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FEDERAL RESERVE'S SECOND MONETARY POLICY
REPORT FOR 1985

HEARING
BEFORE THE

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

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

JULY 18, 1985

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

U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1985

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
JAKE GARN, Utah, Chairman
JOHN HEINZ, Pennsylvania
WILLIAM PROXMIRE, Wisconsin
WILLIAM L. ARMSTRONG, Colorado
ALAN CRANSTON, California
ALFONSE M. D'AMATO, New York
DONALD W. RIEGLE, JR., Michigan
SLADE GORTON, Washington
PAUL S. SARBANES, Maryland
MACK MATTINGLY, Georgia
CHRISTOPHER J. DODD, Connecticut
CHIC HECHT, Nevada
ALAN J. DIXON, Illinois
PHIL GRAMM, Texas
JIM SASSER, Tennessee
M. DANNY WALL, Staff Director
KENNETH A. McLEAN, Minority Staff Director
W. LAMAR SMITH, Economist

(ID

CONTENTS
THURSDAY, JULY 18, 1985
Page

Opening statement of Chairman Gam
Opening statements of:
Senator Proxmire
Senator D'Amato
Senator Dixon

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4
95

WITNESS
Paul A. Volcker, Chairman, Board of Governors, Federal Reserve System
Progress in the economy
Principal risks
Prepared statement
The economic and financial environment
The outlook for the economy
The broad policy challenge
The 1985 and 1986 target ranges
Complementary policies
Conclusion
Table I: Economic projections for 1985 and 1986
Table II: Long-run growth ranges for the aggregates
Chart 1: Ml growth ranges and actual
Chart 2: M2 growth ranges and actual
Chart 3: MS growth range and actual
Chart 4: Debt growth range and actual
"Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978"
Difficult task of decisions
Dollar situation
Forecasting of economy

Effects of volatile trade picture

Reduction of the deficit
Impact of excessive Ml growth
High consumer interest rates
Opinions on trade deficit issue
Massive buildup in debt
Need to increase savings rate
Budget reduction of $40 billion
Deficit reduction targets unattainable
Significance of drop in oil prices
Arrearages of smaller debtors
Effects of slow GNP growth
Tax reform proposal
Assessment of financial system developments
FOCM debates monetary policy
Effects of hostile takeovers
Rapid growth in bank contingent liabilities
Credibility of target changes
Response to written questions:
Senator Garn
Senator Mattingly
Senator Proxmire
Senator Riegle

(III)

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Ill
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Page
ADDITIONAL MATERIAL RECEIVED FOR THE RECORD
Council of Economic Advisers, statement for the record of the midyear monetary policy oversight hearings from Beryl W. Sprinkel, Chairman
Department of the Treasury, views on monetary policy and recent monetary
developments from Manuel H. Johnson, Assistant Secretary {Economic
Policy)
Harvard University, Benjamin M. Friedman, professor of economics, views on
the mid-year report on monetary policy
CoreStates Financial Corp., views on the conduct of monetary policy by A,
Gilbert Heebner, executive vice president

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FEDERAL RESERVE'S SECOND MONETARY
POLICY REPORT FOR 1985
THURSDAY, JULY 18, 1985

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, D'Amato, Gorton, Mattingly, Hecht,
Proxmire, Cranston, Riegle, Dodd, and Sasser.
OPENING STATEMENT OF CHAIRMAN GARN

The CHAIRMAN. The Banking Committee will come to order.
This morning we are convening for the purpose of hearing the
testimony of the Honorable Paul Volcker, Chairman of the Board of
Governors of the Federal Reserve System, regarding the second
monetary policy report for 1985.
I can't help but notice when this Committee's hearing on monetary
policy comes second, after the House's, suddenly the interest level
seems to drop off. I don't think the audience expects you to say
something different today from what you did yesterday, Mr. Chairman.
Mr. VOLCKER. It's all in the interpretations of what I say. I will
say the same thing.
The CHAIRMAN. Well, we'll see if they interpret you differently
today than they did yesterday or when you released your testimony
the day before.
But we are always happy to welcome you before the committee.
I'd like to turn to Senator Proxmire for any statement he wishes to
make before you begin.
OPENING STATEMENT OF SENATOR PROXMIRE

Senator PROXMIRE. Mr. Chairman, your statement may be similar but the questions may be different, and if the questions are different maybe your responses will be different. So we will try to do
our best. I do have a statement.
The Fed has just come off one of the most successful economic
achievements in recent history, breaking the back of the superinflation that engulfed this country in the late 1970's. The Fed has
done this with no help from the Congress. In fact, they have done
it in the face of the most irresponsible congressional fiscal policy in
the Nation's history.
(l)

That's the good news as far as the Fed is concerned. It's impressive. There's also bad news and that's impressive too. This year the
Fed has shown an appalling inability to come within a mile of its
monetary targets. It grossly missed forecasting any hint of the astonishing slowdown of the economy in the first quarter of 1985 and
now the Fed has responded with a changed policy. So far in 1985
and especially in the last 2 months, the Fed has permitted one of
the most explosive growths in the money supply in recent history.
The growth has not only breached the Fed's range for Ml, it has
made that range look ridiculous. The chairman has opined that
maybe the Hutton fiasco has so jarred corporate managers that
they are leaving larger balances in their corporate accounts. Well,
maybe.
But the 10.6 percent increase in Ml in the first half of 1985 is
about 50 percent above the top of the Fed's target range. And, of
course, in June the money supply really exploded out of control
with annual rate increase of 19.6 percent. Chairman Volcker and
the Fed hammered money supply increases down beginning in late
1979 and continuing right through much of the deep recession of
1981 and 1982. They brought inflation to its knees. Of course, it is
true that the prospect of inflation seems to have diminished to a
shrunken shadow of itself at this time. We are told this morning
that real economic growth in the second quarter of 1985 was 1.7
percent. Combine that with the 0.3 percent in the first quarter and
the real growth for the first half of this year and it is a pathetic 1
percent. Unemployment is still high, in fact at the same recessionary rate of 7.3 percent it has been stalled at for 5 months. There is
no inflationary pressure from a wage push in sight. We have a glut
and a growing glut of oil, in fact a surplus so immense that even
that fabulously rich industry is in trouble. Our food glut is so huge
that our farmers are suffering a deep depression and food prices
are almost sure to rise little if at all. Industry operates well below
capacity.
So where is the inflation? Where is the threat of inflation? The
massive and continuing Federal deficits pose an inflationary threat
and that seems to be some time in the distant future after these
colossal surpluses begin to disappear. Does that mean inflation is
licked? Can we forget it? Is the 10.6-percent increase in the money
supply for the first 6 months of 1985 and the nearly 10 percent increase last month along, is this simply a temporary quicksilver
flash that will not and cannot pose any real inflationary threat?
The answer may be yes, we can forget inflation; it's licked. Labor
cannot get inflationary wages when they suffer more than 7 percent unemployment. Oil prices and that means all energy prices
cannot go up with the worldwide glut. Food prices will stay down.
So where could inflation come from?
The answer is that inflation could come from four sources. First,
from the Federal deficit. Second, it could also come from the very
likely decline of the dollar. That decline will ease the competitive
pressure of imports that now hold down domestic prices and directly raise the prices of the hundreds of billions of dollars of imports
this country buys from abroad. The third source of inflationary
pressure could come from a proposed 25-percent tariff on the imports of four of our principal trading partners, including Japan.

That bill has very strong support in the Senate. It's going to have
stronger support as time goes on, particularly if the present trade
situation continues. The fourth and final source of inflation will
emerge from a more comprehensive and certain long-time force.
Our experience and commonsense tells us that inflation is a monetary phenomenon. No matter how the supply of goods and services
increase, if the money supply increases faster, the value of that
money will surely fall. What does that mean? It means that prices
will rise. If the economy is growing at a 1-percent rate in real
terms, which it has been for the first 6 months, and the money
supply is growing at a 10.6 percent rate, let alone a 20-percent rate,
the difference will show up in higher prices. Unfortunately, that
sure and powerful hand of Mr. Volcker won't be around when the
higher prices that follow from this explosion of the money supply
hits the country. Why not? Because in the past we have found that
as the money supply increases a lag of about 2 years or 24 months
follows before they are reflected in higher prices. That means that
sometime in the summer of 1988, a few months before the 1988
Presidential election, prices will begin to climb. Chairman Paul
Volcker will probably not be in charge of the Fed in 1988 to bring
things under control. The fiscal policy of our Federal Government
is likely to continue to be highly inflationary. In fact, our 1988 debt
that will be far above $2 trillion and on its way to $3 trillion will
offer a tempting reason to let inflation have sway so the Government can pay off its towering obligations on the cheap.
The last couple of months have been troublesome months for
those who fear the consequences of inflation and mammoth Federal
deficits. The President and congressional leaders seem to have
signed off on a no new tax and the higher spending figure of the
House or the Senate Budget Committee. The administration's
strongest advocate of fiscal restraint, David Stockman, has announced his departure. And now we are told that the Fed figures
that inflation is licked so it is declaring victory and throwing in the
sponge following a month when the money supply grew at a nearly
20-percent annual rate. Argentina—here we come.
The CHAIRMAN. Senator Hecht.
Senator HECHT. Thank you, Mr. Chairman. I have no formal
statement, but, Chairman Volcker, I'm going to have to leave a
little bit later. I have a conflict with two other committees, but I do
want to say that I do applaud your present policies and I hope you
will continue them.
The CHAIRMAN. Do any of my colleagues wish to make an opening statement before we turn to the Chairman?
Senator CRANSTON. I don't want to impose on his time. I do welcome you, as always.
Senator D'AMATO. Mr. Chairman, I'd like to just submit for the
record my statement in its entirety and I, too, join my colleague,
Senator Hecht, in indicating that I believe that the Fed's policy—
and I don't think Chairman Volcker will say loosening up—but the
policy that you have been following in providing some stimulation,
particularly in the construction area and the money growth area,
has been a beneficial one and has not been inflationary in nature,
and I think it still pursues a steady course, one which I certainly
am supportive of.

STATEMENT OF SENATOR D'AMATO

Good morning Mr. Chairman. Before we begin, I would like to
welcome Paul Volcker here today. As always, Mr. Volcker, you are
diligent in responding to this committee's requests. Today's hearing
will examine the Federal Reserve report in respect to the conduct
of monetary policy for 1985.
The original targets for basic money supply, Ml, projected a
growth of 4-7 percent in 1985. This was approved in February. I
am now informed that the Federal Reserve has widened its Ml
target from the original projection to 3-8 percent in an attempt to
ease credit and to spur an economy which has become sluggish in
recent months. I am concerned that the Federal Reserve may be
becoming overly cautious with respect to the economy and that
your recent monetary policy may spur higher inflation.
In recent months the money supply has been soaring far above
the Fed's target for this year, growing at an 11.6-percent annual
rate through June. As of June the money supply was $15 billion
above the upper end of your original target range. Even with the
new targets issued 2 days ago, it would be $4.7 billion over your
upper end projection.
It is my hope that money growth will slow on its own accord in
the near future. The question of the Fed's role in slowing the
growth of the money supply, however, may now only be month's
away. If the result is the tightening of credit, the outcome may be
less than desirable.
The economy in its present state, as sluggish as it may appear,
remains stable. Inflation has continued to remain in the 4-percent
range, unemployment has been steady at 7.3 percent for the past 4
months, and the economy continues to grow, although at a slower
pace than a year ago.
I realize more can be done here on the Hill to control the Federal budget deficit in attempt to spur the economy, but the role of
the Federal Reserve Board can never be taken lightly. No other
section of the Government has the power over the economy you
hold. It is for this reason this hearing is being held. It is my sincere
hope that the economy will continue to expand under the policies
of the Federal Reserve.
Thank you, Mr. Chairman.
The CHAIRMAN. Chairman Volcker.
STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM

Mr. VOLCKER. Mr. Chairman, as you noted, there's been a certain
amount of publicity about our decisions and my testimony yesterday and the press briefing the day before and I won't read my
statement this morning. I may just take 2 or 3 minutes to make a
couple of introductory comments.
PROGRESS IN THE ECONOMY

The burden of my statement is that there has clearly been a
good deal of progress in the economy over the past 2 or 3 years. We
have had altogether, despite the slowdown in the past year, a

strong business expansion, a business expansion that has helped
lift growth in the rest of the world as well as in the United States,
and so far we have combined that with a more contained inflationary picture. But it is also apparent that there are very large imbalances, a disequilibrium in the economy, that can't be resolved by
monetary policy, certainly not by monetary policy alone.
You are fighting that battle now in the Congress about the deficit, where we urgently need some restraint. The protectionist
threat that Senator Proxmire referred to is certainly there, and I
think it is terribly important that that be contained. Certainly I
would emphasize that it is a serious misreading of our intentions if
you think that in any way we have grown soft on inflation.
Senator Proxmire has cited some of the factors that have been
moving in the other direction on the inflationary front, but certainly the inflation problem has not been licked. There is a good deal of
momentum of past inflation remaining in the economy. Expectations are sensitive, and we have to remain very cautious on that
score.
PRINCIPAL RISKS

He cited the principal risks there, the risk of the deficit, the risk
of the dollar. Those risks would be gravely compounded by excessive growth in money and credit. We may differ on an explanation
of what's going on now, but we don't differ at all in terms of the
importance of maintaining control in that area over a period of
time.
I might say that the GNP data we have this morning, which is a
downward revision from the so-called flash report, deserves a little
analysis. A downward revision is not at all surprising. What's interesting to me is that this new figure shows an even stronger increase in domestic final purchases than we thought we had before
and than I cited in my statement. I cited that it had been running
more than 4 percent the first half of the year. If you look at these
latest figures, it's running nearly 5 percent and over 6 percent in
the second quarter. The downward revision can be entirely traced
to higher imports and lower exports than were initially anticipated
by the Department of Commerce, and particularly to a sharp decline in the rate of inventory investment. I don't think that latter
factor necessarily at all varies for the future. We have maintained
final demands here very well. We have an industrial production
figure that was announced this morning that shows a very small
increase in June which in itself isn't significant, but there are
longer term revisions of that figure which show more growth this
year than we previously had reported.
We are very conscious of the fact that we face some dilemmas
and imbalances that can't be corrected by monetary policy alone,
but the inflation question has to retain priority in our thinking.
With that much general introduction, Mr. Chairman, I would be
glad to entertain whatever questions you have.
[The complete prepared statement follows:]

Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System

1 welcome the opportunity to review with you monetary
policy in the context of recent and prospective economic and
financial developments.

The economic setting and the decisions

of the Federal Open Market Committee with respect to the target
ranges for the monetary and credit aggregates are set out in
the semi-annual "Humphrey-Hawkins" Report.

As usual, I would

like to amplify and develop some aspects of those decisions in
my testimony.
The Economic and Financial Environment
The pattern of slower, and more lopsided, growth in domestic
output that developed during the latter part of 1984 became even
more pronounced during the first half of 1985.

Manufacturing

activity overall has been essentially flat following exceptionally
large gains earlier in the expansion period.

The farming and

mining sectors have remained under strong economic and financial
pressure.

But consumption —

supported directly and indirectly

by large increases in personal and federal debt —

has continued

to rise fairly strongly.

Construction activity has also

expanded, responding in part to lower interest rates.

Despite

recent losses of manufacturing jobs, employment growth in
services and trade has been strong enough to keep the overall
unemployment rate essentially unchanged at about 7-1/4 percent.
The contrast between marked sluggishness in the goodsproducing sector of the economy and rising domestic consumption
and demand is reflected in continuing strong growth in merchandise
imports.

Those imports in real terms are up by about 60 percent

in three years; in manufactured goods alone the increase has been
even more rapid.

Overall, imports have now reached a level

equivalent to 21 percent of the value of domestic production
of goods.

In contrast, exports have stagnated, and now account

for only about 14 percent of goods output.
I can put the same point another way.

Domestic final

sales -- to consumers, to businesses, and to governments —
appear to have been expanding at a relatively brisk rate of

8
more than 4 percent so far this year.

Domestic output of goods

and services has not nearly kept pace, rising at a rate of
around 1-1/2 percent or perhaps less.
inventory accumulation has slowed.

That is partly because

But it is mostly because

more of the domestic demand is being satisfied by growing imports.
That was true earlier in the expansion period as well.
But we have felt it more as growth in demand has slowed to a mere
sustainable rate.

Another potentially disquieting development

has been the apparent failure of productivity to maintain the
strong gains achieved earlier in the expansion period.

The

implication is that the underlying trend may :ict have increased
as much as hoped from the poor record of the 1970s.
Against those cross-currents in the economy this year, the
Federal Reserve, in conducting its open market operations, has
not appreciably changed the degree of pressure on bank reserve
positions, which had already been substantially eased by the
end o£ 1984.

In May, the discount rate was reduced from 8 to

7-1/2 percent.

That action was consistent with the general

tendency of market interest rates to decline further over the
period, extending the rather sharp reductions during the Autumn
and early last winter.

Both the discount and short-term market

interest rates in May and June reached the lowest levels since 1978.
The relatively "accommodative" approach in the provision
of reserves has been designed to provide support for the sustained
growth of economic activity against a background of relatively
well contained inflationary and cost pressures.
agricultural and industrial prices —
petroleum —

Indeed, sensitive

including prices of crude

have been declining appreciably, and prices at the

wholesale level have been almost flat.

It is somewhat reassuring

that the trend in wage and salary increases has, overall,
remained at tJie sharply reduced pace established at the start
of the recovery period, although the slowdown in productivity
has been reflected in higher unit labor costs and some pressures
on prof it margins.

Clearly, even if reduced, some momentum of

10
inflation has persisted in the economy as a whole, and
expectations remain sensitive.

But so far this year, price

increases have been concentrated largely in the service sectors.
Meanwhile, the broader measures of monetary growth
M2 and M3 —

—

have remained generally within the target ranges

established early in the year.

However, currency and checkable

deposits, measured by Ml, have increased much more rapidly than
envisaged.

(See the attached charts. )

Until May, growth in that aggregate remained in an area
reasonably close to the upper band of the target range.

Given

that the more rapid growth during that period followed some
months of subdued expansion, the outcome through April was
reasonably

in line with FOMC intentions and expectations.

Mere

recently, in May and June, a new surge in Ml carried that
aggregate mach further abcve the targeted range.
At the same time, total non-financial debt has continued
to expand substantially more rapidly than the GNP, propelled
particularly by the federal deficit and consumer credit.

11
much as 1 percent of that debt expansion can be traced
to a continuing —
disquieting —

and, from a structural point of view,

substitution of debt for equity as a result of

mergers and ether financial reorganization.

More generally,

these developments also point up the apparent dependency of
economic growth, under circumstances existing this year, on a
relatively high level of debt and money creation.
Unduly prolonged, those developments would not provide a
satisfactory financial underpinning for sustaining growth in a
context of greater price and financial stability.

For the time

being, however, taking account of current and likely economic
developments, the downward pressures on commodity prices, and
the high level of the dollar that has prevailed in the foreign
exchange markets, the growth in Ml and debt has not in itself
justified a more restrictive approach toward the prevision of
reserves to the banking system.

12
After increasing sharply from already high levels in the
early weeks of the year, the dollar more recently has fallen
back against the currencies of other leading industrial countries,
dropping abruptly over the past week or so to about the average
levels of last summer.

At these exchange rates —

still about

60 percent above the relatively depressed levels of 1979 and 1980
prospects for stemming the deterioration an our trade accounts,
much less achieving a turnabout, remain uncertain.

Much depends

upon the rate of growth in other countries that provide the
principal markets for our exports and are the source of our
imports.

In any event, the potential effects o£ interest rates

and decisions with respect to monetary policy on exchange rates
and the external sector of the economy have necessarily been a
significant ingredient in FOMC deliberations.
The Outlook for the Economy
Members of the FOMC generally have projected a pickup in
economic activity over the second half of 1985 and sustained

13
growth through 1986.

In these circumstances, while employment

gains should remain substantial, unemployment would be expected
to drop cr.ly a little if at all.

The overall rate of price

increase woald be expected to remain close to the recent pattern,
assuming dollar exchange rates do net vary widely from recent
levels.

(See Table I attached for the numerical projections.)

Obviously, neither the anticipated "stickiness" of the
unemployment rate nor the projected inflation rate is entirely
satisfactory, and a substantial range of uncertainty must be
associated with any economic projections at this time.

As I

emphasized earlier, there are sharp differences in the performance
of different sectors of the economy.

Demand for and employment

in services, where most upward price pressures have been concentrated,
continue to expand rather strongly.

Most sectors more immediately

sensitive to interest rates and monetary conditions —
construction and automobile sales —
relatively well.

including

have also been performing

Other sectors exposed to strong international

14
competition are sluggish, and agriculture remains under strong
financial pressure.
The Broad Policy Challenge
The cross-currents, dislocations, and uncertainties
in the present situation point up one uncomfortable but
inescapable fact.

We are dealing with a situation marked by

gross imbalances that can neither be sustained indefinitely nor
dealt with successfully by monetary policy alone, however
conducted.
We are borrowing, as a nation, far more than we
are willing to save internally.
We are buying abroad much more than we are able
to sell.
We reconcile borrowing wore than we save and buying
more than we sell by piling up debts abroad in amounts
unparalleled in our history.
0-jr key trading partners, directly or indirectly,
have been relying on our markets to support their

15
growth, and even so most o£ them remain mired in
historically high levels of unemployment.
Meanwhile, our high levels cf consumption and
employment are not being matched by the expansion
in the industrial base we will need as we restore
external balance and service ojr growing external debt.
And, after 2-1/2 years of economic expansion, too
many borrowers at home and abroad remain under strain
or over-extended.
At their core, these major imbalances and disequilibria may
lie outside the reach of monetary policy —
U.S. policy generally.

or in some instances,

But they necessarily condition the

environment in which the Federal Reserve acts, along with all
the current evidence about monetary growth, economic conditions,
and prices.
In all our decisions, whether with respect to monetary or
regulatory policies, we would like to work in a direction
consistent with reducing the imbalances, or at the least to

16
avoid aggravating them.
forward.

That sounds obvious and straight-

The difficulty is that, as things now stand, some

policy actions that might seem, on their face, to contribute
toward easing one problem could aggravate others.

Nor can

we afford to apply a mere poultice at one point of strain in
the hope of temporary relief at the expense of undermining
basic objectives.
Our monetary policy actions need to be conducted with a
clear vision of the continuing longer-term goals —

a financial

environment in which we as a nation can enhance prospects for
sustained growth in a framework of greater stability.

To succeed

fully in that effort, monetary policy will need to be complemented
by action elsewhere.
The 1985 and 1986 Target Ranges
As I indicated earlier, the recent surge in Ml in May
and June has carried that monetary aggregate well above the
target range set in February.

M2 and M3, while also rising

rather sharply in June, have remained generally within, or

17
close tc, their targeted ranges.

Against the background of a

high dollar, the sluggishness of manufacturing output, and
relatively well contained price pressures, guick and strong
action to curtail the recent burst in Ml growth has not been
appropriate.

The potential implications of the relatively

strong growth in Ml since late last year nonetheless had to
be considered carefully in developing our target ranges and
policy approach.
You may recall that somewhat similar high growth rates in
Ml developed during the second half of 1982 and during the first
half of 1983.

At that time, important regulatory changes involving

new accounts and affecting the payment of interest on checking
accounts had taken place.

Pervasive uncertainty during the

latter stages of the recession appeared to affect desires to
hold cash.

Both circumstances made interpretation of the

monetary data particularly difficult, and Ml was deemphasized.
Those circumstances are not present today, at least not in
the same degree.

18
However, one common factor, and an important factor,
was at work during both periods.

The rapid growth in Ml

in 1982 and 1983 and this year followed sizable interest rate
declines, with a lagged response evident for some months.
Analysis strongly suggests that, as market interest rates decline,
individuals and businesses are inclined to build up cash balances
because they sacrifice less interest income in doing so.
possibility today of earning interest on checking accounts

The
—

and the fact that these interest rates change more sluggishly
than market or market-oriented rates —

probably increases that

tendency.
Moreover, as I have suggested in earlier testimony, the
payment of interest on checking accounts may over time encourage
more holdings of Ml relative to other assets, or relative to
economic activity, than was the case earlier.
reason, the upward trend in Ml "velocity" —
to Ml —

Partly for that
the ratio of GNP

characteristic of the earlier postwar period may be

changing.

19
That trend was, of course, established during a period
when inflation and interest rates were trending upward.

Ir.

contrast, over the past three and one-half years, velocity has
moved irregularly lower, with the declines concentrated in
periods of declining interest rates.
The earlier 1982-83 period of rapid growth in Ml was
correctly judged not to presage a resurgence of inflationary
pressures, contrary to some expectations.

1 would emphasize

in that connection, however, that Ml growth was moderated
substantially after mid-1983, and velocity rose during the
period of strong economic expansion, as anticipated.
We simply do not have enough experience with the new
institutional framework surrounding Ml (which will be further
changed next year under existing law} to specify with any
precision what new trend in velocity may be emerging or the
precise nature of the relationship between fluctuations in
interest rates and the money supply.

Moreover, while the

surge in Ml, and the related drop in velocity, can be traced

20
at least in substantial part to the interest rate declines of
the past year, the permanence of the change in velocity will be
dependent on inflationary expectations and interest rates
remaining subdued.

For those reasons, the Committee has continued

to taKe the view that, in the implementation of policy( developments
with respect to Ml be judged against the background of the
other aggregates and evidence about the behavior of the economy,
prices, and financial markets, domestic and international.
None of that analysis contradicts the basic thrust of a
propos it ion that we have emphasized many times —

that excessive

growth of money, sustained over time, will foster inflation.
Certainly the burst in May and June cannot be explained by
trend or interest rate factors.

But, it is also true that

monthly data are notoriously volatile, and sharp increases
unrelated to more fundamental factors are typically moderated
or partly reversed in following months.

21
In all these circumstances, the FOMC, in its meeting last
week decided to "rebase" the Ml target at the second quarter
average and to widen the range for the rest of the year to 3
to 8 percent at an annual rate.

That decision implies some

adjustment in the base of the Ml target range is appropriate tc
take account both of some change in trend velocity and a return
of interest rates closer to levels historically normal.
We are, of course, conscious that, because of strong
June growth, Ml currently is high relative to the rebased
range, and the Committee contemplates that Ml will return
within its range only gradually as the year progresses.
Consistent with the conviction that a marked slowing in the
rate of Ml growth is appropriate over time, the Committee
tentatively set the target range at 4-7 percent for next year —
a decision that will be reassessed on the basis of the further
evidence available at that time.

Meanwhile, the lower part

of the range set for the remainder of this year reflects the

22
willingness of the FOMC, in appropriate surrounding circumstances,
to tolerate substantially slower Ml growth for a time should the
recent bulge in effect "wash out."
No changes were made in the target ranges for M2 and M3
and the associated monitoring range for debt this year.

was the case at the beginning of 1985, the Committee would
find growth in the upper part of these ranges acceptable.
The changes tentatively agreed for 1986 are small, limited to a
1/2 percent reduction in the upper limit for M3 and a 1 percent
reduction in the monitoring range for debt.
These target ranges are felt to be fully consistent with
sustained growth in the economy so long as inflationary
pressures are contained.

I should note again, however, that

members cf the FOMC are concerned about the persistent debt
creation well in excess of the growth of the economy and
historical experience, and therefore lock toward some moderation
in that growth next year, as reflected in the monitoring range
set out.

(The new ranges are set out in Table II attached.)

23
The uncertainties surrounding Ml, and to a lesser extent
the ether aggregates, in themselves imply the need for a
considerable degree of judgment rather than precise rules in
the current conduct of monetary policy —

a need that, in my

thinking, is reinforced by the strong cross-currents and
imbalances in the economy and financial markets.

That may

not be an ideal situation for either the central bank or
those exercising oversight —
rise to it are net happy.

certainly the forces that give

But it is the world in which, for

the time being, we find ourselves.
Complementary

Policies

The massive trade deficit that has rapidly developed over
the period of economic expansion is the most obvious and concrete
reflection of underlying economic imbalances.

The trade deficit,

in an immediate sense, has been primarily related both to the
strength of the dollar in the exchange markets and to relatively
slow growth elsewhere in the world.

In effect, much of the

world has been dependent, directly or indirectly, on expanding

24
demand in the United States to support its own growth.

Put

another way, growth in domestic demand in Japan, Canada, and
Europe has been less than the growth in their GNP, the converse
of our situation.

And, even with surging exports to this

market, output been increasing too slowly to cut into high
rates of unemployment in Europe and elsewhere.

As a consequence,

the demand of others for cur products has been relatively weak.
The strong competition from abroad has( in an immediate
sense, had benefits as well aa costs for this country.

has been a powerful force restraining prices in the industrial
sector and in encouraging productivity improvement.

The related

net capital inflow has eased pressures on our interest rates
and capital markets.

We have been able to readily satisfy the

higher levels of consumption driven in part by the budget
deficit.
But those benefits cannot last.

Sooner or later our

external accounts will have to come much closer toward balance.

25
Indeed, as cur debts increase, we will have tc earn ever, more
in cur trade tc help pay the interest.
In the meantime, the flood of imports, and the perceptions
cf unfairness which accompany it, foster destructive protectionist
forces.

The domestic investment we will ultimately need is

discouraged while cur companies shift mere of their planned
expansion overseas.

And the larger the external deficits and

the longer they are prolonged, the more severe the subsequent
adjustments in the exchange rate and in our economy are apt to
be.

We will have paid dearly indeed for any short-term benefits.
These considerations have tempered the conduct of

monetary policy fcr some time.

Specifically, our decisions

with respect to providing reserves and reducing the discount
rate have been influenced to some extent by a desire to curb
excessive and ultimately unsustainable strength in the foreign
exchange value of the dollar.

But we have also had to recognize

the clear limitations and risks in such an approach.

26
The possibility at some point that sentiment toward the
dollar could change adversely, with sharp repercussions in
the exchange rate in a downward direction, poses the greatest
potential threat to the progress we have made against inflation.
Those risks would be compounded by excessive monetary and
liquidity creation.
As I have said to this Committee before, there is little
doubt that the dollar could be driven lower by "bad" monetary
policy -- a policy that poses a clear inflationary threat of
its own and undermines confidence.
be in our overall interest —

But such a policy could hardly

it would in fact be destructive

of all that has been achieved.
The hard fact remains that so long as we run massive
budgetary deficits, we will remain dependent on unprecedented
capital inflows to help finance, directly or indirectly, that
deficit.
deficit —

The net capital inflows will be mirrored in a trade
they are Siamese twins.

