Second, the currency markets seem to take this view. The
equity markets are somewhat positive, but of course, they're really
hostages to the bond markets, since the major factor in the determination of equity values is the interest rate.
PREMIUM PUT ON LOW INFLATION
In order to return to this financial stability on which, as I say,
the market has put a premium, we need to have some conviction
first about persistent low inflation.
Second, that people can own financial assets as a haven of
wealth, as a haven in which they can store their savings without
abnormal price risk or credit risk. And obviously, there needs to
be, third, improved quality of credit.
Fourth, we need to reduce risk premiums in the bond markets, in
order to generate a secular drop in interest rates. Of course, what
that would bring in its wake is higher equity values and a return
to sustained economic activity, which it seems to me we all hanker
after.
It seems to me that without this transition to financial stability,
what we'll continue to have is the spasmodic economic growth of
the last 15 years, characterized by the shift toward financial instability.
How can we get there? It's really quite simple. As you know, Mr.
Chairman, we need to have a consistent application of public
policy,
Let me just briefly, turn to the two areas of public policy that
matter. First of all, Fed policy. Fed policy is always the key. The
role of the central bank really is to maintain the value of the currency, and one of the paradoxes of life, certainly, with money, that
commodity, is that you have to make it scarce in order to reduce
inflation expectations and so as to raise its value. If you raise its
value, you reduce interest rates and you set the stage for sustained
economic activity.
As I say, that is the central issue in the process.
As we know by now, high money growth ultimately leads to high
inflation. I think sometimes we do relax, but certainly as a rule of
193
thumb, high money growth certainly leads to high inflation and
eventually to high interest rates.
It obviously encourages a situation in which bad credits proliferate. Ultimately, and despite the rumors we hear, high interest
rates do not prevent a secular decline of the currency. In an environment such as this you have problems in maintaining economic
growth.
Now, what we are prescribing here in terms of policy is very
painful. Make no mistake about that. If you get into a period of
high inflation and high interest rates and encourage a speculative
environment, people offer what appears to the borrower to be
cheap credit and which the borrower thinks he can pay back in
cheaper dollars.
If you start that game, as we saw in the period of 1980-82, as you
move from this period of secular inflation through disinflation into
a period of low inflation, it's extremely painful. Long persistent recession, high unemployment, high bankruptcy rates, various
threats to the financial system which we have seen in the last 2
years and which we continue to see, become fairly typical.
But essentially what the market is insisting on and what we
need to do, which can only be done by the Federal Reserve Board,
is in fact to reduce the risk premium so that ultimately we have
low interest rates. By this strategy we can restore credit quality because one of the dilemmas we face is that the bond markets have
been really quite wrong in forecasting inflation for the last 2 or 3
years. The market continues to raise the risk premium.
The market has looked back at the record of 3 or 4 percent inflation of the last few years but it continuously discounts 10 percent
inflation in an understandable frenzy or fear, one might say.
This high-risk premium encompasses a risk of inflation, a bankruptcy risk, second, and third, a price risk since our bond markets
in particular have become far more volatile then they have ever
been historically. Volatility has diminished somewhat over the last
2 years, but all this reflects in the financial instability one has
talked about.
It is for this reason that the bond markets have now taken on a
pattern of behavior which is both counterintuitive and counterfactual. We've seen in the last 4 years when there were rumors of the
Fed easing. A few months ago Fed funds collapsed by off 150-basis
points. The long end of the market promptly sold out. The interest
rate ran up around 40 basis points in very short order.
FED HAS LOST CONTROL OF THE CURVE
When the Fed eases, in the traditional sense by trying to push
down the funds by supplying reserves aggressively, people do not
wait to see the inflation. They discount it almost instantaneously.
The tragedy, therefore, of this dynamic financial instability is that
the Fed has lost control of the curve.
When I started out in this business the Fed used to be able to
manipulate the yield-curve. It looked very simple. We knew what
the information content was of the Fed fund rates. We knew what
information the Fed wanted to transmit to us.
194
Now you can't really tell. It has the information content but
you're not sure what it is. If it goes up you don't know whether it's
because the Fed has not been providing reserves, or if it comes
down we don't know whether the Fed is providing reserves. So
until the numbers come out with the 2-week lag, exacerbated these
days by the contemporaneous reserve requirements, and changes in
reserve requirements, one doesn't know where one is. So, the markets are nervous and anxious.
The paradox, you know, is that in a period of stability the
market went along with the central bank. It doesn't have to keep
the risk premium that high inasmuch as there isn't that much risk
in the financial system.
So, what we need to do here in terms of Fed policy is not only to
set targets but to hit them. But which targets? I certainly agree
that there are too many targets. What we, in fact, are seeing here
are secondary targets. The target that really counts is reserves.
Second, the nonbarred reserves are important and third, Ml, we
certainly don't need three M's.
The central bank doesn't control credit. Credit is a promise to
pay money and if a banker extends credit, with or without collateral, one could anticipate that there will be a shift of wealth on the
part of the borrower or he will use the credit to accumulate some
asset that can generate cash flow.
Clearly the Fed cannot control both quantity and price and what
it should focus on is control of quantity and let the market set the
price. The market's going to set the price anyway.
I also believe that the targets of 4 to 8 percent are much too
high. Targets are much too wide. They reinforce uncertainty and
this is unfortunate because I think the preponderant responsibility
of reducing inflation expectation and reducing the risk premium
falls on the Federal Reserve Board.
Let me just briefly touch on the fiscal policy because I think
fiscal policy has become the scapegoat for everyone. I think that
the frequent tax changes that we re seeing—we've had three major
tax bills in 3 years—is without precedent and it reinforces uncertainty.
The other factor is that the deficit we've spent so much time and
energy arguing about is really a residual and from a financial
point of view, purely from a financial point of view, is a bogus
issue. It's a bogus issue because if you think of it in financial terms
what the tax cuts do is recycle liquidity from the public to the private sector and that is a strategy by which you reduce financial
risk. And it is not accidental that we concern ourselves with financial risk in the throes of recession. Thus, all the tax cuts or nearly
all the tax cuts in the postwar period have come in periods of
recession.
If you accept my statement that we are reducing financial risk
by cutting taxes and recycling liquidity from the public to the private sector, just think of the fact that there is no credit risk in
Government debt. So, in an environment of increased financial stability to raise taxes, when in fact nobody knows what the optimum
marginal tax rate is, to take away liquidity from the private sector
in order to reduce the Federal deficit so that the Federal Government can borrow less, seems to me makes no financial sense.
195
It makes no financial sense because one of the ways in which we
reduce financial riskiness is by issuing Government debt in preference to private debt. Since even in a period in which there is a recovery, the private sector is still accumulating financial assets, and
it would make sense for the private sector to continue to reinforce
its own balance sheet.
TAX SYSTEM FAVORS HEAVY DEBT
I would also, in closing, just point out that there's one number in
this country which hasn't changed in many, many decades. It's the
nonfinancial debt GNP relationship. It's hovered around 1.5 despite
levels of inflation or business activity. What changes dramatically,
however, under that simple number is who generates the debt. And
in most of the postwar period, up until 2 years ago all the debt,
believe it or not, despite the persistent public deficits, was generated by the private sector. Individuals tripled their ratio of debt; corporations doubled it. As I said, the Federal Government ratio
declined.
There's been a reversal of this recently, largely as a function of
the tax cuts and large deficits which in my view the Government is
running in a financially sensible way. It is instructive that the two
attempts to reduce the deficit have failed to shore up the bond
market's confidence. I would ask you to recall that in the last 4
years we heard constantly that these deficits that have been much
larger than people thought, would keep inflation high. That's been
dead wrong. Keep interest rates at record levels. Also dead wrong.
I put it to you, that the burden here of reducing the risk premium or the burden of returning to financial stability falls on the
Federal Reserve Board. The Federal Reserve Board should accept
the responsibility of reducing financial instability. If the markets
had the conviction that this were the case, I think the risk premium would decline, interest rates would come down, the dollar paradoxically would continue to surprise people by staying strong because the forces that are really driving the currency are not really
the interest rates but relative inflation expectations and we could
look forward to a period of sustained growth.
But to do this we have to set lower targets and we have to
narrow the bands. Thank you.
[The complete statement follows:]
196
STATEMENT OF PATRICK SAVIN, VICE PRESIDENT,
CAPITAL MARKETS ANALYST, DREXEL BUENHAM LAMBERT INCORPORATED
The
Federal
Reserve
Board
clearcut
should
policy
continue
which
to
commit
reinforces
a
itself
tendency
to
to
a
consistent
and
low
inflation.
Evidence of that commitment would cause the present fearsome
risk premium in interest rates to shrink, releasing the bond market from
its present
torpor
and causing interest
rises to fall.
this development will keep the dollar strong
higher.
lower
Importantly,
and move equity prices
Lower bond yields and higher equity prices would effectively
the
cost
of
capital,
enhancing
long
term
economic
prospects.
Without this Fed-supported transition to financial stability, economic
growth would remain spasmodic.
Thus the present review can come at no
more critical time.
The
Fed
has
conducting
done
policy
dropped decisively.
an
over
admirable
the
last
but
excruciatingly
three
to
four
difficult
years.
job
Inflation
in
has
Keeping it down is another matter. What America has
come through in that period is the classic and historical move from high
inflation to disinflation, a deceleration of prices with all the hardships which tend to accompany this evolution. In my view monetary policy
can now move in such a way as to reinforce a tendency to low inflation
for a considerable
ground
period.
This progess has been made against a back-
of very considerable uncertainty at crucial periods as to the
technical means
that the central bank would use to actually translate
hopes into deeds.
It is time for this uncertainty to end.
to announce
targets for money growth
goals.
rium
lower
The Fed has
and then deliver on these
Failure to do this would tend to increase the present disequilib-
in asset markets.
If one looks at the various asset markets the
197
information in in the price
inconsistent.
is clearcut individually but confused and
The apparent message from both hard and soft commodities
is that inflation should stay low and that some of the risk are on the
side of deflation.
In the currency market the message since the fall of
1980 has also been clearcut.
The markets seem convinced tnat expected
relative inflation, the main force behind the rally of the dollar, should
continue to run in favor of the U.S..
Moreover, domestic investors are
keeping the risk premium and interest rates high fearing a new round of
inflation, and are offering foreigners very attractive compensation with
little opportunity cost in holding U.S. assets.
The equity markets are
hostage to the discount rate or risk premium in the bond markets and have
given an increasingly poor performance
in the light of higher interest
rates.
Thus, the message from the bond market, the most important asset market
is
forlorn
and negative.
inflation
mechanism
is inevitable
It seems
and
to believe
since the market
it seems unconcerned
that
a new round of
is a forward
looking
that it has been wrong in forecasting
inflation for the last two years.
Historically,
the real
long
hovered between 3% and 4%.
term
interest rate
double
forecasting
premium,
digit
inflation
has
Thus with current yields of 13% in the long
term treasury bond what the market
nearly
in this country
inflation.
is forecasting is a recurrence of
In
for the past
fact
wrong
two years,
the difference between the historic
as
it has
having kept
been
in
the risk
real interest rate and
nominal interest rate at 700 basis points it has now chosen to raise
198
it to over 1,000.
from
these
Clearly something has to give since the information
respective
asset
markets
is asymmetrical.
The currency
markets and the commodities markets are in bbvious disagreement with the
bond market.
The respective markets
have different expectational sets.
It is understandable that the bond market retains enormous anxiety after
a bear market which has persisted for well over thirty years with six of
seven significant rallies.
generations
This is the dominant experience of nearly two
of participants.
Both owners and managers now need some
commitment from the central bank in regard to the secular reversal of
inflation. It is for this reason that the conduct of monetary policy in
particular has become so critical as we try to reverse
expectations.
