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CONDUCT OF MONETARY POLICY
to the Full Employment and Balanced Growth
Act of 1978, P.L. 95-523)
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
NINETY-SIXTH CONGRESS
FIRST SESSION
FEBRUARY 21 AND 22, 1979
Serial 96-3
Printed for the use of the
Committee on Banking, Finance and Urban Affairs
U.S. GOVERNMENT PRINTING OFFICE
42-656 O
WASHINGTON : 1979
HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
HENRY S. REUSS, Wisconsin, Chairman
THOMAS'L. ASHLEY, Ohio
J. WILLIAM STANTON, Ohio
CHALMERS P. WYLIE, Ohio
WILLIAM S. MOORHEAD, Pennsylvania
FERNAND J. ST GERMAIN, Rhode Island STEWART B. McKINNEY, Connecticut
HENRY B. GONZALEZ, Texas
GEORGE HANSEN, Idaho
HENRY J. HYDE, Illinois
JOSEPH G. MINISH, New Jersey
RICHARD KELLY, Florida
FRANK ANNUNZIO, Illinois
JIM LEACH, Iowa
JAMES M. HANLEY, New York
PARREN J. MITCHELL, Maryland
THOMAS B. EVANS, JR., Delaware
WALTER E. FAUNTROY,
S. WILLIAM GREEN, New York
District of Columbia
RON PAUL, Texas
ED BETHUNE, JR., Arkansas
STEPHEN L. NEAL, North Carolina
JERRY M. PATTERSON, California
NORMAN D. SHUMWAY, California
CARROLL A. CAMPBELL, JR.,
JAMES J. BLANCHARD, Michigan
CARROLL HUBBARD, JR., Kentucky
South Carolina
DON RITTER, Pennsylvania
JOHN L. LAFALCE, New York
JON HINSON, Mississippi
GLADYS NOON SPELLMAN, Maryland
LES AuCOIN, Oregon
DAVID W. EVANS, Indiana
NORMAN E. D'AMOURS, New Hampshire
STANLEY N. LUNDINE, New York
JOHN J. CAVANAUGH, Nebraska
MARY ROSE OAKAR, Ohio
JIM MATTOX, Texas
BRUCE F. VENTO, Minnesota
DOUG BARNARD, Georgia
WES WATKINS, Oklahoma
ROBERT GARCIA, New York
MICHAEL LOWRY, Washington
PAUL NELSON, Clerk and Staff Director
MICHAEL P. FLAHERTY, General Counsel
MERCER L. JACKSON, Minority Staff Director
(H)
CONTENTS
Hearings held on—
February 21, 1979
February 22, 1979
STATEMENTS
Brunner, Dr. Karl, professor, University of Rochester, Rochester, N.Y
Miller, Hon. G. William, Chairman, Board of Governors of the Federal
Reserve System
Thurow, Dr. Lester, professor of economics and management, Massachusetts Institute of Technology, Cambridge, Mass
ADDITIONAL INFORMATION SUBMITTED
Brunner, Dr. Karl:
Prepared statement
Response to questions of Congressman Chalmers P. Wylie
Feldstein, Prof. Martin, statement
Lekachman, Prof. Robert, statement
Miller, Hon. G. William:
Letter, dated March 9, 1979, responding to Congressman Ron Paul's
February 22, 1979, letter re potential consequences for monetary
policy of shifts into the United States of deposits now held in the
Euro-dollar market
•__
"Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978," report of the Board of
Governors of the Federal Reserve System, February 20, 1979
"Percent Change in Real Gross National Product and Related Items,"
table submitted in response to question of Chairman Henry S.
Reuss
Paul, Congressman Ron, letter dated February 22, 1979, to Chairman
G. William Miller, re potential consequences for monetary policy of
shifts into the United States of deposits now held in the Euro-dollar
market
APPENDIXES
Appendix I.—Briefing material submitted by staffs of—
Committee on Banking, Finance and Urban Affairs
Congressional Research Service of the Library of Congress
Subcommittee on Domestic Monetary Policy
Appendix II.—Statements of Associations:
American Association of Retired Persons
National Retired Teachers Association
Appendix III.—House Report No. 96-32
(in)
1
115
116
2
131
121
141
153
152
91
11
109
90
157
166
161
171
171
183
CONDUCT OF MONETARY POLICY
(Pursuant to the Full Employment and Balanced Growth
Act of 1978, P.L. 95-523)
WEDNESDAY, FEBRUARY 21, 1979
HOUSE or REPRESENTATIVES,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10:15 a.m., in room 2128 of the Eayburn House
Office Building; Hon. Henry S. Reuss (chairman of the committee)
presiding.
Present: Representatives Keuss, St Germain, Cavanaugh, Vento,
Stanton, Wylie, Leach, Evans of Delaware, Green, and Paul.
The CHAIRMAN. I wish to congratulate you, Chairman Miller, on
your appearance before the Senate yesterday in the midst of a record
snow storm. I congratulate you and your associates in the Federal
Reserve on the way you met this initial responsibility.
These hearings open a new chapter in the relationship between the
Federal Reserve, the administration, and the Congress. For the first
time, we now have a formal procedure that relates the conduct of
monetary policy to a set of explicit economic goals and objectives, and
that requires both sides in these hearings to focus on and evaluate those
goals. The Federal Reserve has done so in the Monetary Policy Report
that was submitted to the Congress yesterday. This committee will
shortly do so in a report to Congress, as required by law.
While I have a number of questions about the report, and a few
thoughts on how it might be made even more responsive to the new
law in the future, I want to commend you and the Federal Reserve
staff for a conscientious effort to prepare and present a truly informative and useful document. The review of recent economic developments is especially thorough and well presented.
I note that your new target for M1? the narrowly defined money
stock, accomplishes something I have long recommended: It makes the
M! target, which has been a perennial understatement of actual Mi
rowth in the past, consistent once again with the announced ranges
Dr the higher M's. This is because you incorporate an estimate that
automatic transfers, NOW accounts and so on, will substitute for 3
percentage points in the normal growth of MI, so that your seemingly
strangulatory MI growth path of 1.5 to 4.5 percent is in effect an
eminently reasonable 4.5 to 7.5 percent, if the figures are made comparable to the MI of less complicated times.