27
As things now stand, if cur trade deficit narrowed sharply,
both the budget deficit and investment needs would have to be
financed internally, with new pressures on interest rates and
a squeeze on other sectors of the economy — "some of which
are now doing relatively well, such as housing, and some,
such as farmers and thrift institutions, already under strong
financial pressure.

The implications for our trading partners

and for the heavily indebted developing countries would be
severe as well.
There has to be a way out of the impasse —

a way that

would maintain and even enhance confidence in our own economy
and prospects for stability, a way that would not simply shift
the pressures from one sector of the economy to another, and a
way consistent with the economic growth of other countries.
But that way cannot be found by U.S. monetary policy alone.

28
What we can do is reduce our dependence on foreign capital,
and the rising imports to meet our domestic demands, by curtailing
the budget deficits that importantly drive the process.
sense, the choice is before you —

In that

in the decisions you will make

in the budgetary deliberations that have been so prolonged.
The needed adjustments would be eased as well if other
industrialized countries became less dependent on stimulus
from the United States for growth in their own economies.
I am a central banker.

I can well appreciate and sympathize

with the priority that those countries have attached to budgetary
restraint and particularly to the need tc restore a sense of
price stability in their own economies.

They have had a large

measure of success in those efforts in the face of depreciation
of their currencies vis-a-vis the dollar, which has made the
process more difficult.

The pull of capital into the United

States, and the reduced outflow from the United States, has also
had effects on their own financial markets and interest rates.

29
and thus on the possibilities for "home grown" expansion.

But

as those adverse factors diminish in force, or even begin to be
reversed, opportunities surely exist for fostering mere expansion
at home, in their own interest as well as that cf a better
balanced world economy.
All of the industrialized countries, working with the
International Monetary Fund, the World Bank, and by ether means,
need to continue to support the efforts of much of the
developing world to restore the financial and economic
foundations for growth in their countries.

That process,

under the pressure cf the "debt crisis," has beer, underway
for some years.

By its nature, the fundamental adjustments

required pose challenging questions cf economic and political
management.

There is a certain irony in observing the enormous

difficulties in cur own political process in achieving —

Ear without success -- deficit reductions equivalent to one
to two percent of our GNP while much poorer countries with much

30
greater demands upon them are cutting their deficits by much
larger relative amounts.
That effort —

along with others —

is justified only

by its necessity to their own economic health.

It is hardly

surprising that progress has been uneven, that from time tc
time setbacks are encountered, and that impatience and
frustration surface politically.

But I know of no realistic

shortcuts or substitutes for the effort to place their cwn
economies on a sounder footing, any more than we can ultimately
escape our own responsibilities tc put our budget in order.
What is so encouraging is that the strong effort that
has been made in most of the indebted countries is yielding
some tangible results.

A measure of growth has been restored

in Latin America as a whole.

With interest rates lower and

many debts restructured, debt burdens are gradually but
measurably being reduced.
Fcr the most part, the heavily indebted countries are
still a long way from regaining easy access to commercial

31
credit markets.

Extraordinary cooperative efforts by the

IMF, the World Bank and commercial banks will continue tc be
required for a time to make sure external financing obligations
are structured in a way that matches ability to pay.
the ultimate success of all those efforts —
by the borrowers thenselves —

As always,

most of all those

will depend upon orderly growth,

reasonable interest rates, and access to markets in the rest of
the world, which will be determined by our actions and those of cjr
trading partners.
Conclusion
We have had a relatively strong economic expansion in
the United States over the past 2-1/2 years as a whole.

the same time, the rate of inflation has remained at the lowest
level in more than 15 years.

That combination should be a

source of great satisfaction.

But 2-1/2 years is not, in

itself, terribly significant in the economic life of the nation.
What will count is whether we can build on that progress, and
extend it over a long time ahead.

32
The inherent strength of our economy and the momentum of
our expansion have carried us a long way.
to lead the world to recovery.

We have done a lot

The longer-term opportunities

are still there for the taking.

But we also do not need to

look far to see signs of strain, imbalance, and danger.
In these circumstances, monetary policy has accommodated
a sizable increase in monetary and credit growth, and interest
rates have dropped appreciably even though they are still
relatively high in real terms.

In that way, economic growth

has been supported at a time when the dollar has been particularly
strong and inflationary pressures, at least in contrast to the
1970s and early 1980s, quiescent.

But there are obvious limitations

to the process of monetary expansion without threatening the
necessary progress toward stability upon which so much rests.
Plainly, there are implications for other policies as well.
The widely shared sense that other nations should do more
to open markets, to deal with the structural rigidities in

33
their economic systems, to encourage growth —
houses in order -- is certainly right.

to get their own

We can legitimately

cajole, and urge, and bargain to those ends.
But there can also be no doubt that it all will come much
easier as the United States does its part.
must be part of that effort.
with the budget deficit.

Monetary policy

But we also do need tc come to grips

We do need to avoid a witch's brew of

protectionism.
The success of the world economy —
within it —

and cf cur fortunes

is in large measure dependent on us.

inescapable consequence of size and leadership.

That is the

34
Table I
Economic Projections for 1985 and 1986*

FOHC Members and other FRB Presidents
Range
Central Tendency
.1 Qft R _ _ _ _ .
•1 JO J — — — — •

Percent change, fourth quarter
to fourth quarter:
Nominal GNP
Seal GNP
Implicit deflator for GNP

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

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

Average level in the fourth
quarter, percent :
Unemployment rate

6-3/4 to 7-1/4

7 to 7-1/4

.1 Q:? ££____..
"1
a D^"— ""

Percent change, fourth quarter
to fourth quarter:
Nominal GNP
Real GNP
Implicit deflator for GNP

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

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

6-3/4 to 7-1/2

6-3/4 to 7-1/4

Average level in the fourth
quarter, percent:
Unemployment 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 has not been
included in this report.

35
Table II
Long-run G r o w t h Ranges for the Aggregates
(Percent i n c r e a s e , QIV to QIV unless o t h e r w i s e noted)

4 to 7

ftdopted J u l y 1985
Tentative
1985
for 1986
I/
4 to 7
3 to 8

6 to 9

6 to 9-1/2

6 to 9

Domestic Nonfinancial debt

9 to 12

8 to 11

Adopted in
February for 1985

!_/ A n n u a l rate of increase over the period f r o m Q I I 1985 to
QIV 1985.

M1 Growth Ranges and Actual
lions of dollars
—1620

610

600

590
CO
Oi
580

ACTUAL M1

570

\
1
O

1984

.._.J
F

I
A

1985

1
A

I
S

1,
O

... I
N

540
D

M2 Growth Range and Actual
Billions of dollars
2650

—U600

H2550

2500

—\2A50

H2400

—\235Q

H230Q

2250
J

1984

1985

M3 Growth Range and Actual
Billions of dollars
—13300

3200

ACTUAL M3

3100

CO
00

3000

2900

J
N

1984

-1

1985

2800

-J

Debt Growth Range and Actual
Billions of dollars
6800

6600

6400

ACTUAL DEBT

6000

5800

N
1984

L. . . I
J

1985

5600
D

For use at 4:30 p.m., E.D.T.
Tuesday
July 16, 1985

Board of Governors of the Federal Reserve System

Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978

July 16, 1985

Letter of Transmittal

BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C.. July 16. 1985
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 ol 1978.
Sincerely,
Paul A. Volcker, Chairman

41
TABLE OF CONTENTS

Page
Section 1:

Monetary Policy and the Economic Outlook
for 1985 and 1986

Section 2:

The Performance of the Economy in the
First Half of 1985

Section T:

Money, Credit, and Financial Markets in the
First Half of 1985

42
Section 1. Jjonetary Policyjjnd the Economic Outlook f o r 1985 and 1986
The fundamental objective of the Federal Reserve In charting a
course for monetary and debt expansion remains unchanged—to f o s t e r a financial environment conducive to sustained growth of the economy, consistent
with progress over time toward price stability.

In working toward those

goals, developments with respect to the dollar and our external position
have necessarily assumed greater prominence.

More generally, while policy

I n i t i a t i v e s are stated In terms of growth rates of c e r t a i n monetary and
credit aggregates, the Federal Open Market Committee has emphasized the need
to I n t e r p r e t those aggregates in the light of other I n f o r m a t i o n about the
economy, prices, and f i n a n c i a l markers.

Moreover, the monetary targets for

1985 needed to be evaluated, and in the case of Ml adjusted, in light of

the

unusual and unexpected behavior of Gfjp relative to money during the f i r s t
half of this year.

Economic and Financial Background

Economic activity continued to expand during the f i r s t half of
1985, but at a relatively slow pace.

Real gross national product probably

increased at an annual rate of less than 2 percent, falling short of the
expectations of many forecasters and of the rate anticipated for the year by
members of the Federal Open Market Committee when they formulated their
annual nonetary policy plans in February.

While the economic environment

was conducive to the containment of I n f l a t i o n w i t h i n the 3-1/2

to 4 percent

range of the past few years, there has been no f u r t h e r progress toward f u l l
employment of the nation's labor resources or industrial capacity.

Indeed,

the unemployment rate has remained at about 7-1/4 percent, well below the
peak of the 1981-82 recession, but still an historically high level.
The slowing of output growth, which began in the middle of 1984,
has brought into sharper focus the unevenness of this business expansion
and the significance of some basic structural imbalances in the economy.
The federal budget d e f i c i t has remained in the neighborhood of $200 billion,
rather than moving in the direction of balance as might normally be expected
in the course of an upswing in economic activity.

The heavy demands placed

on the credit markets by the Treasury's financing activities have, itv turn,
been one f a c t o r helping to hold real interest rates at historically high
levels.

And those high rates have contributed to the strong demand of inter-

national investors for dollar-denominated assets and thus to the strength of
the dollar on foreign exchange markets.
Although the dollar was little changed on balance over the f i r s t
h a l f , with a spike in its

value early in the year being subsequently reversed

the adverse e f f e c t s on the U.S. trade position of the appreciation of the
preceding several years, together with slow economic growth abroad, were very
much in evidence.

U.S. firms continued to face severe competitive pressures,

and our exports f e l l while our imports rose.

The widening current account

deficit was mirrored in the continuing gap between the growth of domestic
spending and domestic production. Moreover, the effects of tM.3 imbalance
were f e l t with p a r t i c u l a r severity in the m a n u f a c t u r i n g , raining, and agricultural sectors of the economy, where p r o f i t a b i l i t y was squeezed overall and
employment declined.
The lagging growth of production, relatively well contained inflationary pressures on resources, and the high value of the dollar on exchange

-3markets provided the backdrop for the conduct of monetary policy In the past
several Tnonths.

Reserves available to the banking system expanded substan-

tially over the f i r s t half of the year, and the discount rate was cut by onehalf percent in the spring.

With the economic expansion slowing, interest

rates—which had declined sharply f r o m the summer of 1984 to early 1985—
dropped somewhat f u r t h e r on balance by mid-year.
The declines in market interest rates in the latter part of last
year and this year had substantial e f f e c t s , lasting for a number of m o n t h s ,
on the demands for assets contained in Ml.

Some savings a p p a r e n t l y were

s h i f t e d into interest-earning checking accounts (NOW accounts) from other
Instrunjents, and demand deposits also rose, as the cost of holding these
accounts in terras of earnings forgone was reduced.

As a result of the s h i f t s

of f u n d s , Ml expanded at about a 10-1/2 percent annual rate over the f i r s t
half of the year (measured from the f o u r t h quarter of 1984 to the second
q u a r t e r of 1985), well above the 4-to-7 percent range established by the FOMC
in February.

At the same time, however, the broader monetary aggregates

remained within their designated ranges.

Over the period, M2 and M3 expanded

at fl-3/4 and 8 percent annual rates, respectively, as compared uich their
growth ranges of 6 to 9 and 6 to 9-1/2 percent.

Growth in domestic n o n f i n a n -

cial sector debt over the f i r s t two quarters of the year was a l i t t l e above
Its 9-to-12 percent monitoring range, as debt issued to f i n a n c e mergers
and otherwise retire stock issues continued s t r o n g e r than earlier expected.
The rapid growth of Ml in the f i r s t half of the year was accompanied by a sharp drop in the velocity of the aggregate;

Ml velocity—the

ratio of nominal GNP to noney—declined aC about a 5 percent annual rate.

In some respects, that development is reminiscent of experience in 1982-1983,
when a large drop in interest rates also was accompanied by a marked decline
in Ml velocity, with the a t t r a c t i v e n e s s of Mi-type balances enhanced by the
availability of explicit interest on NOW accounts.

There is evidence from

recent experience, as well as from research on the interest responsiveness
of the demand for money, suggesting that such episodes might be expected as
the economy and financial markets adjust over time to f u r t h e r progress toward
price stability and as the inflation premium in interest rates consequently
diminishes.

As this o c c u r s , likely In u n p r e d i c t a b l e spurts, the p u b l i c ' s

demand for Ml will tend to rise and the level of Ml velocity could drop more
or less "permanently."

However, there will be u n c e r t a i n t y about such a con-

clusion until it becomes apparent in the period ahead whether velocity is
returning toward trend or whether it is tending to rise r a p i d l y because the
public is reducing I t s "excess" money balances by spending or investing them;
in the latter case, the drop in velocity in the past two q u a r t e r s could be
reversed to some extent.
The recent developments affecting Ml illustrate tlie still considerable uncertainties about the shorter-run behavior and trend of its

velocity.

Over the last three and a half years, the income velocity of Ml actually has
declined slightly on balance.

In contrast, over the preceding three decades,

velocity had increased by more than 3 percent per y e a r , on average. Velocity
changes are influenced by the behavior of interest r a t e s , but the extent of
interest rate impact Is variable and may be changing as the public and depository Institutions adjust to the new deposit instruments and deregulation
of deposit ceiling rates of recent years.

Moreover, the underlying trend of

velocity will also be influenced by the rate of financial innovation.

While

that may slow down once the adjustment is made to a deregulated environment
and with lower intetest rates, increased computerization could also work
toward a rise in velocity over time as the e f f i c i e n c y of the payments system
increases.
Ranges f o r Money and Debt Growth in 198j^ and 1986
In reexamintng its Ml range for 1985, and in setting a tentative
range for 1986, the Committee expected that v e l o c i t y , a f t e r its sharp decline
in the f i r s t half of this year, would cease falling rapidly—while recognizing
that much of the recent decline may not be reversed.

Allowance also needed

to be made for the high degree of u n c e r t a i n t y surrounding the behavior of Ml
velocity, given the experience of the past few years.

To take account of

these considerations, the base for the range of Ml was s h i f t e d forward to the
second quarter of 1985, and the range was set to encompass growth at a 3 to
8 percent annual rate over the second half of this year.

This range contem-

plates a substantial slowing In growth from the pace of the f i r s t half, and
the lower part of the range implies a willingness to see r e l a t i v e l y slow
growth should the recent velocity decline be reversed and economic-growth be
satisfactory.
The appropriateness of the new range will be under continuing
review in light of evidence with respect to economic and financial developments, including conditions in foreign exchange markets.

It was noted t h a t ,

because of the burst of n»ney growth in June, the current level of Ml is
high relative to the new range.

The Committee expected Chat the aggregate

would move into the new range g r a d u a l l y over time as more usual behavior of
velocity emerged.
For 1986, the Ml range was t e n t a t i v e l y set at 4 to 7 percent.

The

Committee recognized that uncertainties about interest rates and o t h e r f a c t o r s
that could a f f e c t velocity would r e q u i r e c a r e f u l reappraisal of the range at
the beginning of that year.

In a d d i t i o n , • i t was noted that actual experience

with institutional and depositor behavior a f t e r the completion early next year
of deposit rate deregulation would need to be taken into account in j u d g i n g
the appropriateness of the ranges.

At the beginning of next y e a r , regulatory

minimum balance requirements on Super NOW accounts and ooney market deposit
accounts will be removed, and at the end of March 1986, deposit celling
rates will be lifted e n t i r e l y , a f f e c t i n g savings deposits and regular NOW
accounts.
The table below summarizes decisions with respect to the ranges of
growth for the aggregates for 1985 and 1986.

Except for Ml in 1985, the

growth ranges apply to one-year periods measured on a f o u r t h q u a r t e r to
fourth quarter basis.

The Ml range for 1985 applies to the second half of

the year, as noted above.

Ranges of Growth for Monetary and Debt Aggregates
(Percent change)
Tentative for

1985

1986

3 to 8*

4 to 7

M2
M3
Debt

6 to 9
6 to 9-1/2
9 to 12

6 to 9
6 to 9
8 to 11

* Applies to period from second quarter to fourth quarter.

With respect to the broader monetary and credit aggregates, Che
Committee reaffirmed the 1985 ranges for M2, M3, and domestic debt that had
been established in February.

It is recognized, as at the start of the year,

that actual growth over the four quarters of 1985 might be toward the upper
parts of the ranges, and it was felt that this would be acceptable, depending
on developments in the velocities of the various measures, as long as inflationary pressures remained subdued.
The tentative ranges for 1986 for M3 and total debt embody reductions
from 1985—in the case of debt by a f u l l percentage point and in the case of
M3 by one-half percentage point on the upper limit.
unchanged.

The range for M2 was l e f t

In the case of the raDnltoring range for d e b t , it

while debt might well continue its
ably Easter than GNP, its

was assumed t h a t ,

tendency of recent years to grow consider-

expansion would be tempered by a drop-off in the net

redemption of equity shares that has boosted corporate credit use dramatically
in the past year or two.
Economic Projections
All the monetary ranges specified were f e l t to be consistent with
somewhat more rapid economic growth than characterized

the f i r s t half of the

year, as long as I n f l a t i o n a r y pressured remain contained.

At the same time,

Committee members felt t h a t the present circumstances in Che economy contain
particular risks and uncertainties that can imperil progress over the next
year and a half toward either growth or price s t a b i l i t y .

Clearly, the serious

imbalances referred to earlier in this section cannot be remedied through
the actions of the central bank alone.

Attainment of f u l l y satisfactory

economic performance and minimization of risks will require timely action in
other areas of policy, here and abroad.

The economic projections

of the members of

the FOMC, as well as of

' t h e Reserve Bank Presidents who are not at p r e s e n t members of the Committee,
are summarized in the table on the next page.

The central tendency of the

forecasts for real GNP points to some pickup in the pace of expansion in the
second half of this year.

The expected s t r e n g t h e n i n g , given the slow growth

in the f i r s t h a l f , still would leave the GNP expansion for the year as a
whole short of the range reported by the Federal Reserve in F e b r u a r y , and
below the f o r e c a s t s published by the Administration to date.
The FOMC members and the other Reserve Bank P r e s i d e n t s expect
growth in the 2-1/2 to 3-1/4 percent range during 1986.

Such a rise in

out-

put Is seen as entailing substantial gains in employment, enough Co bring
about a small decrease in the civilian unemployment r a t e , to around 7 percent
by the end of next year.

With pressures in labor and product markets l i m i t e d ,

most FOMC members and other Presidents foresee only a marginal Increase, if
any,

in the rate of i n f l a t i o n , in 1986.

It should be n o t e d , however, that

these projections are based on an assumption that exchange value of the
dollar w i l l not deviate substantially from its recent levels.
The projections

for a p i c k u p in GNP growth over the reduced rate of

the f i r s t half of this year are based in part on the expectation that the
declines in i n t e r e s t rates (and concomitant rise in stock prices) that have
occurred over the past few quarters will be providing impetus to demand for
goods and services in the months ahead.

Consumer attitudes toward spending

appear favorable, and housing a c t i v i t y already has shown improvement, although
the FOMC members are

somewhat concerned by the rising debt b u r d e n s of house-

holds and the increasing payment problems suggested by f i g u r e s on consumer

Economic Projections for 1985 and 1986*
J^OMC Member^ and other FRB Prejidents^
Range
Central Tendency
•1985Percent change, f o u r t h q u a r t e r
to fourth q u a r t e r :
Nominal GNP

6-1/4 to 7-3/4

6-1/2 to 7

Real GNP

2-1/4 to 3-1/4

2-3/4 to 3

Implicit d e f l a t o r for GNP

3-1/2 to 4-1/4

3-3/4 to 4

Average level In the f o u r t h
q u a r t e r , percent :
Unemployment rate

6-3/4 to 7-1/4

7 to 7-1/4

Percent change, f o u r t h q u a r t e r
to f o u r t h q u a r t e r :
Nominal GNP
Real GNP
Implicit d e f l a t o r for GNP

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

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

6-3/4 to 7-1/2

6-3/4 to 7-1/4

Average level In the f o u r t h
q u a r t e r , percent :
Unemployment rate

*The Administration has yet to publish its mid-session budget review document,
and consequently the customary comparison of FOMC f o r e c a s t s and Administration
economic goals has not been included in this r e p o r t .

and mortgage loan d e l i n q u e n c i e s .

In the business s e c t o r , I n v e n t o r y overhangs

appear Co be l i m i t e d In scope and degree, and f i x e d investment seems to have
picked up a l i t t l e a f t e r e x h i b i t i n g some weakness e a r l i e r this year; the
lower cost of capital and desires to cut costs and m a i n t a i n competitiveness
are expected to keep i n v e s t m e n t on a moderate u p t r e n d , even though pressures
on capacity may not be great.

Spending by the f e d e r a l govennent and by s t a t e s

and localities is expected to grow rather slowly.
A key ingredient

in many of the projections

is the e x p e c t a t i o n t h a t

Chere will be a tendency in Che coming year for our external position
stabilize, so t h a t domestic production w i l l more f u l l y r e f l e c t
of domestic demand.

the expansion

Developments in this area will, of course, depend in

p a r t on the course of economic expansion abroad.

Were the U.S. external

position to continue d e t e r i o r a t i n g as it has been, the sectoral imbalaiices
in the economy would be exacerbated, creating f u r t h e r d i f f i c u l t i e s
companies, their employees, and their communities.

for many

The d r a i n i n g off of

income would jeopardize the s u s t a i n a b i l i t y of economic expansion, and the
risks of economic and financial dislocations would i n t e n s i f y .
The FOMC members and other Presidents also assumed in their policy
deliberations and in the projections

that the Congress and the A d m i n i s t r a t i o n

would achieve d e f i c i t reductions In the range of those in the recent House
and Senate budget resolutions.

Failure to move forward with those proposals

would run a serious risk of reversing the favorable e f f e c t s that

congressional

actions to date have had on I n v e s t o r expectations, and would create a real
impediment to the solution of the s t r u c t u r a l problems plaguing our economy
today.

Section 2:

The Performance of the Economy In the First Half of 1985
A f t e r a year and a half of e x t r a o r d i n a r i l y rapid growth, economic

activity decelerated abruptly in the middle of 198k, and slowed somewhat
f u r t h e r in the f i r s t half of 1985.

Growth in real gross national product

is estimated to have averaged less than 2 percent at an annual rate so far
this year; the unemployment rate has remained f l a t at about 7-1/4 percent.
Inflation has held at the lower pace reached during the 1981-82 recession.
To some e x t e n t , the m o d e r a t i o n in growth during the past year has
reflected the slowing in household and business spending that o f t e n occurs
a f t e r the initial phase of cyclical recovery.

Pent-up demand for housing and

consumer durables generally fades as an expansion period lengthens, and
growth in business fixed investment often exhibits some cyclical deceleration
over time.

Howevet, the recent slowing in growth also reflects f a c t o r s

u n i q u e to this expansion.
In particular, thia expansion has taken place in the context of
a highly stimulative federal fiscal policy.

Real GNP grew more rapidly in

1983 and the Eicst half of 198^ than in any previous recovery since the
Korean War. Ultimately, some slowing in growth would have been required to
avoid inflationary overheating of the economy.

However, even before that

point was reached, the initial e f f e c t of the fiscal stimulus began to wane,
dissipated in part through Its contribution to a worsening U.S. competitive
position in international trade and diversion of demand away from goods
produced in the United States.
The pronounced Increases in the merchandise trade and current
account deficits have occurred as enormous federal deficits and resultant

53
Real GNP

Change from end of previous period,
annual rate, percent

JUL
1979

mn
1981

1983

H2 Q 1 Q 2

1985

Real Gross Domestic Purchases
Change from end of
previous period, annual rate, percent

"TTTTT

1979

1981

1983

1985

Index of Industrial Production
Index, 1967 = 100

165
155
— 145

— 135

1979

1981

1983

1985

heavy borrowing by the federal government have added to other factors helping
to keep U . S . interest rates at high levels, relative both to historical
experience and to the rate of i n f l a t i o n .

These credit demands have been met

partly through a substantial i n f l o w of foreign c a p i t a l , which has been associated with a large appreciation in the foreign exchange value oE the U.S.
dollar.

The strong dollar has encouraged U.S. consumers and businesses to

increase greatly the portion of their expenditures devoted to imports, and
at the same time has Inhibited IJ.S. exports.
strained by slow growth in demand abroad.

Exports also have been re-

As a result, gains in domestic

demand have outstripped those in domestic production by a wide margin throughout the expansion period.
The e f f e c t s of the weakening trade balance in the past few years
have been Jelt keenly in the manufacturing sector.

Industrial production,

which began to level off in the summer of 1984, remained stagnant in the f i r s t
half of 1985, and employment in the manufacturing sector declined.

The

strong dollar also has exacerbated the economic problems of f a r m e r s , many of
whom face d i f f i c u l t adjustments because of f a l l i n g product prices and the
need to service a large volume of debt accumulated during the i n f l a t i o n a r y
period of the 1970s and early 1980s.
Thus f a r , however, the weakness in the m a n u f a c t u r i n g and agricultural areas has been more than o f f s e t by strong gains in other sectors.
Domestic f i n a l demand rose at a 3-1/2 percent annual rate in the f i r s t
quarter of 1985, about the same as in the second half of last year;
second-quarter gains appear also to have been s u b s t a n t i a l .

Spending in

such interest—sensitive areas as autos and housing was particularly strong

in the f i r s t half of 1985, r e f l e c t i n g in part lower credit costs that have
emerged since mid-1984.
The strength of the d o l l a r also has had a restraining influence
on i n f l a t i o n , by reducing import prices and by forcing U.S. producers to
adopt niore competitive pricing strategies.

I n f l a t i o n a r y pressures have

been limited, too, by the lack of pressure on resources here and the slack
abroad.

Most measures of overall price increase remained in the 4 percent

range in the f i r s t half of 1985, but prices of manufactured goods rose
little and significant downward pressures on prices were evident In markets
for oil and basic commodities.
The Household Sector
Growth In real disposable Income continued to slow in the f i r s t
half of 1985, r e f l e c t i n g smaller increases In Interest income as well as
weakness In manufacturing payrolls and farm income.

Nonetheless, gains in

household spending, especially In the interest-sensitive sectors, were sizable,
supported by continued heavy borrowing.

As a result, the personal saving

rate fell appreciably below last year's 6 percent level.
Consumer spending for new cars was particularly strong in the
first half.

Total auto sales averaged nearly 11 million units at an annual

rate, with sales of domestic models around their highest level for a six-month
period since 1979.

The strength In auto sales was partly attributable to the

Improved availability of many popular domestic models since the strike-related
disruptions In production last f a l l .

In addition, auto demand was bolstered

by generally lower Interest rates compared with last year and by some special
financing programs o f f e r e d by manufacturers.

Sales of foreign cars were

56
Real Income and Consumption
Change from end of
previous period, annual rate, percent
Real Disposable Personal Income
Personal Consumption Expenditures

1979

1981

1983

1985

Total Private Housing Starts
Annual rate, millions of units

2.0

1.0

1979

1981

1983

1985

Consumption and income growth lor 1985:Q2 are bassd on April and May data
Income in both 1965:01 and 1985:02 has been adjusted for tax refund delays.

57
held down In the f i r s t quarter because supplies of Japanese models were
limited at the end of the annual period for the voluntary export restraint
program.

However, foreign car sales picked up in the spring and early summer

when Japanese cars shipped a f t e r the start of the new annual period began to
arrive at U.S. dealerships.
Meanwhile, activity In the housing market has rebounded since last
fall.

Housing starts rose to a 1.3 million unit annual rate on average in

the f i r s t five months of 1985, retracing nearly all of the decline that
occurred in the latter half of last year a f t e r rates on fixed-rate mortgages
temporarily rose to the 14 percent range.

Housing activity generally has

been quite robust in this expansion period, despite high real interest rates.
Demand for owner-occupied units has been buoyed by the movement of the "babyboom" generation into its

prime home-buying years, as well as by the benefi-

cial effects of stable house prices and innovative financing techniques such
as adjustable-rate mortgages on the a f f o r d a b i l t t y of homes.
The strong gains in household spending over the past two and a half
years have been accompanied by considerable alterations in balance sheets.
The ratio of household debt to income has increased rapidly, and is now well
above its

1980 peak.

However, asset growth has been strong as well, and the

ratio of financial assets to income has risen sharply in the past year, owing
in part to the rapid rise in stock prices.
The incidence of payment d i f f i c u l t i e s

on consumer I n s t a l l m e n t debt

has risen somewhat In the past half year or so, from relatively low levels.
Delinquency and foreclosure rates on home mortgages have been at high levels
for some time, and they rose f u r t h e r in early 1985.

The large number of

58
-15defaulted mortgage loans partly reflects the still high rates of unemployment
and the weakness of home prices In many locales, which has l e f t some homeowners with little equity to protect when they encounter financial
ties.

difficul-

However, aggressive underwriting of some mortgages, including loans

carrying lower payments in the f i r s t years, appears to be a contributing
factor.

The Business Sector

Conditions in the business sector were mixed in Che f i r s t half of
1985.

Many industrial firms experienced pressures on p r o f i t margins in an

environment of intense price c o m p e t i t i o n and declining capacity u t i l i z a t i o n ,
and widespread financial strains continued to be present In the agricultural
and energy sectors.

At the same time, however, some other sectors of the

economy recorded good gains in sales and income.

Economic profits for

cor-

porations In the aggregate remained at the higher level reached after the
sharp runup earlier in the expansion, with a f t e r - t a x p r o f i t s as a percent of
GNP at the highest levels seen for any sustained period since the late 1960s.
Growth In business spending for fixed capital began to slow in
the l a t t e r half of 1984, a f t e r a period of extraordinary expansion, and a
f u r t h e r slowing occurred in the f i r s t part of 1985.

The weakening has been

most pronounced in equipment outlays, affecting both the high-technology
categories and more traditional types of industrial equipment:.

Nevertheless,

surveys of capital spending intentions taken in the f i r s t half of the year
indicated that businesses still planned a healthy expansion in outlays for
1985 as a whole.