In fact what the bond market, the most critical of the markets is saying,
is that it fears extrapolating the recent past into the future.
What
the Fed must achieve is a commitment to low inflation that would allow
bond markets to reduce the current risk premium.
low inflation in a historic framework
And this commitment to
is a very painful journey with a
very skewed economic and social impact.
Any sustained surge in money, at
some stage generates increases in inflation.
But what also happens in
this period is a excessive use of credit and a deterioration of national,
corporate and individual balance sheets.
As we have learned in the last
few years and continue to learn, a reduction of inflation and a repair of
the national balance sheet require a return to sound credit.
It
is
easy
disinflation
for
some
to
talk
about
as long as the sacrifices
accepting the harsh
fall elsewhere.
the last two years have shown patchwork and inconsistent
lessons of
Moreover, as
legislation of
tax policy reinforces the tendency to uncertainty and does not support
199
a lower risk premium
in interest rates.
The notion that Congress can
reduce the deficit by raising taxes is a prescription for frustration and
disappointment.
The cat is chasing its tail.
Tax increases raise the
probability of economic slowdown, a condition in which would generate an
ever larger deficit.
Surely no one would then prescribe a further tax
The Fed thus plays the central role in this drama around the theme of
the
risk premium.
Obviously,
its role
in masterminding
a return
to
financial stability, or its attempt to take away the profit in inflation
is an extremely unpleasant one.
shaken.
Some
in Congress
Occasionally, everyone's commitment is
even threaten to mastermind
the market by
controlling interest rates in effect, evidence of their awareness of the
unpleasantness of uncertainty.
an unmitigated
deep
disaster,
recession. But
institutions
in
Attempted in the summer of 1980, it was
combining unexampled market volatility
fact,
it is
and a
the market, the people and the
who buy financial assets, that determines what risk they
will take and therefore what the level of interest rates ought to be.
Everyone should understand that the notion of the central bank setting
and masterminding interest rates is not feasible in the present financial
climate.
Obviously, if the market had no role to play it is a safe bet
that rates would, on balance, be low and less volatile. It is a paradox
of finance that central banks can manipulate interest rates - indeed the
markets will allow themselves to be manipulated by the central bank - in
a period of financial stability.
Thus in the 1950's the central bank
could mastermind through its manipulation of reserve growth the level of
the Fed funds rates and that would provide very precise signal to the
200
markets as to what the Feds goals were.
the market would follow the Fed.
In that environment of stability
The Fed was the house and the market
was a player in the Fed's house. However, as the system became very
unstable in the 1970's, the entire role was reversed.
Firstly, the Fed
has had to change its strategic play by moving away from an interest rate
strategy to a reserve strategy.
What this means is that the central bank
no longer controls even the Fed funds rate for a protracted period as it
used to in the 1950's and 1960's.
As the Fed provides reserves in this
new era of aggressive liabilities management in banks, ^Lt is bank demand
for reserves that determines the level of the Fed funds rates apart from
very short interim periods. There is great confusion and
and disagreement about this in the financial markets.
is information
longer
bank.
power
For clearly there
in the price of Fed funds, but that information is no
as accessible.
frustration.
contradiction
Obviously, this creates great uncertainty and
But as importantly, it has reduced the power of the central
Paradoxically, the
rise
of
financial instability
reduces
the
of the central bank especially at a time when so many seem to
expect so much from the Fed. The market has set the tone,
the house
reversal.
and the Fed has become a player
In
my
view,
as
we
return
to
it has become
in its house, a dramatic
financial
stability,
an
environment in which there is a reduction of financial risk, what will
evolve more is that the market will forget about past mistakes, and allow
itself to be manipulated by the central bank.
In
this
context
therefore, what
the
central bank
critical than what happens in fiscal policy.
does
is far more
It is hard for the Fed to
201
convince
the market
increasing
the
odds
that
of
it is about to reduce financial risk
higher
returns
real assets or other commodities.
on
thus
financial assets compared
And in order to do this, it has to
slow the growth of money
and ultimately bring about a slowdown in the
growth
often
of
credit.
Too
the
terms
money
and
credit are used
interchangeably.
High growth rates of money encourage profligate use of
credit.
Credit
is nothing
extension
of credit means that the lender is betting that the borrower
more
than
a promise
to pay
money. The
has either some liquid assets, which might serve as collateral, that can
be converted into money to liquidate the debt or alternatively that the
borrower will use his credit to accumulate some assets which can generate
cash flow to service
and repay that debt.
As a consequence everytime
credit is given, increasingly what take place is a bet on future asset
values and income growth both ultimate products of Fed policy. For these
reasons, it is extremely critical that the Fed continue
to slow the
growth of money in the environment of 1985 and 1986, helping to reduce
the risk premium in interest rates?
The central theme of the operation
of the central bank has to be less the evolution of the business cycle
than a return to financial stability.
The Fed has made its own role more difficult in two ways.
First, it has
changed the manner in which it conducts monetary policy by making three
significant changes in the last five years.
An important rule of thumb
is that these frequent changes are hard for most market participants to
understand
or at best they
take a long
time to grasp.
There is a
tendency for them to cause uncertainty, a factor which raises interest
202
rates.
would
In the fall of 1979, the Fed announced that ^growth of reserves
become the centerpiece of policy as it tried to hit its money
targets.
It thus rejected the postwar focus on the Fed funds rate.
This
was a recognition that the Fed could not control both quantity and price
at the same time and that it ultimately decided to shift its attention to
quantity.
Postwar policy has focused on the price or level the Fed funds
rate and had led to a period of significant inflation by the 1970' s.
But
in
addition
to that, under
Congress, the financial
the Monetary Control
Act passed
by
system had been deregulated, not so much to
insure more competitive markets, but in response to the financial chaos
which deepened in the 1970's.
But these changes allowed the Fed to claim
that since there had been institutional changes in the definition of
money,
it
had
definitions.
came
to have
wider
targets,
to
compensate
for
these
new
Wider target increased uncertainty. The second major change
in the summer of 1962.
The Fed abandoned
its targets for some
months, underwriting a significant spurt in money.
This caused cynicism
to deepen and fears arose that there would be a significant new round of
inflation in late 1983 or early 1984.
incorrect
forecast.
The
validated
by
growth
reserve
money
By now we know that was a terribly
spurt,
as
evidence showed, was
and was merely
a
function of
the
not
new
definitions of money.
In short, some of these balances were not held for
transaction purposes.
The Fed did try to make this clear but few seemed
to understand for a variety of reasons. A member of the Federal Reserve
Board pointed out in a speech made last spring in Chicago, that a third
major change in the conduct of policy took place in the fall of 1983.
There
is reason
to believe that behind the shift to
contemporaneous
reserve requirements the Fed is now using the discount window as a prime
203
focus of strategy with nonborrowed reserves the bulk of reserves as the
residual. This last change has some similarity to the pre-1979 monetary
strategy and should be a source of concern.
To the degree that is causes
confusion, it would tend to keep the risk premium high. In fact the third
policy change was announced
effect.
Moreover, the
contemporaneous
However,
reserve
it
then
said
environments
from
several months
Fed
itself
environments
that
lagged
the
reserve
after it had been put into
initially
but
change
opposed
eventually
to
the
return
supported
contemporaneous
requirements
would
make
to
it.
reserve
little
difference either to inflation expectations or to the conduct of its
policy.
If this is true, then why bother with all these changes?
It is important for the Fed, in as simple fashion as possible, make the
currency secure.
As everyone knows tight money - slow growth of money -
leads to low interest rates and easy money - fast growth of money - leads
to high interest rates.
The difference in outcome lies in both inflation
and inflation expectations.
leads to low inflation.
decline.
Slow growth in money and ultimately credit
Risk premiums and interest rates ultimately
And despite that, the currency tends to stay high particularly
since it also signals a reinforcement to financial stability.
In this
context much of our concern in this country for the budget deficit is
misplaced.
As recent experience in both Japan and Germany show, high budget deficits
do not necessarily lead to high interest rates, high currency and large
trade deficits as the former Chairman of the Council of Economic Advisors
204
suggested.
This
committee heard
three
to four years
ago
that the
high budget deficit - the deficits have been much larger than anyone
thought would keep inflation and interest rates at record
would
indeed prevent the economic recovery.
levels and
The problem now is that
these same people are saying that the high budget deficits will prevent a
sustained recovery.
But this is really a canard.
either accelerating or decelerating.
and
will
continue
premiums.
to
do
so
Business cycles are
This one has started to decelerate,
without policy
support
for
lower
What we need to do is to restore financial stability.
risk
And in
this context budget deficits have a very important utility in that they
improve credit quality
since government
compared to that of the private sector.
debt
is free of
credit
risk
The transition from a persistent
budget deficit to low inflation and low interest rates is feasible as in
the case of Japan.
which
is
financing
industry.
It is a country
a
reinforced by financial stability
significant introduction
of
new
technology
in
What matters is that consistent conduct of monetary policy
reinforces a tendency to lower its risk premiums and keep interest rates
low despite the large budget deficit.
deficit.
budget
No attempt is made to monetise the
Moreover, there are countries such as Italy in which the high
deficit
have
emerged side by
side
with high inflation, high
interest rates, significant trade deficits, and weak currency.
the difference?
What is
It seems clearcut that it is conduct of monetary policy
and the risk premium that financial asset owners demand. In fact one of
the things that has become apparent is that is is possible to have high
marginal tax rates and wealth taxes with a large government share of
GHP
and
still
stability.
have
low inflation
and
interest
rates, and financial
It is clear that the crucial difference is the consistent
205
conduct
in monetary policy and as a consequence
the credibility and
confidence investors have in the central bank.
As we have seen in the last two years, rapid and radical changes in tax
policy
in order to pacify the capital markets, is largely pointless.
Congress passed a massive tax cut in October 1981.
A major bond rally
took place in the surraner of '82, bringing the long term government bond
down to 10^% from its peak of 15*1% in September 1981.
In September 1982,
Congress passed the Tax Equity ancl Fiscal Responsibility Act (TEPRA) in
order to reduce outyear deficits.
And
just
recently Congress passed
the Deficit Reduction Act of 1984 in another obvious attempt to pacify
the market, the first having failed. What is important however, is that
clearly neither piece of legislation by itself has made any difference in
the bond market.
Interest rates are now some 300 basis points higher
than they were when the first piece of legislation was passed, and since
the passage of the Deficit Reduction Act of 1984,
the bond market has
made no significant advance as some people had suggested it would in face
of legistlation.
Monetary policy is the Xey to lower rates and frequent
changes in the tax measures reinforce a tendency to uncertainty.
An analysis of the strength of the dollar is also relevant in the context
of an analysis of the Fed policy. No economically viable society in the
history has ever had a weak currency.
As members of the committee can
recall, in the 1970's when the dollar was in a persistent decline, the
same
industries which
may
have
trouble in holding
market share
had
206
difficulties
expected
then.
inflation
Since
the
strength of
and also reduces
the
currency
reflect
low
flexibility to raise domestic
or
foreign prices in order to maintain a high rate of return on invested
capital it encourages the introduction of the most modern equipment and
technology
to boost productivity and reduce costs.
At the same time
these steps encourage workers to moderate wage gains.
This dynamic cycle
is unsustainable without conviction in financial markets that the central
banks
means to validate
a
low
rate
of
inflation.
Since high
risk
premiums and interest rates and the high cost of capital can in the long
run discourage new investment in countries with weak currencies or high
inflation, all the pressure for lower costs then comes from attempts to
reduce wages.
strategy.
But that is a short run tactic, and not a Zong term
And in this context therefore the return to low risk premium
and interest rates becomes a central issue.
What the foreigners see is
an opportunity to invest in America to produce their goods here in order
to hold
their market share.