Chairman Miller, your report is received in full and will be inserted
in the record.
Would you now proceed ?
(1)
f
STATEMENT OP HON. G. WILLIAM MILLER, CHAIRMAN,
FEDERAL RESERVE BOARD
Mr. MILLER. Thank you very much, Mr. Chairman.
Can everyone hear me satisfactorily ?
I would find it much preferable, if you don't mind, to stand at this
little podium. It is a high technology device, with wastepaper baskets
supporting it; I note that they are turned upside down because we
don't have any wastepaper to throw away today. At least, I hope this
report will be looked upon as something other than wastepaper.
I appreciate your comments, Mr. Chairman, about this report. It is
to us a historic event to report to you for the first time under the new
requirements of the Humphrey-Hawkins Act. And I must assure you
that the credit for this report should be given to the staff of the Federal Reserve, which has worked very hard and diligently to try to be
responsive to the mandates of Humphrey-Hawkins.
We have divided the report into three chapters to follow and track
precisely the language of the monetary policy section of HumphreyHawkins, which instructs us as to the report to be filed with Congress.
With your permission, as you have suggested, the report will be
filed for the record. I would like to walk through the report, just
to make some comments as a preface to questions and comments from
this committee.
The CHAIRMAN. Do members have any objections?
Fine.
Mr. MILLER. Does everybody have a copy, I hope ?
Chapter 1 of the report is "a review and analysis of recent developments affecting economic trends in the nation."
The important thing to note about recent economic trends is that
we are in the process of completing 4 years of expansion from the
trough of the great recession of 1974-75; we are about to enter the
fifth year. This economic expansion is one of considerable longevity
and one which has had a considerable magnitude of gains.
We are moving closer to the point of a relatively high utilization
of our productive and labor capacities, and so we must operate from
here on with considerable caution, in view of the efforts that further
high rates of expansion could have in exacerbating inflationary
tendencies.
If you will follow with me in looking at some of the charts, that
might be the easiest way to hit the highlights.
The upper panel of the chart on page 5, shows the performance of
this economic cycle as compared with the average of previous economic cycles. You will see that there has been a fairly even, somewhat
slower growth in the earlier part of this cycle, and, more recently,
evidence of more vitality and continuity than had been shown in previous expansion periods.
The bottom panel indicates that over the period of the current
expansion—one quarter short of 4 years, since we don't yet have the
data for this quarter—the gross national product in real terms has
grown at an average annual rate of about 5 percent. Housing expenditures have grown a little more than 14 percent, and shows the highest
rate of growth for any component in this cycle. That results, however,
from the abnormally low rate of activity in housing at the trough; in
absolute terms, growth is not as great as it is in relative terms.
Business fixed investment has grown at a 5.4 percent average annual rate; personal consumption expenditures at 5 percent; and Government purchases at just over 2 percent.
On the chart on page 7, you will see that during this period, growth
in real personal income has fluctuated with economic conditions. During the early part of this "up" trend, personal consumption expenditures were running ahead of disposable income. Except for the year
1977, this has continued. So, as you will see in the middle panel, there
has been a general down trend in the rate of savings, as savings as well
as disposable income have been used to maintain consumer spending
during this period.
The bottom panel indicates the growth of consumer credit, which
has also supported consumer spending.
Turning to the chart on page 10, you can see illustrated the point
that I was making a moment ago about housing. With the downturn
that started in housing in 1973, there was a dramatic dropoff in
housing starts from a 21^-million annual rate to about 900,000 within
2 years. That wasn't a recession in housing; it was a depression. So it
is that the recovery has been somewhat stronger in housing than in
other components, but still not back to the previous levels.
The demand for housing, of course, is influenced by demographics.
We do have more family formations, more younger families who are
in need of shelter. And we do have a demand for housing based upon
its perceived value as a store of wealth for families, who are purchasing in anticipation of further price increases from inflation. So housing has been a relatively stable part of the expansion.
The chart on page 13 takes a look at Government expenditures during this cycle. The upper panel shows the nominal and real rates of
Federal expenditure for goods and services. The pattern has been
erratic, but generally we have seen a positive contribution from this
component during this period, although more recently, in real terms,
Federal purchases have dropped off.
The bottom panel shows the growth of State and local government
purchases of goods and services in constant dollars.
Turning to page 15, we can look briefly at the labor market. The
civilian labor force has grown rather rapidly during this period, but
there has also been a record rate of growth in job creation. In the
last 2 years, 71/£ million additional jobs have been created in our economy, which is certainly gratifying. While we still have pockets of unemployment for young, urban and minority Americans, the general
rate of absorption of the labor force has been encouraging. The unemployment rate has trended lower. And, more importantly, the civilian
employment population ratio has trended up to new record highs.
As shown in the bottom panel, civilian employment in relation to the
adult population is now at about 60 percent, an alltime record.
The chart on page 18 gives a breakdown of the unemployment rates.
Generally, at the end of 1978, we were back to roughly the same level
of unemployment overall that existed in 1972. For adults, this is also
generally true. The rate is slightly higher, but in the range that existed
in 1972, as is true for skilled workers. However, we continue to show a
high rate of unemployment for teenagers, for nonwhites, and for unskilled workers. So, as we have expanded and begun to see some strain
in the market that exists for skilled and adult workers, we have found
we still need to concentrate on targeted programs to help provide
skilled training for those who have not yet been able to take full part
in this economic progress.
As to productivity, let me call your attention to the chart on page
21. One of the concerns that we have is the general attenuation in the
growth in output per hour. The trend line shows a general rate of
growth of about 2% percent over the postwar period; you can see that
we have been falling woefully short of this increase in productivity in
the nonfarm business sector in the last few years. The trend at 2%
percent in the period 1947-67 is followed by only 1.2 percent growth
since 1973; last year, even less than that. This is of considerable
concern.