A relatively large proportion of these expenditures

reportedly was earmarked for replacement and modernization rather than

59
Real Business Fixed Investment

Percent change from end of
previous period, annual rate

HI] Producers' Durable Equipment
LJ Structures

1979

1981

1983

1985

Changes in Real Business Inventories
Annual rate, billions of 1972 dollars

1979

1961

1983

1985

60
-16expansion of capacity, reflecting a desire to cut costs and improve competitiveness.

Meanwhile, spending for nonresidential construction, particularly

o f f i c e s and stores, continued at strong rates in the f i r s t half of 1985, and
construction contracts rose f a r t h e r despite very high vacancy rates in many
parts of the country.
The pace of Inventory accumulation in the business sector has been
moderate in recent months.

In real terms, business inventories rose about

$19 billion at an annual rate In the f i r s t q u a r t e r of 1985, compared with an
average gain of $25 billion in 1984; inventory accumulation probably was
still lower in the second q u a r t e r .

Manufacturers, especially ttiose facing

intense import competition, have continued to be cautious in adding to inventories.

Total stocks in this sector declined in both April and May, and

inventory-sales ratios for the most part remain near historical lows.

In the

trade sector—with the notable exception of the car industry—inventory-sales
ratios have remained a bit high, though, and selected e f f o r t s to pare stocks
have continued.
With slower growth In investment In the first half of 1985, the
gap between capital expenditures and internal funds of firms remained moderate.

Nevertheless, businesses continued Co borrow heavily, reflecting a

continued massive amount of equity retirements by f i r m s engaged in mergers
and other corporate restructurings.

As a result, debt-equity ratios have

risen for a number of f i r m s , especially in the petroleum industry, where
a major restructuring is currently taking place.

However, for most other

firms, equity additions through retained earnings or sales of new shares
have been considerable.

With rising stock prices, debt-equity ratios for

these f t r r a s , when their assets and liabilities are measured at current
market values, have shown some decline In recent months.
Nonetheless, financial strains, In many cases related to the high
f o r e i g n exchange value of the dollar, persist in some areas of the economy.
In particular, low capacity utilization rates In a number of Import-sensitive
m a n u f a c t u r i n g industries, including machine tools, steel, some types of chemicals, and textiles have i n t e n s i f i e d pressures on p r o f i t a b i l i t y .

In addi-

tion, large segments of the farm sector continue to s u f f e r greatly from
reduced exports, depressed land prices, and low Incomes; many farmers f a c e
serious debt-servicing problems, causing problems in t u r n for agricultural
lenders.

In the energy s e c t o r , continued downward pressure on world oil

prices has caused p e t r o l e u m d r i l l i n g to be c u r t a i l e d , which has strained
the earnings of many o i l f i e l d equipment and servicing flrras.
The Government Sector
Federal tax receipts continued to rise s u b s t a n t i a l l y in the f i r s t
half of 1985, but so too did outlays, and the fiscal year 1985 d e f i c t t likely
will he around $200 billion.

This represents about 5 percent of total GNP,

and more than half of net private domestic saving.

Federal purchases of

goods and services, the part of federal spending that enters directly into
GNP and constitutes about a third of total outlays, rose comparatively
moderately In the f i r s t half of 1985; defense procurement, an area of rapid
growth In spending over the past few years, grew at a reduced pace as outlays
lagged more than is typical relative to appropriations.

Real nondefense

purchases (excluding the Commodity Credit Corporation) continued to be relatively f l a t .

Purchases by s t a t e and local governments were essentially unchanged
In the f i r s t q u a r t e r , but evidently

rose in the s e c o n d , as c o n s t r u c t i o n out-

lays increased s i g n i f i c a n t l y In the spring.

States and localities, many of

which had serious fiscal d i f f i c u l t i e s In the last recession, generally have
been cautious in raising spending throughout this expansion p e r i o d , though
they have been endeavoring to address the problem of an aging i n f r a s t r u c c u r e .
The combination of spending restraint and improved revenues owing both to
legislated tax increases and to rising incomes, has resulted in a s u b s t a n t i a l
rise in Che operating and capital account surpluses of s t a t e and local governments since 1982.

The External Sector
The external sector has come to play an increasingly important role
in the U . S . economy.

Merchandise imports have risen rapidly in this expan-

sion, moving above 15 percent of real domestic expenditures on goods in the
f i r s t half of 1985.

The increase In import p e n e t r a t i o n has been widespread,

occurring In both the consumer and capital goods sectors, as well as in
Industrial supplies.
Although U . S . exports increased in 1983 and 1984, they grew much
less than Imports, and have not yet regained their previous peak.

In the

f i r s t half of 1985, exports, particularly of a g r i c u l t u r a l products, have
declined somewhat.

As a r e s u l t of these t r e n d s , the current account d e f i c i t

has widened dramatically over the past few y e a r s , reaching an annual rate of
S120 billion in the f i r s t q u a r t e r of 1985.
Part of this imbalance r e f l e c t s the stronger growth of demand In
the U . S . economy since 1982 relative both to the other industrial countries

Exchange Value of the U.S. Dollar
Index, March 1973= 100

— 150

— 125

— 100

1979

1981

1983

1985

U.S. Real Merchandise Trade
Billions of 1972 dollars

— 120

1979

1981

1983

1985

U.S. Current Account
Billions of dollars

120

1979

1981

1983

1985

64
-19and to the debt-burdened developing countries.

Although this influence has

lessened with the slowing of the U.S. economic expansion since the middle
of last year, there has been no acceleration in growth in the other Industrial countries, and many developing countries have continued to face financial constraints.

The greater share of the imbalance, however, probably is

a t t r i b u t a b l e to the substantial appreciation of the dollar over the past
few years.

On average during the f i r s t half of this year, the trade-

weighted value of the dollar was roughly 70 percent above its level five
years earlier.
The appreciation of the dollar and the underlying demand of investors for dollar-denominated assets and other claims on the United States has
been partly associated w i t h d i f f e r e n t i a l s between real rates of return on
U.S. and foreign assets.

The enormous federal budget d e f i c i t s "nave been an

important f a c t o r contributing to these d i f f e r e n t i a l s .

The moderation in

interest rates that has accompanied the slowing of the economic expansion in
the United States since mid-1984 appears to have eased some of the upward
pressure on the d o l l a r ; a f t e r rising sharply through the f i r s t two months of
this year, the exchange value of the dollar has trended downward and is now
around the level of late last summer.

Nevertheless, the high level of the

dollar continues to l i m i t the a b i l i t y of U.S. producers to compete both at
home and abroad.
Labor Markets
Growth in labor demand generally remained strong in the f i r s t half
of 1985, and the number of workers on nonfarm payrolls increased 1.4 million.
The bulk of the j o b growth was in the service and trade sectors, in which

65
Payroll Employment-Nonmanufacturing

Minions of persons,
quarterly average

1979

1981

1983

Payroll Employment-Manufacturing

1985
Millions ol persons,
quarterly average

21
20

1979

1981

1983

1985

Civilian Unemployment Rate
Quarterly average, percent

1979

1981

1983

1985

66
-20employment in the past six months has expanded at rates similar to last
year's rapid pace.

Increases in the restaurant and business services areas

have been especially large.

C o n s t r u c t i o n employment also showed a sizable

gain In the f i r s t half of 1985, along with s i g n i f i c a n t growth in both residential and nonresidential construction.

In c o n t r a s t , manufacturing employ-

ment dropped about 220,000, with cutbacks in payrolls widespread among
industries.
Despite the substantial gains In overall payroll employment, the
unemployment rate has remained at about 7-1/i percent, the level that has
prevailed since last June.

The labor force participation rate was up appre-

ciably on average during the f i r s t h a l f ; the rise occurred primarily among
adult women, who evidently were responding to the Increase in job opportunities in the service and trade sectors, where 80 percent of adult women are
now employed.
Wage inflation has remained restrained.

Year-over-year changes in

the employment cost index for wages and salaries, a relatively comprehensive
measure for the private nonfarm business economy, have held steady at j u s t
over 4 percent for nearly a year.

This Is about one percentage point less

than In 1983 and early 1984, and substantially below the peak rate of about
9 percent reached in 1980.

The slowing in union wage increases over the

past several years has been especially large.

Union wage gains both in and

out of manufacturing have been below the increases posted in nonunionized
sectors for the past year and a h a l f , causing a partial erosion of the differential that had built up over the years prior to the last recession.
Major collective bargaining agreements negotiated in e a r l y 1985 Indicate
continued moderate wage growth in the unionized sectors.

67
Hourly Earnings Index

Change from end of previous period,
annual rate, percent

1985

Consumer Price Index

Change from end of previous period,
annual rale, percent

1983

GNP Prices

1979

Change from end of previous period,
annual rate, percent

1981

1983

•Consumer price change (or 1985iHt is Cased on December lo May period.

5985

1985

68
-21Productivity in Che nonfann business sector appears to have declined
in the first half of 1985, following increases amounting to 4 percent in 1983
and 2-1/2 percent in 1984.

Both the recent slowing in productivity and the

substantial gains earlier in the recovery largely reflect the fact that
employment tends to respond more slowly than output to changes in demand.
However, improvements in productivity appear to continue to be a major
priority of both workers and management, as evidenced by widespread reports
of modernization of facilities as well as relaxation of work rules and other
steps to enhance efficiency and hold down costs.
The combination of improved productivity growth and relatively restrained wage gains in this expansion has resulted In a sizable deceleration
in the average rate of increase in unit labor costs relative to the previous
several years.

Although unit labor costs have risen this year in response

to the downturn in productivity, they are still only about 3 percent above
their year-ago level.
Price Developments
After slowing sharply in the recession, the broadest measures of
inflation have held fairly steady at about 4 percent during much of the
expansion.

While the stability of the inflation rate during this expansion

partly reflects some special factors, significant

progress appears to have

been made in reversing the underlying momentum of the inflationary process
that sustained the wage-price spiral of previous years.

Inflation expecta-

tions have been more subdued, and both labor and management have exhibited a
better appreciation of the fact that gains in real incomes cannot be achieved
simply by marking up nominal wages or prices.

69
-22The strong dollar has reinforced other factors holding down
i n f l a t i o n in this expansion period, both directly by reducing the prices of
imported goods and indirectly by forcing U . S . manufacturers to restrain
price increases in order to remain competitive.

Retail prices of goods

excluding food and energy rose about 3-1/2 percent, at an annual r a t e , in
the f i r s t half of 1985, about the same as the average rate of change in the
two preceding years.

Increases in prices of nonenergy services, which have

not been a f f e c t e d nearly as much by import competition, have continued to
be substantial, averaging a 5-1/2 percent rate in the last six months, the
same as in 1984.
Energy prices have been quite volatile over the past y e a r , mainly
reflecting movements in gasoline prices.

From the autumn of 1984 through

February of this y e a r , gasoline prices f e l l by about 3-1/2 percent, as refiners sought to reduce excess inventories.

Production was adjusted downward

as well, resulting in a spurt in prices in the spring.

However, gasoline

prices appear to have stabilized more recently, as inventory levels have
returned to normal while crude oil supplies remain abundant.

Food prices

have risen only a little this year, r e f l e c t i n g the moderate rate of increase
in processing costs as well as p l e n t i f u l agricultural supplies.
Prices of basic industrial commodities, which rose markedly in the
initial stages of this upswing in business a c t i v i t y , have been trending downward for the past year and a h a l f .

The demand for materials by U.S. manu-

facturers has been weak, and world supplies have been ample, owing in part
to the expansion of capacity in many developing countries in the past decade
and their need to maintain export revenues.

70
-23Scctlon 3:

Money, Credit, and Financial Harkets^in the First_Half of 1985

In February of this year, the FOMC established target growth ranges
for the year (measured from the fourth quarter of 1984 to the fourth quarter
of 1985) of 4 to 7 percent for M l , 6 to 9 percent for M2, and 6 to 9-1/2
cent for M3.

per-

For domestic nonfInanclal sector debt, an associated monitoring

range was set at 9 to 12 percent.

The Ml range for 1985 represented a one

percentage point reduction at the upper end from the range of the preceding
year, while the range for M2 was unchanged.

To reflect changes In the pattern

of f i n a n c i a l f l o w s , the 1985 range for M3 was raised by a half point at

the

u p p e r end, and the whole range for the debt aggregate was raised by a percentage point.

It was expected that these ranges would be adequate to encourage

f u r t h e r real economic growth at a Sustainable pace consistent with containment
of i n f l a t i o n a r y pressures and a movement over time toward reasonable price
stability.
In implementing policy throughout the period, the FOMC emphasized
the need to evaluate growth in the monetary aggregates In the context of
information available on economic a c t i v i t y , p r i c e s , and financial market conditions.

Among other f a c t o r s , the strength of the dollar and the related

sluggishness of m a n u f a c t u r i n g activity required a t t e n t i o n .

As an operational

m a t t e r , the degree of pressure on reserve positions of depository i n s t i t u t i o n s
was relatively unchanged during the p e r i o d , and the discount rate was reduced
once.
Honey, Credit, and Monetary Policy
The unusually sharp drop in velocity In 1982 and early 1983, when
growth of Ml greatly exceeded that of nominal GNP, had led the FOMC to place

GROWTH OP MONEY AND CREDIT
Percentage changes

Period

Domestic
nonf inanclal
sector debt

Fourth quarter to
second q u a r t e r 1985

10 .5

8.8

7. 9

12 .8e

Fourth quarter to
June 1985

11 .6

9.1

8. 7

12 .7e

8.1
9.0
9.2
9.1
12.2
7.7

10. 3
9. 6
12. 4
10. 0
10. 0
10. 4

12 . 1
9 .6
10 .0
9 .1
10 .8
13 .6

Fourth quarter
to f o u r t h q u a r t e r

1979
1980
1981
1982
1983
1984

7. 5
7. 5
5. U 2 . 5) 1
8. 8
10. 4
5. 2

Quarterly growth rates
1984-qi
Q2
Q3
Q4

6. 2
6. 5
4. 5
3. 2

7.2
7.1
6.8
9.1

9. 2
10. 5
9. 5
11. 0

13 .0
13 .0
12 .6
13 .4

1985-Q1
Q2

10. 6
10. 1

12.0
5.3

10. 7
5. 0

13 .4
11 .8e

e—estimated.
1. Ml figure In parentheses ts adjusted for shifts to NOW accounts in 1981,

72
-25-

less reliance on Ml as an operational guide to policy.

During the latter

part of 1983 and in 1984, however, the patterns of Ml growth relative to
other economic variables proved more consistent with historical experience,
and Ml was given more weight in the conduct of policy.

Nonetheless, consid-

erable uncertainty remained, in part because of limited experience with the
impact of deposit deregulation and financial market innovations on the
behavior of Ml under varying economic and financial circumstances.

Similar

concerns about possible changes tn the account offerings and pricing behavior
of depositories and the asset demands of households a f f e c t all
aggregates to some extent.

the monetary

These factors accounted in part for the need

to interpret movement in the aggregates in the light of other information,
including evidence on s h i f t s in velocity.
In the event, monetary policy during the first half of the year
had to be adapted to a f u r t h e r slowing in economic growth, as manufacturing
activity was essentially f l a t and the agricultural sector remained under
pressure, to a continued high value of the dollar on exchange markets, and
to a tendency for the velocity of money, particularly of Ml, to fall.

Price

and wage pressures remained relatively well contained; indications of some
acceleration In the early part of the year were followed by more moderate
increases in subsequent months.
In that context, monetary policy basically accommodated the strong
demands for reserves by depository institutions that emerged during the f i r s t
half of the year.

The total of adjustment plus seasonal borrowing varied

within a generally narrow range over the period, though increasing for a
time in the spring as a result of special situations a f f e c t i n g non-federally

73
Ranges Adopted in February and Actual Money Growth
M1
Billions ol dollars
Annual rates of growth
1984 Q4 to 1985 Q2

—

590

—

580

—

570

10.5 percent
1984 04 to June 1985
11.6 percent

— 560

—

1984

550

1985

M2
Billions of dollars
Annual rates of growth
1984 Q4 to 1985 02

2550

— 2500

2450

2400

— 2350

1984

1985

8.8 percent
1984 04 to June 1985
9 3 percent

Ranges Adopted in February and Actual Money and Debt Growth

M3
Billions of dollars
Annual rates of growth
1984 Q4 lo 1985 Q2

— 3200

7.9 percent
1984 Q4 to June 1985
8.2 percent

— 3100

— 3000

— 2900

1984

1985

Domestic Nonlinancial Sector Debt
illions Of dollars
Annual rates of growth
1984 Q4 to 1985 Q2

— 6500

12.8 percent
(estimated)
1984 Q4 to June 1985

6300

6100

5900

1984

1985

12.7 percent
(estimated)

75
-26Insured t h r i f t s In Ohio and Maryland.

Reserve positions had been eased

considerably in the latter part of 1984 and the early weeks of 1985.

With

an easing of reserve pressures and a slowing In economic g r o w t h , interest
rates had declined sharply from their late summer peaks through Che very
early weeks of this year.
The decline of interest rates appeared to s t i m u l a t e , with usual
lags of some months, a sizable increase in demands for assets contained in
M l , principally interest-bearing checking accounts (NOW accounts).

Shifts

of long-term savings and liquid funds out of market Instruments and time
deposits Into these accounts in the early months of the year entailed a
substantial rise in total reserves to support them.
preferences shifted toward components of Ml, its

As Che p u b l i c ' s asset

income velocity declined

sharply, because holdings of these assets increased relative to the GNP.
Only minimal e f f e c C s on Ml growth likely resulted from s h i f t s of funds into
"Super NOW" accounts a f t e r the minimum balance requirement was reduced from
S2.500 to SI,000 at the beginning of the year, because Che bulk of the funds
shifted appeared Co come ouC of regular NOW accounts.
MosC raarkeC inCeresC rates rose by abouC a f u l l percenCage point
from their January lows in the course of the winter, though Che level of
rates remained well below Che 1984 peaks.

Demands for credit remained s t r o n g .

Economic growth had picked up in the f o u r t h q u a r t e r and e a r l y data for the
f i r s t q u a r t e r , Chough mixed, seemed g e n e r a l l y consistent with moderate growth.
While as noted reserve growth was sizable d u r i n g the q u a r t e r to accommodate
s h i f C s in the p u b l i c ' s asset p r e f e r e n c e , reserves were provided somewhat
more cautiously through open market operations during the period of most
rapid acceleraCion of Ml growth In Che f i r s t q u a r t e r .

76
Short-term Interest Rates
Percent

Federal Funds

3-month Treasury Bill

1979

1981

1983

1985

Long-term Interest Rates
Percent
Home Mortgage
Fixed Rate
18

30-year Treasury Bond

1979

1981

1983

1985

By early spring incoming economic data made it clear that the rate
of economic expansion remained limited.

Inflation rates continued generally

low, prospects for f u r t h e r oil price declines helped damp inflation expectations, and the market responded positively to signs of possible Congressional
action to reduce the budget deficit.

Growth of Ml moderated substantially,

and the aggregate began to decelerate toward its longer-run range in late
winter and early spring.

Interest rates reversed their earlier rise, as

market expectations changed.

Rate declines were also influenced by a cut in

the Federal Reserve's discount rate in May by 1/2 percentage point to 7-1/2
percent, which took place in the context of continued signs of economic weakness, and against the background of restrained inflationary pressures, and a
strong dollar on exchange markets.

By midyear short-term rates were down to

3/4 to 1-1/4 percentage point from levels around year-end, while long-term
rates had declined by about 1 to 1-1/4

percentage points.

Growth In Ml spurted once again in the late spring.

To some extent,

interest rate decreases contributed to a strengthening of demand for Mi-type
assets during the latter part of the second quarter.

Growth of NOW accounts,

which had moderated in late winter, picked up, as o f f e r i n g rates on Super NOW
accounts adjusted sluggishly to the renewed decline in market rates of
interest.

However, the strength of Ml also reflected an unusual surge in

demand deposit expansion in May that extended into June at an even more
rapid pace.

The rise seems greater than is explainable by usual reactions

to the reduced opportunity cost of holding such funds, or to adjustments in
compensating balances, and may be partly related to sharp swings in U.S.
Treasury balances.

A question has been raised as to whether corporate cash

78
Velocity of M1 and Treasury Bill Rate
M1 Velocity

6.8

6.6

6.4

1982

1983

1984

1985

3-month Treasury Bill Rate
(2 quarlor moving average)
Percent

12-0

1982

1983

1984

1985

79
-28manageTaent practices have become less aggressive in recent months, but there
is no clear evidence on the point.
With the sharp late-spring expansion of Ml, its

velocity in the

second quarter again declined, at about the same rate as in the f i r s t .

The

decline in the velocity of Ml over the f i r s t half of this year—and the
lesser declines in the velocity of M2 and M3—are reminiscent of experience
in 1982-83.

Indeed, in both the f i r s t half of this year and over the one-

year period from raid-1982 to mid-1983 the income-velocity of Ml declined at
annual rates of about 4-1/2 to 5 percent.

The drop in Ml velocity in both

periods appears to have reflected, to a considerable degree and with usual
lags, declines in market interest rates, although the magnitude of the
declines was in both cases somewhat more than could be expected based on
past relationships of money, income, and interest rates.
Episodes of velocity decline may be inherent in the d i s i n f l a t i o n a r y
process.

As interest rates a d j u s t downward in r e f l e c t i o n of lowering infla-

tion r a t e s , households and firms become increasingly less reluctant to tie
up portions of their funds in lower-earning transactions balances.
adjustment has not been steady.

The

Yield declines have been bunched in time,

and the ensuing bunched additions to money balances have led to sudden drops
in velocity.

U n f o r t u n a t e l y , the timing of such velocity changes is no easier

to predict than is the timing of interest r a t e changes.

Deposit deregulation

may have c o n t r i b u t e d to the extent of velocity adjustments by making the
demand for the group of assets in Ml more responsive to Interest rate changes
than it used to be.
While growth of Ml was quite high relative to its

long-run range

for 1985, the broader aggregates remained generally within their ranges.

80
-29-

Growth of M2 from the fourth quarter of 1984 to the second quarter of 1985,
at an 8-3/4 percent annual rate, was a little below the upper limit of its
range, expressed as a cone based in the fourth quarter of 1984.

However,

expansion of this aggregate in June brought its monthly average a little
above the upper end of the range.
Given the deregulation of bank deposit rates, the growth of M2
should be less a f f e c t e d over periods of as long as a half year by Interest
r a t e developments because o f f e r i n g yields on most of its

components are

adjusted in line with market rates and many of the s h i f t s of funds engendered
by I n t e r e s t rate changes are among assets within this broader aggregate.

But

because the adjustments in o f f e r i n g yields tend to lag market changes, M2
does show considerable

short-term responsiveness to interest rate changes.

Deposit rates, especially on MMDAs, fell much less than market yields last
f a l l , so M2 rose rapidly for several months.
February and March held back M2.

Then rising market yields in

The nontransactlons portion of M2 actually

declined in April for the f i r s t time in 15 years, although this may have been
p a r t l y the r e s u l t of d i f f i c u l t i e s in seasonal adjustment owing to the limited
experience with IRA accounts (which are excluded f r o m M2) and with tax payments made out of MMDAs and money market funds.

After rates f e l l back, M2

picked up again strongly in late spring.
M3 growth, meanwhile, was comfortably within its
ing the f i r s t half of the year.

target range dur-

Issuance of large CDs has slowed substan-

t i a l l y from last year at both banks and t h r i f t s .

Core deposit flows have

accelerated while the rate of loan expansion has held about steady.

Further-

81
-30more, perhaps in response to new Federal Home Loan Bank Board regulations
raising net worth requirements for fast-growing institutions, t h r i f t s have
reduced net acquisitions of assets.

In doing so, some Institutions have

taken advantage of declining yields by using the capital gains from asset
sales to boost reported earnings.
Growth In total debt remained extremely strong in the past two
quarters, averaging a bit above its monitoring range, though below the record
pace of 1984.

Federal government borrowing continued to absorb more than a

fourth of total funds made available tc domestic nonfinancial sectors. An
Increasing proportion of the Treasury's d=bt carries distant maturity dates;
90 percent of net marketable borrowing this year has been in issues of notes
and bonds maturing in 2 to 30 years.

Issues of 20- and 30-year debt, in

p a r t i c u l a r , are increasing and now dominate the new issue market for taxable
long-term bonds, accounting for over two-thirds of new o f f e r i n g s in that
maturity class.

This large volume of new long-term debt has changed the

makeup of the secondary market as well.

The supply of Treasury issues out-

standing with 15 or more years remaining to maturity has doubled In l i t t l e
more than 2 years, while the amount of private issues in that m a t u r i t y range
has shown little net change.
Borrowing of state and local governments has been unexpectedly
strong so far this y e a r , but an unusually high proportion has been for
advance refunding of existing issues, as governments have sought to take
advantage of lower interest rates.

Because the funds borrowed in such opera-

tions are reinvested in financial instruments, they have little net impact
on credit market pressures.

Indeed, most of these funds are required by law

82
-31to be invested in specially-issued Treasury debt, thus reducing the Treasury's
need for public o f f e r i n g s .

Single-family housing revenue bonds have slowed

from Che second half of last year.

But last year's issues were heavily con-

centrated in the later part of the year because of delays in the reauthorizatlon of such bonds; recent volume has been close to the 1984 average rate.
Business credtt demands have remained strong this year.

Slowing

growth of both p r o f i t s and expenditures for fixed capital and inventories
has, on balance, bad little e f f e c t on total borrowing needs.

Corporate

borrowing has been heavier in the short-term paper and loan categories than
in bonds, b u t not to the same extent as in the early p a r t of 1984, when
interest rates were r i s i n g .

In a d d i t i o n , while new issue bond volume has

picked up in response to the lowest long-terra yields in f i v e years, m a t u r i t i e s
of new bond issues have been concentrated in the short- and intermediate-terra
areas, as they were last year.
An unusual portion of the borrowing, also like last year, has been
used to finance equity retirements of one sort or another.

Mergers, b u y o u t s ,

share repurchases, and swaps with shareholders of new debt for stock have
continued on the same massive scale as last year.

Borrowing i n i t i a t e d with

the purpose of financing these transactions nay have accounted in gross terras
for more than a percentage point of the growth rate of total n o n f i n a n c l a l
debt over the f i r s t half.

But such an estimate may overstate the net e f f e c t s

of recent corporate recapitalizations

on debt growth.

A number of firms

involved in mergers or r e s t r u c t u r i n g s this year and last have recently completed large assets sales, some for the explicit purpose of repaying debt.
Furthermore, merger a c t i v i t y may be indirectly responsible for some of the

increased new equity o f f e r i n g s because of its

generally s t i m u l a t i v e e f f e c t

on stock prices as funds paid to shareholders

are reinvested.

Household borrowing also has remained s t r o n g .
loans has been buoyed by declining interest costs.

Demand for mortgage

At the lower rates,

households have found adjustable-rate loans less a t t r a c t i v e than last year,
reducing f r o m two-thirds to about a half the p r o p o r t i o n of new conventional
mortgages with these f e a t u r e s .

Installment debt continued to rise f a s t e r

than income In the f i r s t h a l f of the y e a r , but the second-quarter data show
some deceleration in line with signs of a slowing in the growth of consumption
spending on large ticket items.

Other Developments in Financial Markets
Signs of strain in financial markets have persisted this y e a r , but
without causing major d i s r u p t i o n s in general credit market conditions.

Al-

though the government securities market as a whole has been p e r f o r m i n g w e l l ,
the f a i l u r e s of three secondary government securities dealers caused losses,
sometimes s u b s t a n t i a l , for

some of their customers.

A number of local govern-

ments and savings and loans were among those hurt, and losses by one large
t h r i f t i n s t i t u t i o n in Ohio had further repercussions, t h r e a t e n i n g to bankrupt:
the statewide private Insurance system and, for a t i m e , generating some
concerns here arid abroad about the s a f e t y of other f i n a n c i a l i n s t i t u t i o n s .
Runs on privately Insured savings and loans In Maryland, some of which also
lost money as a result of the f a i l u r e of securities f i r m s , followed the
problems In Ohio.

Privately-insured S&Ls in both states were closed or

limited to small withdrawals for a t i m e , causing serious Inconvenience to
some d e p o s i t o r s , and some i n s t i t u t i o n s remain closed or r e s t r i c t e d .

84
-33-

However, these various problems have been relatively well contained,
without significant effects on other Institutions and markets.
institutions hava switched to federal insurance.

A number of

And the Federal Reserve,

acting in its role as lender of last resort, made advances to non-federally
insured t h r i f t institutions in Ohio and Maryland to help facilitate adjustments in the face of large deposit outflows.

For a while, the borrowing

affected the amount of adjustment credit at the discount window but, because
of the special conditions, did not add to reserve market pressures as perceived by other institutions.

After a time, the borrowings were classified

as extended credit.
The t h r i f t industry as a whole continues to s u f f e r from low net
worth and mismatched balance sheets, but the recent interest rate declines
are improving earnings.

The FHLflB has taken 3 number of steps, including

increased capital requirements for rapidly growing institutions to encourage the stabilization of the industry over time.

Capital requirements also

have been raised for banks, some of which have s u f f e r e d from a high incidence
of nonperforaing loans and loan losses in recent quarters.

The troubled

loans are concentrated In energy, agriculture, and real estate sectors and
to borrowers of some foreign countries.

Bad news about the loan p o r t f o l i o s

of individual institutions and other reported losses have produced some
ripples in market rates generally, but spreads between borrowing rates of
financial institutions and the Treasury have been quite low for the most
part.

To some e x t e n t , loan losses reflect overly aggressive lending decisions,

but the problems of borrowers in the hardest hit Industries are partly a
result of d i f f i c u l t adjustment to a higher value of the dollar and lower

85
-34-

rates of I n f l a t i o n than ware expected when the loans were made.

In the

agricultural as in other sectors, investors and borrowers have discovered
that the i n f l a t i o n of land and commodity prices can no longer be taken for
granted.
In light of strains relating to agricultural credit, the Federal
Reserve liberalized Its regular seasonal borrowing program and Initiated a
temporary special seasonal program.

However, there has been only relatively

limited use of seasonal credit owing to the easing of money market conditions
as the spring progressed.
With regard to conditions among nonfinancial businesses, the prospects of some of those in the weaker industries—especially those most
adversely affected by the high dollar—are subject, of course, to considerable
uncertainty.

But, in addition, many firms have deliberately chosen a more

precarious financial structure in order to enhance current market valuations
of shares or to fend off undesired takeover bids.