What the significant devaluation of the
dollar in the 1970's has done is to make it attractive for them to invest
here.
A ten year recovery in the deutschmark above 2.80 from 1.65 leaves
it substantially below the four marks to the dollar of the 1960's.
The yen has held its own against the dollar in recent years after a
period of strength in the 1970's.
With its greater financial stability,
the currency should strengthen against the dollar, encouraging Japanese
portfolio and direct investment in America.
207
As to fiscal policy, there is no question that despite present economic
stringencies, government should strive for efficiency.
Government has to
make sure that its programs are efficient and it also has to ensure a
further
deceleration
in
the
growth rate of
government
expenditures.
Congress has cut the growth rate of government expenditures since 1980
despite the recession.
It is the first time that this has happened in
over twenty five years.
However, frequent
attempts
to manipulate and
change the tax system in an effort to reduce the deficit, is counter
productive.
the
debt
variance.
One of the ratios that has not changed in over 50 years is
GNP
relationship.
This
ratio
has
It has
held
hovered
despite
the
around
1.5 with little
variability
of economic
conditions and inflation. What changes dramatically within this ratio are
the sectors that generate the debt.
Two things stand out.
The first is
that in the postwar period it is the private sector, both consumer and
business, which has increased its share of financial debt.
share of debt has been declining until recently.
that in recessions private sector debt tends
government debt rises.
Government
The second point is
to decline cyclically as
The reason for this is quite simple.
What tax
cuts do is recycle liquidity from the public to the private sector and
the concern about liquidity is highest in recession.
tax cuts take place in recession.
Consequently most
In recession, as the private sector
cuts back on consumption and investment, and increases its liquidity, or
in short
public
saves more
and changes the composition
sector is obviously
able to borrow
more.
of its savings, the
But what is also
important is that the private sector then buys risk-free public
debt to bolster
risk.
sector
its balance sheet and reduce its exposure to financial
Some now argue that without shrinkage of the budget deficit, in
208
contrast to past periods, the private sector will not be able to to
finance its growth, the "crowd out" effect. But past deficits have been
widely off the mark.
Consequently, nobody knows what the deficit is
going to be in the future since it hinges not only the tax level which
Congress has been trying to raise to cut the deficit but also on the
level of economic activity.
from
something
Therefore,
virtually
and
basing
they
public
Budget deficits are residuals. They result
really do not cause very much
policy
unforecastable makes
therefore,
what Congress ought
on
some
little
expected
sense.
of
deficit
As to
anything.
which
fiscal
is
policy
to do is to try to come as close as
possible to efficient outlays, however difficult this is politically, and
allow the central bank policy to play the dominant role in reducing the
risk premium.
turbulence
In any event in a period of such financial instability arid
it can make little sense
to raise private sector taxes to
reduce the government deficit in order to let the government borrow less.
Government debt has price risk but no credit risk.
obviously has both price risk and credit risk.
this
paper
country had owned more
Private sector debt
If many of the banks in
government paper and less private sector
fewer banks would have gone bankrupt
and fewer banks would now
barely survive. Thus, in purely financial terms tax cuts that take away
private
sector
resources to reduce
government debt requirements
make
little sense and increase risk in the financial system.
Very uncomfortable burdens fall on the central bank.
fair as everyone knows.
responsibility
But life is not
To run a central bank is to take on an awesome
for the course of inflation, interest rates, the value of
the currency and ultimately economic activity. We need in this society to
209
leave little question that the aim is to return to financial stability.
The only way
to achieve this, having reduced inflation, is to reduce
inflation expectations.
bank
to
reduce
the
And the only way to do this is for the central
growth
o£
money
inflation expectations will shrink.
and ultimately
credit
so
that
That in turn will bring about low
interest rates, maintain the value of the currency, raise equity values
to higher levels thus reducing the cost of capital implied by both lower
interest rates and higher equity values.
In such an environment there
would be an increased probability
that we would
stronger
growth and away
and
sustainable economic
growth that the USA has experienced
not
a pleasant
prescription,
return to periods of
from the
spasmodic
in the last fifteen years. This is
particularly
since
it would
be
nice to
suggest that the pain of the last few years has insured solution to all
our problem.
And yet the pain itself is a justification to complete this
phase of the job.
What the markets are saying, particularly the bond
market, is that there is a need to see more consistency in the conduct of
Federal Reserve Board policy if the risk premium and interest rates are
to come down.
210
The CHAIRMAN. Thank you, gentlemen. Your entire statements
will be included in the record.
PROPER PROCEDURE FOR MONETARY POLICY
Currently the Federal Reserve is now seeking to implement monetary policy on a day-to-day basis by controlling net borrowed reserves. Do you believe this is an appropriate procedure for monetary policy?
Mr. MEIGS. No, the procedure of using borrowed reserves came
out of the 1920's. It's very unreliable. It gives the Federal Reserve
very little control over the rate of growth of money supply. It tends
to produce a procyclical change in the rate of growth of bank credit
and the money supply, just as would be the case if they were targeting interest rates. If credit demands tend to rise, then banks
borrow more from the Federal Reserve and the Federal Reserve accommodates. Then you have an increase in money growth at just
exactly the wrong time. I think this is a step backward. They
would be far better off, as I think Mr. Poole suggested, to focus on
total reserves not net borrowed reserves.
The CHAIRMAN. Your statement, Mr. Savin, argues that inconsistent changes in tax policies in recent years have contributed to
current risk premiums in interest rates. To what extent do you believe that inconsistent tax policies contribute to high interest
rates?
Mr. MEIGS. I believe, too, that a fiscal policy should be very
stable long term and I agree changes in tax rates do generate much
uncertainty among business people, consumers, and investors.
So, it would be desirable, given a stable monetary policy, to set
fiscal policy by long run reasons. That is, decide how much of the
national income should be devoted to public purposes, Federal purposes, stick to it and minimize changes in tax rates. They are not
useful in stabilizing the economy. They raise uncertainty and they
reduce incentives of people. Increases in taxes reduce incentives for
people to work, save, and invest. It's as simple as that.
The CHAIRMAN. Mr. Savin, do you believe that financial markets
today are convinced that the Federal Reserve is committed to an
anti-inflationary policy?
Mr. SAVIN. Well, sir, it's always very presumptuous to speak for
the markets, but if I may, I think there are severe doubts about
that, and you see those doubts reflected in what people call the
real rate of interest. I prefer myself not to use that formulation. I
prefer to speak about the high-risk premium. The risk premium is
the difference between that real interest rate and the nominal interest rate. And we haven't seen the risk premium that we now
have in many decades. So no, I don't think the financial markets
are convinced.
The CHAIRMAN. Do you believe that Congress is largely responsible for that? We tend to gloss over, as I talked about with Dr. Poole
before, about Congress never including itself in these resolutions,
to demand stability in everything from the President and the Fed,
but never from us. We just go merrily along being irresponsible
without anybody condemning us very much.
211
We also find that there is a constant demand for expansion of
the money supply. I can't believe that after 10 years of sitting on
this committee, invariably some member of the committee and
others will jump on the bandwagon of pushing the so-called low interest rate. But all we've got to do is demand that the Fed pump
more money out there. Despite all the charges, despite all the evidence, despite all the inconsistencies of economists in other matters, there's one area where they're pretty darn consistent in all
the ones I've listened around there, that expansion of the money
supply too rapidly causes inflation and high interest rates.
My colleagues don't want to do that, obviously, because it's much
nicer to blame the Fed and blame a President, this one or any
other, for the failures of our fiscal policy.
CONGRESS IS RESPONSIBLE FOR UNCERTAINTY IN THE MARKETPLACE
Would you agree with me that Congress is responsible for a good
deal of the uncertainty in the marketplace?
Mr. SAVIN. You know, sir, in institutions, we exist to be scapegoats for each other. [Laughter.]
The CHAIRMAN. But who is Congress the scapegoat for? I see us
scaping.
Mr. SAVIN. You're obviously a scapegoat for everybody.
The CHAIRMAN. And when we have testimony, most witnesses
can come in and condemn everybody else, but because they're
facing a panel of Senators or Representatives on the other side,
they're very timid in being honest about us, being not just the
scapegoat, but the real cause of most of these problems.
Mr. SAVIN. It's simple what you have to do, isn't it? It's very
hard in practice to do it, when you have to insist on a consistent
monetary policy too, you have to have a consistent tax policy, you
have to learn to tell special interests, no. The third thing you have
to do is, you have to try and hold down the growth rate of Government expenditures.
The CHAIRMAN. Tax policy and fiscal policy are set here; right.
No place else.
Mr. SAVIN. Absolutely.
The CHAIRMAN. Two of the three variables you're talking about
are set by us.
Mr. SAVIN. Yes, and you have to strive to do a better job.
The CHAIRMAN. You're very kind. [Laughter.]
A better job—better than what?
Mr. SAVIN. Than what has been done.
The CHAIRMAN. Anything would be an improvement, in this Senator's opinion.
Senator Hecht, do you have questions you wish to ask?
Senator HECHT. Senator Garn, I'd like to pass, so I can hear the
next speaker.
The CHAIRMAN. Senator Humphrey.
Senator HUMPHREY. With respect to one of the three elements
we're addressing, namely, monetary policy, the difficulty cited by
our witnesses, if I understood them, is that the financial markets
have little faith that we will not return to inflationary monetary
policy, either deliberately or indeliberately; is that correct?
212
The point I'm trying to make in putting that question is, once
again, that monetary policy and all of the things that gather
around it that control interest rates and so on, are in the hands
and at the discretion of a few human beings set instead of determined by some other constraint, mechanical system or whatever. I
don't know exactly what that alternative should be, but I'm trying
to find someone who will tell me what it should be, because I think
what we have is very poor.
Mr. SAVIN. Whatever mechanical constraints you'd design, would
be designed by human beings, I'll remind you.
Senator HUMPHREY. Yes, but you can still instill discipline, if the
marketplace has a greater say in these matters, as opposed to exclusive reliance on the judgment of human beings, a few human
beings, who are unaccountable, essentially, to anyone.
Mr. MEIGS. I agree. You ought to have long-term monetary
policy. And the degree of discretion that the Federal Reserve uses
now is one of the great causes of market uncertainty. If people in
the market knew that the Federal Reserve was aiming at a particular rate of growth in the money supply, the market then could
adjust to all sorts of things. But if they think, well, today, they're
aiming at the money supply, next week it will be something else,
the week after that still something else, and every time something
happens to the market, they're going to do something, the market
is continuously in a fever of anxiety over what the Federal Reserve
is going to do next. That is the great cause of the risk premium
that he's talking about. And you, I think, in the Senate have the
responsibility, if the Federal Reserve gives you a set of monetary
targets, to see to it that they deliver.
FED NEEDS TO BE HELD ACCOUNTABLE
Mr. SAVIN. There have been about four major changes in Federal
Reserve Board policy in the last 4 years. I don't know if you people
have tried to ask them for rhyme or reason. There was one that
one of the members of the Board announced quite by chance this
spring in Chicago.
And you know, that's the whole thing.
Senator HUMPHREY. The difficulty is that we have no means of
holding them accountable, have we?
Mr. MEIGS. The Federal Reserve Act was written by the Congress. The Federal Reserve Act can be amended, if you see reason
to change the system. In effect, I think that's one of the great fears
that the Federal Reserve has, which is one of the reasons they like
to be as little accountable as possible.
Senator HUMPHREY. My view is that we have to make some reforms. The system we have now is not working; it has no stability;
it changes from year to year. We try and they try one method one
year and another method another year. They bounce off one wall,
and then in reaction, they bounce off another wall. It's incredible.
It would be funny, if it weren't so tragic, if it didn't have such
tragic consequences for every citizen of our country.