On the chart on page 23, you can see one of the reasons we have had
this poor performance. The ratio of capital stock to the labor force
has been dropping off. If we fail to create the investment to support
the growth of the labor force and growth in jobs, we indeed run into
difficult problems.
The bottom panel shows that the average annual rate of growth of
capital stock from 1962-67 was over 5 percent; from 1972-77, it was
only 2.9 percent. This is one of our serious concerns, looking at longterm trends in the economy.
The chart on page 26 makes this point in terms of international comparisons. Not only has the United States been falling behind its own
prior rates of investment, but it is continuing to fall behind other
countries. In the period 1966-76, in real terms, the United States expended about 13.5 percent of GNP on capital investment. Other industrial countries have invested much more: Japan, 26-plus percent;
Germany, over 17 percent; Canada, over 17 percent.
I must point put that it is not proper to make direct comparisons
because of the different structural characteristics of the various economies, but there is no way that such differences account for this significantly lower rate of investment. It is clear, as a general proposition,
that the United States is falling behind in its investment.
The international situation in terms of trade and current account
balances is shown on page 28, in the upper panel. The chart shows us
in a favorable position in our trade balance until the oil boycott and
in its immediate aftermath. With the recession of 1974-75, we came
back to a balanced trade position. But now, because of the rapid growth
of our economy and the slower growth in other countries of the world
coupled with our high demand for imported oil, we have moved into a
record deficit position.
I point out, however, that the trade deficiency in annualized terms—
we reached the largest trade deficit in the first quarter of 1978—it has
been improving since that time.
The current account balance follows somewhat the same pattern. In
any case, the current trends are toward improvement in our trade
balance and substantial improvement in our current account balance.
The bottom panel shows the ratio of foreign real GNP to U.S. real
GNP, which accounts for some of this problem.
The United States has been growing more rapidly relative to other
countries of the world, so that our demand for imports has been high,
while the international demand for our exports has not kept pace.
In terms of recent trends, the upper panel of the chart on page 30
shows that we are now beginning to benefit from increased dollar demand for U.S. exports, both from the change in the value of the dollar
and the general change in relative growth rates in the world. Volume
is trending upward now, and of course, value is also. This will make a
contribution to closing, the trade gap.
The bottom panel shows oil imports, which have been such a large
part of the deficit. Volume escalated very rapidly, but fortunately
that has shown some decline and stabilization. In terms of dollar value,
we have had a period when oil prices were not increasing and we were
stable for a while. This line, of course, may trend upward again with
the recent OPEC increases and the condition in the international oil
markets.
Page 32 traces the path of the trade-weighted value of the dollar
over the last few years.
It was erratic during the seventies, as there were changes in the International Monetary System—the floating exchange rate. Immediately following the recession, the dollar was relatively strong. But because of our large trade deficit, because of pur large current account
deficit, and because of our high rate of inflation relative to many other
countries, the dollar has been on a sharp decline since the fall of 1977.
This reached very alarming levels in the summer and early fall of
1978. From September 1977 until the end of October 1978, the dollar
declined by over 20 percent. At that time, as you know, we took forceful action: the November 1,1978, initiative included both fundamental
actions, and bridging actions, to insure a stable dollar. Since that
time, the dollar has, first, recovered and, second, been in a rather stable
channel increasing in value about 7 to 8 percent. Overall depreciation
of the dollar since the fall of 1977 has been adjusted to about 15
percent.
As to prices, let me first call your attention to the chart on page 37.
One of the natural phenomena of this inflationary time has been the
continuing rapid increase in compensation per hour, shown in the
upper panel.
Output per hour—productivity—has been trending downward, as
shown in the middle panel, and this means that we dp have a disturbing,
continuing upward trend in unit labor costs, which has contributed
to the inflationary bias that creates so much difficulty for us.
The charts on page 38 show other components of prices. The upper
panel shows nonf arm unit labor costs trending upward. GNP prices—
which is perhaps our most important measure of price increases—even
excluding food and energy—which have been serious problems—shows
an upward bias that parallels the growth in unit labor costs.
The middle panels show the rapid increase in food prices, which has
exacerbated the problem; the continued annual high rates of increase
in energy prices. The bottom panel shows the total, price condition: the
inflation rate for 1979, measured on the GNP deflator, shows an
8.75-percent increase, a rather disturbing rate that is causing us difficulty in adjusting the economy to our long-term objectives.
Page 41 calls attention to some of the financial aspects of this cycle.
The necessity for monetary restraint became apparent in 1977 and
continued through 1978. In 1978, short-term interest rates moved up
6
3 to 4 percentage points as the Federal Reserve moved to restrain the
growth of money and credit and to dampen inflationary forces.
Long-term rates, shown in the bottom panel, moved up to a lesser
degree, generally about 1 percent.
Page 44 shows the performance of the money aggregates in the last
few years.
The upper panel deals with MI. The rate of Mx growth had
slowed during the recession years of 1974-75; increased slightly in
1976; but then moved up rather rapidly to approximately an 8 percent
annual rate of increase in 1977.
With the restraining monetary policy of 1978, and while there was
some delay or lag in beginning to bring the growth rate down, we did
end up the year with a growth of Mx of about 7.3 percent. In the
fourth quarter, as you know, the growth rate was only 4.4 percent. So
we were successful toward the end of the year in bending down the
rate of growth of MI toward what we felt appropriate.
I would point out, however, that with the new automatic transfer
service that began last November 1, there has been some shift out of
demand deposits into savings deposits that can be accessed by automatic
transfer. Our estimate is that if ATS had not existed, there would have
been about a 1-percent greater growth of Mi in the fourth quarter.
So when we say 4.4 percent for the fourth quarter, you probably
should think of that as 5.4 percent in pre-ATS terms, still quite
satisfactory in terms of our restraining objective.