Nevertheless, financial

markets have not shown generalized concern about corporate financial structure; notably, spreads between corporate and Treasury debt are unusually
narrow, having shrunk since the beginning of the year.

The CHAIRMAN. Thank you, Mr. Chairman. Your entire statement will be printed in the record.
I certainly agree with Senator Proxmire and his comments about
irresponsible fiscal policy. It clearly compounds the problem of
the Fed in trying to decide what the monetary targets should be.
When we started talking about this 4 years ago, I simply did not
believe that Congress would ever get to the point where we would
continue to allow $200 billion a year deficits.
DIFFICULT TASK OF DECISIONS

It's also interesting to me, as you mentioned, the interpretations
of the advance release of your testimony and what you said yesterday. You are correct, the interpretations come out quite differently.
I also remember what Senator Proxmire said to you in your second
confirmation hearing when he said:
You poor devil, it doesn't matter what you do. If you increase the money supply,
interest rates will go up. If you decrease the money supply, interest rates will go up.
And you will be blamed either way.

So as I watch it, it's interesting. When you're tightening, all the
comment out there is that you're tightening too much. If you start
to ease, then you're easing too much. So I think you learned a long
time ago that it makes no difference what you do, somebody will
position themselves on the other side just in case you're wrong. But
you are presented with an extraordinarily difficult task in the light
of Congress, either inability or unwillingness to do something on the
fiscal side of the ledger.
Getting back to your comments about news analysis, this morning's New York Times concludes:
The Federal Reserve is apparently determined to fight a new public enemy—the
trade deficit, by keeping a loose grip on the money reins and fostering low-interest
rates.

According to the Times, the Fed has decided to use lower interest
rates to push down the value of the dollar and thereby reduce the
trade deficit.
But this morning's Wall Street Journal interprets your same testimony differently by saying: "A declining dollar is limiting the
ability of the Fed to ease monetary policy."
So who is right? What is the correct interpretation of what you
said? Would you tell us what you said?
DOLLAR SITUATION

Mr. VOLCKER. Let me try to clarify the matter. I don't think
there is any question that, looking backwards the dollar has been
high and rising for a good part of the last year. That has been
symptomatic of some of these underlying imbalances that I referred to. That, in itself, of course, is a rather powerful disinflationary force on sectors in the economy that are exposed to international competition. And, under those conditions, that tendency of
the dollar to be very strong and rise, was an influence on the judgments that we have had to make on policy and pressures on bank
reserve positions over the past year.

I would not interpret that as a desire to push the dollar lower. I
think there is a difference between an ingredient in policy of
making some decisions at the margin differently when the dollar is
strong and rising, and interpreting that as pushing it down.
Of course, in the past week or two the dollar has tended to decline, and you do face a different situation. Speaking for myself, I
am not interested in jumping on a downward decline of the dollar
and pushing it lower.
The CHAIRMAN. The financial markets have been guessing for
the last couple of months whether the Fed would tighten up on the
provision of bank reserves to offset the surge in Ml growth that
began essentially in May. On page 6 of your statement you indicate
the decision was not made to tighten in light of current and likely
economic developments, the downward pressures on commodity
prices and the high level of the dollar that has prevailed in the foreign exchange markets.
What harm would you have done if the Fed had ended the uncertainty in the financial markets by announcing in May or June that
the decision had been made not to tighten up on reserves to slow
the growth of Ml?
Mr. VOLCKER. I think what we were doing was evident in the financial markets at that time. There was not evidence of a tightening of reserve positions through that period or that the Federal Reserve was pressing to tighten up. The trouble with making an announcement of the kind that you're suggesting is overinterpretation of such an announcement. We are not giving any commitment
that a persistence of that kind of development, particularly against
a change in the general economic environment, a change with respect to the dollar, would not lead to a change in that posture. And
I m afraid that if you make too many overt announcements it gets
overinterpreted in the market as a commitment to maintain a certain position in this technical sense of providing reserves or maintaining or changing reserve pressures.
I think we are better off making our policies evident in the
market from week to week in that respect. It's always subject to
change in the light of new evidence, which is not the interpretation
that is often given when you make a public statement; that is inevitably interpreted by some people anyway as a commitment for a
period of time that doesn't exist.
The CHAIRMAN. Well, this is an old discussion you and I have
had over when to disclose and what to disclose, but what I hear
you telling me this morning is that the uncertainty isn't as bad as
over or under interpretation?
Mr. VOLCKER. That is correct. You are always going to have uncertainty. We've had this conversation many times. People want to
know where interest rates are going to be next month and next
quarter and they would love to know and feel—maybe overinterpret—that what the Federal Reserve does is going to produce that
result. That's their job, to speculate and hedge about future interest rates. They are looking for a degree of reassurance in a sense,
or a degree of certainty, that we are incapable of giving them.
I don't want to feed what's essentially an illusion that we can
promise what conditions in the financial markets are going to be
like down the road. That depends upon a whole lot of factors.

The CHAIRMAN. Well, I agree. I guess the only place we would
disagree—I say I agree in the sense that you can't make those kind
of accurate predictions, but I still feel that the most difficult decisionmaking process out in the business world is dealing with uncertainty and, as you know, I have always fallen on the side of more
disclosure. If they want to misinterpret, that is their problem. But it
seems to me there is a bigger guessing game going on, more
uncertainty, by not letting them know than the risk of over or under
interpretation of what you're doing.
Mr. VOLCKER. This is an old discussion that we have had and all
I can say is that I have been in this business a long time.
The CHAIRMAN. But how much do we contribute to the gross national product with all those who are paid large sums to try and
guess what you're going to do?
Mr. VOLCKER. They're going to sit there anyway, I'm afraid. 1
don't know of any way to diminish that drag on the real gross national product by diminishing the market for people who are trying
to outguess the future. They are going to be there, and I just think
in the end there's going to be more confusion rather than less if, in
a well intentioned effort to provide more certainty, we end up providing less and also making it more difficult to conduct policy in a
flexible way in response to changing circumstances as the unknown future unfolds.
The CHAIRMAN. I suppose you would still agree that the most difficult part of your job is the uncertainty over what we are going to
do with the budget. Is that correct? That's the biggest variable of
all?
Mr. VOLCKER. I don't know whether it's uncertainty about what
you're going to do or the fact that you haven't done anything.
We're left with this persistent, big deficit and the imbalances that
are associated with it. That's just a hard fact, apart from any uncertainty about what you're going to do. Obviously, if we knew that
an aggressive and successful attack was going to be made on the
deficit, it would make our decisions much easier.
The CHAIRMAN. And I would assume that your position is still
the same, that you would prefer to reduce it with expenditure cuts,^
but if not possible, you would then go to tax increases?
Mr. VOLCKER. That is correct.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Thank you, Mr. Chairman.
Mr. Chairman, I would like to follow up on your line of questioning with Chairman Volcker. In fact, I would go a little farther than
Chairman Garn has gone and you've gone.
FORECASTING OF ECONOMY

It seems to me the forecasting by our economic experts, including
the Federal Reserve, has been just about useless for the last 12
years. I can't think of any purpose they have served. Looking back
at the record, none of the major economic forecasters called the
1973-75 recession. None of them called the outbreak of double-digit
inflation in 1978-79. None of them called the strength of the early
recovery from the 1980 recession. They all missed the 1981-82 recession. They all missed the strength of the recovery from that re

cession or the extent of the slowdown in the first half of this year.
Every single one of these changes which are so important for our
economy has been missed by the forecasters.
I don t know whether we should pay any attention to them at all.
Now having asked that, let me ask you to make another forecast
right now. Could we hit another outbreak of inflation or a deep recession next year and would this be any more unlikely than the
real GNP growth of around 3 percent or around 4 percent as forecasters now predict.
Mr. VOLCKER. That either a recession or an inflationary outburst
Senator PROXMIRE. That's right.
Mr. VOLCKER. I share a lot of your skepticism about economic
forecasting and let me just—while you give me the opportunity—
just make a modest note in that respect. This so-called flash GNP
report is in itself a forecast or a guesstimate that I think we could
do without myself; it attracts a lot of attention and by its nature
it's not a reliable figure. It just attracts more attention than it's
worth.
But in terms of your general strictures, while I share your skepticism about a good deal of forecasting, let me say rightly interpreted—I will give a definition of rightly interpreted—that there is
some central tendency, so to speak, some best guess for the future,
some range of best guesses. I certainly think the idea of some
growth over the next 18 months is a better guess than a great inflationary outburst or a recession. I would not interpret that too literally in terms of the precise figure as to what may develop over
the next 18 months because nobody knows that.
But if the question that I understand you posed is, "Is it better to
operate to some degree on that premise than a premise of a sharp
recession or an inflationary outburst," I would say, yes, we would
operate on the premise of growth someplace in the neighborhood of
what we projected and what many other people are projecting,
keeping a wary eye out for symptoms of change, rather than
simply taking a view that we know absolutely nothing about the
future.
Senator PROXMIRE. Well, the important thing, then, is to recognize that these forecasts are very, very fallible. They can go either
way.
Mr. VOLCKER. I agree.
Senator PROXMIRE. And that there are all kind of ranges like
predicting a 70-percent chance of rain.
Mr. VOLCKER. That is precisely the way they are predicted.
The CHAIRMAN. I would suggest though, Senator, after what you
said, if they are all wrong, they can be very helpful. Then we just
take the opposite view and you and I will be right
Mr. VOLCKER. I don't know which is the opposite, up or down.
Senator PROXMIRE. Well, your current projections show real economic growth at close to 3 percent for all of 1985 and 1986. Given
the fact that there was only 1-percent growth in the first 6 months
of 1985, that implies a strong second half of around 5 percent
growth followed by a weaker performance in 1986,
What developments are on the horizon that leads you to anticipate fairly strong growth in the second half? Most of your com

ments about the growing trade deficit, the surge in consumer debt,
and so on, would seem to suggest the opposite.
Mr. VOLCKER. When those projections were made I suspect most
of the members of the committee making those projections were assuming a somewhat stronger first half than are actually in the
GNP figures. They wouldn't necessarily have been expecting 5-percent growth in the second half, but within the range of uncertainty
that we are talking about, they were certainly projecting a stronger second half.
When I look at these GNP figures—and I haven't had a chance
to analyze them carefully—there is nothing in those figures that
suggests to me that growth in the second half couldn't well be
more rapid and significantly more rapid in GNP terms than in the
first half. I noted earlier that domestic final purchases have been
well maintained during this period, not only well maintained but
they were at quite a rapid pace in the second quarter. We had a big
decline in the rate of inventory accumulation that you wouldn't
necessarily think is going to be repeated or continued, and if you
maintain final demand and had a change in the inventory picture—in the sense it didn't take a great acquisition of inventories,
it just takes no more decline in the rate of growth—that's what
changes the GNP, and you could get a significantly higher GNP
figure in the second half of the year simply by a change in inventory behavior.
EFFECTS OF VOLATILE TRADE PICTURE

The other swing factor—and one of the reasons the economic
forecasts have been so bad, even the short-term ones recently—is
the swings in the trade balance of a magnitude that we simply
haven't been used to in the past. Exports and particularly imports
are so big now and so volatile from quarter to quarter that they,
themselves, swing the GNP figure significantly from quarter to
quarter.
We have had an adverse trade picture in terms of change in the
second quarter, and if that becomes adverse at a less rapid rate of
speed—if you just make that assumption, not that it gets better but
that it stops getting worse or stops getting worse at the same rate
of speed—the effect of that against maintaining final purchases is
to boost the GNP figure. So I don't see anything in this picture
that says it's impossible or even unlikely for a somewhat more
rapid growth in the GNP in the second half of the year.
Senator PROXMIRE. How about the enormous increase in consumer debt?
Mr. VOLCKER. That is a
Senator PROXMIRE. That has gone up very sharply. It's close to
$2.5 trillion.
Mr. VOLCKER. It is bothersome. The fact that this recovery or expansion has been accompanied by and in some sense, I suppose, dependent upon a big expansion of debt is an unsettling factor. Our
big expansion of debt has been partly the Government, but the
other area where it's been expanding very rapidly is in consumer
credit.
Senator PROXMIRE. Even more than Government.

Mr. VOLCKER. At pure rate of percentage increase, that's correct.
We also now have some evidence that delinquencies in that area
are rising. They have been quite low, but there is that kind of evidence that consumer debt burdens are now getting clearly on the
high side. That could be a drag on growth as well as another source
of financial weakness, but I don't think it's reached dangerous
levels. Those delinquencies have been low. That has been the most
solid part of the credit picture in a sense, but there are some signs
consistent with developing strain in that area, too, and so I think
that is a potential drag.
Senator PROXMIRE. On page 7 of your testimony you say:
The potential effects of interest rates and decisions with respect to monetary
policy on exchange rates in the external sector of the economy have necessarily
been a significant ingredient in Federal Open Market Committee deliberations.

Now that statement seems to lend credence to those who contend
that you're easing monetary policy because of your concern that a
slowdown in our economy caused by high interest rates due to a
tighter monetary policy could deliver a knockout punch to the
Third World debtor countries; that is, by shrinking their market
for exports here and by increasing the servicing cost of their debt
by higher interest rates.
Is that an accurate surmisal of at least one key factor that you
or the Federal Open Market Committee must consider when deciding on monetary policy even at the risk of some future inflation
here?
Mr. VOLCKER. I think the factors of that sort enter into my thinking certainly. I don't know just how to weigh it. Again, these are
all a question of how it affects decisions at the margin. I wouldn't
put it just the way you put it, that you take more risks on the inflation side. In one sense, those risks that exist with respect to less
developed countries [LDC] det>t or growth elsewhere or financial
problems domestically are a risk in some sense on the deflationary
side.
Senator PROXMIRE. Now as you know, Governor Gramley has left
the Board and Governor Partee's term expires next January. Moreover, there have been rumors that another Governor may be resigning soon. This brings up the question of your continued service
on the Board.
Can you tell this committee what your current plans are?
Mr. VOLCKER. My status has not changed from the last time we
discussed this. I certainly have made no decision on that matter.
Senator PROXMIRE. That means you will stay on how long?
Mr. VOLCKER. We'll see.
Senator PROXMIRE. What was that?
Mr. VOLCKER. We'll see.
Senator RIEGLE. He said through the end of the day.
Mr. VOLCKER. I have no present plans to leave.
Senator PROXMIRE. Well, this is very heartening. At one point
when you were confirmed you indicated you probably wouldn't
serve out your full 4-year term.
Mr. VOLCKER. I didn't deny that today.
Senator PROXMIRE. What's that?
Mr. VOLCKER. I didn't deny that today.

Senator PROXMIRE. But you didn't confirm it either.
Mr. VOLCKER. I didn't confirm it either.
Senator PROXMIRE. Well, you are certainly a fountain of information.
Mr. VOLCKER. What I said was I didn't feel committed to stay.
Senator PROXMIRE. What's that?
Mr. VOLCKER. What I said was I didn't feel committed to stay.
Senator PROXMIRE. Well, I hope you stay. I hope you get reappointed, too. Thank you.
My time is up. I'll be back.
The CHAIRMAN. Senator Hecht.
Senator HECHT. Thank you, Mr. Chairman.
Chairman Volcker, you have never been so brief since I have
been in the Senate. Does that mean the economy is great and everything is coming up roses?
Mr. VOLCKER. No, I'm ready to stay here all morning, Senator,
that's the first comment I should make. But the economy overall
has been doing pretty well, and we have, as I said, a kind of extra
burden of carrying the rest of the world to a considerable extent.
But everything is not coming up all roses. As I tried to emphasize,
there are very, very difficult problems underneath the surface, and
not very far underneath the surface. They are quite evident.
Senator HECHT. As I mentioned before in my opening remarks, I
applaud your recent stands. Let me ask you a question now.
REDUCTION OF THE DEFICIT

About 1 year or IVa years ago, I asked you, to get interest rates
down what would we have to do, and you said, "Take $50 billion off
the deficit immediately."
About 1 or ll/2 years ago, I asked you to get interest rates down
what would we have to do, and you said, "Take $50 billion off the
deficit immediately."
Now my question is, what will happen if we don't get a compromise and cut the $50 billion off?
Mr. VOLCKER. I think the result will be adverse. I think you are
right. I can't quantify it, but during the period when there was
growing optimism that the budget cuts would be made that was a
reassuring factor in the financial markets generally and in the
bond markets on interest rates, and it probably was part of the favorable background for the stock market as well.
I think most people are a lot more uncertain about that prospect
now, but they retain some hopes. If they really had the feeling that
all hope of progress in that direction was shattered, I think it
would be disconcerting. It would be particularly disconcerting if
something else happened to touch off an adverse reaction in the
markets.
Interest rates have been favored, if that's the right word, by a
feeling that the economy is moving quite sluggishly at the moment,
and that's a very important short-term influence on interest rates.
But if you combine lack of progress on the deficit with some other
signs that in the minds of the market might point to more pressures on the credit markets—say, either more strength in the business picture that became evident or a declining dollar, or both—

you would have quite a problem, in my judgment, without progress
on the budgetary side.
Senator HECHT. Chairman Garn mentioned something while he
was speaking and you said a tax increase might be necessary. Let
me ask you this question.
If we do not cut $50 billion off and we do not have a tax increase,
what will be the result of that?
Mr. VOLCKER. It depends on how much progress you do make,
but I think you clearly begin running those risks that I just discussed. The lack of progress or the lack of adequate progress on the
budgetary side could well aggravate other forces that would leave
us in a very unfortunate circumstance of continuing large imbalances in the economy, less favorable credit market conditions, less
favorable financial conditions generally, and much, much more uncertain prospects about the sustainability of the business advance.
Senator HECHT. Thank you.
Mr. Chairman, that's all.
The CHAIRMAN. Senator Cranston.
Senator CRANSTON. In view of the expansion of the money
supply, are you really more concerned now about a recession
rather than renewed inflation?
Mr. VOLCKER. I think we've always got to worry about the inflation thing and I'm not going to prioritize my short-range concerns.
There are a lot of things we have to worry about and that I certainly worry about. So long as the sources of those imbalances in
the economy exist, I think we take unnecessary risks in both directions.
I just have never thought that the inflation concern is something
we can put aside. It is here and it is going to continue to be here.
The risks on that side, as I indicated, now primarily arise out of
the possibility of a change in the international dimension in the
short range. To aggravate that by prolonged excessive growth in
money would be very adverse.
IMPACT OF EXCESSIVE Ml GROWTH

Senator CRANSTON. It wasn't clear to me from what you said earlier exactly what you think the increase of the money supply will
do in terms of its impact on the value of the dollar.
Mr. VOLCKER. I would not like that to be an independent influence. As I suggest in my statement, you could carry monetary expansion to the point where concerns about a renewal of inflation
from that source interact with a decline of the dollar or precipitate
a decline of the dollar that could have very serious implications.
We haven't got the luxury or the freedom to permit that to
happen, and that is a restraint.
I discuss in some detail and analyze in my statement the increase in Ml. I should say in that connection that the increase in
the other monetary aggregates, M2 and M3, has been broadly
within our intentions. The increase in Ml itself, as Senators Proxmire or Garn noted, while it's been running fairly high all year,
was really within the range of our intentions until May and June.
The big bulge has been only 2 months. And we know that these figures can be very volatile. We would certainly not like to see that

persist. The whole sense of rebasing Ml with the new target is to
indicate our intention that that not persist. If it's a 2-month phenomenon, that's one thing; if it persisted longer, it would raise a
whole different set of concerns.
Senator CRANSTON. Do you feel that the present decline in the
value of the dollar is going to continue and be adequate to remedy
the impact it has on our trade imbalances?
Mr. VOLCKER. I don't think it can constructively remedy our
trade imbalance as long as our fiscal posture is in the place that it
is.
One of my concerns is that, as things now stand, with the fiscal
situation as it is, we can't correct the trade deficit without creating
equally serious problems in other areas of the economy, because
that trade deficit, by the same token, is a big capital inflow. We are
relying upon that capital inflow, in effect, to finance the deficit.
When you talk about correcting the trade deficit, I have to ask
you a question—how are we going to finance the budget deficit? We
are not going to finance it externally under those conditions, and
we're just going to push the pressures onto some other sector of the
economy.
So, in a sense, some day we are going to have to correct that
trade imbalance. But if you tell me, in a vacuum, it would be nice
to correct it next week or next month or next quarter, in a very
real sense we almost can't afford to because we are relying upon
that capital inflow. I don't know how we would finance the deficit
if the trade balance were suddenly corrected.
The only point of that comment is, if you want to correct the
trade balance in a context of a growing economy without pushing
the pressures elsewhere, you've got to do something on the deficit,
because we can't do it by monetary policy. And to try to do it by
monetary policy by simply driving the dollar down would have all
the inflationary implications that are a matter of legitimate concern.
Senator CRANSTON. Would you comment on Lester Thoreau's
thesis that while we do need to do what you advocate on fiscal
policy for many reasons, among them to get the dollar down, that
the dollar isn't going to really come down unless we intervene in
the money markets internationally in order to do so?
Mr. VOLCKER. I think intervention in foreign exchange markets
can be a moderately useful tool from time to time, but the importance of that shouldn't be emphasized. I don't think we are going
to do this by intervention alone and I don't think it would work if
the fundamentals are not more in line with equilibrium.
Senator CRANSTON. Of course, I don't think he was suggesting
that it be done alone.
Mr. VOLCKER. I think the contribution that can make is probably
rather marginal, and it can be important at times if it is consistent
with other policy measures. If it's working against them, it can be
destructive.
Senator CRANSTON. One final question on a different matter.
While interest rates of the prime have been down as low as 10
percent, consumer loans with many banks are still up around 18
percent. Why is that?

95
HIGH CONSUMER INTEREST RATES

Mr. VOLCKER. I don't think they have been—given their problems
as they see them—terribly eager to lead the parade downwards in
the consumer loan area. Consumer loans are normally more sluggish than other loan rates. They have been coming down in areas
like automobile loans where they are more flexible and the competition is quite strong. Where you see very little or no decline, at
least until very recently, is in the credit card area where I think
there are administrative and other considerations that lead to a lot
of stability in those rates and you have seen practically no movement in that area. But you have begun to see some movement in
auto loans or straightforward installment credit where transactions
are of some size as compared to the consumer credit card area.
Of course, there are substantial fixed costs of something like
credit cards, and banks, as well as other credit card providers, are
very reluctant to change those rates very frequently.
Senator CRANSTON. Thank you very much.
The CHAIRMAN. Before I turn to Senator Riegle, Senator Dixon
has a statement and I would ask unanimous consent that it be
placed in the record.
STATEMENT OF SENATOR ALAN DIXON

Senator DIXON. Mr. Chairman, I am pleased to be here this
morning as the banking committee conducts its semiannual oversight hearing on the conduct of monetary policy. I always find the
presentations of the distinguished Chairman of the Federal Reserve
Board to be informative.
The Federal Reserve has already announced it is increasing the
target range for Ml, the most basic money supply figure. I believe
this is a necessary step. Economic growth has been slowing. The
gross national product is increasing a too low 2-percent 1rate so far
this year. Unemployment is stagnant at a far too high I /* percent.
Inflation, however, is likely to remain at 4 percent or below for the
year, and it seems unlikely that inflation would be reignited by the
modest stimulus this change in monetary policy represents.
Interest rates have declined over the past year, but they are still
far too high relative to historical experience. Pressure from Federal budget deficits that will exceed $215 billion this year keeps interest rates well above where they would otherwise be.
It is long past time for Congress to address the fiscal policy issues
these figures represent. We must act to substantially reduce Federal deficits and bring Government spending back under control.
Monetary policy alone, in the absence of correct fiscal policy decisions, canot ensure stable, long-term economic growth with low unemployment.
I want to take this opportunity, therefore, to say that I think we
cannot afford to have the current budget stalemate continued. We
need to take the tough actions and to find the difficult and distasteful compromises that are necessary if we are to get the budget savings we so desperately need. Congress and the administration need
to work together on a bipartisan basis to reduce the growth of Federal spending. This must be our No. 1 priority. The current low

economic growth rate demonstrates we cannot allow the continuing
budget crisis to remain unresolved.
The CHAIRMAN. Senator Riegle.
Senator RIEGLE. Thank you, Mr. Chairman.
OPINIONS ON TRADE DEFICIT ISSUE

Chairman Volcker, as I listened to your response to Senator
Cranston on the trade issue, the trade deficit, I must say if I understood you correctly I just think you're wrong. So maybe I didn't
hear you correctly or we just have a sharp difference of opinion.
As I understood your answer, you were in effect saying that the
benefit of the trade deficit is that it helps ensure that foreign countries will take up our debt, buy our debt instruments, and they are
providing a lot of the capital that we are using now to finance our
deficit, and I gather that was the thrust of your point in your response.
Mr. VOLCKER. Yes; that's basically the other side of the coin.
Senator RIEGLE. Well, the way my thinking works on this, it
seems to me that if we could stop the trade deficit, produce the
goods that we are buying abroad internally, generate the wealth in
our country, keep the money circulating in our system which presumably would drive up plant utilization rates and would lower unemployment and increase the gross national product, you would
have that wealth in-country and you might still have to borrow it
for credit purposes, but you would be borrowing it from yourselves
rather than borrowing it from foreigners.
I don't understand how we come out ahead by running up an increasing trade deficit and then having to borrow the money that
we've just given the foreigners—have to borrow it back from them
in order to finance our own overspending. I don't understand the
reasoning.
Mr. VOLCKER. Because we don't generate enough savings at home
even with a higher GNP to finance that deficit plus all the other
things we want to finance. You would get somewhat more total
savings out of a higher GNP, but not nearly dollar-for-dollar. It's
like $1 for $10 of expansion in GNP. It's less than that; it's maybe
$1 for $15 of increased GNP in terms of savings. And that simply is
not enough to offset this capital inflow that we're getting from
abroad. Suppose just for arithmetic purposes you took that $125 billion current account deficit and added it to our GNP, you're only
going to generate out of that maybe 10 billion dollars' worth of savings, but you have to make up $125 billion of loss of capital inflow;
and that arithmetic isn't very good. You've lost $115 billion that's
going to have to be squeezed from someplace else in the economy.
Senator RIEGLE. I don't think, though, that what you're suggesting is a workable answer and it seems to me that a workable
answer is to find a way to drive up the savings rate in this country
or lower your debt accumulation.
Mr. VOLCKER. Exactly.
Senator RIEGLE. One or the other. But if you go the route we're
on now, what happens is we're sending in effect equity money out
of the country. In other words, we are exporting American wealth.
We're buying basically consumer goods, consumer durables from

VCR's to cars to whatever from foreign countries. And when these
foreign countries, because they have higher savings rates and lend
the money back to us, in effect lending what was our money—that
was our equity money but now becomes their equity money because
we traded the money for some of their goods—they send it back to
us and it's a debt transaction. So we go from having an asset on
the balance sheet to having a liability on the balance sheet in the
sense that we have now borrowed from them so we are not only
going to be obligated in the future to pay back the money we borrowed but we now have this debt service cost on top of it.
Mr. VOLCKER. We had no equity money in the United States
originally. Otherwise, I agree with that analysis. We are exchanging goods for paper.
Senator RIEGLE. But it seems to me that in the process we are
accumulating an increasing debt of a dimension that we've not
dealt with in contemporary history.
Mr. VOLCKER. That's correct.
MASSIVE BUILDUP IN DEBT

Senator RIEGLE. And when we add up everything we've talked
about today—others have mentioned this massive buildup in consumer debt. The data shows that the consumer debt is running at a
rate of 72 percent of personal income and in fact is rising above
that level. We've got the massive buildup of internal domestic debt
coming off the fiscal deficit which we are all alarmed about. And
now we've got this situation where we've just become a debtor
nation in terms of our international balance sheet last month, according to the Commerce Secretary, and within 12 months, if we
stay on these trend lines, we are going to surpass Mexico and
Brazil and become the No. 1 debtor nation in the world because of
the severity of this erosion in our financial condition worldwide.
So when I add these things up, this massive pileup of debt, consumer debt, national internal debt, now international debt—I don't
know any contemporary parallel to this. We haven't been a debtor
nation since 1914, so we've got to go back a long time.
Mr. VOLCKER. There is none.
Senator RIEGLE. It seems to me that what we are doing here is
putting ourselves in a highly vulnerable condition financially and
to say that the trade deficit in any manner of speaking helps us I
think is just wrong thinking. I think what it's doing is it's masking
the problem. In a sense, it's buying us some improvement on inflation because presumably we are paying less for the foreign goods,
but we are exporting scarce capital which we don't have enough of
and we are not saving and reinvesting enough internally, so what
we are doing is we are sending the capital out of the country for
the foreign goods; they're lending it back to us so we're going
deeper in debt for the savings that we are not able to generate by
ourselves, and somehow this is seen as a remedy. This is no
remedy. We are putting ourselves, I think, in terrible jeopardy.
Mr. VOLCKER. I don't disagree with what you're now saying.
We're not sending any capital out of the country, but that's a semantic point.

I accept your interpretation that we're masking the problem and
I think you put your finger on it earlier. What we've got to do is
either increase the savings or reduce our deficit. I think the prospects of increasing our savings rate significantly are nil over a relevant period of time. Therefore, you're left with one remedy—
reduce the deficit.
Senator RIEGLE. Well, maybe we have to do both in a way that
we haven't talked about. Maybe we have to take the biggest bite
out of the spending side that we can manage to accomplish and get
every last dollar of spending savings, and then maybe we're going
to have to induce a level of national saving, if you will, by another
means that we haven't yet discovered. I mean, one way to do it in a
sense, if the savings rate is going to run about 6 percent, give or
take, depending on what income levels are, and people tend to keep
some savings in reserve, maybe what we're going to have to do is
find a way to lower consumption levels, at least for a period of
time, by one means or another, to keep that money in an equity
form to try to offset this debt buildup.
The thing that I worry about right now, the stock market rocketing up, and partly it's the movement of money between financial
instruments. As interest rates have come down there's been a disinvestment in the bond market, a lot of people taking profits on
bond holdings and institutional investors, and now the stock
market looks more attractive, relatively speaking, and so you get a
lot of movement there. Prices go up and I think it tends to create a
sense of optimism generally and it's an aura that everything is fine
and everything is upbeat and we're making great strides. But at
the same time, if you look at this fundamental financial underpinning and our debt structure, it seems to me every trend line in that
area is running the wrong way.
Mr. VOLCKER. I don't disagree with that.
Senator RIEGLE. And when I think about the fact that in a year's
time we're going to be the leading debtor nation in the world, what
do we make of this? This is something that hasn't even become yet
a part of the national debate as yet, but how are people to make
any meaning out of what the implication is of that fact?
NEED TO INCREASE SAVINGS RATE

Mr. VOLCKER. The meaning they ought to give it, it seems to me,
is that we have a gross disequilibrium that indicates that something is wrong. What it indicates is that we are borrowing more
than we are saving. You can talk about increasing the savings rate.
I just note that the savings rate in the first quarter of this year
was 4.5 percent, and in the second quarter it's estimated at 5.3 percent. If we could get that up, it would be wonderful. But I think
you're operating under an illusion if you think that that's simple
or that people know how to do it. The savings rate has been in a
channel of 4 to 7 percent or so for 20 or 30 years, and I don't know
of any way, with any assurance at all, that you can introduce any
heroic measure that is going to magically produce a change in a
trend that's persisted for so long. I don't think you ought to count
on that at all.