Mr. MEIGS. And the world.
Senator HUMPHREY. If you were us, what would you do, specifically?
213
Mr. MEIGS. One suggestion was made at the beginning. In 1981,
the program that the new administration proposed included a provision that the Federal Reserve reduce the growth rate of the
money stock on a preannounced track and gradually, over a period
of 4 and 5 years. But that was not the policy that the Federal Reserve delivered, and as far as I know, the Federal Reserve never
accepted that as a policy instruction. It preferred to go year-toyear, or month-to-month, or day-to-day in its policy.
Senator HUMPHREY. Mr. Savin, did you think that changes were
needed in the Federal Reserve Act to address the other problems
that you've cited here?
Mr. SAVIN. Clearly.
Senator HUMPHREY. What changes would you recommend?
Mr. SAVIN. I think that we have to first of all separate what the
Fed is from what the Fed is not and what the Fed cannot do. The
Fed's prime targets are reserves. The secondary targets are the
money targets, and ultimately what happens in the business cycle.
And what we should do now is focus on the primary targets, set
them by legislation and simplify things.
Senator HUMPHREY. So you would change the act to strive
toward consistency and clear goals?
Mr. SAVIN. Oh, yes.
Senator HUMPHREY. You're satisfied that the Federal Reserve
System would pay out money?
Mr. SAVIN. Sure; absolutely. I don't see fiat money as a problem
per se. You know, people forget that even under the gold standard,
we had inflation, deflation, and cycles. Again, you have the human
restraint. That's something you always have to deal with. You have
the human problem that we talked about.
Senator HUMPHREY, That's precisely the problem. It's in the
hands of human beings, a small number of human beings. It just
seems as though there's got to be a better way, but failing fundamental changes, I certainly agree with what you said we need to
make changes in the Federal Reserve Act to clarify goals and
assure consistency.
Is there any legislation of which you are aware that would do
that?
Mr. SAVIN. I am sure that the Senate and House have got several
bills on Federal Reserve Board policies, one aspect of it or the
other, but I don't know whether they are specifically the same with
regard to simplifying the job.
Senator HUMPHREY. I wonder if the chairman knows of any such
legislation or if he's been following our discussion here.
The CHAIRMAN. I have been following your discussion. The discussion has been going on for many years in various forms over
what to do with the Fed to make them perform. I know of no legislation that can accomplish that. We've had lots of different suggestions, I don't know a year that we haven't had bills to make the
term of the Chairman cotertninus with that of the President, put a
farmer or a small businessman, and all of that, require various
things. I personally do not know of any legislation that can accomplish that. I think we're kidding ourselves if we think we can legislate the kind of decisionmaking that goes on in the process of
trying to make monetary decisions, plus I'm also not much of a
214
monetarist. You haven't been on the committee long, but you know
my bias against deficits in the fiscal policy. And I'll just make one
more comment.
In years when we had stable fiscal policy with reasonable expenditure rates and tax policies, nobody in this country knew the
Fed existed. It was practically nonexistent. It wasn't in the press.
The Chairman of the Federal Reserve Board was not called the
second most powerful man in the country. And it was a relatively
easy job.
The Fed has been forced into the forefront, in my opinion, by the
irresponsible fiscal policy of the Congress. And I don't care who
you make Chairman of the Fed or how long his term is, or what
you do to him, as long as Congress sends him $200 billion deficits,
it is one heck of a tough job and no legislation can change that.
Senator HUMPHREY. I agree with the chairman; he doesn't have
to make a speech. [Laughter.]
Fiscal policy is grossly irresponsible, but that's not what we're
discussing here today. In the confines, or within the constraints of
the mess the Congress is making, the Federal Reserve has to operate, and I think it has been doing pretty poorly, even given those
outside external problems.
CONGRESS IS SCAPEGOAT FOR THE FED
Mr. SAVIN. May I interrupt you, sir, to say that you have become
their scapegoat. The fact is, also, there are countries which have
financial stability, which have had for many years much larger
budgetary deficits than we have, and indeed, the reason why we
never heard about the Fed in the 1950's—I think that was the
period to which you make reference
The CHAIRMAN. And the 1960's.
Mr. SAVIN. And the early 1960's. We started hearing about them
in the mid-1960's—is that we had a stable financial system which
has bequeathed us with low-interest rates, nonexistent risk premiums, and there was no need. As I said, in those days, the Fed controlled the market by manipulating Fed funds. You knew what the
specific content of that information was. You have to change the
game.
Senator HUMPHREY. I think we have to remove the human element as much as possible. The question is, how to do that. The financial markets are going to be nervous, as long as the human element is largely controlling it, it seems to me.
Mr. SAVIN. With respect, Mr. Senator, you cannot remove the
human element. The human element is the center of the circle.
Senator HUMPHREY. Not entirely, but of course we're dealing in
human matters. The center of economic matters. It's all about
human behavior. But in case of control of the money supply, it's
entirely in the hands of a few human beings who are accountable
to no one, and who have no accurate tools with which to work.
Mr. SAVIN. If you would say, sir, if you want to reduce their
scope of government, I would agree with you, and all you'd have to
do is lower the target and reduce the targets. Because if you have a
target like 4 to 8 percent, and you say, "Well, if we look out next
year, we'll probably reduce it in 1985, you're setting the stage for
215
an inflation accident. We can call it an accident, of 4 percent more
inflation. So if we don't know if the inflation is going to be 3, 8, or
10 percent, just in terms of self-protection, we'll discount 10.
Senator HUMPHREY. If somehow by legislation or otherwise you
could persuade the Federal Reserve to focus on one specific growth
figure, 4 percent or whatever it would be, have they the means of
doing that for us with the imperfect tools they work with?
Dr. MEIGS. They have all the tools. They've had the tools. You
gave them the power to extend reserve requirements to many,
many more financial institutions. The tools are in their hands. The
question is how they use them.
I would say ask them to set one monetary target. It really
doesn't matter so much which one they set, just so there's one of
them and they behave consistently thereafter and deliver what
they say they're going to do.
Senator HUMPHREY. With all the lags, how could they hue that
closely to it?
Dr. MEIGS. That's a good point. With all the lags, discretionary
policy becomes very risky. They tend to act on the pressure of
what's happening today as though they can affect everything today
when we know what they do today may affect prices 2 years later.
If they were keeping that in mind they would be doing much less
changing of policy from week to week and month to month. They
wouldn't need to. The economy could adjust to that in expectations
and the markets would become more stable, as I would argue for
the Japanese example. It's a very good example. Other countries
can do it and are doing it. So, why can't we do it?
Senator HUMPHREY. It beats me.
The CHAIRMAN. Because we have too much politics involved.
That's why.
Gentlemen, thank you very much. We appreciate your testimony.
Next we would like to call Beryl Sprinkel, Under Secretary for
Monetary Affairs of the U.S. Department of the Treasury.
I might just say for those who are interested, that is not a vote.
It looks like one, but apparently we have a burned out light.
Mr. Secretary, if you'd like to proceed.
STATEMENT OF BERYL SPMNKEL, UNDER SECRETARY FOR
MONETARY AFFAIRS, U.S. DEPARTMENT OF THE TREASURY
Mr. SPRINKEL. Thank you, Senator Garn and the other distinguished members of the committee. It's a pleasure to be here again
to discuss with you the administration's view on monetary policy.
This administration came to office in 1981 with the conviction
that inflation was a major obstacle to sustained economic prosperity and growth. An important part of President Reagan's economic
program was, therefore, the recommendation that money growth
be gradually decelerated to a noninflationary pace. This recommendation was based on the belief that a process of continued inflation
can persist only when accommodated by excessive monetary expansion.
216
DELETERIOUS ECONOMIC EFFECTS OF INFLATION
By the late 1970's evidence of the deleterious economic effects of
inflation was plentiful: Soaring interest rates, highly unstable financial markets, a precipitous decline in the international value of
the dollar, speculative activity in commodity and real estate markets, a secularly rising unemployment rate and an erosion in the
ability of U.S. industry to compete internationally.
The experience of a decade and a half of accelerating inflation
had radically altered the behavior and expectations of the American public. In general, productive activity became less profitable
than speculative activities or those designed to beat inflation. The
uncertainty generated by rapid inflation made more difficult all
types of economic decisionmaking—from the household decision of
whether to buy a household appliance to a corporate decision of
whether to expand capital spending.
After several short-lived attempts to restrain money growth and
control inflation in the 1970's, by the end of the decade the problem of inflation was viewed by many—including many economists—as inherent and intractable. In contrast the past 3 years
have brought progress on inflation that is truly remarkable. Since
it reached its peak in mid-1980 we have seen the largest decline in
CPI inflation in more than three decades. Even those of us who
were totally committed in 1981 to the view that inflation could and
would be brought under control, would not have dared to be so optimistic.
The experience of the past 3V2 years has demonstrated inflation
is not a disease that modern industrialized nations must accept. Inflation is not imposed upon us by uncontrollable forces. Sustained
inflation is largely a monetary phenomenon. It can be controlled
when monetary discipline is pursued. This is an important lesson
for us all. For Government officials, Members of Congress, and
voters in general. Only by learning from this experience can we
permanently avoid repeating the policy mistakes of the past.
There is no reason why progress on inflation cannot be extended
and inflation ultimately be brought to zero. Price stability does not
mean there would be no changes in the prices of specific goods and
services. Changes in individual prices are the essence of the market
system at work. Despite inevitable—and desirable—changes in specific prices, some of us are old enough to remember when the general price level was basically stable from year to year. That was
the period you were referring to a few moments ago, Senator Garn.
At the current time there is an enormous divergence of opinion
among experts about the future course of inflation. At one extreme, some analysts foresee continued low rates of inflation, some
have even suggested actual deflation. At the other extreme some
analysts are predicting a significant reacceleration of inflation by
the end of this year.
Some analysts believe that variables such as gold and other commodity prices are good leading indicators of inflation; so far, these
variables have shown no convincing signals of rising future inflation. In addition, wage pressures appear to be moderate and productivity is rising. It has been argued that these developments
should allay our concerns about inflation. The problem with this
217
analysis is that these leading indicators of inflation have in the
past sometimes given misleading signals—failing to foreshadow
rising inflation or signaling a change in inflation that never materialized. Thus, such predictors of inflation, unfortunately, are not
infallible.
The more pessimistic views of future inflation are usually based
on the historical money-price relation as depicted in chart 1 of my
testimony. Given the close relation in the past between money
growth and inflation, money growth over the past 2 years raises serious concerns about the outlook for inflation. With the trend well
above the rates of money growth associated with the acceleration
of inflation in the mid-1970's, Ml growth, based on historical patterns, is giving off ominous signals for future inflation.
The regulatory changes instituted in late 1982 and early 1983
created uncertainty about the meaning of behavior of the monetary
aggregates, especially in the shorter run. That uncertainty leads
some analysts to doubt the forecasts of inflation based on money
growth rates that encompass that period of time. Some analysts, include myself, incidentally.
The uncertainty about the effects of financial deregulation can
be summarized by observing the behavior of velocity over this
period of time. Velocity is the relationship between nominal GNP
and the money supply; it is a summary description of the public's
behavior with respect to total spending [GNP] and the money
supply. Since the deregulatory changes in 1982-83 authorized
transaction accounts that pay a market rate of interest, it is plausible that the public is now holding larger money balances for a
given amount of spending. This would have the effect of suppressing velocity.
Chart 2 shows the historical behavior of velocity. As can be seen
in the chart, it is not unusual for velocity to decline during a recession as increased uncertainty and lower interest rates typically
induce the public to hold more cash balances. As money balances
rise relative to spending, velocity falls.