M2 is not influenced by this phenomenon. For M2 we have seen the
rate of growth move down from 11 percent in 1976, to about 10 percent
in 1977, to 8.5 percent in 1978, consistent with our general efforts to
restrain growth. The pattern is somewhat the same with M3.
Now, one of the new aspects of our financial system has been the
money market certificates authorized last June 1. On page 46, you
will see the rather interesting growth of these certificates in savings
and loans, in mutual savings banks and in commercial banks. At the
end of January, this form of saving had growth to about $105 billion,
and was responsible for maintaining a flow of funds to thrift institutions, and thereby a contributing factor to the maintenance of housing
at a more appropriate level than otherwise would have been the case.
In previous cycles, without such certificates, there had been massive
disintermediation from thrift institutions, and a lack of funds available for housing. In this cycle, because of the money market certificates,
thrift institutions have been able to compete for funds, and funds
have continued to flow through to housing. However, there is now some
effect upon thrift earnings, and concern about how these certificates
will work in future quarters.
Looking at the overall financial picture, page 48, you will see that
the total demand for credit from the nonfinancial sector was more or
less level between 1977 and 1978. The interesting factor here is that
there was a reduction in demand by the Federal Government, which
permitted an increase in funds available to the private sector. So,
while aggregate demand was generally level, the private sector received
a larger portion of funds, which is a trend in the right direction.
There are some developments as to the debt structure of households
and businesses that are worth noting in passing, as we look at the
demand for funds.
As shown on page 50, one of the developments during 1978, a
continuation of the trend in prior years, was the rapid growth of
household debt—not only as represented by mortgages, but in installment credit and other forms.
Part of this is no doubt for demographic reasons. There are more
younger families who are in that stage of life where they need credit
to form their households and support their demand for durables and
for shelter.
But there is also, perhaps, a growing use of credit to meet the desire
to purchase in anticipation of further price increases.
The upper panel shows this growth in household debt. It has now
reached the point where repayments relative to disposable income are
quite high, almost 23 percent, and while this debt is being served well
and there is no increase in delinquency, it is one of the factors we want
to watch closely. It will be a factor affecting overall demand over coming quarters.
The bottom panel shows that corporations have reacted to the interest rate cycle with a preference to borrow funds short term, rather
than long term, but unwilling to pay the present rates for long-term
funds. And so, their ratio of liquid assets to short-term liabilities has
dropped as they have come to depend more on short-term borrowings
to finance expansion.
Overall, the economy is in balance. In referring to the charts, I have
only touched upon the analysis presented to you in the full report.
I hope that my comments will provide you with the background you
need to assess our plans and objectives for monetary policy and how
these relate to the objectives of the administration.
Chapter 2 of the Federal Eeserve report to you deals with the objectives and plans of the Board of Governors and the Federal Open
Market Committee with respect to the ranges of growth or diminution
of the monetary and credit aggregates for the calendar year 1979.
These objectives and plans are made taking account of past and
prospective developments in employment, unemployment, production,
investment, real income, productivity, international trade and payments, and prices.
The objective of this Federal Eeserve is to foster financial conditions conducive to a continued, but more moderate, economic expansion during 1979 that should permit a gradual winding down of
inflation and the maintenance of the stronger position of the dollar
in the international exchange markets. Given the limited margin of
unutilized labor and industrial resources remaining in the economy,
it is critically important to avoid strong aggregate demand measures
that would aggravate our already serious inflation problem. At the
same time, the current condition of general balance in the economy
suggests that it should be possible to continue restraint to relieve inflationary measures without triggering a recession.
The particular growth rates, or ranges for growth of the aggregates,
can perhaps best be illustrated to you this morning by following the
charts that begin on page 59.
I have already commented on past rates of growth of MI, shown
on this chart over the period from 1975 to the current time.
The dotted line indicates the range of growth for M19 that has
been adopted as an objective by the Federal Open Market Committee
8
for the period from fourth quarter 1978 to fourth quarter 1979. The
range is from 1.5 percent to 4.5 percent.
I pause to call your attention to the fact that this range has been
adopted taking into account our best estimate of the effect on MI of
the new automatic transfer service. Our best estimate is that with the
automatic transfer service, MI would grow at a rate of 3 percent less
than it otherwise would have grown.
The midpoint of our range is 3 percent. If we were to adjust upward
by 3 percent for the effect of ATS, our midpoint would be about a
6-percent growth rate, as compared to a 7.3-percent growth rate in
1978.
Let me point out that we are not certain of the effects of ATS, and
so our ranges are designed to permit adequate adjustment for the
growth of MI should the effect of ATS be greater or less than we
estimate.
As to M2, shown on page 60, it is not affected significantly by ATS.
So, we are looking at growth rates that would be more or less consistent with past experience in measurement.
The range that has existed for M2 throughout the last couple of
years has been 6.5 to 9 percent. The proposed range for 1979 brings
the objective down to a lower range of 5 to 8 percent.
Similarly, with M3 shown on page 61: the previous growth range
was 7.5 to 10 percent; we are proposing a lower range of growth of
6 to 9 percent.
For bank credit, page 62, the range we adopted is consistent with
the other aggregates; we contemplate growth within the 7.5- to 10.5percent range.
I would just call your attention to the fact that we have a new
procedure under Humphrey-Hawkins; that is, these are ranges for
an entire year. We are to report back to you in July with any adjustments we think are appropriate. We no longer have the "rolling
forward" from quarter to quarter, so you are going to be judging us
on the basis of a more or less stabilized objective. This may 'be
beneficial; we may be able to keep better track of how we are
proceeding.
These particular ranges have been adopted after consideration of
the outlook for the economy in terms of all of its various components.
I would just call your attention to the fact that the new orders for
capital goods have continued high—the chart on page 69—and so
there is momentum for capital investment in 1979. Surveys indicate
that capital investment will continue to expand in 1979, although at
a lower rate of growth than in 1978.
The panel in the upper right points out the 3-month moving average
growth in real construction contracts. This has been quite strong,
picking up during 1978.
The bottom panel relates the same sort of information as to plant
and equipment expenditures, real and nominal, projecting a lower
but continuing expansion in 1979.