Obviously, it's even better if you can work on the side of reducing the demand for debt and that clearly is within your power.
Senator RIEGLE. And that we should do. It seems to me that
taxes—an issue that nobody wants to talk about—but it's something that must be looked into. If the Nation finds itself overspending, either in terms of its national spending efforts through a Federal Government system or overspending in terms of the sum total
of what all the individuals are spending, another way to cut down
on the consumption is to tax off some of that money and not spend
it, use it to reduce maybe past debts or other obligations and so, in
a sense, you create a national savings rate increment above whatever that residual 4 to 6 percent is by individuals.
But it seems to me we could even do some jawboning here. We
are a Nation that is conditioned on consumption and spending—we
could go through any paper today and find that we are encouraging people to take on more debt. I've just been looking through the
papers here today. There are sales going on on credit all over the
country by all kinds of financial institutions and, frankly, as you
increase the Ml targets and make money more available, that
helps cause that to happen. Maybe we need to have more conversation from yourselves and from the Fed and from the President and
other important national leaders that maybe it's time for people to
save a little more and consume a little less. I mean, can we say
that or does that jeopardize the economy right now because of how
fragile things are?
Mr. VOLCKER. We can say it, but I have no faith in that as an
important policy tool in producing a significant change in the savings rate or in the dilemmas that we face. And I think we would be
kidding ourselves if we think we are going to deal with these imbalances by jawboning.
Senator RIEGLE. But I'll just finish with this—if it's your belief
that the savings rate is dangerously low, given our overall pressures, and it needs to go up—we need to find a way to drive it up—
it seems to me then it becomes an obligation to talk about that
problem and how we make that happen, and not to act in the reverse way and that is to sort of give the signal that everything is
fine and dandy and people ought to continue to increase their
debts. Obviously, the Federal debt needs to be reduced notwithstanding, but the general tone and the thrust today is that we can
continue on this spending binge as long as we want without any
great consequence, and it seems to me that as I look at it, we are
right out to the very outer edges of our financial capacity to absorb
new debt at all these different levels and, in fact, they all combine.
You can't really in the end separate consumer debt from national
debt from international debt. If they are all negative and growing
and you add them up, it seems to me you have to say it's time to
sober up.
Mr. VOLCKER. I don't disagree with that, but I think the way to
attack the excessive increase of debt, and the place where it should
be attacked, first of all, it seems to me, is the Federal deficit. If the
message that comes out from the kind of approach you're suggesting is that we can deal with that by increasing the personal savings rate, I think we would be doing a disservice.

100

Senator RIEGLE. Well, I'm also saying do something about the
trade deficit. You sound awfully passive on that issue and it seems
to me that when you're running a deficit of $150 billion a year and
it's rising and you've just become a debtor nation, you'd better pay
attention to the trade deficit.
Mr. VOLCKER. I think we ought to pay attention to the trade deficit. All I am saying is that in the condition in which we now find
ourselves, getting rid of the trade deficit is no freebie.
Senator RIEGLE. Well, my time is up. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Gorton.
Senator GORTON. Chairman Volcker, two of the Senators who are
sitting in front of you today are members of the conference committee on the budget and I would like to ask you for a little bit of
your advice with respect to that process.
BUDGET REDUCTION OF $40 BILLION

You began this year and have consistently held to the position
that it was important that we reduce the budget deficit for 1986 by
some $50 billion or more. Nominally at least, budget resolutions
passed both by the Senate and by the House reached that goal. Perhaps you will assume for the purposes of this question the validity
of the accompanying analysis. We sometimes engage in a little bit
of false advertising. Probably the Senate version was closer to
somewhere between $50 and $52 billion than $56 billion in real
numbers. The House version is about $12 billion less than that, say
$40 billion in real numbers when you take out things like transferring money from one pocket to another in connection with offshore
ocean revenue.
Several of us on that conference committee made a more broadbased proposal which included revenues to the extent of $1 for
every $5 of spending cuts but had far more in the way of spending
cuts than did any of the other proposals that roughly on the same
analysis probably had $70 billion in deficit results for the first
year. That's been rejected and it's unlikely to be revised at this
point.
My question is a two-part one. Is something better than nothing
even though that something is only $40 billion; and how much difference is there between doing a minimal job which must be approached again next year or doing something more decisive and
something which even objective analysis might say would lead us
to a balanced budget within the foreseeable future? What is your
advice and counsel to us as far as our short- and long-range future
with respect to this conference committee is concerned?
Mr. VOLCKER. I think you're getting into an area where I just
can't make a judgment. I don't know what the negotiating situation is. I am certainly not fully qualified to judge the reality of
some of these figures as opposed to the cosmetics of some of these
figures.
But, in concept, obviously, something is better than nothing. And
what you can get in practice, in some sense, is what we have to
settle for.
I would hate to see getting something for the sake of getting
something, at the expense of giving up a more adequate program.

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But that's not a judgment that I can make, whether you have that
realistic choice before you.
The more, the better, within reason. And as I said before, there
is no danger that you are going to get too much. I would certainly
feel the more you could get, the better. But in the end, something
is better than nothing, quite obviously.
I think there is inevitably—it can't be completely identified—
some kind of psychological threshold in terms of market response,
and if you go under $50 billion—which, I think, has become kind of
a symbol—I don't see any way you're going to get any positive psychological impetus from it. You will avoid some disappointment.
I don't know whether that adequately answers the question or
not.
Senator GORTON. It certainly gives some direction but let me
push you a little further. If we were able during the course of this
year to come up with a program which would realistically be believed outside the debate in Congress to promise something close to
a balanced budget within 3 or 4 years, how positive an impact on
the economy would that be likely to create?
Mr. VOLCKER. If you could realistically come up with a program
that approached a balanced budget—I'm not sure that that s within
your grasp, but if you could
Senator GORTON. I said within 3 or 4 years.
Mr. VOLCKER. I understand. That would have I think a very positive impact on sentiment in the financial markets. A lot would
depend upon the credibility of that. But I don't think there's any
doubt that that would have a positive impact on financial market
sentiment and it would set up a backdrop, so to speak, where you
could realistically look toward an elimination of the trade deficit or
a very sharp decline in the trade deficit without posing the kind of
threat that I was discussing with Senator Riegle. That is one of the
important aspects of that. It would put us in a position to absorb a
reversal of that trade deficit with minimal inflationary and other
impacts.
Senator GORTON. That certainly bridges to the next subject on
which I would like to have your advice on.
You have talked about that bridge and about the fact that the
trade deficit helped us cover these horrendous budget deficits in
one sense at least, and that the strong dollar has helped reduce inflationary expectations. Now obviously, we have something of that
story in the Washington Post this morning. We have a dollar
which has begun at last to weaken which, from the point of view of
many, seems very important with respect to at least the reduction
in the trade deficit.
If the dollar continues to weaken, say as much in the next 3
months or so as it has in the last 3 months, is it likely to increase
inflationary expectations? Is it likely to be enough to put the trade
deficit on a decline? And how do we judge the value of those two
courses of action or those two possible results against one another?
Mr. VOLCKER. Let me say flatly I would be concerned about that
if it came against a background of lack of progress on the budget
deficit. I think the reasons that the dollar might decline, and the
effect it would have on the trade balance, would vary and are very
important. If the dollar tended to decline some from levels that are

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still historically high because there was a genuine relief in pressure currently or prospectively on our financial markets and a
growing conviction that inflation will in fact remain under control,
it could have some constructive effects. If you have that same kind
of decline because people fear inflation and wonder about the
future of the American economy and the deficit, the flip side of the
coin looms very prominent in my mind.
I think a great deal depends upon the environment in which that
happens, if it does happen. I don't think we are in any position to
look upon appreciable declines in the dollar, particularly after the
declines that we have had, as a good thing if we haven't gotten our
domestic house in order.
Senator GORTON. Thank you, Chairman Volcker. That's a very
clear explanation.
Thank you, Mr. Chairman.

The CHAIRMAN. Senator Sasser.
Senator SASSER. Thank you, Mr. Chairman.
Mr. Volcker, let me pursue just a moment the line of questioning
that Senator Gorton was pursuing
DEFICIT REDUCTION TARGETS UNATTAINABLE

I think clearly now we are not going to reach the deficit reduction targets that you were widely quoted in the press as recommending somewhere in the neighborhood of $50 to $55 billion.
There was some controversy at the outset between the Senate
Budget Committee and others as to whether even the Senate
budget that was passed here met these targets because we were
using OMB numbers to arrive at our $56 billion deficit reduction
package, which David Stockman has even backed away from now,
as you know. And using the more realistic CBO numbers, I think
our deficit reduction package here in the Senate was coming in
somewhere in the neighborhood of $38 to $42 billion.
Well, it now appears that no matter whose numbers you use
that's going to be unattainable. The President has indicated that
he is not going to stand for any revenue increases and the Speaker
of the House, responding to his Members whom I assume are responding to public opinion— they all run for office over there every
2 years so I expect they know what their constituents want perhaps even better than we do here in the Senate—they are saying
that there's not going to be any cut in the Social Security totals, so
there will be no significant reduction in entitlements.
Well, given that, we are not going to meet the targets that you
laid out early, or have been quoted in the press as having laid out.
Now what happens if we do come in here with a deficit reduction
package for this fiscal year that reduces the deficit somewhere in
the neighborhood perhaps of $42 billion, using OMB numbers, and
$30 billion, using CBO numbers? Hasn't that already been discounted—that possibility or even probability—hasn't it already
been discounted by the financial markets? I see the stock market
continuing to go up. I didn't observe it yesterday, but it's been
reaching all-time highs in recent days.
I suppose my question to you is, what happens if we do come in
with these lower deficit reduction targets—lower by about 20 or 25

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percent? Can we say that the financial markets have already discounted that probability?
Mr. VOLCKER. That's a difficult question for me to answer.
Senator SASSEK. It's a difficult question. That's the reason I
asked you, Mr. Chairman.
Mr. VOLCKER. I don't think the financial markets ever were fully
convinced that you were going to do the $50 billion plus in realistic
terms. I don't know what the effects would be. You're within an
area that may reflect the assumptions in the marketplace right
now.
But whatever the case may be with respect to those expectations,
I think you are certainly leaving the economy more vulnerable
than it would otherwise be.
Senator SASSER. Well, how extensive is that vulnerability?
Mr. VOLCKER. Very.
Senator SASSER. Very vulnerable in your judgment?
Mr. VOLCKER. Yes.
Senator SASSER. Well, I must say that I concur in that judgment,
but I wonder why all these people who put their money on the line
in Wall Street don't appear to concur with the judgment that you
and I have on this matter. That's the mystery to me.
Mr. VOLCKER. I think politically you're dealing with a situation
where the economy is advancing. It's had a rapid advance. Inflation is down and people can say, "Where's the problem?" And I
think, as perhaps Senator Riegle was suggesting earlier, the underlying problems have been masked in some sense by the trade deficit and the accompanying capital inflow. But it gives a lot of pain
to sectors of the economy that are affected by the trade balance,
which is practically the whole goods-producing side of the economy.
How and why is Wall Street reacting the way it is? They have
seen the slowdown in the economy and the GNP. That, in itself,
has been a factor bringing interest rates down in the short run. I
will leave explanations of the stock market to you.
Senator SASSEK. Well, I gave up on the stock market long ago,
Mr. Chairman. I have never made a dollar on the stock market and
don't anticipate that I ever will. I have just given up understanding
that.
SIGNIFICANCE OF DROP IN OIL PRICES

Let me move on to another topic. There's a lot of conversation
now that we may see a rather significant reduction in world oil
prices. Some economists worry that a further drop in oil prices may
mean a resurgence of the threat to world economic stability. I
direct your attention particularly to some of our countries south of
the border. Mexico, for example, loses $545 million a year in export
revenue for every $1 decline in oil prices and Venezuela loses close
to $600 million for every $1 or decline. If oil prices do in fact
drop—let's say they drop $5 a barrel, which some say is well within
the realm of possibility, what happens to the oil exporting Latin
American debtor nations? Are they threatened then with economic
collapse? What does this do to our banks and our financial structure in this country if that starts?

104

Mr. VOLCKER. I think "collapse" is too strong a word, but it
would obviously increase the external financing needs of Mexico. If
you got that sharp a decline in the oil price, on a worldwide basis it
would have an effect of reducing the general price level and I
think, all things equal, you would expect that that would be a force
toward lower interest rates. Mexico benefits very substantially; so
does Venezuela, but less so.
Senator SASSER. Is it a wash?
Mr. VOLCKER. It depends upon what the relative numbers are. A
decline of 1 percent in interest rates is of more benefit than the
hurt of a $1 decline in the oil price. But you've got to fill in the
numbers that are relevant on both sides. So far, in some sense, if
you take as a base point interest rates last summer and look at the
decline in interest rates and look at the decline in oil prices since
last summer—just looking at those two factors—Mexico is a net
beneficiary. They are better off from those two changes. But if you
changed the relative proportions, obviously—of the decline in the
interest rate and the oil price—you get a different answer. The
idea of having a 5-percent decline in interest rates, carrying shortterm interest rates of a Treasury bill rate down to 2 percent, I
don't think is on the likely horizon, so you would not get a wash if
oil prices declined by $5, but there tends to be an offset in direction
anyway.
I think a lot would depend, in the case of Mexico, on whether the
price decline was $1 or $2, or whether it was $5, assuming there's a
further decline at all. They have reduced their oil prices, as you
know, in the last couple weeks.
Senator SASSER. There have been significant improvements, I
read, in the debt situation for the big four Latin American debtors—Mexico, Venezuela, Brazil, Argentina. But there have been a
number of defaults among smaller debtors such as Bolivia and
Peru.
A report by the Overseas Development Council indicated that
our American bankers are virtually ignoring the problem among
the smaller debtors since they are perceived in any case to pose
less of a threat to the financial institutions and to the financial
system overall.
Mr. Chairman, do you see these defaults taking place among the
smaller debtors as being something serious that we should be concerned about, and do they portend further problems for the big
four, either economically or politically, in your judgment?
ARREARAGES OF SMALLER DEBTERS

Mr. VOLCKER. Well, I think they are a matter of concern. You
say defaults. That's a relative word, I suppose, these days. They
have arrears in differing amounts. But there is the danger of contagion in this process and I think to the extent possible we need to
work—the banks, or governments, or the IMF, or the World
Bank—with all these creditors to see whether we can arrive at a
reasonable solution. That's more difficult in some cases, and there
are differing degrees of willingness on the part of those borrowers
in each individual case.

105

In the end, if you have a situation with some smaller country
where there is not a willingness on the part of that country to do
what seems necessary or their problem is intrinsically too difficult,
I don't think that needs to create a major crisis for the whole
world, but I think there is always a danger of some contagion. I
don't think the situation even with the four major borrowers is
uniform and as comforting as you may have suggested in all cases.
They have their ups and downs too, although I think by and large
there's been progress.
Senator SASSER. My time is up. Thank you, Mr. Chairman.
The CHAIRMAN. Senator Dodd.
Senator DODD. Thank you very much, Mr. Chairman.
You have covered a lot of ground this morning, Mr. Chairman.
Just a couple of points, if I could.
EFFECTS OF SLOW GNP GROWTH

One, the Fed has estimated GNP growth to be somewhere between 2.75 and 3 percent between I think it is the fourth quarter of
1984 to the fourth quarter of 1985—that's about 1 percent less than
estimates of a year or so ago, if my memory serves me well.
What is that going to do in terms of projected increases in budget
deficits, assuming that my colleagues here are correct in their pessimism and that they are unlikely to get a budget resolution? We
have a member of that distinguished committee sitting with us.
But assume for a second we don't get one.
Senator GORTON. There's one sitting right beside you, too.
Senator DODD. What do we get as a number coming out of that?
Mr. VOLCKER. Maybe I can give you an estimate. It doesn't have
a lot of effect in the first year. If it were continued into another
full fiscal year, I guess the estimate would run for 1 percentage
point lower real growth—I don't think our estimate has been reduced by quite that much. You get in the $15 to $20 billion area
when it's had time to have a full year's effect.
Senator DODD. Everyone else has been commenting in the last
several weeks about the various tax proposals—the Administration's tax proposals. I can't resist asking you, since you're here this
morning and I may not get a chance to see you again—if you care
to comment on the President's Treasury II proposal.
How important, first of all, is that issue as opposed to the question of budget deficits? For a while it elbowed out, it seemed to me,
the budget deficit question. I think that's come back a little bit, but
at least for a short period of time it seems to have crowded out that
question from the concern of the administration and many here on
the Hill. So the first question is, in relative importance where
would you put it; and second, what do you think of it?
Mr. VOLCKER. In terms of its relative importance, the first comment I would make is that they are both very important subjects
and while they overlap at some points they are basically directed
against different problems. I think the question of tax reform and a
proper tax system is obviously terribly important intrinsically.
If you were looking at it from the standpoint of the impact on
the economy and the development of the economy over the coming
years, I think the deficit question is more important and more

106

urgent. But that is not in any way to say that tax reform is not, in
itself, for other reasons, a terribly important subject and I would
hope you could manage both.
Senator DODD. Did your staff or anyone take a look at the proposal and, if so, did you draw any conclusions about its impact on the
deficit?
Mr. VOLCKER. Our staff has looked at the proposal, but I'm not
sure we're the leading experts in this area. There are a couple of
questions which I'm sure you're familiar with as to when you get
beyond some transition period what the net effect might be over
time on the deficit, and a lot depends on what assumptions you
make about inflation. I would like to make an assumption near
zero, but that's not what other people want to make when they get
out to 1995 or whenever the transition is over. You get different
answers depending on what assumption you make. Most of the assumptions produce revenue loss, but that's out quite a period into
the future.
I think the question that arises in the shorter run—to which I
don't know the answer—is whether some estimates of revenue loss
are harder than some of the estimates of revenue gain from closing
loopholes. I think that's an inherent difficulty in this kind of estimate.
Senator DODD. But it would be totally inaccurate to call the tax
proposal Treasury II as revenue neutral? That's for sure, isn't it?
Mr. VOLCKER. I don't know. For this transition period which is
rather long, I think it depends upon a judgment that you make as
to the relative hardness of the estimates for the savings as opposed
to the losses. And while I know that question has arisen, I don't
have a strong judgment about it. I have not looked at it in that
degree of detail.
Senator DODD. And your staff hasn't drawn any clear conclusions
on it?
Mr. VOLCKER. I think they have raised that question but I don't
think the conclusions are that clear.
Senator DODD. Has the Treasury asked the Fed to comment on
this proposal at all?
Mr. VOLCKER. Not really. I made some informal comments in the
course of very informal discussions but we were never asked per se
to comment on it, and I don't think I'm competent to comment on
the great bulk of the program. I am interested, obviously, in some
aspects of it. I don't like the idea of indexing things, let me just say
that flatly. That's not a new term and this proposal increases the
tendency to index things. I just don't like that tendency to think
you can cure problems by indexing, for a variety of reasons. You
cure the inflation problem by getting rid of inflation, in my judgment.
TAX REFORM PROPOSAL

It's a very difficult issue, but one of the areas of tax reform that
is relevant to the performance of the total economy, I think, is this
inbred bias we have in the present tax system against equity financing and in favor of debt financing. In any tax reform proposal,
the more progress that can be made toward correcting that—and

107

there are some things in this proposal that make a little progress
in that direction—the better off we are.
Senator DODD. But isn't a good portion of it oriented toward increasing consumption?
Mr. VOLCKER. You can raise that question, too. I am not sure the
answer to that is fully clear even in the long run. You're getting
out of an area that I've looked at closely. I think a lot depends—in
terms of the effective tax rate on business—on what kind of inflation assumptions you make, because of the indexing provisions.
Senator DODD. Just one other question quickly. It may have been
asked by the chairman. The chairman of our committee is going
through the difficult time of trying to decide what we ought to do
with the bill we passed last year here dealing with financial institutions 'expanded powers.
I wonder if you might just quickly give us an assessment of what
would be the repercussions or what would happen if we don't do
anything in the Congress in that area, what happens—is there as
much of a need today, given the recent court decisions in some of
these areas, for us to move in this Congress? Just give us any comments you may have on that.
ASSESSMENT OF FINANCIAL SYSTEM DEVELOPMENTS

Mr. VOLCKER. Let me give you one example of the kind of mess
that we're in and the kind of, at the very least, risk you take of
this thing getting out of the hands that it should be in, which I
think are yours. What kind of direction do you want the financial
system to go in as opposed to almost random developments in the
marketplace?
We have a case in the Supreme Court now where one of our decisions, giving a reasonably broad interpretation of our power to
define a demand deposit and a commercial loan in connection with
this nonbank bank issue, was overturned in the district court and
in the appeals court. It's now in the Supreme Court. The courts
said we took an overly expansive definition.
In the meanwhile, we have a decision in another appeals court
saying we take an overly narrow definition or position with respect
to our powers and we must rule out nonbank banks; that nonbank
banks are really banks and the Bank Holding Company Act says
they must be ruled out of order.
I don't know what way the Supreme Court is going to decide, but
they are going to decide the issue. You're not going to decide the
issue. And that doesn't seem to me to be appropriate. One said we
are too expansive and the other said we are too narrow. I don't
know what kind of court decision we are going to get, but if they
supported the position that we are overly expansive you've got an
open door again to nonbank banks. If they decide the other way,
you've got a completely closed off door, I suppose, so far as national
banks are concerned; I'm not sure you've got it closed off for State
banks. Again, it's Congress who ought to be telling us what public
policy is in this area; we ought not to be getting decisions that are
based on some particular interpretation of law written in a different context that are completely arbitrary and often conflicting, as

108

we have now—two specific, conflicting decisions in the appeals
court. That's one area.
One area that I am, frankly, very concerned about—and I think
Congress has to tell us our position—concerns both the savings and
loans as well as banks. There has been a kind of competition
among States to provide very expansive powers that raise real
questions about the safety and soundness of the financial system,
in my judgment. I think that some limits ought to be put around
the ability of States under the cover of Federal insurance, to provide powers to institutions that seem to me basically incompatible
with the safety and soundness of the system, and at the very least
put risks on the insurance system that weren't contemplated by
the Federal Government in creating the insurance system in the
first place.
We have certain powers and we are discussing that issue so far
as bank holding companies are concerned, but at the very least it's
clear that existing law does not leave us or the other regulators—
and the Home Loan Bank Board feels very strongly about this—
with clear cut powers to deal with this situation straightforwardly.
Senator DODD. My time is up. I agree with you wholeheartedly
on that. You don't see any direct threat to the dual banking system
as a result of that, do you?
Mr. VOLCKER. I think the dual banking system rests upon a kind
of comity between the State and Federal authorities and, as I view
it, the State authorities are violating that sense of comity. They
can experiment and should experiment and have a certain discretion without undercutting the Federal interest in a safe and sound
banking system, which the Federal Government protects. I am kind
of bemused, I suppose, by some of the comments about the dual
banking system, particularly from the banking community. When
it comes to a question of usury statutes, they are very vigorous in
saying that's a national interest that ought to override the States,
but when it comes to the States doing something they want to do,
it suddenly becomes a matter of States rights.
Senator DODD. Well, I couldn't agree more with you on that and I
appreciate your digressing as well from the major thrust of this
hearing, Mr. Chairman, but I didn't want to miss the opportunity
of having the chairman hear his comments.
The CHAIRMAN. Senator Proxmire.
Senator PROXMIRE. Thank you, Mr. Chairman.
Chairman Volcker, I want to get back to the future of the Federal Reserve Board. Has the White House given any indication to you
that you will be consulted on filling vacancies on the Board?
Mr. VOLCKER. No, not one way or another. I haven't discussed it
with them.
Senator PROXMIRE. Do you think it's appropriate and desirable
that you be consulted?
Mr. VOLCKER. Yes, sir.
Senator PROXMIRE. Well, I'm glad to hear you say that. I think
it's very important that you be consulted.

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FOMC DEBATES MONETARY POLICY

Mr. Chairman, the minutes of the Federal Open Market Committee [FOMC] meeting of last March 26 indicate a strong debate on
the future course of monetary policy. While a majority of
Mr. VOLCKER. The minutes of when?
Senator PROXMIRE. Of last March 26. While a majority of the
Committee was concerned about an economic slowdown and was
willing to tolerate more rapid monetary growth, some members believed that the money supply was growing too fast and would have
supported greater restraint.
Now that we have 3 more months of experience, how substantial
is this "let us show restraint" element on the Open Market Committee, and are they still advocating restraint or have they moved
over to the majority viewpoint that a more rapid growth in Ml can
be safely tolerated?
Mr. VOLCKER. I don't remember anything special about the
March discussion, but these various points of view are usually debated. It's absolutely typical of a meeting that varying degrees of
concern are reflected about these different crosscurrents, whether
in the monetary figures or otherwise. I think there are bound to be
differences in view in terms of emphasis within the Committee on
weighing the growth in the money supply against other factors;
that, in a qualitative sense, continues.
I think it's also true that the decisions that we have been able to
arrive at have not necessarily been unanimous but they have commanded a large degree of concurrence.
Senator PROXMIRE. My question is, is there more of a consensus
now in view of the fact that the economy is more clearly slowed
down and unemployment has not improved for 5 consecutive
months and is at a very high level on a historical comparison? Is
there more of a consensus now that the economy has
Mr. VOLCKER. I'm not sure, because what you say is true and in
one sense has probably strengthened that view in some people's
minds. On the other hand, we did have this surge in the money
supply in May and June which we had not had in March and that's
obviously a point of concern.
I have no clear memory of it, which reinforces my feeling that
the discussion in the March meeting was not exceptional in terms
of presentation of different views or the vigor with which they
were argued. These differences are quite natural and they are
characteristic in some degree, of every meeting.
Senator PROXMIRE. Let me ask you, what caused the unforeseen
economic slowdown? Last February, when you appeared before this
committee, your report indicated the Federal Reserve was projecting real economic growth of close to 4 percent in 1985. Instead, the
rate of growth for the first half of this year was only 1 percent. As
you look back with the benefit of hindsight, where did you go
wrong last February and what assumptions did you make that
proved to be too optimistic and what developments did you fail to
anticipate?
Mr. VOLCKER. I can only answer implicitly, because those projections are an average of the members of the committee, and I didn't
review their forecasts to see what went wrong. But I suspect the

110

overall answer is evident. They probably were not assuming, as a
whole as sharp a reduction in the rate of inventory accumulation
during this period as we in fact had, and it may be that many of
them were not assuming this further deterioration of the trade balance to the extent we have had it. I suspect it is those two factors.
I would be very doubtful that it was slower growth in gross domestic demand, which has been very well sustained. If anything, I
would guess that is higher than people were projecting. And I
would say in that connection—you're talking about a two-quarter
period—just in reference to your own earlier comments, that a deviation of presently estimated GNP growth for two quarters in the
neighborhood of 1 or 2 percent at an annual rate is not unusual
and I might say should be anticipated. Nobody's forecasts are that
accurate even for that short a period of time.
I think it's at least as important to look at the composition of
what's going on, and as I look at these figures
Senator PROXMIRE. This is a colossal mistake. Here it is a 1 percent growth, not a 4 percent. It was one-quarter of the growth that
you anticipated.
Mr. VOLCKER. You say a colossal
Senator PROXMIRE. This is a colossal mistake. Here it is a 1-perMr. VOLCKER. It didn't take much of a drop to get it less than
you're anticipating. They were probably anticipating slower growth
during the first half of the year. Say they were anticipating 3 percent, which is just a little below what they were anticipating for
the year in the first half of the year. It comes out to an average of
a little over 1 percent. If you looked at the flash figure of the Department of Commerce only 1 month ago, which was 3.1, just the
difference between a flash figure and another estimate for one
quarter was more than 1 Vz percent.
Senator PROXMIRE. Well, I don't want to press you too much on
that, but the fact is that a 3-percent growth is a good—a predictable growth. We have had that over the years by and large on the
average. One percent is stagnation. One percent just doesn't do the
job. You know that.
Mr. VOLCKER. I know that, as prolonged over time. But nobody is
going to predict in a two-quarter period what the rate of inventory
accumulation is.
EFFECTS OF HOSTILE TAKEOVERS

Senator PROXMIRE. Let me ask you about another subject. When
this committee held hearings on hostile takeovers, we were told by
OMB that hostile takeovers involving a substantial debt restructuring were generally good for the economy. OMB argued that many
corporate managers who were sitting on a low debt-equity ratio
were not doing a good job for their stockholders, they could get a
greater return on equity by higher leveraging, and if they were unwilling to restructure their balance sheet corporate raiders were
ready, willing and able to do so for them.
What's your view of the economic effect of higher debt leveraging? Is it an unmixed blessing, as OMB suggests, or are there some
downside risks to the economy resulting from the higher debt
structure?