DECLINE IN INFLATION CAUSES VELOCITY TO FALL
In addition, the decline in inflation and/or inflationary expectations would be expected to cause velocity to fall as the public is
willing to hold larger cash balances. Thus the decline in velocity in
1981 and 1982 may not have been atypical. As can be seen in chart
2, however, velocity did not rebound in 1983 as the economy recovered as has been its historical pattern. This has led some analysts
to conclude that the regulatory changes in 1982-83 have had a permanent effect on the behavior of velocity.
If so, it's reasonable to infer that the rapid money growth of
1982-83 will not have the inflationary impact that one would
expect, based on historical experience; it is then logical to conclude
that the outlook for inflation is less ominous. However, if one believes that despite financial innovation, the velocity relationship
remains basically intact and that velocity will return to its historical level and growth path, then one must conclude that money
growth over the past 2 years will result in a significant rise in inflation by the end of this year.
218
This is not the only source of uncertainty about future inflation,
but it is an important one. That uncertainty is not without consequence. As President Reagan has stated on several occasions, the
uncertainty about future inflation is a major factor in keeping interest rates high, relative to the current rate of inflation.
Despite the uncertainty about the behavior of Ml over the past 2
years, it does not appear that a serious reacceleration of inflation is
on the horizon, provided that monetary policy is sound and noninflationary in the future. The bulge in money growth from mid-1982
to mid-1983 is behind us. If, nonetheless, the result is a surge in
inflation, there is now nothing that can be done about it beyond
adhering to a noninflationary monetary policy, designed to limit
and contain the inflationary threat.
Beginning in mid-1983 the Federal Reserve Board decelerated
money growth from the rapid rates of the preceding year. At that
time the administration agreed completely that money growth had
to be decelerated; our concern was that the deceleration be a gradual one, in order to avoid aborting the recovery or causing another
economic downturn. The Federal Reserve did an excellent job of
achieving that goal. In the past year, Ml growth has averaged a
more modest 6.8 percent; during the first half of 1984, Ml growth
has been extremely well behaved, remaining generally in the upper
half of the Federal Reserve's target growth range.
In the last three or four quarters, velocity appears to be paralleling its historical trend, but along a lower path. While a few quarters' observations are not sufficient from which to confidently draw
inferences, it is possible that this will turn out to be the ultimate
result of recent deregulations: A one-time shift in the level of velocity, after which it will continue to follow a growth path parallel to
the growth path projected from historical patterns. If so, the 198283 bulge in money growth can be viewed as an offset to the shift in
velocity and no further adjustment of money growth targets is
needed.
It is still too early to know whether or not regulatory changes
have permanently altered the fundamental relationship between
money growth and GNP. The policy dilemma is, of course, that by
the time there is sufficient information on public behavior available to infer a statistically sound answer to the question, it will be
too late to design and implement the appropriate policy actions.
In the interim, the most prudent course is to pursue a policy of
money growth that subjects the economy neither to the danger of a
monetary restriction nor to any additional risks of accelerating inflation. This implies a moderate rate of money growth that implicitly assumes velocity growth in the range of historical experience.
The target growth range for Ml tentatively set by the Federal
Reserve for 1985 is prudent and consistent with this risk minimizing view of future velocity behavior. Chairman Volcker has indicated that in the future the FOMC will be giving roughly equal treatment to the various monetary aggregates in the implementation of
monetary policy. This decision as well as the narrowing of the Ml
target range and the 4 to 7 percent range itself, all imply that the
Federal Reserve expects Ml velocity to behave more typically,
based on historical experience. If this is the case, there is compelling historical evidence to recommend that Ml be the primary
219
target of Federal Reserve policymaking. Among the various monetary aggregates, Ml historically has been the most reliable indicator of real economic activity in the short run and inflation in the
long run.
The downward adjustment of the 1985 target ranges for Ml and
M2 are, I believe, appropriate to our long-run goal of gradually decelerating money growth to a rate consistent with price stability.
PRICE STABILITY IS GOVERNMENT'S ECONOMIC FUNCTION
Thus, the administration agrees with and supports the target
money growth ranges announced by Chairman Volcker last week. I
take money growth targets very seriously; I hold this conviction for
several reasons. First, I believe that providing basic price stability
is among the most important economic functions of the Government and the function of a central bank. Whatever else Government may decide to do in the areas of redirecting resources or redistributing income, our efforts to promote economic expansion and
stability are likely to be thwarted if basic price stability is not provided.
Whatever the problems that may arise with monetary control
that can cause some to lose faith in the exercise, a monetary policy
that focuses on reasonably close control of the monetary aggregates
remains—like democracy—far superior to the alternatives. While
the relationships between money and economic activity and money
and inflation are by no means precise ones, they are more reliable
than other relations, such as that between interest rates and economic activity, that are frequently suggested or employed as a
guide to monetary policy.
Second, effective money growth targets convey to the public in
general—and specifically to the financial markets, business, and investment planners—the intentions of the central bank with respect
to future inflation. Preannounced money growth targets that are
consistently met become a meaningful policy statement on which
the business and investment communities can rely; predictable and
prudent monetary trends minimize the uncertainty about future
economic performance and inflation and provide a more stable economic and Financial background in which savers and investors can
more confidently plan and commit funds.
The value of money growth target—in imposing discipline and
acting as a messenger of the Fed's intentions—is greatiy diminished if targets are frequently not achieved or if they are changed
at will. It is in this context of the overall usefulness of money
growth targets that we urge the Federal Reserve to achieve the targets they have set. In addition, I urge that the Congress, as the
branch of Government to which the Federal Reserve is ultimately
responsible and accountable, join in that admonition.
While the Federal Reserve has been very successful in controlling money growth so far this year, the policymaking procedures of
the Federal Reserve, in my view, contain inherent policy risks. The
current policy approach of the Federal Reserve appears to be focused almost exclusively on targeting emerging real economic activity. The financial markets are completely aware of this. It is for
this reason that announcements of economic statistics that imply
220
continued economic expansion often cause interest rates to rise, as
market participants expect the Fed to react by "tightening" monetary policy; in this way, "good" economic news becomes "bad"
news, at least in the financial markets. It is particularly ironic that
the Fed has sent this message to the financial markets during a
period when money growth—the Fed's ultimate responsibility—has
been quite well-behaved.
A policy of tailoring monetary growth to contemporaneous real
economic developments implies significant potential dangers to the
economy. Such a policy approach presumes that the Federal Reserve can foresee all the potential economic and political shocks to
the economy, accurately predict their impact, and take offsetting
policy actions in a timely fashion. That is a near-impossible task. A
policy of targeting real economic growth subjects the economy to
the risks of considerable destabilization as economic developments
emerge that are unanticipated or inaccurately forecasted.
Since late 1982, the day-to-day operating procedures of the Federal Reserve have been designed to provide a prescribed degree of restraint or ease in money market conditions and bank reserve positions. This is functionally equivalent to a policy of targeting the
Federal funds rate which was the Fed's operating procedure during
the 1970's.
For periods of time, appropriate money growth may be generated
by the Fed's practice of targeting money market conditions. This
may occur either when market interest rates are well-behaved, or
when there are no unforeseen movements in interest rates, or if
the Fed is exceptionally good or even lucky at judging interest rate
movements and their meaning for money growth. Under such a
control procedure, money growth is not a variable that is deliberately controlled by policy actions, as it could be. Rather, money
growth is a byproduct of the relation between market interest
rates—which move frequently in response to a multitude of economic and political factors—and a Federal funds rate target that
the Federal Reserve moves only infrequently and typically only
with a delay.
If money growth is to be consistently well-controlled, the Federal
Reserve, the administration, and the Congress must be willing to
let interest rates move as market forces dictate. By allowing
market forces to determine interest rates, the Federal Reserve
could focus its day-to-day operations on controlling bank reserves
or the monetary base, the growth of which ultimately determines
money growth. The result would be a more stable and predictable
pattern of monetary expansion.
The alternative—monetary instability—imposes important costs
on the economy. Because of the close association between changes
in money growth and real economic activity, volatile money growth
induces similar fluctuations in the economy. In addition, each
swing in money growth generates uncertainty about economic performance: on the upside, it renews fears about inflation; on the
downside, it generates concerns about an economic downturn. That
uncertainty adds a risk premium to the level of interest rates.
More predictable and stable money growth would minimize the
policy-induced fluctuations in the real economy, help reduce uncer-
221
tainty, and consequently hasten the downward adjustment of inflation expectations and therefore interest rates.
In conclusion, institutional changes during late 1982 and early
1983 generated some atypical uncertainty about the meaning of
money growth over that period. From a policymaking standpoint,
those uncertainties appear to be behind us, even though the implications for future inflation may remain uncertain. The uncertainty
about the inflation outlook is not inconsequential. Plainly stated, it
causes interest rates to be higher than they otherwise would be.
I know of no reasonable or prudent way to quell the fears about
future inflation other than adhering to a preannounced noninflationary path of money growth. Any alternative path of money
growth implies serious risks to the economy. It is possible that inflation will rise in response to the accelerated growth during the
last 2 years. There is little that can now be done about that, except
pursuing a policy that limits any potential rise in inflation; attempts to abruptly reverse that bulge in money growth would certainly risk a monetary restriction of the economy. Alternatively, ignoring the potential for an increase in inflation would be equally
irresponsible; we have come too far in reducing inflation, at too
great a cost, to risk squandering that progress.
Our best chance of both protecting our gains toward price stability and avoiding any monetary restriction of the economy is for the
Federal Reserve to provide moderate money growth. The target
ranges announced last week by Chairman Volcker imply that this
is the intended policy of the Federal Reserve. The administration
supports this stated policy and strongly recommends that the Federal Reserve take the policy actions needed to assure these results.
Thank you, Mr. Chairman.
[The complete statement follows:]
222
TREASURY NEWS
Department Of the Treasury • Washington, D.c. • Telephone 566-2041
FOR RELEASE JJPOH DELIVERY
Expected at 11 a . m .
STATEMENT BY BERYL W. SPRINREL
UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS
BEFORE THE
SENATE COMMITTEE OH BANKING, HOUSING, AND URBAN AFFAIRS
WASHINGTON, D . C .
Tuesday, July 31, 1984
Senator G a r n , Senator Proxmire, d i s t i n g u i s h e d Members of
the Committee, it is a pleasure to be here again to d i s c u s s
w i t h you the A d m i n i s t r a t i o n ' s views on m o n e t a r y policy.
This A d m i n i s t r a t i o n came to o f f i c e in 1981 w i t h the
conviction t h a t i n f l a t i o n was a m a j o r obstacle to sustained
economic prosperity and g r o w t h . An important part of President
Reagan's economic program was therefore the recommendation t h a t
money growth be g r a d u a l l y decelerated to a n o n i n f l a t i o n a r y
pace. This recommendation was based on the belief that a process
of continued i n f l a t i o n -- as d i s t i n c t from an increase in the
price of one good r e l a t i v e to others — can persist only when
accommodated by excessive monetary expansion.
By the late 1 9 7 0 ' s , evidence of the deleterious economic
e f f e c t s of i n f l a t i o n was p l e n t i f u l : soaring interest r a t e s ,
highly unstable f i n a n c i a l markets, a precipitous decline in the
international value of the d o l l a r , speculative a c t i v i t y in
commodity and real estate m a r k e t s , a secularly r i s i n g unemployment r a t e , and an erosion in the a b i l i t y of U.S. industry to
compete i n t e r n a t i o n a l l y . The experience of a decade and a
half of accelerating i n f l a t i o n had radically altered the behavior
and expectations of the American public. As savers, we had
learned t h a t there was l i t t l e point in a b s t a i n i n g from current
consumption so t h a t i n f l a t i o n could reduce the real purchasing
power of accumulated f u n d s .