As to Federal outlays, as shown on page 66, the last few years have
seen a slight decline in the rate of growth of Federal expenditures in
nominal terms.
In 1978, for example, expenditures rose almost 12 percent from the
prior year. The projection is for those expenditures to increase only
9
9.4 percent in 1979, and 7.7 percent in 1980, a slowing in the rate of
expansion of Federal expenditures.
On the other hand, there will be a continuing significant gain in the
growth of Federal receipts, shown in the center panel. In 1978, Federal
receipts were 12.3 percent ahead of the prior year; they are expected to
be 13.4 percent ahead of 1978 in 1979; and yet a healthy 10.2 percent
ahead of 1979 in 1980.
This means a shrinking Federal deficit. The deficit was about $49
billion in 1978; it is expected to be $37 billion or so in fiscal year 1979;
and there is before Congress a proposal for a $29 billion deficit in fiscal
year 1980.
Mr. Chairman, if I may turn to the final chapter, I will briefly relate
these objectives of the Federal Reserve to the objectives in the President's economic report. This would then complete my verbal
presentation.
Corresponding to the mandate of the Humphrey-Hawkins Act,
chapter III reports to you on the relationship of the Federal Reserve's
objectives and plans to the short-term goals set forth in the recent economic report of the President.
The table on page 69 shows the President's economic goals. I am
not going to read all the figures, but let me call attention to a few of
them.
In terms of real GNP, the President's economic goal contemplates
a 2.2-percent growth in real GNP in calendar year 1979, and a 3.2percent growth rate in 1980.
It contemplates, also, an increase in consumer prices of 7.5 percent in
calendar year 1979, down from the 8.9 percent of last year; it targets
a further decline to 6.4 percent in 1980.
The unemployment rate in the fourth quarter of 1979 and 1980 is
now expected to be 6.2 percent.
These goals of the President contemplate expansion in nominal
GNP of about 9.75 percent from the fourth quarter of 1978 to the
fourth quarter of 1979.
It is the view of the Federal Reserve that the ranges that have been
adopted for the monetary aggregates are consistent with achieving
that rate of growth of nominal GNP.
As we have gone through this economic cycle, and as short-term interest rates have risen in response to higher inflation and the restraint
on the growth of money and credit, there has been an increase in the
velocity of the monetary aggregates, particularly of Mj.
Individuals and businesses, in the face of higher interest rates, economize more and more on the holding of their money in noninterest
bearing form. This phenomena is expected to continue, and we expect
some further increase in velocity in 1979 and 1980. This is why we feel
that the ranges we have presented for the monetary aggregates are
consistent with the rate of growth in nominal GNP.
Since the President submitted his goals, we have acquired additional
data that he did not have, and that the Council of Economic Advisers
did not have. The initial data for January, for example, show a slower
rate of growth in personal income, a slower rate of growth of retail
sales, a slowing in the rate- of housing starts, and a somewhat disappointingly high level of producer price increases.
All of these new data indicate that it will, perhaps, be difficult to
predict that the exact mix as presented in the President's goals can be
10
achieved. But the mix suggested for 1979 also seems reasonable; and
the aggregates seem reasonable.
It is more difficult to assess, at this time, whether future inflationary
pressures or other activity in the economy will change the mix between
real growth and price growth in 1980. But we feel we are within the
range of reasonableness, and that the goals adopted by the Federal
Eeserve are consistent with the President's goals.
Recognizing the risks and uncertainties that currently exist, the administration's 1980 forecast will serve as an appropriate goal for Congress as it considers the plans for fiscal year 1980. If inflationary pressure subsequently should prove stronger than the administration has
projected, then the prudent course for Government policy would be to
exercise a substantial degree of t restraint, even if it risks less real
rowth in 1980 than the 3.2-percent goal. Such a policy would lay the
3undation for balanced economic growth over the years to come, and
help us to maintain the integrity of the dollar.
Thank you very much, Mr. Chairman.
[Text resumes on page 89.]
[The first Monetary Policy Report to Congress pursuant to the
Full Employment and Balanced Growth Act of 1978 submitted by
Chairman Miller follows:]
t
Board of Governors of the Federal Reserve System
Monetary Policy Report to Congress
Pursuant to the
Full Employment and Balanced Growth Act of 1978
February 20, 1979
12
Letter of Transmittal
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Washington, D.C., February 20, 1979
THE PRESIDENT OF THE SENATE
THE SPEAKER OF THE HOUSE OF REPRESENTATIVES.
The Board of Governors is pleased to submit its first Monetary Policy Report to the Congress pursuant to the
Full Employment and Balanced Growth Act of 1978.
Sincerely,
G. William Miller, Chairman
13
TABLE OF CONTENTS
Letter of Transmittal
Chapter 1.
Recent Economic and Financial Developments
Section
Section
Section
Section
Section
Section
Section
Section
Chapter 2.
1.
2.
3.
4
5
6
7
8.
Overview
Aggregate Economic Activity
Labor Markets
Productivity
Investment
International Trade and Payments
Prices
Financial Markets
Objectives and Plans of the Federal Reserve
Section 1. The Objective of Monetary
Policy in 1979
Section 2. Growth of Money and Credit in 1979
Section 3. The Economic Outlook
Chapter 3.
1
3
14
20
24
27
35
40
54
55
63
The Relationship of the Federal Reserve's
Plans to the Administration's Goals
Section 1. The Short-Term Goals in the
Economic Report of the President
Section 2. The Relationship of the Federal
Reserve's Monetary Growth Ranges
to the Short-Term Goals in the
Economic Report
69
70
14
CHAPTER 1
"a review and analysis of recent developments
affecting economic trends in the nation"
Section 108(a) Full Employment and
Balanced Growth Act of 1978
15
Section 1.
Overview
The current economic expansion is about to enter its fifth
year.