Ill
Mr. VOLCKER. Obviously, it increases risk, speaking as a generality.
Senator PROXMIBE. And by and large, we've had a big increase in
corporate debt, a diminution in equity, because of corporate takeovers over the past 2 years. Isn't that correct?
Mr. VOLCKER. Yes. I think that looked at overall that increases
the financial risks in the economy. Now I can't say, quite obviously, about any particular firm. It increases the risks for any individual firm, too, but it may be that they are still reasonably conservatively financed. That's a question of the facts of a particular circumstance.
Senator PROXMIRE. But overall, we've had a transfer of equity to
debt of about $90 billion just because of corporate takeovers over
the last year. That seems to me to be a negative factor.
Mr. VOLCKER. Takeovers and leveraged buyouts and other restructuring are on that order of magnitude. And, overall, I don't
think there's any question that that increases the degree of leverage in the economy as a whole and the risks in the financial
system as a whole.
RAPID GROWTH IN BANK CONTINGENT LIABILITIES

Senator PROXMIRE. Now there have been a number of recent stories about the rapid growth in bank contingent liabilities that are
not fully reflected on the balance sheet of the banks. That includes
standby letters of credit, financial guarantees, the sale of loans to
affiliates and the like.
Someone suggested that the nominally higher capital ratios
achieved by the larger banks are not really present when you take
a close look at what the banks are really doing.
How serious a problem is this and do you share the concern
about off-balance sheet banking; and, if so, what is the Fed planning to do about it?
Mr. VOLCKER. I certainly share the feeling that this is an area
that we have to look at and consider what risks there are. We have
a very considerable effort underway to get further understanding
and to make sure the bankers themselves understand what risks
are on or off the balance sheet and take them into account in appraising the adequacy of a bank's capital.
I think there is a tendency, a kind of inherent difficulty, in the
kind of capital ratios that we have announced and enforced, and
the other agencies have announced and enforced, that what we
consider a minimal kind of ratio for any bank is taken as a satisfactory ratio regardless of their condition and the activities of the
bank, which it clearly is not. In our analysis, that is a starting
point.
We think that any bank ought overall to have that kind of ratio,
but they may well need a higher ratio, depending upon the kind of
risks they undertake. And one of those risks—or a large share of
those risks and an increasing part of the risks—may be off-balance
sheet.
It begins to suggest in my mind—and we are working in this direction—a question as to whether we should supplement the overall minimum capital ratio with what might be thought of as a

112

more sophisticated approach of assessing different kinds of balance
sheet and off-balance sheet risks with respect to capital need, and
kind of superimposing that kind of analysis on top of a rough and
ready minimal overall capital ratio.
Senator PROXMIRE. Mr. Chairman, that's very reassuring. I hope
you will move ahead with that.
CREDIBILITY OF TARGET CHANGES

I have one more question. Some monetarist economists believe
the Fed is in danger of losing its credibility if it keeps changing its
targets to accommodate faster money growth. They argue there is a
systematic bias in the way the Fed changes its targets. When
money growth exceeds the targets because of an unexpected decline
in velocity, the targets are raised. But when velocity increases unexpectedly, the money growth targets are not lowered. Over a
longer period, the Fed will create more money than is consistent
with price stability. The end result is an inflationary bias in the
economy because of Fed policy. Once the market catches on, inflationary expectations and real inflation will rise.
What's your response to that analysis? Isn't the Fed running a
substantial risk that it is about to lose its hard-won credibility in
the fight against inflation?
Mr. VOLCKER. I was about to say that my answer to that question
is: When did we stop beating our wife. There is no question that
there are points of possible misunderstanding that arise every time
you change your base or raise a target in a situation in which
there is legitimate concern about current and future inflation.
The question, in the end, will be whether we were right or wrong
and whether the judgment was right or wrong that we are not increasing inflationary risks but rather are adjusting to the facts of
the circumstances that suggest that velocity trends may be changing. If you misgauge that and not change your base when the real
situation has changed, you would engage, in practice, in a tighter
policy than you intended to. You may be hitting the numbers, but
the practical effect would be that the policy was not what you intended.
Senator PROXMIRE. Well, the first doesn't seem to apply.
Mr. VOLCKER. We think it does apply here. Now it's a question of
how much. If I go back to the earlier experience in 1982 and 1983,
the same question was raised. You will remember all of the discussion, by monetarists in particular, that the inflation rate by the
end of 2 years after, in mid-1984 was going to take off and we were
going to go back to double-digit inflation. We could find the old
statements made to that effect; it didn't happen.
I think most monetarists would judge that the adjustment that
was made at that time in retrospect, turned out to be the correct
adjustment of allowing for a more or less permanent shift in velocity—or however they want to express it—because the price implications now, 3 years later, have not developed in the way that was
predicted.
I can't prove that for the current adjustment. We have dilemmas
in making a change of this sort and trying to be conservative, and I
think we are being reasonably conservative. As I pointed out in my

113

testimony, rebasing has not allowed for just forgiving this exceptional surge in May and June. We recognize that even now, on the
rebased number, if you just looked at those targets in a very technical sense, they were high relative to that range. That expresses
our concern that this rate of monetary growth not continue and
that is clearly the feeling of the Committee.
At the same time, we recognize that there is considerable uncertainty in appraising this with precision. If things develop in such a
way that some of this May-June increase washes out more or less
by itself, we would be delighted. It would end some of these questions. We widened the range and provided for the possibility of
only something like a 3-percent growth in the second half of the
year because we would be delighted if it turned out that some of
this increase was temporary. And if the money supply tended to relapse on its own depending upon the circumstances surrounding
the economy, that would be quite acceptable to us.
Senator PROXMIRE. Thank you very much, Mr. Chairman.
The CHAIRMAN. Thank you, Mr. Chairman. I'm sure you're all
aware that next week the committee will commence hearings on
deposit insurance reform and I'm also certain you would concur
that the time is ripe to consider changes in reforming the depository insurance system. So I look forward to hearing the testimony of
some of your fellow regulators from the FDIC and the FSLIC next
week and once again thank you for your willingness to testify.
Mr. VOLCKER. I was hoping our testimony might be in September.
The CHAIRMAN. It is. I said your fellow regulators will be next
week and yours will be in September.
Mr. VOLCKER. Thank you.
THE CHAIRMAN. The committee is adjourned.
[Whereupon, at 11:15 a.m., the hearing was adjourned.]
[Response to written questions with additional material received
for the record follows:]

114
Chairman Volcker subsequently submitted the following
in response to written questions from Chairman Garn in connection with the hearing before the Senate Banking Committee held
on July 18, 1985:
Question 1: When you appeared before this Committee
last February during the first monetary policy oversight hearings for 1985, you pointed out that, while it would be bad for
the economy in the long run, sufficiently rapid monetary growth
could push down the value of the dollar on foreign exchange
markets.
To what extent do you believe that recent declines in
the dollar's value are attributable to the surge in M-l growth
since May?
Answer;

I would not say that the surge of Ml growth in

the past two months has directly contributed significantly to
the recent dollar decline.

The recent drop in the dollar seems

to have been associated in part with the downward movement of
U.S. interest rates over the spring and early summer relative to
rates In other cou^1"1"1"*"', and in part to changing expectations,
influenced to some extent by the further increases in the trade
deficit.

Interest rates were in turn related to the relatively

sluggish behavior of the U.S. economy over this period.

The

surge in Ml growth at the same time reflected to a degree the
increase in money demand as interest rates fell as well as an
unusual surge in demand deposit growth perhaps reflecting
changing cash management practices or transitory responses to
sharp changes in Treasury balances.

Accommodation of this

increased demand for money helped account for the lower interest
rates in the short run, thereby influencing indirectly the value
of the dollar.

Given the moderation in economic activity and

the absence of any signs of additional price pressures, this
rapid money growth did not seem to have aroused much concern
that a resurgence of inflation was likely.

Concerns of that

kind related to excessive money growth over time could result in
a much sharper drop in the dollar's value.

115
Question 2: Your statement seems to say that the
recent surge in money growth was a result of an increase in the
demand for checking account balances and other assets included
in M-l.
An alternative explanation would be that M-l has been
growing because the Fed has been pumping reserves into the
banking system. This explanation would appear to be more consistent with the fact that the "adjusted monetary base" as
calculated by the St. Loxiis Federal Reserve Bank has also surged
since January.
Why do you emphasize the demand for checking account
balances, etc., instead of the. increased supply of bank reserves
in explaining the recent surge in money growth?
Answer:

Money growth necessarily represents the

interaction of tht forces of demand and supply for the assets
included in irioney and the reserves required to back these assets
and both forces are relevant in any analysis.

Preserves have

increased rapidly this year, as the Federal Reserve supplied
sufficient reserves to accommodate strong demands for money
relative to income.

The decision to meet these demands was made

in light of conditions in the economy, financial markets, and
foreign exchange markets that seemed to indicate that relatively
rapid money growth for a time was unlikely to lead to future
inflation.

I have emphasized the detrard side of the market

becau.se this expectation rested in part on a judgment that to a
significant extent growth in the first half of the year represented a relatively permanent increase in the demand for cash
balances and downward shift in velocity.

Clearly if the Federal

Reserve had not allowed reserves to grow as rapidly, money should
have increased, less rapidly, and interest rates would have been
higher at least for a time.

The risk then would be that

economic activity would be weaker.

116
Question 3:

On page 14 of your statement, you say:

"We simply do not have enough experience with the new
institutional framework surrounding M-l...to specify
with any precision what new trend in velocity may be
emerging..."
If you can't forecast trends in velocity and you must
repeatedly adjust money growth to compensate for unanticipated
changes in velocity, what is the value of setting targets for
monetary growth?
Answer;

There is substantial uncertainty about the

trend or cyclical behavior of velocity, as the public and depository institutions adapt to the progressive deregulation of
deposit rate ceilings.

Even so, we do have some general expec-

tations, based on historical experience and ongoing analysis of
current developments, about how money growth is likely to be
related to the nation's ultimate goals for spending, prices, and
employment under most circumstances.

The objectives we estab-

lish for Ml growth are based on this analysis, and are given in
a fairly wide range to reflect uncertainties about velocity
behavior.

Barring unusual developments in financial markets and

the economy, the Federal Reserve would expect HI growth within
the range adopted to lead to satisfactory economic performance.
Money remains a useful guide to policy in that context.

It, in

effect, provides certain presumptions that should be overturned
only in the light of reasonably strong evidence that the expectations about monetary relationships are wrong.

Because of the

uncertainties involved, I do not believe the monetary tarpeff.
can be ar. unbending policy "rule"; rather, monetary growth must
be interpreted in light of other financial, economic, and exchange market developments.

Clearly, if the relationships

between money and the economy were always uncertain and
unpredictable, the targeting procedures would have little value,
but I do not believe the uncertainties are so great as to
justify such abandonment.

117
Question^ 4: The following statement appears on page 22
of the Fed's mid-year "Monetary Policy Report":
"Increases in prices of nonenergy services, which have
not been affected nearly as much by import competition,
have continued to be substantial..."
Given that increases in prices not subject to import
competition remain "substantial", some analysts say that the
Fed's rebasing of M-l and the decision to widen its target
growth range mean that the Fed ha? downgraded the importance of
the battle against inflation.
How would you respond to those analysts?
Answer;

The rebasing of Ml and adjustment in its range

do not imply any lessening of concern about inflation or any
weakening in the resolve of the Federal Reserve to pursue a
monetary policy consistent with moving to price stability.
Indeed, these changes in the Ml objectives would not have been
made if the Committee members considered them to be inconsistent
with this fundamental goal of monetary policy.
The rapid growth of money in the first half of the year
is not expected to result in new pressures on prices partly
because a significant portion of the nonetary expansion apparently represented relatively permanent buildup in cash balances,
partly in response to declining interest rates.

With rates

ratcheting down owing to a recognition of lower inflation and
weakness in the economy, incentives to economize on cash
balances diminished and interest-earning transactions accounts
became more attractive repositories for savings.

118
The adjustment to the Ml target was also made in the
context of continued moderate current inflation, and with no
indications of greater price pressures ahead.

Although service

price increases continue substantial, prices of goods—which are
probably more sensitive to monetary factors--have been relatively flat and sensitive commodity prices have been declining.
Wage increases also have remained quite moderate, and there is
some slack Jn labor and rinal product markets.

Inflationary

momentum is still untouched in some service areas.

I suspect

that will decline only gradually, but it's important that it do
so.

The use of a second quarter base for Ml assunies that
velocity will return over time to more usual patterns--that
money demands in the second half will be neither extremely large
nor extremely small — and thst the money provided in the first
half will be largely held as part of the public's saving and not
employed to generate inflationary demands for goods and services.

To help ensure that inflationary pressures remain

subdued, the new Ml range entails a substantial moderation in
growth from the first half of the year.

Moreover, the width of

the range recognizes some uncertainty surrounding

the judgment

about the effect of the more rapid expansion of the noney stock
in the first half of the year.

The low end of the new range

provides for a very marked slowing of Ml should a subsequent

119
pickup in velocity seeci to indicate more active use of these
balances.
Finally, I would note that the Committee adopted a
tentative range of A to 7 percent for Ml in 1986, lowering the
upper limit of the rebased 1985 range; lowered the upper linit
of the H3 range for next year by one-half of a percentage point;
and lowered the range for credit growth by a full percentage
point.

These decisions also affirmed the Cotmittee1 s intention

to move toward reasonable price stability over tine while encouraging sustainable economic growth.

120
Question 5: On pages 12 and 13 of your statement you
draw a parallel between the recent surge in money growth after a
drop in interest rates and the experience of 1982-83.
You do not point out, however, that the earlier surge
in money growth was followed by a surge in real economic growth
beginning in the second quarter of 1983.
The Federal Reserve's projections for real growth later
this year and in 1986 do not show a speedup like that in 1983
and 198*.
Why won't the recent surge in money growth be followed
by accelerating economic growth as in 1983?
If the economy should begin Co grow faster later this
year than you now expect, will you allow money to grow faster
than the upper boundary of the new target range?
Answer;

We do expect a pickup in real economic growth

in the second half of the year, as I indicated in my discussion
of the FOMC members' projections, but not to the same degree as
occurred in 1983-84.

The surge in money growth extended for a

considerably longer period in the earlier episode; over the
year, from the third quarter of 1982 through the third quarter
of 1983, Ml grew 13.1 percent, with growth at or above a 10
percent annual rate in each quarter.

The current burst in money

growth has been two quarters in duration, has been at around a
10-1/2 percent annual rate, and followed two quarters of relatively slow growth.

The earlier episode coincided with the

trough of our deepest post-war recession, and very rapid economic growth could be accommodated without generating renewed
inflationary pressures.

121
Although somewhat faster growth in the economy than we
have experienced in recent quarters is expected and welcomed,
clearly a repeat of the extent of the earlier expansion is
unlikely, given the lower margins of unutilized resources at
present.

Should the economy grow faster than expected in the

second half of the year accompanied by a tendency for Ml to
remain above the new target range, my general expectation would
be that the Federal Reserve would attempt to constrain money
growth to its range.

Still, our exact response would depend on

che surrounding circumstances, including the behavior of other
monetary aggregates, any indications of possible pickup in inflation, and the behavior of the dollar on exchange markets.
But the situation would differ fundamentally from that in the
first half of this year when tolerance of monetary expansion
above the target range occurred in an environment of relatively
slow economic growth and falling velocity.

122
Question 6: In your statement you indicate that the
high value of the dollar on foreign exchange markets was one
reason the Fed did not move to slow the growth in M-l during May
and June: i.e., action to slow money growth would have raised
interest rates and driven the dollar even higher.
Given the recent declines in the value of the dollar,
should financial markets assume that the Fed now has more leeway
to raove to offset above-target growth in M-l?
Answer;

The dollar's value is one of the factors we

look at in evaluating the likely effects of money growth on the
economy and inflation.

This spring, money growth well in excess

of the Committee's paths was accompanied not only by a relatively strong dollar, but also by sluggish economic activity-tspecially in the industrial sectors--while inflation remained
moderate.

Under these circumstances, decisive action to

restrain money growth could well have pushed the exchange rate,
and also interest rates, higher with further depressing effects
on output.

The recent, drop in the dollar does in that sense

provide a little more leeway, other things unchanged, to restrain Ml growth vithin its range.

But, in practice, the dollar

would be only one factor among many in assessing responses to
money growth--and policy would necessarily have to consider
other developments in financial markets, the business outlook,
and overall price pressures.

123
RESPONSE TO WRITTEN QUESTIONS OF SENATOR MATTINGLY

Chairman Volcker subsequently submitted the following
in response to written questions from Senator Mattingly in connection with the hearing before the Senate Banking Committee
held on July 18, 1985:
Question 1: Monday's Wall Street Journaj. reported the
following news quip: "Minutes released Friday(July 12) show
that the Fed's policy setting arm voted 11-1 at its May 21
meeting to leave monetary policy unchanged." What's disturbing
to me about that report is the fact that the Fed withheld the
May 21 meeting minutes for almost 7 weeks. I personally have
problems with the withholding of such information and for such a
long period of time. What is the Fed's justification for such
action?
Answer;

While the FOMC's basic monetary policy de-

cisions with respect to growth rates for the year for monetary
and credit aggregates are reported to the public promptly, its
decisions concerning the short-run implementation of monetary
policy are not released until shortly after the subsequent
meeting of the Committee.

This schedule is adhered to because

of concern that earlier release of the decision—while it was
still controlling for open market operations—would focus more
attention on the short-run aspects of monetary tactics and foster even more speculation about the day-to-day implementation of
policy, resulting in greater short-run swings in interest rates
and market volatility.
The information in question takes the forci of instructions to the Federal Reserve Bank of New York specifying the
criteria to be used in carrying out open market operations in

124
the period until the next FOMC meeting.

These instructions are

necessarily conditional in nature; that is, the actual stance of
the Federal Reserve in supplying reserves will depend on the
data that become available on growth in the money stock and
information about the economy and financial markets as well.
The so-called "directive" therefore does not give unequivocal
instructions about how bank reserve conditions might evolve over
a span of several weeks.

The danger is that market participants

would not adequately recognize the conditional and judgmental
nature of the directive.

In trying, with a false sense of cer-

tainty, to outguess the Federal Reserve, they would tend to
impart even wider swings in domestic and international market
conditions than we now experience.

It would be especially

difficult for the Federal Reserve to make relatively minor,
probing adjustments to its stance in supplying reserves without
provoking market over-reaction.
Immediate release of the directive would also tend to
focus attention on the short-run tactics of monetary policy,
rather than the long-run strategy that is important to achieving
national objectives for output, employment, and prices.

De-

cisions bearing on these more important strategic questions are
released within a few tieys after they are made in February and
July, and are accompanied by a report to Congress and testimony
spelling out fully the Federal Reserve's assessment of the
economy and the reasons for its policy choices.

Quite properly,

they are the subject of intense scrutiny and debate, both within
Congress and in the public at large.

Immediate release of the

FOMC's short-run decisions as well could deflect needed and
appropriate attention from these nore fundamental issues of
monetary policy.

125
Chjestign 2: Since December, Ml has risen at a super
fast annuaT rate" of more than 12 percent, roughly double the
Fed's target range for 1985 of 4 percent to 7 percent. I assume
that the overshooting of the targets was in part to stimulate
economic growth. I have no problem with that policy as long as
inflation continues under control; nonetheless, what is the lag
time between money growth as a stimulus and the resulting economic growth?
Answer;

Money growth affects the economy over a

considerable period and to varying degrees, with the timing and
extent depending on a number of factors, including the state of
the economy and financial markets, price and interest rate expectations, and changes in the demand for money not directly
related to transactions uses of money balances.

Some have

observed that an acceleration of money growth seems to have its
greatest impact on business activity in around two quarters, but
this is not necessarily consistent.

The timing and extent of

any subsequent effect on inflation are also quite variable,
though most analysts believe the lags are longer than for real
economic activity, on the order of 18 to 24 months.

However, in

that respect, it should be noted that the very rapid money
growth of 1982-83 was not followed by a pickup of inflation.
The economy is just too complex, and the route by which money
affects spending and prices too circuitous and too loose, to
have confidence in estimates of a very precise relationship
between money and the economy.

126
The overshoot of Ml growth relative to the ranges was
tolerated in the first half of the year given the drop in
velocity and the sluggish economy, in an effort to encourage
economic growth.

FOMC members do expect a pickup iu economic

activity in the second half of the year, but with inflation
remaining subdued, a substantial proportion of the increase in
money the first half is thought to represent relatively longterm additions to cash balances.

127
Question 3: Pending before the Fed is an application
by Citicorp tu form a subsidiary in South Dakota to sell insurance. Has the 91-day period begun to run, when do you
anticipate consideration of the application, and how will you
rule on the application?
Answer:

On July 31, 1985, the Board denied the

application by Citicorp to acquire American State Bank, Rapid
City, South Dakota, and thereby to engage in a broad range of
insurance activities, including underwriting life insurance and
acting as agent for the sale of all types of insurance.

The

Board held that the proposal was in reality an acquisition by
Citicorp for the purpose of engaging in insurance activities
otherwise prohibited for bank holding companies under the
Garn-St Germain Depository Institutions Act of 1982.

Question 4: An economist from Irving Trust Company was
recently quoted in USA Today as follows: "I think the (Federal
Reserve Board) has in mind a dollar level that's about 10 percent lower than where we are now." Is that statement accurate
and how will the Fed accomplish such a reduction?
Answer:

Neither the Federal Reserve Beard nor the FOMC

has in mind any particular reduction in the exchange value of
the dollar.

As noted in our Report to Congress, the projections

made by FOMC members and the other Reserve Bank Presidents are
based on an assumption that the exchange value of the dollar
will not deviate substantially from its recent levels.

That, I

should emphasize, is not the same as a forecast, and the
experience of recent years has reemphasized the difficulty of
any such forecast.

Much would depend upon surrounding circum-

stances in evaluating responses to significant changes in the
value of the dollar.

128
Question 5: Assuming a 10 percent reduction of the
dollar was achieved, what would be the effect on our balance of
trade and the federal deficit?
Answer;

It is difficult to quantify with any con-

fidence the effects of a change in the exchange value of the
dollar, especially without specifying the causes underlying the
dollar's assumed decline.

As a very rough order of magnitude,

standard econometric analysis suggests an exogenous 10 percent
reduction in the dollar to result in a reduction in the U.S.
trade deficit of more than $5 billion after one year and of more
than $15 billion after a longer adjustment period.

Other things

equal, nominal GNP might be a bit higher, and federal tax
revenues night be enhanced.

However, unless some other steps

were taken independently to reduce the budget deficit, the
reduction in the capital inflow associated with the reduction in
our trade deficit would tend to add to pressures in U.S. financial markets and on interest rates.

The effects on the net

budget deficit would then not be large.

129
RESPONSE TO WRITTEN QUESTICWS OF SENATOR PROXMIRE

Chairman Volcker subsequently submitted the following
in response to a written question from Senator Proxinire in connection with the hearing before the Senate Banking Committee
held on July 18, 1985:
Question: I recently wrote to Secretary of the
Treasury Baker aTmut our international debt strategy and among
other things asked what effect the Administration's new lower
economic growth forecast would have on the ability of the Latin
American debtor nations to service their debt.
The Secretary responded yesterday that "slower growth
in the U.S. would lead to lower export growth rates from such
countries," but said that difficulty would be offset by lower
U.S. interest rates. He said the Administration estimates as a
rough rule of thumb that a "one percentage point drop in dollar
interest rates would result in savings due to lower interest
payments far exceeding the slower growth in exports to the
United States which would result from 1 percent slower U.S.
growth rate."
I was very surprised by this "rough rule of thumb
calculation" as I understood most observers felt each percentage
point growth in the OECD countries could add $12 billion or so
to debtor country export earnings as compared to the $4 billion
or so they would save from each point drop in interest rates.
*

Can you comment on the Treasury's rule of thumb calculation?
Do you think that a growing U.S. economy is absolutely critical to a favorable solution of the third world debt problem?

If so, for how much growth must we maintain and over what
period oi years?
Answer:

I cannot comment directly on the Treasury's

calculations, since I do not know the details.

I am inclined to

think that the negative impact on the export earnings of nonOPEC developing countries of one percent lower economic growth
in the United States may be about half as large as the

130
positive impact from one percent lower dollar interest rates.
Whether such an offset is substantial is, of course, a matter of
judgment.

Moreover, such calculations, which are rough at best,

vary considerably depending on which developing countries are
included, how changes in growth rates or interest rates are
assumed to be brought about, and how long they persist.

As for

your reference to the relative effects of OECD growth and interest rates, I do not recognize the figures you cite, and I am
inclined to feel—with all the caveats just noted—that the
figure for improved export receipts, in particular, overstates
to a considerable degree the impact on exports of non-OPEC
developing countries of one percent faster growth in the OECD
area.
It is clear, however, that continued growth in the
United States and in other industrial countries—with continued
access to those growing markets—is essential to the economic
well-being of developing countries.

What is more inportant than

achieving any particular growth rate, I believe, is that growth
in the United States and elsewhere be sustained over the long
term in an environment of low and stable inflation rates.

such an environment, developing countries can benefit from both
growing demand for their output and reasonably low interest
rates.

131
RESPONSE TO WRITTEN QUESTIONS OF SENATOR RIEGLE

Chairman Volcker subsequently submitted the following
in response to written questions from Senator Riegle in connection with the hearing before the Senate Banking Committee
held on July 18, 1985:
Question 1;
Real Estate Market
In your prepared testimony you point out that "spending
for nonresidential construction, particularly offices and
stores, continued at strong rates in the first half of 1985, and
construction contracts rose further despite very high vacancy
rates in many parts of the country." (p. lO — emp^asis addedT)
I am concerned about a possible over-capacity in the
real estate market and especially so in light of remarks made
earlier this week by Eric Kernel, the director of the office of
policy and economic research at the Federal Home Loan Bank
Board. This senior official was widely quoted as saying that
because of a softening market for office buildings and other
commercial properties "we're in for a debacle that will take a
number of savings institutions and commercial banks with it."
He was
that "There are
paired, and who
are still doing
the line."
*

also quoted as saying in unusually blunt remarks
some banks whose capital is significantly immay be in a true economic sense underwater, who
business." He added, "That means trouble down

(a) How concerned are
from farm loans, real
American loans, a lot
are dangerously close
Answer:

you that between deferral of losses
estate loans, energy loans and Latin
of respectable financial institutions
to, or actually are, under water?

Many banks have failed because of problems

encountered in the loan areas mentioned, and a large number of
others are now experiencing difficulties of greater or lesser
severity — over 1,000 banks are now on the FDIC's problem list.
The question seems to imply, however, that many banks, not on

132
the FDIC's list, have serious problems which they have been
permitted to avoid recognizing.

That is not the case.

Banks

have been required to charge off bad loans on their books and to
build up loan loss reserves and capital to position themselves
to deal adequately with future loan problems.

Thus, roost if not

all banks whose current financial statements show them to be in
healthy condition should be able to weather problems that may
arise in the future.

(b) How likely are we to see a serious overcapacity of office
buildings in areas such as Denver, San Diego, Phoenix,
Columbus, Houston, Miami and Dallas, and what are likely to
be the ripple effects throughout the economy?
Answer;

Office vacancy rates have been soaring in many

major cities around the country, and with much space still under
construction, serious gluts seem a distinct possibility in a
number of locales.

Office building appears, unfortunately, to

be following its all-to-familiar bcom-bust pattern.

It is im-

possible to predict what the precise economic effects of a
decline would be:

much would depend on the severity of the

downturn and on whether the general economic circumstances at
the time would be such that the capital freed up by reduced
office construction would be an effective stimulus to spending
of other types.

133
As a bank supervisor, I of course have a particular
interest in the financial side of the office building boom.

have seen more deviations on the parts of lenders and equity
investors from traditional and prudent financing practices than
1 would like, and I believe that the calculations underlying
many projects have rested too much on unwarranted inflation
expectations.

We have been urging the institutions we oversee

to exercise due caution in their lending, so as to avoid excessive credit risks and in the process avoid giving impetus to
excessive speculation in this market.

134
Question 2:
Withholding Tax
In 1982 the 20 percent withholding tax was repealed for
foreign investment on T-bills, notes and bonds. Subsequently
foreign demand for U.S. dollars increased; the value of the
dollar on international money markets climbed; and U.S. exports
were hurt.
*

On balance what have been the net effects of repealing the
withholding tax and specifically why should foreign investors
be allowed to invest in the United States tax-free while U.S.
citizens have to pay taxes?

Some commentators have suggested that rcinstituting the withholding tax would help lower the demand for U.S. dollars;
lower the value of the dollar on international markets; help
our balance of payments deficit; and help the U.S. compete in
world markets. What is your reaction to these views?
Answer:

Even before the repeal of the 30 percent

withholding tax, U.S. tax treaties that have been negotiated
with most major foreign countries effectively enabled many
foreign investors to avoid paying U.S. tax on interest earned in
this country.

Thus, repeal of the tax probably had only a ninor

effect on incentives to invest here.

Tax incentives to hold

securities are provided, as well, to U.S. investors, as with IRA
or Keogh plans.
Since it is not likely that repeal of the withholding
tax has had a major impact on the dollar or on U.S. international payments, reinstituting the tax is not likely to have a
major impact either.

135
Question 3:
Debt
What do you see as the short-term and longer-term
economic implications of our current budget deficit, trade
deficit, increased corporate debt and record consumer debt?
Answer;

All of these items give rise to risks and

uncertainties in the economic outlook, short or long terra.
Clearly, the sorts of imbalances we see in our internal fiscal
posture and in our external accounts are unsustainable and are
incompatible with strong, balanced economic growth and rising
living standards over the long run; moreover, they heighten the
risks in the near term of financial pressures that could disrupt
the ongoing economic expansion and exacerbate the strains already present in our financial system.

I also view the tre-

mendous growth of corporate and consumer debt as a cause for
some concern, for heavy debt burdens imply a greater vulnerability in the event of unanticipated shocks; we have indicated, in
our monitoring ranges for debt growth this year and next, our
expectation that these trends in private indebtedness will be
moderating somewhat in the period ahead.

136
Question 4:
Interest^ Expense and the Gross National Debt:
I have been told that if we only add interest expense
to the gross national debt (GHD), meaning we are able to balance
all other federal obligations with budget receipts, the GND
would still grow astronomically. Some estimate that the GND
would grow to approximately $7 trillion by the end of the century (SI.8 trillion x 10Z compounded over 15 years = $7.5
trillion).
':

(a) Assuming anywhere near this rate of growth in GHD and the
fact that the Federal Reserve has traditionally kept its
total money supply figures above the GND, what are the
implications for future inflation?
Answer:

Whether it is reasonable to assume such rapid

growth in the national debt depends, of course, in large measure
on one's optimism or pessimism about our ability to deal with
the deficit problem.

The example certainly does underscore in a

dramatic way one important point;

the sizable interest payment

element in the budget means that delays in reducing the deficit
lead quite literally to a compounding of the problem!
As regards the implications for inflation, you are
quite right in suggesting thst. excessive money creation would
tend to raise the general level of prices.

But there is no

automatic or mechanical connection between the rates of growth
in federal debt and the money supply, and I believe that we will
be able to maintain sufficient control over monetary expansion
to avoid reinvigorating inflation.

This is not to say that

rapid increase in the federal debt is benign, however; to the

137
contrary, it would tend over time to displace other assets In
the public's wealth portfolio, with distinctly negative
consequences for capital formation, productivity, end living
standards.