As workers, we learned the need
to demand «ver-rising wage r a t e s , as i n f l a t i o n eroded the real
value of income earned and b r a c k e t creep imposed h i g h e r and
h i g h e r tax rates on incomes, that in many cases, were declining
in real teems. As l e n d e r s , the u n c e r t a i n t y about rising i n f l a t i o n
made us increasingly r e l u c t a n t to commit f u n d s on a longterm
basis. Profits declined as producers were faced w i t h rising
costs, d e c l i n i n g p r o d u c t i v i t y , and i n t e n s i f i e d i n t e r n a t i o n a l
competition.
In g e n e r a l , productive a c t i v i t y became less
p r o f i t a b l e than speculative a c t i v i t i e s or those designed to
"beat" i n f l a t i o n .
The u n c e r t a i n t y generated by rapid i n f l a t i o n
223
made more d i f f i c u l t all types of economic decision-making —
from the household d e c i s i o n of whether to buy a household
appliance to a corporate decision of whether to expand capital
spending.
After several short-lived attempts to r e s t r a i n money growth
and control i n f l a t i o n in the 1 9 7 0 ' s , by the end of the decade
the problem of i n f l a t i o n was viewed by many — i n c l u d i n g many
economists — as inherent and intractable. In contrast, the
past three years have brought progress on i n f l a t i o n that is
truly remarkable. Since it reached its peak in mid-1980, we
have seen the largest d e c l i n e in CPI i n f l a t i o n in more than
three decades. Except for a f l e e t i n g period j u s t a f t e r price
controls were in e f f e c t , recent a n n u a l rates of i n f l a t i o n have
not been experienced in the U . S . since the early 1960's. Even
those of us who were totally committed in 1981 to the view that
i n f l a t i o n could and would be brought under control, would not
have dared to be so optimistic.
The experience of the past three and a half years has
demonstrated i n f l a t i o n is not a disease t h a t modern, i n d u s t r i a l ized nations m u s t accept.
I n f l a t i o n is not imposed upon on us
by uncontrollable forces. Sustained inflation is largely a
monetary phenomenon; it can be controlled when monetary discipline is pursued. This is an important lesson for us all -for government o f f i c i a l s , Members of Congress, and voters in
general. Only by learning from t h i s experience can we permanently
avoid repeating the policy mistakes of the past.
There is no reason why progress on i n f l a t i o n cannot be
extended and i n f l a t i o n ultimately be brought to zero.
Price
stability does not mean there would be no changes in the prices
of specific goods and services. Changes in individual prices
are the essence of the market system at work; it is through
increases or decreases in relative prices that shortages or
excess supply conditions are resolved by the m a r k e t . Attempts
to suppress or subvert changes in relative prices prevent the
market system from f u n c t i o n i n g as it should; invariably they
only prolong the market imbalance, and u l t i m a t e l y d i s t o r t the
allocation of economic resources. Despite inevitable — ana
desirable — changes in specific prices, some of us are old
enough to remember when the general price level was basically
stable from year-to-year.
The_0utlook; fqr__Infl_ation
At the current time there is an enormous divergence of
opinion among experts about the f u t u r e course of i n f l a t i o n . At
one extreme, some analysts foresee continued low rates of
i n f l a t i o n , some have even suggested actual d e f l a t i o n .
At the
other e x t r e m e , some analysts are predicting a s i g n i f i c a n t
reacceleration of i n f l a t i o n by the end of this year.
224
Some analysts believe that variables, such as gold and other
commodity prices, are good leading indicators of inflation; so
f a r , these variables have shown no convincing signals of rising
future inflation. In addition, wage pressures appear to be
moderate and productivity is r i s i n g . It has been argued that
these developments should allay our concerns about inflation.
The problem with this analysis is that these leading indicators
of inflation have in the past sometimes given misleading signals
— f a i l i n g to foreshadow rising i n f l a t i o n or signalling a change
in i n f l a t i o n that never m a t e r i a l i z e d . T h u s , such predictors of
i n f l a t i o n are not infallible.
The more pessimistic views of f u t u r e i n f l a t i o n are usually
based on the historical money-price relation as depicted in
Chart 1. Historically, i n f l a t i o n has been closely related to
the long-term, trend rate of Ml growth. The e f f e c t of money
growth on inflation occurs w i t h a lag, typically estimated to
be 1-1/2 to 2 years. Chart 1 i l l u s t r a t e s the a n n u a l rate of
change in Hi and the GNP d e f l a t o r , plotted so that money growth
lags i n f l a t i o n by two years.
Given the close relation in the past between money growth
and i n f l a t i o n , money growth over the past two years raises
serious concerns about the outlook for i n f l a t i o n .
For the two
years e n d i n g in J u n e , Ml growth averaged nearly 10%. U n t i l
very recently the two-year rate of money growth was higher than
at any time in the post-World War II period. With the trend
well above the rates of money growth associated with the
acceleration of i n f l a t i o n in the 1970's, Ml g r o w t h , based on
historical patterns, is g i v i n g off ominous signals for f u t u r e
inflation.
The regulatory changes instituted in late 1982 and early
1983 created uncertainty about the meaning of behavior of the
monetary aggregates. That uncertainty leads some analysts to
doubt the forecasts of inflation based on money growth rates
that encompass that period of time.
The Behavior of Velocity
The uncertainty about the e f f e c t s of f i n a n c i a l deregulation
can be summarized by observing the behavior of velocity over
this period of time. Velocity is the relationship between
nominal GNP and the money supply; it is a summary description
of the public's behavior w i t h respect to total spending (GNP)
and the money supply. Since the deregulatory changes in 1982-83
authorized transactions accounts that pay a market rate of
interest, it is plausible that the public is now holding larger
money balances for a given amount of spending. This would have
the e f f e c t of suppressing velocity.
Chart 2 shows the historical behavior of velocity; the
solid line is the actual level of velocity and the dotted line
is a trend line statistically estimated from the historical
225
growth of velocity. As can be seen in the c h a r t , it is not
u n u s u a l for velocity to d e c l i n e d u r i n g a recession as increased
uncertainty and lower i n t e r e s t rates typically induce the public
to hold more cash balances; as money balances rise relative to
spending, velocity f a l l s . In a d d i t i o n , a d e c l i n e in i n f l a t i o n
and/or i n f l a t i o n a r y e x p e c t a t i o n s would be expected to cause
velocity to f a l l as the p u b l i c is w i l l i n g to hold larger cash
balances. Thus the decline in velocity in 1981 and 1982 may not
have been a t y p i c a l ; it may be a t t r i b u t a b l e to the normal cyclical
d o w n t u r n , reinforced by the s i g n i f i c a n t drop in i n f l a t i o n . As
can be seen in Chart 2, however, velocity did not rebound in
1983 as the economy recovered, as has been its historical
pattern. This has led some analysts to conclude that the
regulatory changes in 1982-83 have had a permanent e f f e c t on
the behavior of velocity.
If one believes that f i n a n c i a l d e r e g u l a t i o n has caused
e i t h e r a one-time s h i f t , or a permanent change, in the historical,
behavioral relation between money growth and aggregate spending
( v e l o c i t y ) , it is reasonable to i n f e r that the rapid money
growth of 1982-83 w i l l not have the i n f l a t i o n a r y impact that
one would expect, based on historical experience; it is then
logical to conclude that the outlook for i n f l a t i o n is less
ominous. However, if one believes that despite f i n a n c i a l
innovation, the velocity relationship remains basically intact
and that velocity will r e t u r n to its h i s t o r i c a l level and growth
p a t h , then one m u s t conclude that money growth over the past
two years will r e s u l t in a s i g n i f i c a n t rise in i n f l a t i o n by the
end of this year.
This is not the only source of u n c e r t a i n t y about f u t u r e
i n f l a t i o n , but it is an important one. That u n c e r t a i n t y is not
w i t h o u t consequence. As President Reagan has stated on several
occasions, the uncertainty about future i n f l a t i o n is a major
factor in keeping interest rates h i g h , r e l a t i v e to the c u r r e n t
rate of i n f l a t i o n .
Implications for Monetary Policy
Despite the u n c e r t a i n t y about the behavior of Ml over the
past two years, it does not appear that a serious reacceleration
of i n f l a t i o n is on the h o r i z o n , provided that monetary policy
is sound and noninflationary in the f u t u r e . The bulge in
money growth from mid-1982 to mid-1983 is behind us.
If,
n o n e t h e l e s s , the result j.s a surge in i n f l a t i o n , there is now
nothing that can be done about it beyond adhering to a
n o n i n f l a t i o n a r y monetary policy designed to l i m i t and contain
the inflationary t h r e a t .
Beginning in mid-1983, the Federal Reserve decelerated
money growth from the rapid rates of the preceding year; in the
last two quarters of L983, Ml growth averaged "7.3%. fit that
time the A d m i n i s t r a t i o n agreed completely that money growth had
to be decelerated; our concern was that the deceleration be a
226
gradual one, in order to avoid aborting the recovery or causing
another economic d o w n t u r n . The Federal Reserve did an excellent
job of achieving that goal.
In the past year Ml growth has averaged
a more modest 6 . 8 % ; during the f i r s t half of 1984, Ml growth
has been extremely well-behaved , remaining generally in the
upper half of the Federal R e s e r v e ' s target growth range.
In the last three or four q u a r t e r s , the behavior of velocity
has become more typical, based on h i s t o r i c a l experience. As
can be seen in Chart 2, velocity appears to be paralleling its
historical trend, but along a lower path.
While a few quarters'
observations are not s u f f i c i e n t from which to c o n f i d e n t l y draw
inferences, it is possible that this will t u r n out to be the
ultimate result of recent d e r e g u l a t i o n s : a one-time s h i f t in
the level of velocity, a f t e r which it will continue to follow a
growth path parallel to the growth path projected from h i s t o r i c a l
patterns.
If so, the 1982/1983 bulge in money growth can be
viewed as an o f f s e t to the s h i f t in velocity and no f u r t h e r
a d j u s t m e n t of money growth targets is needed. That judgment
would also imply that there was no need for the Federal Reserve
to reverse the surge in money growth from mid-1982 to mid-1983
by a severe r e s t r i c t i o n of money growth.
W h i l e the uncertainties about velocity b e h a v i o r t h a t have
arisen recently &re troublesome, u n c e r t a i n t y is i n h e r e n t in the
process of monetary p o l i c y m a k i n g , especially d u r i n g a period of
i n s t i t u t i o n a l change. It is the challenge of policymakers, in
the face of u n c e r t a i n t y , to pursue policies t h a t m i n i m i z e the
associated risks to economic performance.
This can be demonstrated
by considering more extreme j u d g m e n t s about the f u t u r e behavior
of velocity and the implications for the economy of basing
policy actions on them.
It could be argued t h a t the decline in velocity in 1981-83
was temporary, that velocity w i l l recover as it has in the
p a s t , and r e t u r n to its previous level and follow its historical
growth path.
This assumption implies the need to restrict
money growth immediately in order to m i n i m i z e or prevent a
major resurgence of i n f l a t i o n .
The r i s k of t a k i n g t h a t policy
action, however, is that if t h a t judgment about velocity behavior
turns out to be i n c o r r e c t , a monetary restriction of the economy
is likely. Thus the risk associated w i t h this policy option is
a monetary-induced slowdown or recession in economic a c t i v i t y .
fit the other extreme, one could argue t h a t v e l o c i t y growth
has been permanently affected and that it w i l l in the f u t u r e
grow more slowly than its 3% historical trend. If so, the
policy implication is to accelerate money growth in order to
provide enough l i q u i d i t y to support economic a c t i v i t y . The
economic risk associated with this policy is t h a t , if the
judgement on velocity is incorrect and velocity grows at or
near its historical growth rate, the acceleration of money
growth w i l l be i n f l a t i o n a r y .