It thus outranks in longevity every prior cyclical upswing
of the postwar era with the exception of that in the 1960s. Yet it
has maintained considerable vigor, with real gross national product
rising more than 4 percent during the past year. The attendant increases
in employment and industrial capacity utilization have reduced considerably the margin of unutilized productive resources in the economy.
The narrowing of the gap between actual and potential output
implies that a tighter hold on the Nation's aggregate demand for goods
and services is necessary if inflationary forces are to be contained.
The urgency of such restraint is reinforced by the fact that there
has already been an acceleration in the rise of wages and prices.
Aggregate measures of unit labor costs and prices advanced around
9 percent in 1978, appreciably more than in the preceding years of this
economic expansion.
Apart from the hardship that this large and generally unanticipated surge in inflation created for many families and business
enterprises, the behavior of prices deepened concerns around the world
regarding the stability of the U.S. economy and the soundness of the
dollar. The value of the dollar on foreign exchange markets declined
through most of 1978, exacerbating domestic inflationary pressures in
the process.
To prevent a serious disruption of the international
financial system, abroad program of corrective actions was initiated
last November. The dollar has since strengthened, but remains vulnerable
to shifts in sentiment among exchange market participants.
16
The Longer-range strength of the U. S. economy and of the dollar depends greatly on our success in retarding inflation.
This was
recognized during the past year in actions taken to reduce the size
of the Federal budget deficit, in the establishment of voluntary wageprice standards, and in efforts to curtail the inflationary impact of
Federal regulation.
In the monetary sphere, too, there was movement
toward moderation of aggregate demand growth and restraint of inflation
as the Federal Reserve acted to prevent excessive growth of money
and credit.
17
Section 2.
Aggregate Economic Activity
The current economic upswing, which began in the spring of
1975, ranks among the most durable in this Nation's history.
In the
period since World War II, only the expansion of the 1960s was longer,
and it was marked by massive increases in military outlays associated
with the Vietnam War.
The past four years have seen sizable gains in production and
employment. Between the first quarter of 1975 and the fourth quarter
of 1978, real gross national product rose more
than 20 percent. By
last month, industrial production had increased about 35 percent and
nonfarm payroll employment more than 14 percent from their
levels
art the cyclical trough in March 1975.
The momentum of expansion, furthermore, has been well maintained.
Real GNP increased 4.3 percent from the fourth quarter of
1977 to the fourth
quarter of 1978—a bit slower
than the average
pace over the earlier part of the expansion, but
still well above
the trend growth of potential output in the economy.
The persistent
strength of aggregate demand was demonstrated by the surge in activity
during
the final quarter of last year, when GNP grew at an annual
rate in excess of 6 percent.
Available indicators suggest that the
economy has remained generally strong in the opening months of 1979.
Residential construction, which
provided a good deal of
impetus to the early recovery, stayed on a high plateau last year
in the face of rising interest rates and a continued rapid escalation in building costs.
Household demands
for shelter have been
bolstered by demographic trends as well as by an inflation-hedging
18
motive.
The sustained advance in economic activity also has been
fostered
in good part by strength in consumer spending.
turnaround in the willingness of consumers
A marked
to spend—reflected in
a sharp drop in the personal savings rate—provided much of the
impetus to over-all expansion in the early stages of the economic
recovery, and
consumption expenditures
have remained
unusually
robust throughout the upswing.
In the business sector, spending on new plant and equipment
has continued to rise, but there have not as yet been the large
increases seen in some earlier cycles.
Business
fixed investment
actually declined during the initial quarters of the economic expansion, as firms concentrated
positions in an environment
on the repair of strained financial
of low capacity utilization.
Capital
spending policies have continued to be characterized by considerable
caution, and it was not until mid-1978 that the previous peak level
of real outlays was reattained.
Firms also have exercised caution
in managing their inventory positions, and stocks generally have
remained lean relative to sales.
Government purchases of goods and services rose briskly at
both the Federal and State and local levels during the second half of
1978, but have been a moderating influence on over-all activity during
most of the cyclical upswing. The over-all budgetary position of the
Government
sector, including transfer payments and revenues,
has
remained stimulative throughout the expansion, albeit in diminishing
degree. An improving net export position contributed to the expansion
of GNP during
the early recovery phase, but deterioration in the
4
19
REAL GNP
1972 Dollars
Index, trough quartar=100
120
Average of the
Five Previous Cycles
110
Current Cycle
100
1975
1976
1977
1978
REAL GNP AND MAJOR SECTORS
1975Q1 -1978Q4
Percentage change, annual rate
Housing
Expenditures
GNP
15
Business
Fixed
investment
Personal
Consumption
Expenditures
Government
Purchases
20
trade balance was a decidedly negative factor from 1976 to early
1978.
The U.S. trade deficit did narrow over the course of 1978,
however, owing in part to the strengthening of economic expansion
in other major industrial countries.
Personal Consumption Expenditures
Consumer outlays grew 3.8 percent over 1978 after averaging
5-1/2 percent, at an annual rate, earlier in the economic recovery
and expansion.
The slower growth of spending reflected relatively
smaller recent gains in real disposable income; increases in real
personal income were eroded by larger tax burdens related to higher
contributions for social security and the interaction of inflation
and a progressive tax system.
The proportion of consumption in gross national
has held at a high level over the course of this upswing.
cycles this share typically fell as the expansion matured.
product
In prior
In par-
ticular, household spending for durable goods has hovered at around
10 percent of GNP throughout the past three years, while during other
economic expansions it accounted, on average, for about 7-1/2 percent.
This exceptional strength in consumption and the associated rapid
increase in instalment credit and low savings rates can be attributed,
in part, to the higher relative number of younger households.
But
it also appears to be in some degree a reaction of households to
persistently
high
inflation rates.
For example, opinion surveys
suggest that many consumers have been buying durable goods in anticipation of price increases.