(b) What effect will such GND growth have on our retired
population including individuals on fixed pensions and Social
Security?
Answer:

If inflation is held in check, then those

living on fixed incomes might not be especially hard-hit by
sustained rapid growth of the national debt.

Rather, because of

the effects I noted above, it is those who are now young and
generations yet to come who most likely would have to pay the
greater price.
*

(c) What projections and assumptions has the Federal Reserve
Board made, or would you now make, with respect to GND growth
over the next 15 years through the year 2000?
Answer:

The Board has not made such long-range projec-

tions—and I'm not sure that we can do so usefully because so
much depends on the actions of the fiscal authorities, which we
are in no special position to prognosticate.

I do believe,

tho-ugh, that the Congressional Budget Office's discussion of
debt, interest payments, and the deficit in its February report
(The Economic and Budget Outlook:

Fiscal Years 1986-1990? high-

lights in a sobering way the problems that your question
addresses.

138

Dear Senator Garn:
Enclosed is my s t a t e m e n t on m o n e t a r y p o l i c y , s u b m i t t e d
for the record of the raid-year monetary p o l i c y oversight
hearings.
I a p p r e c i a t e the o p p o r t u n i t y to present the
Administration's views on this i m p o r t a n t subject.
Sincerely,

Beryl jW. b p r i n K e i
The Honorable Jake Garn
Cha irman
Commit tee on Banking, Housing
and Urban Affairs
U. S. Senate
Washington,D. C. 20510

139
EXECUTIVE OFFICE OF THE PRESIDENT
COUNCIL OF ECONOMIC ADVISERS
WASHINGTON, D.C. 20SOO

Statement

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

to the
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
UNITED STATES SENATE

July 26, 1985

140
Chairman Garn, Senator Proxmire, distinguished members
of the Committee, I am pleased to have the opportunity to
submit for the record this statement of the Administration's
views on monetary policy.

Long-Term Objectives
The monetary policy objectives of the Administration
are completely consistent with the stated policy goals of
the Federal Reserve.

Over the long run, the Administra-

tion's objective is to continue to reduce the inflation rate
until, ultimately, price stability is restored.

The decline

in inflation that has occurred over the past four years has
been a significant achievement, but we believe that it would
be a serious mistake for the government—and for the
American public'—to accept as permanent our current
inflation rate.

While 3 to 4 percent inflation is certainly

a substantial improvement over the double-digit rates of the
late 1970's, it is also not price stability.

If we are to preserve the gains already made in
reducing inflation and ultimately extend those gains until
true price stability is re-established, the rate of money
growth must be gradually reduced downward over time.

The

historical, long-term relationship between money growth and
inflation is one of the most widely-tested and reliable of
all economic relationships.

Chairman Volcker and other

141
Federal Reserve officials have on many occasions restated
and reaffirmed their intentions to pursue such a policy and
the Administration fully supports that objective.

The transition of the economy to a reduced inflation
rate has been difficult; for some sectors of the economy,
that adjustment has been particularly painful and, in some
cases, is not yet complete.

I do not believe that the

economic dislocation associated with reducing inflation was
inevitable; a more gradual deceleration of money growth
than actually occurred, and a more stable and predictable
pattern of money growth during the deceleration, would have
reduced the uncertainty about monetary policy, implied lower
interest rates, and facilitated a more orderly transition to
lower inflation.

This was the premise of the Administra-

tion's original recommendation in 1981 that money growth be
gradually decelerated in a smooth and predictable path to a
noninflationary pace.

Even under the best circumstances, moving an economy
from an inflationary path to price stability is a difficult
and potentially costly process.

Because it requires a

fundamental readjustment of public behavior and thinking,
price stability cannot be restored overnight.

Once

inflation and inflationary expectations become embedded in

142
an economy, investment, saving, spending and pricing
decisions are all profoundly affected by expectations of
inflation.

These expectations--and the economic decisions

based on them--must be realigned in the process of restoring
price stability.

In recent years, we have seen important progress in the
basic attitudes and economic behavior that is characteristic
of an inflationary economy.

The fact that we are yet to

enjoy all the economic payoff from a lower inflation rate
only underscores the need to persist in our efforts to
contain inflation.

With the worst of the transition to

lower inflation behind us, it would be particularly tragic
to allow inflation to reaccelerate again, necessitating yet
another painful period of readjustment to reduce inflation
at some point in the future.

Short-Run Concerns
While our commitment to long-run price stability is
firm, the Administration is concerned about shorter-term
fluctuations in the rate of money growth.

Administration

officials believe that wide swings in money growth have
important, adverse effects on economic performance.

It is

widely recognized that it is not technically feasible for

143
the Federal Reserve to avoid week-to-week or month-to-month
changes in money growth; it is also clear that those
short-term fluctuations have little or no economic impactAdministration concerns focus on a pronounced pattern of
many months of excessive money growth, followed by a
prolonged period of very slow money growth.

We believe that

this stop-go pattern of money growth is detrimental to the
economy for two important reasons.

First, sharp swings in money growth that last 5 or 6
months or more have a significant impact on economic
activity.

The initial effect of a change in money growth is

to induce a similar change in the real economy.

Thus/ an

acceleration of money growth provides a short-term stimulus
to the economy and a deceleration of money growth depresses
economic activity.

This is not to say that every short-term

wiggle in money growth alters the course of the economy.
But fluctuations in money growth that persist for 5 or 6
months or longer cause similar fluctuations in economic
activity.

This relationship is illustrated in the attached

chart which shows the two-quarter rate of change in Ml
growth and quarterly real GNP growth.

The short-run relationship between changes in money
growth and real economic activity is by no means precise

144
with respect to either timing or intensity.

In the short

run, many other factors affect the real economy and the lags
in the effect of changes in money growth vary, depending
upon economic conditions, expectations and previous monetary
policy.

Nevertheless, the direction of influence on the

economy of a sustained acceleration or deceleration of money
growth is clear.

Therefore, a monetary policy that allows

prolonged swings in money growth causes —
to —

or at least adds

fluctuations in economic activity.

The second reason that volatile money growth is of
concern relates to expectations and the outlook for
inflation.

Erratic money growth increases the uncertainty

about monetary policy, about the long-run trend of money
growth, and consequently the outlook for inflation.

This

increased uncertainty must be compensated for by higher
interest rates.

There is considerable empirical evidence on

the effects of monetary volatility on uncertainty and
financial markets which supports this view.

In addition,

volatile money growth adds to the uncertainty and
speculation about the short-term economic outlook as well as
the Federal Reserve's policy response to money growth and/or
economic performance.

While difficult to quantify, it is

likely that such speculation and uncertainty has additional,
destabilizing effects in financial markets.

145
The path of monetary expansion over the past year
provides an example of the Administration'a concerns about
short-term monetary fluctuations.

Even though the average

rate of Ml growth during 1984—5.2 percent—was consistent
with our long-term goal of controlling inflation, and
although Ml generally was within its target range during the
year, those desirable average results mask less desirable,
prolonged swings in Ml growth.

After growing at a

7.3 percent compound annual rate for the first 6 months of
the year, the Federal Reserve slowed Ml growth
substantially; the result was a period of near-zero Ml
growth from June to October.

Thus, the direction of influence of monetary policy
beginning in the late spring of 1984 was clearly one of
restraint.

The slowdown in economic activity over the past

three quarters is therefore at least partially attributable
to the influence of monetary policy.

Since late 1984, Ml

growth has accelerated to a rate which, if allowed to
continue, would not be consistent with our long-run goal of
price stability.

Thus, money growth so far in 1985 implies

the need for a slowdown in money growth which, if not
successfully engineered as a very gradual deceleration, will
pose yet another risk to sustained economic growth.

146
It is these repeated policy-related risks to economic
performance that Administration officials find
unacceptable.

It is because of the economic risks of highly

variable money growth that the Administration has
continuously recommended a more stable and predictable path
of money growth in the short run, as the trend of money
growth is reduced over time.

Wide fluctuations in money

growth can and should be moderated.

The Federal Reserve has

the technical capacity to control money growth precisely
enough to provide for a more stable, and predictable pattern
of monetary expansion.

The Administration believes that a

reduction in the variability of money growth would minimize
the policy-induced fluctuations in real economic activity,
reduce the speculation about monetary policy and the outlook
for inflation, and generally enhance the stability of
financial markets.

The Uncertainty About Velocity
Financial deregulation in recent years has caused
uncertainty about the relation between money growth and
nominal GNP.

It is possible that the inclusion in Ml of

interest-bearing transactions accounts will prove to have
altered the relation between Ml growth and nominal
spending.

The Administration is sensitive to these concerns

147
and agrees that the Federal Reserve should be vigilant to
empirical evidence of a change in the trend growth of
velocity (the ratio of nominal GNP to the money supply).

It should not be inferred, however, that the
Administration supports attempts to fine-tune money growth
to short-term changes in velocity.

On a quarter-to-quarter

basis, velocity is, and always has been, highly volatile.
It is therefore dangerous to draw policy conclusions from
short-term movements in velocity.

Those of us who have

emphasized monetary control and targeting as an operating
principle for monetary policy never did so on the premise
that velocity was well-behaved on a quarter-to-quarter
basis.

As a matter of arithmetic, short-term fluctuations in
velocity will be greater whenever money growth is highly
volatile.

For example, velocity fell about 5 percent during

the first two quarters of 1985.

Many have concluded that

this justifies or necessitates more rapid money growth.
Based on past money growth, however, slow velocity growth in
the first part of 1985 is not particularly surprising.

The

slowdown in economic activity is partly attributable to the
monetary slowdown in mid-1984; the subsequent rapid
acceleration of Ml growth in late 1984 and early 1985 all

148
but guaranteed that velocity would be weak early in 1985.
Since velocity is simply the ratio of nominal GNP to the
money supply, a decline or slowdown in velocity is the
arithmetic result of the combination of weak GNP growth and
high money growth.

Thus fluctuations in money growth can

induce fluctuations in velocity given the lagged relation
between changes in money growth and economic activity.
Attempts to tailor money growth to such policy-related
fluctuations in velocity implies a short-term fine-tuning
approach to policymaking that the Administration does not
endorse.

Setting these short-term considerations aside, however,
a more fundamental question remains: has financial
deregulation altered the policy behavior with respect to Ml
holdings and spending?

One can plausibly argue that the

interest-bearing deposits now included in Ml function as
saving as well as providing transaction functions, and
therefore that the public will hold more Ml balances per
dollar of spending.

If so, trend velocity growth will be

lower and our standard for prudent, noninflationary money
growth that is sufficient to accommodate real growth must be
increased.

149
We must be extremely cautious, however, in drawing such
conclusions because if we are wrong/ what is at risk is a
reacceleration of inflation.

It is for this reason that I

am very wary of drawing inferences about the long-term
behavior of velocity from its short-term movements,
particularly in an environment of highly volatile money
growth.

Until sufficient time passes that we can draw firm
conclusions about the effect of financial deregulation on
velocity, uncertainty will remain.

It is important to

recognize, however, that there is always uncertainty
surrounding policymaking; that is, any policy that is
adopted implies some risk to the economy if unforeseen
developments emerge.

However, it is the job of prudent

policymakers to adopt policies that minimize the associated
risk to economic performance.

In the current environment of

uncertainty about velocity, it is clearly not a
risk-minimizing policy either to ignore the possibility that
financial deregulation has altered the basic relationship
between money growth and nominal spending, or to base money
growth on an extreme-case assumption that velocity growth
will be substantially lower than its historical norm.

150
Summary and_ Recommendations
The Administration lias consistently endorsed the
long-term deceleration of money growth that is needed to
.reduce inflation, but has recommended that the deceleration
be gradual and predictable, in order to avoid the economic
fluctuations associated with large, prolonged swings in
money growth.

Consequently, the Administration cannot

support monetary policy actions that would lead to higher
money growth over time or that increase the potential for
increased volatility in money growth.

The over-shooting of the Federal Reserve's target range
in the first half of the year poses a difficult policy
dilemma.

If money growth continues at the pace recorded so

far this year, a subsequent reacceleration of inflation is
inevitable.

While uncertainty about velocity behavior

exists, recent monetary expansion implies a significant
acceleration in nominal GNP growth in the

months ahead,

even if velocity does not grow at all over the second half
of the year.

Thus a transition to slower money growth is required
now to limit the threat of future inflation and prevent
inflationary expectations from rising.

However, the

significant and protracted deceleration of money growth that

151
would have been necessary to bring HI into its original 4
to 7 percent target range would have subjected the economy
to a period of strong monetary restraint and would very
likely have caused an economic downturn.

In this context,

the Administration understands the Federal Reserve's
decision to rebase the Ml target range to the second
quarter.

Given the money growth that has occurred so far

this year and the economic risks associated with returning
Ml to its target range, the rebasing appears to be the
least risky policy alternative available at this time.

As was explained in detail in the 1985 Economic Report
of the President, the Administration is in principle opposed
to allowing the base period for monetary targets to be
shifted.

The rebasing and redefinition of target ranges is

not new.

The Federal Reserve rebased (upward) its target

ranges frequently over the 1974-80 period.

This introduced

an inflationary bias into monetary policy as rapid money
growth was permitted within escalating target ranges.

The

purpose of monetary targets is to impose long-term monetary
discipline.

There is no such monetary discipline if target

ranges are abandoned, rebased on redefined when exceeded.

We are hopeful that monetary growth will gradually
decelerate in the period ahead, in order to limit inflation

152
and avoid a monetary shock to the real economy.

We expect

that future money growth targets will be consistent with the
long-term deceleration of money growth that is necessary for
price stability and hope that the increase in money growth
allowed by the rebasing of the 1985 target range is
gradually offset in subsequent years.

The Federal Reserve has also widened the target range
from 4 to 7 percent to 3 to 8 percent.

This target range is

wider than any previous range adopted by the Federal
Reserve.

Wide target ranges permit substantial variability

of money growth within the range.

The long periods of flat

money growth that are disrupting to the real economy are
often permissible with an excessively wide target.

general, the Administration recommends more stable money
growth than is implied by such a wide target range.

AND

REAL GNP GROWTH

0 ' I I I I I l-t-t -M I I I I I I I I I I I I I I I I I I I I I I I I I t I I I t •! I I I I I M 1 1 1 1 1 ( 1 1 1 l-t I I -t I I I I

1980:1

1981:1

1982:1

1983:1

1984:1

1985:1

M1 growth is a 6 month average, at annual rates.
Real GNP growth is quarterly, at annual rates

154
STATEMENT OF THE HONORABLE MANUEL H. JOHNSON
ASSISTANT SECRETARY (ECONOMIC POLICY)
U.S. DEPARTMENT OF THE TREASURY
BEFORE THE
SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
JULY 18, 1985

INTRODUCTION

The Treasury Department welcomes this opportunity to present
its views on monetary policy and recent monetary developments.
In general, we agree with the broad outlines of the approach
taken by Chairman VolcXer in his July 17 testimony before this
Committee. In particular, the decision to rebase the Ml target
range on the average level of the money supply in the second
quarter would appear to have been correct under the
circumstances. The rebasing exercise removed the threat that the
Federal Reserve might feel obliged to force Ml back within the
original target range — a clearly impractical undertaking. With
the rebasing, successful adherence to the new targets appears to
be a realistic possibility and given some recovery in monetary
velocity should be consistent with a fairly strong second-half
expansion of the economy. While the decision to rebase makes
sense in this short-run context, it will be extremely important
for the Federal Reserve to avoid any sustained period of overly
rapid monetary expansion that would bring inflation back into the
picture. The experience of the last two decades in this country
and a wide range of experience abroad suggests very strongly that
the appropriate time to fight inflation is long before the inflationary process has been allowed to build up momentum.
Granted that the recent modification of the monetary targets
is defensible, the erratic short-run pattern of monetary growth
in recent years — of which this is only the most recent episode
— remains a source of some concern to the Administration. It
would be highly desirable if such wide monetary swings could be
avoided in the future. It must be conceded that the Federal
Reserve has faced a difficult set of circumstances in recent

155
years. Institutional change has been rapid in the financial
area, monetary velocity has become an increasingly erratic
parameter and the international monetary dimension has been an
additional complicating factor. But it is doubtful that these
and other special factors are sufficient to account for the fact
that since 1980 Ml has been outside the target range much more
frequently than it has been within and that on a 13-week basis Ml
growth has ranged from a high of a 17.7 percent annual rate to a
low of -1.3 percent.
The Administration has consistently supported the Federal
Reserve in its efforts to control inflation and promote growth.
It will continue to do so. But there are some respects in which
the recent record of monetary policy clearly stands in need of
improvement. It may assist in clarifying these issues to state
explicitly some general principles by which the Administration
believes monetary policy should be guided.
II.

GENERAL STATEMENT OF PRINCIPLES OR MONETARY POLICY

The Administration desires a steady, moderate rate of growth
in money and counts on the Federal Reserve to carry out that
responsibility.
There have, of course, been occasional differences of opinion between the Administration and the Federal
Reserve on specific issues of monetary technique; but there has
been no difference of opinion as to the importance of controlling
the growth of money over the longer run.
Agreement is general within the economics profession that
over the long run inflation is a monetary phenomenon and inflation can persist only when it is accommodated by monetary expansion. This is one of the few theorems in economics which seems
to have been firmly established. Therefore, control over monetary growth is absolutely essential as a long-run proposition if
inflation is to be avoided. This has bean a basic guiding principle of the Administration's view of monetary policy and it will
continue to be.
The Administration has also felt that it is highly desirable
for monetary policy to avoid short-run disturbances to the economy and to promote as low a level of interest rates as possible.
It must be conceded, however, that there is far from unanimous
agreement within the economics profession on the extent to which
short-run variations in monetary growth exert predictable effects
upon economic activity and real output. Because the short-run
relationship between money and economic activity is looser and

156
less exact than the long-run relationship between money and the
price level, the Administration has favored a cautious and
gradualist short-term approach in the monetary area rather than
rigid application of a monetary rule.
The original Administration plan in the monetary area to
deal with double~digit inflation called for a gradual deceleration of monetary growth extending over the period from 1980 to
1986.
Instead, there wag an abrupt deceleration of monetary
growth by the Federal Reserve in 1981 which triggered and intensified the 1981-82 recession. Subsequently, there have been a
aeries of abrupt accelerations and decelerations in monetary
growth as shown in Chart 1. The most recent episode was the
virtual cessation of growth in Ml in the second half of 1984
followed by a burst of double-digit growth in Ml in the first
half of this year which is still continuing to the present time.
This is not a desirable pattern. It tends to force the
economy into a stop-go pattern instead of a phase of steady
expansion. In addition to exerting undesirable effects on output
and employment, a volatile pattern of monetary growth increases
financial market uncertainty and may build an uncertainty premium
into the entire structure of interest rates. Econometric work by
the Treasury has suggested that this has been an important influence in recent years, holding interest rates at an earlier stage
of the expansion some 200 to 300 basis points higher than they
might have been if the pattern of monetary growth had been
smoother.
A consistent short-run relationship between changes in
monetary growth and subsequent changes in economic activity as
measured by nominal GNP depends upon the existence of some degree
of stability in monetary velocity (the turnover of money). As
shown in Chart 2, the HI velocity growth trend was positive
throughout the period following World War II. (Monetary velocity
displayed a generally negative trend in the late 19th and early
20th centuries.) A 3 percent annual increase in velocity is frequently taken as a rule of thumb estimate of the postwar trend.
Research at Treasury suggests that the regularity of any stable
trend in velocity is open to question. That point of view has
gained force with the very erratic behavior of velocity in recent
years. The reasons for the instability of velocity are complex
and not yet fully understood.

157
The break in the velocity trend has also apparently
disrupted shorter-run cyclical patterns in monetary velocity as
shown below.
Changes in Monetary Velocity during
Postwar Expansions
(in percent)
Average of
Previous
Expansions
1st four quarters
2nd four quarters
3rd four quarters

5.5
3.3
4.2

Current
Expansion
0.0
4.1
-5.1

NOTE: Five previous expansions for the first eight
quarters, four for the final four quarters. First half of
1985, which constitutes the ninth and tenth quarters of the
current expansion, is expressed at an annual rate.
The recent instability of velocity has meant that a rigid
and literal adherence to the original monetary targets would have
been unwise. But it would be equally unwise to assume that
monetary velocity will necessarily persist in its recent sluggish
pattern. All that is known with certainty is that during a
period of rapid institutional change in financial markets and
continuing disinflation in commodity markets, velocity has grown
much less than in the past. Rebasing of the monetary targets is
an appropriate step to take under the circumstances, but the
future behavior of velocity will require careful attention. A
cautious approach should be followed since the growth rate of
money will need to be cycled down if it becomes apparent that
velocity is returning to growth rates more consistent with the
postwar trend.
The Administration adheres to the view that the long-run
rate of growth in Ml must be held to moderate proportions since
it is the primary long-run determinant of inflation. In the
short run, monetary volatility has been excessive in recent years
and needs to be reduced. The best initial approximation for the
monetary authorities should be as stable a rate of growth in Ml
as they can achieve along the upper band of the rebased target
range.
Monetary policy is an extremely important part of the Administration's overall economic strategy. Properly executed, monetary policy can help provide a non-inflationary environment and
assist in the promotion of economic growth. But monetary policy
is far from the only influence on the economy. There is a clear

158
need at the present time to get Federal spending under better
control and thereby to move the budget deficit in a downward
direction. It is equally necessary to proceed with tax reform
and similar steps to enhance incentives for private sector
activity. These actions are desirable in their own right and
would also probably increase the ability of the monetary authorities to make a more effective contribution to economic policy.
III.

MONETARY POLICY AND THE RECENT BEHAVIOR OF THE ECONOMY

Economic growth has slowed over the past year after a period
of rapid expansion in the first 18 months of recovery. The rate
of advance of the economy during the early phase of the recovery
was the fastest for any comparable period since the recovery of
1949-50 merged with the economic impact of the Korean War. Monetary policy played a strongly supportive role in the expansion.
Ml growth began to accelerate after mid-1982, after two separate
periods of monetary flatness in 1981 and 1982, and the economy
began to expand by late 1982, approximately six months after the
upturn in money. Ml grew at nearly a 14 percent annual rate from
July 1982 to June 1983 and at about a 7-1/2 percent annual rate
from June 1983 to June 1984.
One of the striking features of this early phase of the
expansion was the rapid advance of interest-sensitive sectors:
o

business spending for capital equipment rose at a
21 percent annual rate from late 1982 to mid-1984
residential construction rebounded at a 30 percent
annual rate during the same period.

The rapid pace of the recovery and the strength of interestsensitive sectors came as a surprise to those who overemphasized
the short-run effects of budget deficits and high real interest
rates. Most standard econometric models consistently underestimated real growth and overestimated inflation during this
period. One reason for the relative failure of these economic
forecasts to predict the strength of the recovery was probably
their underestimation of the directly stimulative effects of
accommodative monetary growth, particularly since it followed a
period of intense monetary restraint and may have been largely
unanticipated. Another factor of equal, if not greater,
importance was the 1981 tax incentives which had powerful effects
on after-tax rates of return and contributed to the stronger than
expected performance of investment during the expansion.

159
After growing at about a 7 percent annual rate during the
first six quarters of the current expansion, the economy has
slowed to about a 2 percent annual rate of growth over the most
recent four quarters. Employment gains have continued, although
confined to the service sector of the economy, and the civilian
rate of unemployment has remained stable near 7.3 percent in the
first half of this year. While the overall performance of the
economy has remained satisfactory and inflationary pressures are
still remarkably subdued, it is understandable that this slower
pace of growth would arouse concerns as to the future path of the
economy and raise questions about the appropriate role of monetary policy.
There is some difference of opinion as to the causes of the
current slowdown. On monetary grounds it might be argued that
the current slowdown has largely been induced by very slow growth
in Ml in the second half of 1984 when Ml was virtually flat from
June to October, and that these effects have not yet been reversed by the rapid expansion of Ml at more than a 10 percent annual
rate since last October. The recent monetary pattern is shown in
Chart 3.
While this monetary view of the slowdown in real economic
growth is the most likely explanation, some questions remain.
The sharp drop in the growth of monetary velocity to a negative
level in the first quarter of this year was probably to be
expected since velocity does typically decline temporarily when
monetary growth accelerates. But the persistence of negative
growth in velocity through the second quarter and the absence of
clear signs of resurgent economic activity have been somewhat
unexpected. It is also disturbing in this connection that on
purely monetary grounds a very weak first quarter was predicted
for the first quarter of 1984 (which turned out to be the
strongest quarter of the current expansion) and a return to high
rates of inflation was predicted for 1984 (which turned out to be
a very good year in terms of inflation performance).
The inherent difficulty of attempting to move from known or
assumed rates of monetary growth over brief periods of time to
resulting rates of growth in real activity can be seen rather
readily from Chart 4. It is reasonable inference that the
prolonged, if somewhat irregular, acceleration of monetary growth
after late 1981 helped pull the economy to higher levels of real
growth by mid-1983. It is equally reasonable to infer that a
prolonged deceleration of money growth from peak levels near a
15 percent annual rate in late 1982 to less than 5 percent by
1984 has been at least partly responsible for the eventual
slowdown of the economy. But it is questionable whether much

160
more could safely be inferred or whether the timing and extent of
the economy's reaction to the latest burst of monetary growth
could be predicted with very much confidence on purely monetary
growth grounds.
It is generally recognized that the short-run relationship
between monetary growth and economic performance is uncertain at
best. Over the longer haul, however, the experience since World
War II suggests that there is a close association between the
two. Specifically, and without exception, periods of significant
acceleration of monetary growth have been followed by some
increase in the pace of economic activity. For example, the long
steady acceleration in Ml growth in the late 1960's that
accommodated Keynesian-type fiscal policies and the Vietnam war
effort was associated with an upswing in economic activity which
peaked at the end of 1969 — with undesirable consequences in
terms of inflation. More recently, as noted previously, growth
of the money supply picked up sharply in late 1982 and brought
the economy out of the 1982-83 recession. In the same manner,
periods of significant slowdowns in monetary growth have been
followed by deceleration of economic growth, for example, the
1973-1974 slowdown in money growth was followed by a recession
as, more recently, was the slowing of money growth over 19811982.
There has never been a speedup of monetary growth in the
period since World War II of the duration and magnitude that has
taken place since last October without some resulting pickup in
economic activity. It is therefore reasonable to expect that a
recovery in economic growth lies ahead. However, the recent
instability of monetary velocity introduces some additional
uncertainties and leaves the exact timing and extent of any
monetary-induced pickup in the economy somewhat open to question.
In addition to purely monetary influences, the current phase
of slower growth can be viewed as stemming partially from real
factors. Inventory restocking was an important element in the
economy's initial phase of rapid advance. There was a swing from
accumulation in real terms at a 525 billion rate at the recession
trough in late 1982 to accumulation at a $27 billion rate during
the first half of 1984.
By the first half of this year,
inventory accumulation had fallen back to about a $12*5 billion
annual rate. Much the same pattern of a cutback in the rate of
inventory accumulation following an early recovery rebound has
emerged at roughly similar stages of earlier expansions, e.g., in
1962 and 1976. As such, this could be construed as a normal
cyclical response to the speed of gains early in the expansion.
With inventory-sales ratios now pulled down to relatively low
levels, the stage may be set for a renewal of cyclical expansion.

161
Another real factor that may also have a bearing on the
current slowdown is the behavior of the net export component of
GSP. There has been a fairly steady deterioration in net exports
from a surplus in late 1982 of about $25 billion at an annual
rate in real terms to a deficit at nearly a $35 billion annual
rate in real terms by the second quarter of this year. Since
mid-1984 when the current slowdown began, industrial production
has been relatively flat and manufacturing employment has
declined. It is possible that steadily intensifying competition
from imports since that time has been responsible for the current
slowdown, but the case is weakened by the fact that the gap
between changes in Gross Domestic Purchases and Gross National
Product in real terms was actually slightly wider earlier in the
expansion than it has been recently. It seems likely that the
net export effects were masked by the rapid early pace of the
expansion and are now simply more visible as growth in domestic
demand has slowed.
A more mature stage of expansion is normally characterized
by a transition to slower growth. Some of the reasons have been
cited here and there may well be still other influences from the
real side of the economy. However, a good portion of the recent
slowdown in the economy can probably be attributed to last year's
slow growth in money. Because of the looser relation recently
between money and nominal GNP it is not possible to be precise as
to the monetary influence.
Despite this uncertainty as to the proper weight to be given
to real and monetary factors in explaining the recent slowdown in
growth, the near-term economic outlook appears to be generally
favorable. The second quarter rise in real GNP was marked down
to a 1.7 percent annual rate from 3.1 percent in the flash estimate. Paradoxically, however, the composition of the revised set
of figures was more favorable than the higher flash estimate and
seems to point to the likelihood of better economic performance
in the second half of the year.
o

The bulk of the markdown from the flash estimate came
in business inventory investment which is now calculated as dropping in real terms from $19 billion in the
first quarter to $6 billion in the second (both figures
in 1972 dollars and at annual rates). As shown in
Chart 5, inventory-sales ratios are currently at relatively low levels, particularly among manufacturing
industries. Thus, the second half could witness a
step-up in production for inventory, which would give a
lift to the economy.

162
After a small decline in the first quarter, real final
sales (GNP less inventory investment) grew at a
5.1 percent annual rate, according to the latest estimates, just a shade less than had been estimated in the
flash. Greatest strength was in spending for structures, as residential construction, business investment
in structures, and state and local construction all
rose sharply. Real final sales of durable goods also
registered a good gain, boosted by a resumption of
shipments of computers following a hiatus in the first
quarter.
Indeed, all major components of real GNP turned in
strong showings in the second quarter, with the exception
of inventory investment and the net export balance.
Private economic forecasts generally call for a faster pace
of expansion in the second half of the year and a continuation of
real growth in 1986. Results of some major economic forecasts
are summarized below:
Growth in Real GNP
(percent change, annual rate)

Data Resources Inc.
Chase Econometrics
Wharton EFA
Townsend-Greenspan
Blue Chip Consensus

(7/85)
(6/25/85)
(6/26/85)
(5/85)
(7/10/85)

III
2.7
2.9
3.6
4.1
3.9

1985
IV
IV
270
3.2
2.9
4.3
3.7

to IV
2.1
2.3
2.4
3.3
2.7

1986
IV to IV
575
2.3
2.4
2.1
2.3

The Administration is currently reviewing its own economic
projections which will be released with the Mid-Session Budget
Review. The slower than expected first half will ma>ce some dent
in the real growth performance for the year but for the reasons
indicated previously stronger second-half performance seems very
likely. Despite the generally favorable indications, stronger
second half performance cannot simply be taXen for granted. The
duration of the current slowdown has been something of a surprise
and economic forecasting is at best an uncertain art. This
argues for prompt legislative action on the budget and tax reform
coupled with reasonably accommodative monetary policy.