227
Clearly neither of these options represents a risk-minimizing approach to monetary policy. It is still too early to
know whether or not regulatory changes have permanently altered
the f u n d a m e n t a l relationship between money growth and GNP.
The policy d i l e m m a is, of course, that by the time there is
s u f f i c i e n t i n f o r m a t i o n on p u b l i c behavior available to infer a
statistically sound answer to the q u e s t i o n , it will be too
late to d e s i g n and implement the appropriate policy actions.
In the i n t e r i m , the most prudent course is to pursue a
policy of money growth t h a t s u b j e c t s the economy neither to the
danger of a monetary r e s t r i c t i o n nor to any additional risk of
accelerating i n f l a t i o n . This implies a moderate rate of money
growth that implicitly assumes velocity growth in the range of
historical experience.
The target growth range for Ml t e n t a t i v e l y set by the
Federal Reserve for 1985 is prudent and c o n s i s t e n t with this
risk-minimizing view of f u t u r e velocity behavior. Chairman
Volcker has indicated that in the f u t u r e the FOMC will be g i v i n g
r o u g h l y equal w e i g h t to the various monetary aggregates in the
implementation of monetary policy. This decision, as well as
the narrowing of the Ml target range and the 4-7% range i t s e l f ,
all imply that the Federal Reserve expects Ml velocity to behave
more t y p i c a l l y , based on historical experience. If this is the
case, there is compelling historical evidence to recommend that
HI be the primary target of Federal Reserve policymaking.
Among the v a r i o u s monetary aggregates. Ml has historically been
the most reliable indicator of real economic activity in the
short run and inflation in the long run.
The downward a d j u s t m e n t s in the 1985 target ranges for Ml
and M2 a r e , I believe, appropriate to our long-run goal of
g r a d u a l l y d e c e l e r a t i n g money growth to a rate consistent with
price stability. Thus, the A d m i n i s t r a t i o n agrees w i t h , and
supports, the target money growth ranges announced by Chairman
Volcker last week. We urge, as we have consistently in the
past, t h a t the Federal Reserve adopt the policy actions needed
to achieve those target ranges.
The Importance of Money _Growth_ Targets
I take money growth targets very seriously; I hold t h i s
conviction for several reasons. First, I believe that providing
basic price s t a b i l i t y is among the most important economic
functions of the government and the f u n c t i o n of a central bank.
Whatever else government may decide to do in the areas of
redirecting resources or redistributing income, our e f f o r t s to
promote economic expansion and stability are liXely to be
thwarted if basic price stability is not provided. While price
stability w i l l not preclude economic problems and disruptions,
the environment of economic growth, lower interest rates and
expanding job opportunities that we all seek w i l l not likely be
s u s t a i n e d , in the absence of reasonable price s t a b i l i t y .
228
Whatever the problems that may arise w i t h monetary control
that cause some to lose f a i t h in the exercise, a monetary policy
that focuses on reasonably close control of the monetary
aggregates remains far superior, in my view, to the alternatives.
While the relationships between money and economic a c t i v i t y
and money and inflation are by no means precise ones, they are
more reliable than other relations, such as that between interest
rates and economic a c t i v i t y , that are frequently suggested or
employed as a guide to monetary policy. Given the close historical relation between money growth and i n f l a t i o n , I believe
t h a t control of the monetary aggregates, prudently executed,
provides the monetary discipline that is a prerequisite for
long-run price stability.
Second, e f f e c t i v e money growth targets convey to the public
in general — and specifically to the f i n a n c i a l markets and
business and investment planners — the intentions of the
central bank with respect to f u t u r e i n f l a t i o n ,
Preannounced
money growth targets that are consistently met become a m e a n i n g f u l
policy statement on which the business and investment communities
can rely; predictable and prudent monetary trends minimize the
uncertainty about f u t u r e economic performance and i n f l a t i o n and
provide a more stable economic and f i n a n c i a l background in
which savers and investors can more confidently plan and commit
funds.
The value of money growth targets — in imposing d i s c i p l i n e
and acting as a messenger of the F e d ' s intentions -- is greatly
diminished if targets are frequently not achieved or if they
are changed at will. Monetary targeting can be an important
device for promoting c r e d i b i l i t y and reducing u n c e r t a i n t y , but
it cannot serve that f u n c t i o n if we consistently excuse errors
and redefine the targets. It is in this context of the overall
usefulness of money growth targets that we urge the Federal
Reserve to achieve the targets they have set. In a d d i t i o n , I
urge that the Congress, as the branch of Government to which
the Federal Reserve is u l t i m a t e l y responsible and accountable,
join in that admonition.
Concerns _fpj:_the_Future
While the Federal Reserve has been very successful in
controlling money growth so far this year, the policymaking
procedures at the Federal Reserve, in my view, contain inherent
policy risks. While their procedures may be successful for a
period of time — as they have been recently -- they are likely
over time to needlessly expose the economy to policy-related
risks.
The current policy approach of the Federal Reserve appears
to be focused almost e x c l u s i v e l y on targeting emerging real
economic activity. The f i n a n c i a l markets are completely aware
of this. It is for this reason that announcements of economic
statistics that imply continued economic expansion o f t e n cause
229
interest rates to rise, as market participants expect the Fed
to react by " t i g h t e n i n g " monetary policy; in this way, "good"
economic news becomes "bad" news. It is particularly ironic
that the Fed has sent this message to the f i n a n c i a l markets
during a period rfhen money growth — the Fed's ultimate
responsibility — has been q u i t e well-behaved.
A policy of tailoring monetary policy to contemporaneous
real economic developments implies s i g n i f i c a n t potential dangers
to the economy. Such a policy approach presumes that the
Federal Reserve can foresee all the potential economic and
political shocks to the economy, accurately predict their
impact, and take o f f s e t t i n g policy actions in a timely fashion.
That is a near-impossible task because of the inaccuracy of
economic forecasting, the lags and inaccuracies in reported
contemporaneous economic d a t a , and the length and variability
of the lags in monetary policy. Thus, a policy of targeting
real economic activity subjects the economy to the risks of
considerable d e s t a b i l i z a t i o n as economic developments emerge
that are unanticipated or inaccurately forecasted.
Since late 1982, the day-to-day operating procedures of
the Federal Reserve have been designed to provide a prescribed
degree of "restraint" or "ease" in money market conditions and
bank reserve positions. This is functionally equivalent to a
policy of targeting the Federal funds r a t e , which was the Fed's
operating procedure during the 1970's. Since the relationship
between interest rates and money growth is not a dependable or
predictable one (particularly as economic conditions v a r y ) ,
t a r g e t i n g the Federal funds rate generally yields very imprecise
control of the monetary aggregates. This was recognized by the
Federal Reserve when it abandoned that control procedure in
1979.
For periods of time, appropriate money growth may be
generated by the Fed's practice of targeting money market
conditions. This may occur either when market interest rates
are well-behaved, or when there are no unforeseen movements in
interest rates, or if the Fed is exceptionally good (or lucky)
at j u d g i n g interest rate movements and their meaning for money
growth. Under such a control procedure, however, money growth
is primarily determined by the movements of market interest
rates relative to the Federal funds rate target. As a result,
money growth is not a variable that is deliberately controlled
by policy actions, as it could be. Rather, money growth is a
by-product of the relation between market interest rates — which
move frequently in response to a multitude of economic and
political factors — and a Federal funds rate target that the
Federal Reserve moves only infrequently and typically only w i t h
a delay.
If money growth is to be consistently well-controlled, the
Federal Reserve (the A d m i n i s t r a t i o n and the Congress) must be
willing to let interest rates move as market forces dictate.
230
By allowing market forces to determine interest rates, the
Federal Reserve could focus its day-to-day operations on
controlling bank reserves or the monetary base, the growth of
which ultimately determines money growth. The result would be
a more stable and predictable path of monetary expansion.
The alternative — monetary i n s t a b i l i t y — imposes an
important costs on the economy. Because of the close association
between changes in money growth and real economic a c t i v i t y ,
volatile money growth induces similar f l u c t u a t i o n s in the
economy. In addition, each swing in money growth generates
uncertainty about economic performance: on the upside, it
renews fears about i n f l a t i o n ; on the downside, it generates
concerns about an economic d o w n t u r n . That uncertainty adds a
risk premium to the level of interest rates. More predictable
and stable money growth would minimize the policy-induced
f l u c t u a t i o n s in the real economy, help reduce u n c e r t a i n t y and
consequently hasten the downward adjustment of i n f l a t i o n a r y
expectations and therefore interest rates.
Conclusion
The institutional changes d u r i n g late 1982 and early 1983
generated some atypical uncertainty about the meaning of money
growth over that period. From a policymaking standpoint, those
uncertainties appear to be behind us, even though the implications
for f u t u r e i n f l a t i o n remain uncertain. The u n c e r t a i n t y about
the i n f l a t i o n outlook is not inconsequential; plainly stated,
it causes interest rates to be higher than they otherwise would
be,
I know of no reasonable or p r u d e n t way to quell the fears
about f u t u r e i n f l a t i o n other than adhering to a preannounced,
noninflationary path of money growth. Any alternative path of
money growth implies serious risks to the economy. It is
possible that i n f l a t i o n will rise in response to the accelerated
money growth d u r i n g the last two years. There is little that
can now be done about t h a t , except pursuing a policy that limits
any potential rise in i n f l a t i o n ; attempts to abruptly reverse
that bulge in money growth would risk a monetary restriction of
the economy. Alternatively, ignoring the potential for an
increase in i n f l a t i o n would be equally irresponsible; we have
come too far in reducing i n f l a t i o n , at too great a cost, to
risk squandering that progress.
Our best chance of both protecting our gains toward price
stability and avoiding any monetary restriction of the economy
is for the Federal Reserve to provide moderate money growth.
The target ranges announced last week by Chairman Volcker imply
that this is the intended policy of the Federal Reserve. The
A d m i n i s t r a t i o n supports this stated policy and strongly recommends
that the Federal Reserve take the policy actions needed to
assure these results.
MONEY LEADS INFLATION BY TWO YEARS
Growth Rates in GNP Price Deflator and Money Supply*
70
CHART 1
71
72
73
74
75
76
77
78
79
80
Bl
82
83
84
85
73
74
75
76
77
78
79
80
Bl
82
83
84
85
86
87
^Quarterly figures.
Latest date plotted:
Growth measured from one year earlier.
Second quarter, 1984.
OtfiKT 2
VELOCITY AND TREND VELOCITY. 1960Q1 - 19B4Q2*
(velocity«=line. trend velocity=dot)
P T
P
T
P
T
P T P
T
Trent} Velocity
-7
•AotAal
Veli city
to
60
62
64
66
68
70
72
74
76
7B
80
82
84
*VELOCITY IS MI-VELOCITY. TREND VELOCITY IS BASED
ON A TIME TREND ESTIMATED OVER 1960Q2-1981G3
AND FORECASTED OUTSIDE THIS INTERVAL.
233
The CHAIRMAN. Senator Hecht, do you have any questions?
[No response.]
The CHAIRMAN. I have a few questions I'd like to ask you.
May I gently chide both you and Dr. Poole for not having your
statements in in advance so that we could have an opportunity to
review them. The committee rules request the statements to be in
the day before.
When you testified before the committee in February you stated,
and I quote:
The slowdown in money growth during the last half of 1983 subjects the real economy to the risk of an unacceptable slowdown or downturn in the first half of 1984.
That threat continues and grows the longer the money growth is constrained to a
slow rate.
Now, your prediction appears to be wrong in light of the continued much more rapid expansion than was anticipated and we've
also maintained price stability at least so far.
Would you now say the Fed was precisely on the right course,
that we should stick to that course or were they wrong last fall?