21
D REAL PERSONAL
CONSUMPTION EXPENDITURES
m REAL DISPOSABLE
Change from previous period,
PERSONAL INCOME
annual rate, percent
I
1975
1976
1977
1978
SAVINGS RATE
Percent
10
8
6
4
I
1975
1976
1977
1978
CONSUMER CREDIT OUTSTANDING
Billions of dollars
—1350
300
250
1975
1976
1977
7
1978
22
Business Fixed Investment
Real business fixed
1978.
investment rose 8-1/4 percent over
This was nearly the same pace of advance as in the two previous
years and almost twice the rate of expansion in aggregate activity.
Recently, nonresidential construction activity has become an important
source of business investment growth.
such structures
In 1978, real spending for
increased 12-3/4 percent as outlays for commercial
and industrial buildings showed
particularly impressive gains.
On
the other hand, investment in producers1 durable equipment grew about
6-1/2 percent in real terms during 1978 compared with increases of more
than 10 percent in each of the previous two years. Demands for motor
vehicles, which were exceptionally strong earlier in the expansion,
began to tail off in 1978, while machinery outlays continued to advance
at about the same moderate pace experienced since early 1976.
Inventory Investment
Investment in business inventories was characterized by caution in 1978, as it generally was in the three previous years.
As
a result, aggregate inventory-sales ratios remained at or below historical averages.
This caution, which can be traced back to the severe
inventory cycle of 1974-75, appears to have been responsible for the
avoidance of the types of overhangs that preceded several prior cyclical
downturns.
Incipient build-ups of stocks have been met with prompt
increases in sales promotion or curtailments of orders and production.
Most recently, overhangs that developed at general merchandise retail
outlets in the fall apparently were corrected by the sharp rise in
8
23
sales during the holiday season and a slowing of production of durable home goods.
Residential Construction
The rate of private housing starts advanced briskly during
the 1975-77 period and in 1978 they were sustained at the high annual
rate of 2 million units.
Spending for residential construction
in real terms increased at an average annual rate of 21 percent
from the 1975 trough before leveling off in 1978.
In addition
to production capacity constraints, the recent developments in housing activity reflect the tightening in financial markets.
Interest
rates on both construction loans and long-term mortgages rose appreciably in 1978 and by year-end they had reached usury ceilings in
a number of states and record postwar highs in many other areas.
Even so, the variable-ceiling six-month time accounts introduced
in June of last year buoyed deposit growth at key mortgage lenders
and helped maintain the high rate of housing construction.
Within
the housing sector, the rise in single-family
starts led activity early in the recovery.
More recently, multi-
family starts—supported by an increase in Federally subsidized
rental units—have increased while single-family starts have remained
above their 1972-73 peak levels.
Indeed, in the fourth quarter
of 1978, total housing starts averaged an annual rate of 2.1 million
units, the same as a year earlier.
9
24
PRIVATE HOUSING STARTS
1970
Annual rate, millions of units
1978
25
International Trade
After providing some initial stimulus to economic growth
during the early recovery period in 1975, the U.S. balance of trade
began deteriorating.
In large part this reflected the relatively
stronger rate of economic expansion in the United States compared
with our major trading partners. The deficit in net exports narrowed
during 1978, however, as activity abroad picked up in contrast to
the moderation in the U.S. expansion.
In addition, the more favor-
able trade balance reflected a 20 percent rise in agricultural exports
last year, associated with unusually poor harvests of wheat and
soybeans in the Southern Hemisphere.
Government
Growth of purchases by the Federal Government has been
uneven in this expansion.
In real terms, such purchases increased
little during 1975 and 1976, rose substantially in 1977, and then—
despite a surge in the second half of the year—declined slightly
in 1978.
Total expenditures, however, have risen consistently,
reflecting increased grants to State and local governments and transfers to individuals for Social Security, food stamps, and retirement
benefits.
Revenues have increased even more than outlays over the
past several years, so that the Federal budget deficit has declined
from $66.4 billion in fiscal year 1976 to a projected $37 billion
for the current fiscal that ends next September.
11
26
State~ and local government purchases also have grown irreover the past four years.
In real terms, outlays by this
sector for goods and services expanded at a 2-1/4 percent annual
rate during the second half of 1978, matching the average pace
over the expansion as a whole.
This is well below the trend rate
of increase experienced during the 1960s and early 1970s. The slowing
of growth reflects changing requirements for services, associated
with demographic developments, and a degree of fiscal conservatism
prompted partly by the financial difficulties encountered by some
communities in recent years.
In 1978, however, a tendency toward
tax relief—occasioned in part by voter preferences expressed in
California's Proposition 13 and like measures elsewhere—outweighed
the impact of spending economies on budgets. As a result, although
the aggregate operating surplus of State and local governments totaled
$6 billion for the year, this was only half the size of the 1977
surplus.
27
GROWTH OF FEDERAL GOVERNMENT
PURCHASES OF
Change
GOODS AND SERVICES
from previous period,
annual rate, percent
D Nominal
• Real
12
•f
0
I
I
1975
1976
1977
1978
STATE AND LOCAL GOVERNMENT
PURCHASES OF
GOODS AND SERVICES
Billions of 1972 dollars
— 180
170
160
I
1975
I
1976
I
1977
13
1978
28
Section 3. Labor Markets
Labor demand has been strong throughout the current economic expansion. During the three years following the cyclical trough
in early 1975, nonfarm payroll employment advanced at an average
annual rate of 3.7 percent—compared with a 2.8 percent median
rate of gain during the five previous postwar expansions.
During
the past year—at a stage when in earlier cycles employment levels
had begun to level off or even fall—payroll employment has continued
to advance at a 4.2 percent annual rate. Over the almost four years
of expansion, employment has increased by 12 million, and today
the ratio of employment to total civilian population aged 16 and
over stands at the highest level on record.
Employment in the goods-producing sector of the economy
rose rather slowly early in this, recovery, reflecting in part the
sluggish behavior of business fixed investment.
It was not until
late 1978—as a result of large hiring increases in the hard goods
industries—that factory employment reached its pre-recession peak.
Similarly, construction hiring showed only small increases for nearly
three years after the trough.
During 1978, however, employment
in contract construction surged ahead to record levels.