163
IV.

SOME AREAS OF MONETARY UNCERTAINTY

Monetary policy will have to be conducted cautiously during
the remainder of the year. There are risks on both sides. Too
rapid a pace of monetary expansion on the heels of the sharp
monetary growth since last October could sow the seeds of future
inflation. Too restrictive a stance could deepen the current
slowdown, widen the budget deficit and aggravate the
international debt situation.
Currently, the economy is advancing while inflation is still
under good control. But there are some aspects of the monetary
situation which, while perhaps not unique, do seem to depart
significantly from recent experience. There appear to be three
of these major areas of uncertainty which make a cautious
approach to monetary policy almost obligatory. Each may be
clarified by experience during the balance of the year but for
the time being considerable uncertainty remains.
A.

The Puzzling Behavior of Monetary Velocity

Reference has already been made to the fact that the postwar
trend in Ml velocity appears to have been interrupted in recent
years. Velocity has behaved very unpredictably in the current
expansion. In the first year of the expansion, velocity did not
rise at all despite the fact that historically it has had a
strong pro-cyclical pattern. That cyclical strength seemed to
emerge — a little behind schedule — in the second year of the
expansion when velocity rose at a 4 percent annual rate. But
velocity has now declined at about a 5 percent annual rate during
the first half of this year. This is simply another way of
saying that the previous relationship has shifted in an
unexpected fashion. There is still a link between money and
nominal GNP but more Ml is needed to support a given level of
economic activity.
In his July 17 statement. Chairman Volcker reviewed recent
velocity experience and concluded thati
"We simply do not have enough experience with the new
institutional frameworX surrounding Ml (which will be further changed next year under existing law) to specify with
any precision what new trend in velocity may be emerging or
the precise nature of the- relationship between fluctuations
in interest rates and the money supply."

164
A major difficulty in this connection is separating the
effects upon velocity which might be independently attributable
to changes in interest rates from effects which may reflect much
broader influences. As interest rates decline, the opportunity
cost of holding larger cash balances also declines which may tend
to reduce velocity as more money is held at any given level of
GNP. But if the velocity decline is the driving force in the
sequence, interest rates will decline because the economy is
declining. While a decline in velocity might be regarded with
relative equanimity in the first sequence it hardly would be in
the second. The difficulty is knowing in advance whether interest rates are moving velocity, or whether velocity and the economy itself are moving interest rates.
Attention has been directed recently to the possibility that
the observed decline in velocity may be due to the growing
importance of interest-sensitive components contained in Ml.
Until 1980, Ml was a fairly pure measure of money held for transactions purposes. Subsequently, payment of interest on NOW and
Super NOW accounts, which are included in Ml, may have drawn into
Ml a large amount of deposits which prior to 1980 would have been
included in M2. The result may be that Ml has become more like
M2 and for a given level of nominal GNP the measured level of
velocity would be lowered. This conforms with the general pattern of below-trend levels of velocity in recent years and may be
a partial explanation of some of the observed behavior of velocity.
It does not, however appear to offer an adequate explanation
for the recent velocity slowdown which has been associated with
slower economic activity this year. Some analysts have attributed the drop in velocity to the rapid growth of interest-bearing
checkable accounts which have become more competitive with other
interest bearing instruments. However, even if these checkables
had grown no faster than noninterest bearing demand deposits,
velocity still would have fallen during the first half of this
year — at about a 2 percent annual rate. Typically in the past
velocity has increased by about 4 percent during the third year
of an expansion.
With velocity behaving so unpredictably, the Federal Reserve
cannot be sure what path of total spending and nominal GNP is
likely to be associated with any given rate of growth in money.
This certainly does not mean that the monetary (and credit) targets can safely be abandoned. Inflation is still a serious
potential threat. But the success of a rigid monetarist approach
depends ultimately on the predictability of velocity. This may
not be too significant where the objective is limited to the long
run control of inflation, but it assumes dominating importance
where a particular short-run relationship is assumed to exist
between money and nominal GNP.

165
The fact that recent experience is BO difficult to interpret
implies a need to continue to give attention to the growth rates
of Ml and the other monetary aggregates, but also watch carefully
other indicators of the economy's performance in order to
determine whether the targets are consistent with maximum
noninflationary real GNP growth.
B.

Growing Importance of the International Dimension

The U.S. situation since 1980 has featured a massive net
capital inflow without parallel in the postwar period. This has
been the driving force in exchange markets. The reasons include
low U.S. inflation, generally good to excellent U.S. economic
performance, and the traditional role of the U.S. money and
capital markets as a safe haven for foreign funds when there are
economic difficulties abroad. Above all, the free-market orientation of the Reagan Administration and the higher prospective
rate of return here on productive investment "has acted as a
powerful magnet attracting foreign capital.
Flows of the type, magnitude and duration we have experienced are not induced by fleeting interest rate differentials as
if foreigners were shopping for a better money market fund.
These massive flows have been induced by a generalized perception
that the U.S. economy has found a new direction and offers significantly higher after-tax rates of return on productive investment. Some observers completely reverse these obvious lines of
causation and argue that the U.S. budget deficit has driven up
interest rates and pulled in foreign capital. Surely it must be
obvious that this does not explain five years of dollar appreciation during which time budget deficit projections have risen and
interest rates have fallen. Foreigners invest in the U.S.
despite our budget deficits not because of them. It is true that
our failure now to take effective action to reduce government
spending coupled with overly rapid money growth could drive the
dollar down, but obviously that is a sequence that we must avoid.
Capital inflows and the appreciating dollar are not the only
influence on the U.S. balance of payments by any means. Differential rates of growth here and abroad, trade barriers, changing
patterns of competitive ability, and U.S. export losses associated with the LDC debt situation have all exerted an important
influence from time to time. The list could be lengthened. It
is also important to recognize that there has been a changing

166
pattern within the capital accounts in the last 18 months or
BO. The more recent pattern has been a continuing net capital
inflow to this country because of reduced U.S. outflows, partly
because of reduced bank lending to Latin America.
The strength of the U.S. dollar is a testimonial to the
essential correctness of the policies that the Reagan Administration has introduced. Greater emphasis on incentives to
work, save and invest — the supply side of the economy — has
been coupled with effective control of inflation — to which the
strong dollar has itself made its own important contribution. As
a result, the U.S. economy has been strong, capital has flowed to
this country and the dollar has been bid up in price. It is
understandable that we do not want to see those successful
policies reversed in an ill-advised effort to bring the dollar
down.
There is considerable evidence which would suggest a fairly
direct linkage between growth in the money supply and the dollar
exchange rate. Because the dollar has appreciated steadily due
to real factors, the monetary influence has not always been
recognized but it surely exists. From October 1980 to July 1982,
sharply slower money growth (4.8 percent annual rate) and lower
inflation led to a rapid climb in the dollar (19.9 percent annual
rate), as confidence in its purchasing power was restored and
people worldwide began trying to rebuild their dollar holdings in
the face of tight supply. Faster money growth from July 1982 to
June 1984 (10.4 percent annual rate) accommodated the worldwide
dollar build-up and slowed the dollar's advance (6.6 percent
annual rate). A renewed slowdown in money growth from June 1984
to December 1984 (4.1 percent annual rate) led to a renewed surge
in the dollar (23.5 percent annual rate). These successive
episodes are shown in Chart 6.
Faster money growth since December 1984 finally caught up
with the dollar in late February, and the dollar has fallen back
from its peak levels. It is to be hoped that a more stable monetary policy and a steadier dollar will benefit hard-pressed
sectors of the U.S. economy. Agriculture and mining have suffered from commodity price declines related to overly tight money
and the strong dollar. Exporters and import-competing industries
have also had difficulty coping with the rapid climb in the
dollar's value.
The risk is that continued rapid monetary growth would begin
seriously to undercut the dollar's value. This, in turn, could
begin to add to inflationary pressures and to reverse the gains
in that area that have been achieved in recent years. The best

167
course of action is for monetary policy to pursue a neutral, noninflationary course and allow the dollar exchange rate to be
determined on the basis of real factors such as comparative costs
and anticipated real rates of return here and abroad.
C.

The Process of Disinflation

It is clear that a disinflationary process is still continuing here and abroad. In the three months ending in March of this
year, the crude materials component of the U.S. producer (wholesale) price index fell at nearly a 20 percent annual rate and by
about a 10 percent annual rate in the latest three month period
ending in June. When commodity prices slump, or even when commodity futures prices decline sharply, it can be a signal that
the Federal Reserve is moving too rapidly toward disinflation,
and is risking recession.
Some economists feel that the disinflationary process is
proceeding too fast. They argue that the Federal Reserve
concentrates too closely on regulating the growth of the money
supply. In their view, the dollar has been made very scarce both
at home and in international markets. This can be inferred, they
argue, from the appreciation of the dollar since 1980, the fall
in the price of gold from nearly §900 to about $300 and the
persistent weakness in basic commodity prices here and abroad.
Some would even argue that the Federal Reserve should substitute
a price rule for a quantity rule, i.e., seek to stabilize some
index of prices rather than to regulate the growth of the monetary aggregates.
The weight of economic opinion favors a quantity of money
approach and that is where emphasis has been placed. However,
those who have directed attention to the disinflationary process
have performed a useful service. Prices have not responded to
monetary growth as would have been expected on the basis of past
experience. In the last analysis, it is doubtful whether any
permanently rigid rule for monetary policy is likely to deal adequately with the complexities of the economy.
With the disinflationary process still continuing, the risks
of a return to accelerating inflation seem to be low but the
costs of being wrong would be enormous. Not quite fifteen years
ago, wage and price controls were imposed with inflation little
higher than it is now — except in the wholesale price area.
Following that ill-advised experiment, U.S. inflation surged to

168
double-digit levels and some nominal interest rates reached
record peaks. Those past errors must never be repeated. And,
rapid monetary growth continued long enough has always generated
inflation.
On the other hand, there are signs here and abroad that
inflationary pressures are much reduced. Actual deflation has
been occurring in some key areas although not, of course, in
terms of general price levels. This suggests that the monetary
authorities will need to follow the disinflationary process by
monitoring a wide range of price and cost indicators. They will
also need to follow the position of the dollar in the foreign
exchange markets as well as the growth of velocity in determining
whether or not a certain target range for money growth is
appropriate. When there is clear evidence of change, the targets
can be rebased but not so frequently as to permit a purely
discretionary policy with the monetary targets serving as stage
scenery. There will be a continuing need for rules in the
execution of monetary policy but they must be applied and
interpreted in the light of changing circumstances.
V.

CONCLUSION

It would probably be a mistake to draw sweeping conclusions
from recent experience with the conduct of monetary policy. The
Federal Reserve appears to have been doing a reasonable job this
year in dealing with a rather complex situation. The
Administration has been critical of some aspects of monetary
policy in the past and reserves the right of criticism in the
future. But the Federal Reserve is most likely correct now in
deciding to rebase its money supply target for Ml and in
proceeding with caution with respect to the new target. For
example, it would be possible for Ml to grow at a flat or
slightly negative rate for the remainder of 1985 and still be
within its new target range. This kind of swing in Ml growth
would be entirely unacceptable from the Administration's point of
view. However, Ml growth consistent with its upper target band
seems acceptable at this point.
The economy needs the support of an accommodative monetary
policy and would benefit from lower interest rates. The monetary
authorities must also remain closely alert to the needs of the
international situation and — above all — prevent any significant acceleration of inflation. They will need to follow the
course of the economy very closely in the period immediately
ahead.

Chart 1

VERSUS TARGET RANGE*
Variability of M1 Growth
since 1980
Ocl. BO to Dec. '80
Dec. 'BO to Apr '81
Apr. '81 to Ocl. 'B1
Oct. '81 to Jan. '82
Jan. "82 to Jul. '82
Jul. '62 lo Jun, '83
Jun. '83 to Nov. '83
Nov.'63 lo Jun.'84
Jun. '84 lo Oct. -84
Oct. '84 to June'85

Oi
ED

Pnr(o<l-1o-p*rtod growth; Musonolly ottjualod com
pound annual rain based on monthly averages.

380
1980

1981

1982

1983

1984

Ml data-. *eeWy meragea. seasanely wlwsted.
Fed target ranges: seasonaty adjusted simple annual rales based on guarterty averages.
ki 1981 both M1-B and M1-B "shift adjusted" ranges are shown: the M1-B range is 6—6V4W; me Mt-B "3hm ad|usled"
range la 3W—B^t. Monetary Dan* are aSo shown tar 1985.

1985

Chart 2

ACTUAL Mi VELOCITY VERSUS TREND VELOCITY

1959

'61

'63

'65

'67

'69

'73

'75

'77

'79

'81

'83

'85

Charts

Mi VERSUS TARGET RANGE*

J F M A M J J
1984

M A M J J
1985

* M 1 data: weekly averages, seasonally adjusted
Fed target ranges: seasonally adjusted simple annual rates based on quarterly averages.

O N

Chart 4

Growth of Real GNP and Money Supply (M1)
(Percent change at annual rates)
20

Ml, five month moving average

10
ro

Real GNP

-5

-10
1981

1982

1983

1984

1985

Chart 5

Constant-Dollar Inventory-Sales Ratios

2.0

Manufacturing
1,9

1,8

1.7

1.5

-a

Manufacturing
& Trade*

1.7

Retail Trade

1.5

1.4

1.3

1.2

1.3

1976
1977
1978
1979
1980
Second Quarter 1985 is estimated.
•Includes wholesale trade not shown separately.

1981

1982

19B3

1984

1985

1.2

Charts

TRADE-WEIGHTED VALUE OF THE DOLLAR
March 1973 = 100
Index

Index

Monetary Growth and the Value of the Dollar

160

-160

(percent change at an annual rate)

150-

140 *

January
October
October
July
June
December

1977
1978
1980
1982
1984
1984

-150

— October 1978
— October 1980
— July 1982
—June 1984
— December 1984
— June 1985

140

130-

-130

120

-120

110 <T

-110

100-

100

1972 73

Source: FedwS Reserve BoarO.

175
August 12, 1985

STATEMENT TO THE UNITED STATES SEMATE
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS

Mr. Chairman:
I am grateful for this opportunity to offer my views to the Committee
as it considers the mid-year report on monetary policy submitted last month
by the Board of Governors of the Federal Reserve System.
As is already widely recognized, the major news contained in this
report was the decision of the Federal Open Market Committee to maintain the
recent more accommodative posture of monetary policy, rather than reverse
course in response to the rapid growth of the narrowly defined Ml money
stock during the first half of this year.

By June Ml had risen from its

average level in the fourth quarter of 1984 by 11.65., measured at a
seasonally adjusted annual rate —

well beyond the 4-7% target range that

the Federal Reserve had reported to the Congress in February.

To have so

constrained Ml growth in the latter half of this year as to achieve a total
growth of 71?, or less for 1985 as a whole would have required sharply
slower growth of bank reserves and sharply higher short-term interest rates.
Rather than shift policy in this way , the Open Market Committee! chose
formally to disregard the unexpectedly large Ml growth in the first half,
and to adopt a 3-8% per annum target range for growth of this aggregate in
the second half.
This decision was a correct one.

The events of recent years have

shattered confidence in rigidly fixed monetary growth rules as the central

176
focus of monetary policy.

In the 1970s the acceleration of price inflation

outpaced that of any familiar measure of money growth.

In the 1980s

neither the depth of the recession nor the subsequent deceleration of
inflation corresponded at all closely to major sustained movements of
money growth.

Widely publicized predictions of either renewed recession

or renewed inflation, based on temporary swings in money growth, have
repeatedly proved embarrassingly wrong.
The unreliability of the relationship between macroeconomic activity
and "money" is hardly surprising in light of the vast changes that have
occurred in financial instruments and institutions in recent years.

It is

no longer possible in the United States to separate transactions balances
from saving balances, or even to draw clear lines between deposits and other
liquid claims.

Money market deposits, sweep accounts, and money market

mutual funds have irretrievably blurred such distinctions.

Appeals to the

tradition of the "quantity theory" today founder on having to say what
is the quantity and what is the theory.
The Federal Reserve's decision to disregard the most recent growth
of the Ml money stock makes sense in today's context for three reasons.
First, even from the perspective of the Ml aggregate considered in isolation,
the rapid growth in the first half of this year did little more than
offset the sluggish growth in the latter half of 1984.

From the second

quarter of 1984 to the second quarter of 1985, Ml increased by 7.0%,
easily within the 4-8% target range for 196-3, and just at the top of the
1985 target range of 4-7%.

If U.S. monetary policy operated on a June year

instead of a December year, there would have been no aberrant Ml growth this
year to consider in the first place.
growth within the past year —

Moreover, the unevenness of Ml

3.8% per annum in the latter half of 1984

versus 10.3% per annum in the first half of 1985 —

is little cause for

177
concern either.

There is no serious evidence indicating that monpy growth

variations of this magnitude, sustained over periods as short as six months,
affect the economy in any significant way.
Second, recent movements of the other monetary and credit aggregates
now targeted by the Federal Open Market Committee do not confirm the
impression of sharply excessive expansion qiven by Ml.

The much broader

M2 aggregate, which includes Ml as well as such major components of the
general public's liquid holdings as money market deposit accounts, savings
and small time deposits, and inoney market fund shares, increased through
June by 9.3% per annum,barely in excess of the 6-9% target range set in
February.

The still broader M3 aggregate, which includes M2 as well as

mostly institutional holdings like time deposits in anounts of 5100,000
or more, increased through June by 8.2% per annum, well within the corresponding
6-9 1/2% target range.

Even the outstanding debt of domestic nonfinancial

borrowers, which had expanded at a record pace in 1984, has increased
this year (through June) by 12.7% per annum, only slightly in excess of the
corresponding 9-12% monitoring range.
Finally —

indeed, most, importantly —

available information bearing

more directly on U.S. nonfinancial economic activity does not now suggest
excessive strength that would call for a more restrictive monetary policy.
After a rapid rebound from the unusually severe 1981-82 business recession,
the U.S. gross national product has grown during the last year by only
1.9% after allowance for inflation.

The economy's industrial sector has grown

even more slowly during this period, and utilization of industrial capacity
has been declining since last summer.

Total employment has '"jhown little

recent growth, and the unemployment rate, which declined especially rapidly
from its 11% recession peak, has now remained essentially unchanged at. 7 1/4%
for more than a year.

Although the recent overvaluation of the U.S. dollar in

178
international exchange markets has led to unusually wide disparities in
the performance of different sectors of the economy, overall there is little
evidence to suggest that excessive expansion is any more likely a threat than
insufficient strength over the horizon that matters for today's monetary
policy decisions.
In this setting a major retreat from the kind of commitment to
monetary targets that characterized the 1979-82 period was —
certainly warranted.

and remains —

Even so, financial quantities like the money and

credit aggregates still have some role to play in the monetary policy
process for several reasons.

The available evidence indicates that money

and credit aggregates do contain some, albeit limited, useful information
about subsequent swings in economic activity.

Quantitative objectives

for money and credit growth can also serve a useful function in the
important process of Congressional oversight of monetary policy.

It is

also possible that public awareness of such objectives may be helpful in
some further way, although on this subject there is little if any
supporting evidence.
What role, then, should money and credit aggregates play in the
design of monetary policy?

The logical starting point for setting monetary

policy should be the relationship between the macroeconomic objectives that
policy seeks to achieve, in terms of prices, income and employment, and
the actions that the Federal Reserve can actually implement —

in practice,

setting either nonborrowed bank reserves or short-term interest rates (or,
equivalently, some measure of free reserves).

Given the state of economic

science, either relationship is subject to enormous uncertainty.

Because

banks and other depository institutions hold reserves not voluntarily but
to back their outstanding deposi ts, the connection between reserve aggregates
and economic activity suffers from all of the same problems as does that for

179
monetary aggregates.

Interest rates are subject in this context to a

different set of shortcomings, including the difficulty of knowing the
"real" interest rate on any but very short-term debts when price inflation
is uncertain, and of weighing the diverse effective interest rates on
various borrowers and lenders subject to differential taxation.
Precisely because of these uncertainties, it is useful for
monetary policymakers to do more than simply implement the rate of reserves
growth or the short-term interest rate that they think is most likely
to achieve their macroeconomic objectives.

Specifying in addition the

accompanying paths of money and credit growth that are most likely to
be consistent with these objectives provides a benchmark for gauging,
along the way, whether the chosen policy actions are having the desired
effect.

To the extent that the movements of these financial aggregates

contain information about future economic activity, aberrant growth of
money or credit flashes a signal warning that monetary policy may not be
producing the desired effect, and that new action may be warranted.
Because these signals are not fully reliable, however, any consequent
action should hardly be automatic.

Money and credit are appropriate

"information variables" to be used along with other kinds of economic
intelligence, not "targets" to be pursued willy-nilly as if they were of
some value by themselves.
What the Federal Reserve should do is to treat the range that it
specifies for each aggregate on which it focuses as what it now calls a
"monitoring range."

At the same time that it reports its macroeconomic

policy objectives to the Congress, the Federal Reserve should specify
ranges for money and credit growth that, as a matter of technical judgment,
it considers most likely to be consistent with achieving those objectives.
If growth of either money or credit then moves outside the specified range.

180
in its next semi-annual report the Federal Reserve either should state
explicitly why it has changed the corresponding technical judgment or,
alternatively, should reaffirm its original judgment and state explicitly
how it is modifying its policy actions.
The latest action by the Federal Reserve appears, in substance,
to be consistent with this "information variable" approach to monetary
policymaking.

The Federal Reserve did not simply disregard the recent

rapid growth of the Ml money stock.

Its mid-year report to the Congress

explicitly considered the behavior of M l , as well as of M2, M3 and nonfinancial
debt, and discussed possible explanations for the aberrant Ml growth.
These technical judgments may be correct or incorrect, of course, and the
policy decision taken may ultimately prove approprirate or counterproductive.
On the basis of the evidence at hand, however, it was a right decision.
Conducting monetary policy in this matter clearly leaves important
room for Federal Reserve discretion.

Such a procedure neither follows a

fixed rule for setting money and credit growth ranges, nor institutes
automatic policy responses to movements of money or credit growth outside
the set ranges.

This choice of guided discretion over rigid rules may be

unsatisfying to some, but today it is inevitable.

The relevant relationships

are too unreliable to warrant imposing any simple rule, and the plausible but
unforeseeable

shocks to these relationships -— including further financial

innovations, side effects of today's anchorless fiscal policy, international
capital movements mirroring the nation ls enormous trade imbalance, shifts
in the public's portfolio preferences, changes in lending practices at
major financial institutions, and so on —

are too varied and complex to make

feasible a more involved rule that attempts to lay down in advance a full
complement of appropriate policy responses.

Under today's circumstances

discretion is inevitable, and in this case the Federal Reserve appears
to have exercised it wisely.

181

A Gilbert Heebner
Executive1 Vice President

August 5, 1985

The Honorable Jake Garn
Chairman, Committee on Banking,
Housing and Urban Affairs
United States Senate
Washington, DC 20510
Dear Senator Garn:
I am pleased to have the opportunity to share
my views on the conduct of monetary policy in
connection with the mid-year review of your
Committee.
Monetary Policy Overview
In a fundamental sense the question at these
review periods is always the same: has monetary
policy been too accommodative, too restrictive, or
about right? Even though economic activity was
sluggish during the first half of this year, I
would not argue that monetary policy has been too
restrictive. Money growth was certainly not slow.
Rates of growth in the aggregates placed Ml well
above the target range for 1985, M2 near the top
of the range, and M3 near the middle. Moreover,
recognizing that the Federal Reserve more directly
affects bank reserves than the money supply, total
reserves grew at a rapid annual rate of 16.5
percent from December 1984 to June 1985. Chairman
Volcker's description of the "approach in the
provision of reserves" as "relatively
'accommodative'" (page 4 of his testimony) was by
no means an overstatement.
While less conclusive as a gauge of monetary
policy, it is also worth noting that interest
rates and the foreign exchange value of the dollar
declined significantly after the early months of
the year.

182
If, as in my opinion, monetary policy has not
been too tight in the period under review, has it
been too easy? This question is raised
principally by the rapid growth of Ml. To be
sure, such growth has not been accompanied by
signs of higher inflation or of strong economic
expansion. Accordingly, Ml velocity — the ratio
of nominal gross national product to Ml — has
fallen. An argument that monetary policy has been
too easy must rest on the assumption that velocity
will rise substantially in the period ahead and
that the Federal Reserve will not at the same time
be willing or able to slow the growth of Ml.
I have little, if anything, to add to
Chairman Volcker's extensive comments on the
velocity question. The secular upward trend of Ml
velocity may have shifted to a horizontal or even
downward trend since interest is now paid on a
substantial volume of checking accounts. The
decline in velocity this year may have been
associated with the fall in interest rates.
Given the uncertainties about velocity, I
believe that the Federal Reserve was wise to
rebase the Ml target to the second quarter of 1985
and to widen the target range for the balance of
the year to an annual growth rate of 3 to 8
percent. To have continued with the original
target range for 1985 and endeavored to come
within it would potentially have been very
restrictive, and might have sent the economy into
a recession. On the other hand, to have
downgraded the importance of Ml and eliminated a
target range for that aggregate would have courted
the risk of accelerating inflation. The option
chosen by the Federal Reserve (rebasing and
widening the range) seems to be a compromise
intended to steer a course between the risks of
recession and inflation. I believe that is how
the option has been interpreted by the financial
markets.
Nevertheless, we cannot rule out the
possibility that the new range for Ml will prove
to be too generous. If velocity were to return to
the increasing rate that has in the past been more
typical of the rising stage of the business cycle,
money growth in the upper part of the 3-8 percent
target range would be excessive (a judgment that
seems consistent with the economic projections of
the Federal Open Market Committee). This

183
combination of velocity and money growth would
result in a rapid increase in nominal GNP.
The Federal Reserve is best advised to watch
economic activity and money growth closely and be
ready to apply the monetary brakes promptly upon
evidence that money growth is stoking economic
activity. We should not be lulled by the fact
that at first rapid growth of nominal GNP would
consist largely of increased real output. To wait
until inflation accelerates before acting to slow
the growth of bank reserves and money is to wait
too long. We paid a high price to bring inflation
down, and it would be unconscionable to allow it
to rise again. Moreover, the current inflation
rate of somewhat under 4 percent is not zero; it
is not price stability.
I expect that economic activity will speed up
in the months ahead, partly in lagged response to
recent money growth and lower interest rates.
Recent information on new orders, employment, the
leading indicators, business inventories, and
housing lend some support to this viewpoint. If
indeed the pace of general business activity does
accelerate significantly, manifesting a rise of
velocity, I hope and presume that the Federal
Reserve will not hesitate to slow the growth of
the monetary aggregates.
Related Issues
I would like to mention a few other issues
relevant to monetary policy. It would, in my
opinion, be a mistake for the Federal Reserve to
try to drive down the dollar by rapid money
creation in the hopes of reducing the trade
deficit. The dollar has already declined
appreciably since early this year against major
trading currencies. While a further decline would
be helpful to spur exports and slow imports,
deliberately trying to induce the decline at this
stage by monetary policy would risk a plummet of
the dollar.
Once foreigners perceived that the Federal
Reserve was seeking to drive the dollar down by
money creation, they would try to reduce their
dollar holdings, accelerating the dollar's
decline. This would, with a lag, raise the
inflation rate in this country. Even sooner,
interest rates would be pushed up as foreigners

184
sold dollar-denominated assets in face of rising
inflationary expectations.
So much has been said about the Federal
budget deficit that it is tempting to omit comment
on it. But I do want to add my voice to the many
others urging action to reduce the deficit.
Economic logic suggests that our large deficit has
contributed to higher interest rates than would
otherwise prevail, although I recognize that the
statistical evidence on this point is less than
clear. A cut in the Federal budget deficit could
help to bring about an orderly decline in the
dollar. Furthermore, a good case can be made that
in the longer run a large budget deficit crowds
out capital investment and thus reduces productivity,
Finally, I want to draw attention, as did Mr.
Volcker's testimony, to the rapid expansion of
domestic nonfinancial sector debt. It is notable
that this pattern is not peculiar to the past
year. Debt has been growing significantly faster
than gross national product in recent years, as
shown in the accompanying chart of the ratio of
debt to nominal gross national product. From the
late 1960s to the late 1970s there was an upward
drift in the debt-to-GNP ratio, but since then it
has risen sharply. Total nonfinancial debt rose
from 1.42 times GNP in 1978 to 1.55 in 1984.
Importantly, this rise was not only a result of
the increase of federal debt. The ratio of total
nonfederal debt to GNP also rose sharply.
We need more information on the factors
responsible for the rapid, and potentially
dangerous, expansion of debt in the U.S. economy.
Over the past year the substitution of debt for
equity in connection with corporate mergers,
leveraged buy-outs, and other types of financial
restructuring has been a contributing factor. In
the late 1970s and early 1980s, high current and
expected rates of inflation may have encouraged
borrowers to go heavily into debt with the
expectation of repaying in cheaper dollars.
Whatever the reasons for the high debt
position of the U.S. economy, there are important
economic and policy implications. The current
environment of reduced inflation and high real
rates of interest is tough on debtors. Failures
and debt problems are likely to continue to

185
surface among business firms and individuals. I
feel strongly, however, that it would be a serious
mistake for the Federal Reserve to respond to
these problems by an easy monetary policy aimed at
increasing the liquidity of the financial system.
We should not try to "reflate" our way out of debt
problems. If Congress decides that there is an
overwhelming case for granting relief to a
particular sector, it should do so individually,
not by urging a change in monetary policy.
In closing, I feel that the semi-annual
reviews of monetary policy conducted by your
Committee and the corresponding one in the House
of Representatives serve a most useful purpose. I
appreciate this opportunity to submit my thoughts
as part of your recent review.
Sincerely yours.

AGH:mr

DOMESTIC NONFINANCIAL SECTOR DEBT TO NOMINAL GROSS NATIONAL PRODUCT

00
OS

~ i
66 67

Source:

i
68

T^
69

\
70

i
71

i
72

i
73

r
74

i
75

r^ i
76 77

i
78

i
79

i
80

Board of Governors of the Federal Reserve System and
Department of Commerce

i
81

84-

Full text of Monetary Policy Oversight : Senate Hearings : Federal Reserve's Second Monetary Policy Report for 1985 : Hearing Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Ninety-ninth Congress, First Session

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