Mr. SPRVNKEL. First, the interpretation of what that sentence
might mean. The important part of the statement was that continued low, decelerated money growth could mean problems. Fortunately it did not continue. As I pointed out in my testimony, money
growth has been 6.8 percent over the past year. Since the early
part of this year it has been a little higher than that, 7 to 8 percent.
There was not continued deceleration of money growth, although
there was very significant deceleration in the last half of 1983. We
never in the administration, to my knowledge, predicted a recession this year. We merely pointed out that if continued significant
deceleration of money growth had occurred, it would have been a
very good possibility. Fortunately, it did not occur.
CHANGE IN THE DEFINITION OP Ml
In looking back at what happened, during the period of deregulation, which of course we supported, created some unusual noise in
the numbers. And it seems to me increasingly probable that the
major noise that occurred was in one sense a change in the definition of Ml.
We now include in Ml, as you know, super-NOW accounts and
certain other interest-bearing instruments, which were previously
closer to M2. If you try to extract from that effect, then you do not
see the massive deceleration that occurred in late 1983 and very
early 1984, because the growth rate did not rise in the first place to
the same degree.
So it seems very probable to me that we are on the right track.
Gradual deceleration of money growth over the next 3 years will
get us to our goal of zero inflation, without the necessity of bringing on another very costly slowdown in economic activity.
The CHAIRMAN. Would you agree with the previous witnesses
that we try to take in too many indicators and we ought to have
one?
Mr. SPHINKEL. I would personally much prefer concentration on
one. During periods of institutional change, there can be consider-
234
able uncertainty about the meaning of the behavior of the monetary aggregates. But if you look at the long-term history of Ml
versus the other series, it's been more closely related, both to inflation and in the longer run, IVi to 2 years later, and also in the
shorter run, 6 to 9 months, I'd add this to the real economic activity.
I wouldn't ignore the others, but in terms of targeting, my own
judgment is that Ml deserves the greater weight.
The CHAIRMAN. Six months ago you attributed the failure of interest rates to fall, to the fact that inflationary expectations take a
long time to break and the volatility of a money supply growth, I
should add an uncertainty premium and a nominal interest rate,
we had another 6 months not only of low inflation but also a relatively stable monetary growth,
How much longer do we have to wait for interest rates to fall?
Mr. SPRINKEL. I wish I knew that, Senator Garn, and I don't. I
still believe that is the major force accounting for the relatively
high market rates that presently exist.
Now, I have noted, but I'm not certain it's important, that in the
last few weeks, there has been much more discussion about disinflation. Interest rates are off their highs by 50 basis points or so,
depending upon the portion of the market.
If we can continue to convey, with the help of the Congress, the
view that we're going to get the deficit down, and that the Fed is
going to continue to gradually decelerate money over time, I think
that will help.
But it won't happen quickly. It didn't happen in the late 1970's.
You may remember when we were going the other way, as inflation accelerated, we observed negative real rates, if you compute
real rates as actual inflation subtracted from nominal interest
rates. But it took some time before the markets really believed that
we were heading for a significantly higher inflation rate.
Eventually it got the message. It's taking a while this time and
the sooner the better. There are certain people that are benefiting
from the -high interest rates—savers. But most of the investors are
being hurt.
Rising interest rates have serious implications for international
debt problems and we want to recommit ourselves to going toward
a zero inflation target. We're not there yet, but we're two-thirds of
the way there and we want to go the other third. And with the
help of the Congress and the Federal Reserve we will.
The CHAIRMAN. I think the major factor there that you mentioned is the deficit. I realize these are monetary policy hearings
that we conduct every 6 months but we always seem, at least in my
opinion, to gloss over the impact of the deficits.
REAL INTEREST RATES STILL HIGH
I get around a great deal around this country and I don't hear
nearly as much discussion about the M's, the rate of growth of the
M's, as I do about deficits. And in my own opinion I think that's
why the predictions of everybody, not just you, most everyone 6
months past, another 6 months past, and everybody complains that
real interest rates are still too high.
235
I don't think it's nearly as much what the Fed is going to do as
the fact that Congress has not yet come to grips with the deficit. If
you're in the money lending business and you have been lied to by
Congress after Congress after Congress for decades about what
they're going to do about fiscal policy and it never comes true,
after 30 years maybe you finally decide, hey, they don't really
mean it.
They're really not going to do anything about it. And we had
them. That downpayment isn't enough to qualify for a home loan
mortgage that we put on the deficit. It's almost a shame to call it a
downpayment. It's a token at best- An election year token.
So, as I say I'm not a trained economist. But for 10 years I've sat
here at this bench listening to trained economists and most of
them have been wrong. And I understand that. It's very difficult to
predict but, on the other hand, it just becomes more and more evident to me all the time that deficits are the major culprit in the
psychological impact on the markets.
They say, hey, these guys aren't going to do anything about this.
All we see is a return to inflation. All we see is ever increasing
deficits, AH we see is more Treasury borrowings to finance that
debt.
So why should we loan money at a reasonable rate. Why should
we get trapped again. I really think if we would do something significant about the deficit, I think you would see a remarkable reduction in interest rates in a very short period of time.
In fact, I would go so far to say as if the Congress would make a
significant debt reduction effort this year I think you'd see single
digit prime within 6 months.
Just knowing that we've made structural changes within the
budget that will guarantee the trend lines leveling of deficits and
then starting down. Even if it took us decades to reach a balanced
budget. I think that psychological impact on interest rates should
be very dramatic.
But I can't believe Congress—I don't know why the market
should, we talk a lot. There are no liberals in Congress this year.
They're all born-again converts to the balanced budget regardless
of what their past performance has been.
They're all born-again converts to the balanced budget except
when it comes time to vote. I think that's a factor we don't talk
enough about. Maybe again, that's what I've said before but to the
previous two gentlemen.
Witnesses are intimidated by sitting up here in Congress. They
don't want to say how fiscally irresponsible we are to our faces.
Maybe that's the way we talk about others' monetary policies in
these hearings rather than the truth of the matter, because we
don't want to.
Some day I would like to come back after I'm fortunate and have
the good enough sense to retire from this body to come back as a
witness.
Mr. SPRINKEL. Senator Garn, as I've said, there are weaknesses
in our institutions, but the alternatives seems to be worse. I fully
share your view that the deficit be brought down over time, I do
not look upon monetary and fiscal policy as substitutes. I look upon
them as complements. We need sensible monetary policies, and we
236
need sensible fiscal policies. It's very difficult in our institutional
arrangements to get the discipline on spending that is really necessary, in order to make major changes toward getting the deficit
down.
BALANCED BUDGET AMENDMENT
President Reagan has argued, and I fully support his view that,
if he can get some additional tools with the help of the Congress,
he will go about reducing the deficit primarily by reducing spending. I am talking here about taking advantage of the sense that we
have, that everybody wants to balance the budget. Let's get a balanced budget amendment. That would force competing interests for
spending at the Federal level to compete against each other, instead of competing against a box and merely increasing the deficit
more and more, which Secretary Regan and I have to finance.
Second, I know there is great sensitivity in the Congress about
the line-item veto. But again this would be a very helpful device, in
terms of getting more discipline into the spending proclivities.
The CHAIRMAN. Besides the balanced budget amendment and a
line-item veto, which I would support, and did on the floor of the
Senate, a constitutional amendment limiting a President to one 6~
year term, Senators to two 6-year terms, and Representatives to
three 4-year terms, you might see some statesmanship again, and
they might not try to make a living until they're being here until
they're 95 years old. Maybe that would be the only way to get that
kind of amendment passed is to make it effective in the year 2050,
when nobody currently here would think that they would still be
around.
There are some who I think expect to be here. [Laughter.]
Last February you echoed what I take it to be a fairly traditional
monetarist sentiment in stating that "Money growth affects the
rate of inflation over a lag of IVa to 2 years." Now, l¥z to 2 years
ago from today, we were experiencing very rapid money supply
growth. Shouldn't we have been, experiencing a burst of inflation
then right now?
Mr. SPRINKEL. It's very important to follow numbers carefully,
but it's also important to investigate what those numbers really
are.
The CHAIRMAN. Let me say in your defense that the other witnesses^ this morning talked about the same thing.
Mr. SPRJNKEL. The so-called monetarists and those expecting a
rapid reacceleration of inflation are walking to a different drumbeat than I am, and I think they're walking to an incorrect one.
The major bulge that occurred in the Ml series was due to the deregulation which we all supported, which led to a massive surge in
certain interest-bearing instruments, primarily super-NOW accounts. That surge has tapered off. Therefore, I think we should
look upon that as a temporary aberration in the series. Most of the
liability side of banks' balance sheets, that is monetary components, are now deregulated. There are no more big shocks coming.
Hence, I would argue that the probability is that the money numbers are more believable now than they were a couple of years ago.
237
So, no, I do not believe that we are on the verge of a major resurgence of inflation. It is possible we could be, but if you adjust the
money numbers, they do not suggest it. And if you look at sensitive
commodity prices that sometimes help you in analyzing whether
inflation is about to accelerate, I do not see any real pressure on
the upside. So my best sense is that we're not looking forward to
sharp acceleration, provided we continue to hew to moderate
growth in money.
The CHAIRMAN. I don't anticipate renewed inflation this year or
early next year.
Getting back to the psychological value of what we do or do not
do here, I personally feel that with all the talk about the downpayment this year, and then next year we're really going to do something about it after the election, that has been so widely spread,
that we've set ourselves up, and I'm glad we have.
If we don't follow through on that promise, I don't think we can
have, regardless of what Paul Volcker, or the Fed, or the Open
Market Committee does with the money supply next year, if Congress does not fulfill that promise that they have laid out and continue to do and will do every day until November 6, if that's the
election day, then I think the only consequence can be renewed inflation and higher interest rates. I don't think there's another possibility. The markets will respond and say, "Hey, we believed you.
We got the downpayment. We expect you to do this." And all the
other reasons we hear.
Well, that's been discounted in the bond market. We already anticipated that. But we haven't anticipated yet the failure of Congress to do something next year.
So I can't emphasize enough that this is something Congress,
ought to be laid totally at our doorstep. We set it up, no one else.
We've said we're going to do that next year. So we'd better. Then I
think you could have a burst of inflation. And those who vote that
way ought to be then punished in the 1986 elections for not voting
the way they talked before the 1984 elections.
And I'm obviously trying to set it up more to put pressure on my
colleagues to vote like they talk.
Mr. SPRINKEL. I'm very supportive of your efforts. We appreciate
it, and we will do our part to try to keep the budget numbers that
we submit to you under control. And we hope the Federal Reserve
will do its part. Given the stable, moderate growth of money, I
gather we could solve this problem.
The CHAIRMAN. I would agree with that. The point I was making
earlier about the Fed not having a difficult time with fiscal policy,
their job, and I'm certainly not always pleased with the job they've
done, I've been very critical of some of the mechanics of how they
have handled the money supply, not their overall objectives but the
mechanics of going through it, but their job has been made incredibly difficult, when you've had such an irresponsible fiscal policy.
My point is, the Fed would become much less visible, if we had a
stable fiscal policy, because then it would be much easier to be a
member of the Federal Open Market Committee. You could have
much more stable monetary policy and everybody would be congratulating you for the good job you're doing.
238
So I don't disagree that it takes two. One side of the equation has
been trying, the Fed, however critical we may be of them. The
fiscal side has not been trying. So I think we've got to get our act
together first. I think in this case it's pretty easy to see which
comes first, the horse or the cart. I think we've had it backwards,
We'll look forward to seeing you again in 6 months, and we'll see
how your predictions are for that period of time.
Mr. SPRINKEL. Thank you, Senator.
The CHAIRMAN. The committee is adjourned.
[Whereupon, at 12 noon, the hearing was adjourned.]
@FedFRASER