In the private service-producing sector, employment dipped
only briefly in early 1975 and has been on a steady uptrend since
then—far exceeding the gains of previous expansions. Hie trade and
service industries have continued to grow faster than other sectors,
and by the end of 1978 they accounted for more than 4 of every 10
14
29
LABOR MARKET
Change from previous period,
annual rate, millions
ijvilian Labor Force
— Dfl Employment
—
4
__
A
Percent
Unemployment Rate
Percent
Civilian Employment Population Ratio
SO
58
56
1975
1976
1977
15
1978
30
jobs in nonfarm establishments.
In contrast to the private sector,
Government hiring has been modest. Federal Government civilian employment has been fairly stable at around 2-3/4 million over the past
4 years, about
1960s.
the same level that has prevailed since the late
State and local government employment has risen, but growth
has slowed substantially in recent years as a consequence of reduced
needs for education personnel and fiscal retrenchment by many units.
The reduction in educational labor demand reflects the
shift in the age structure of the population that has been affecting not only school enrollments, but also the size of the work force.
Growth of the teenage population (ages 16 to 19) in the late 1960s
and early 1970s was exceedingly large, reflecting the attainment of
working age
by
the postwar baby boom cohort.
At the same time,
labor force participation rates for teens rose sharply. In the mid1970s, growth of the 16 to 19 age group slowed, and in 1978 the
teenage population actually
began to contract.
Nonetheless, with
participation rates still rising rapidly, the teenage labor force
continued to grow at a rapid pace (up 3.2 percent in 1978 compared
to 1.6 percent on average in the preceding four years).
An even more significant factor in the expansion of the
work force has been the continued rise in the participation rates of
adult women.
as well
The longer-run trend, which reflected low birth rates
as changing attitudes and social
trends, apparently was
augmented in the 1970s by a desire of families to maintain their
material living standards in the face of rapid inflation.
16
As a
31
result of these participation rate patterns, the total civilian labor
force grew 3 percent during 1978—about the same as in 1977, but
up considerably from the 2-1/4 percent annual rate during preceding
years of the decade.
With the growth of employment outstripping even the large
increase in the size of the labor force, the unemployment rate fell
one-half percentage point over the course of 1978 to just under 6
percent.
Labor market conditions improved significantly for most
groups of skilled and experienced workers.
For example, unemploy-
ment rates for workers 25 to 54 years old, skilled blue collar workers,
and workers seeking full-time employment all were at or near the
levels reached in 1972 when labor and product markets were beginning
to tighten noticeably.
While there was as yet no general shortage
of skilled workers during 1978, many firms reportedly were finding
it increasingly difficult to fill certain job vacancies at prevailing
wage rates.
The improvement in employment conditions during the current
expansion has not been uniform.
Despite the gains made by many
groups, unemployment rates for younger workers, minorities, and the
unskilled were still very high at the end of 1978.
For example,
the unemployment rate for teenagers at the end of 1978 was 16-1/4
percent, more than four times the rate for workers 25 to 54 years
old; for minority youth the rate was over 35 percent. Younger workers
between 16 and 24 years of age accounted for about one-half of all
joblessness in the fourth quarter of 1978.
17
32
UNEMPLOYMENT RATES
Percent
Percent
Adults
25-54 Years
Total
16 Years and Over
10
1972
1975 1978Q4
1972
1975 1978Q4
Percent
Percent
— 10
Unskilled Blue-collar Workers
1972
1975 1978Q4
1972
18
1975 1978Q4
33
The enlarged proportion of the labor force accounted for by
teenagers and women means that the over-all unemployment rate does not
imply the same degree of labor force pressure that it would have
in past years.
These groups tend to have relatively high rates of
joblessness for a number of reasons, including generally more limited
training and work experience. As a rough adjustment for such structural
influences, the average unemployment rate can be recomputed using
the age-sex composition of the labor force in the mid-1950s.
The
result of such a calculation is an unemployment rate about one percentage
point below its current level, which vividly illustrates that the
level of labor utilization consistent with price stability may change
considerably over time.
To enhance the possibility of simultaneously
achieving low unemployment and price stability, it may be necessary
to augment monetary and fiscal policies with carefully focused programs
to facilitate job placement and to provide skill-training.
19
34
Section 4. Productivity
The 3\5 million increase in payroll employment during 1978
was much larger than would have been expected on the basis of the
historical relationships between output changes and labor demand.
Although real GNP growth decelerated from 5-1/2 percent in 1977 to
4-1/4 percent in 1978, businesses added to their payrolls at almost
the same rate.
Output per hour of work rose only slightly over
the four quarters of 1978.
Much of the slowdown in productivity growth last year occurred
outside the manufacturing sector; output per hour in manufacturing
increased 3-1/2 percent during 1978.
Normally productivity growth
slows as labor markets tighten and capacity constraints are approached,
but the fall-off in productivity gains in the past two years has
been particularly sharp.
This poor performance of labor productivity continues a trend
toward slower growth evident since the late 1960s. During the period
from 1947 to 1967, productivity in the nonfarm business sector rose
on average by 2-2/3 percent per annum, and accounted for almost 70 percent of the gain in output for this sector.
Since 1967, the rise
in output per hour has slowed, with average annual gains of only
1.2 percent recorded since 1973.
As a result, less than 50 percent
of output growth over the last five years can be attributed to gains
in efficiency.
The deterioration of productivity performance in recent
years is a complex phenomenon that is not completely understood.
20
It
35
OUTPUT PER HOUR
Nonfarm Business Sector
Ratio scato, lnd*x 1987-100
—1140
130
120
1947-1967 Trend
100
80
80
I
'48
'53
'58
'63
21
'68
I
I
I
'73
I I
I
I I
'78
36
appears, however, that a crucial factor has been the failure to maintain an adequate rate of capital formation. Indeed, the Nation's stock
of capital has shown little growth relative to the size of the labor
force over the past decade; in contrast, the capital-labor ratio trended
upward rapidly in the preceding 20 years.
Other factors that may
have contributed to reduced productivity growth in recent years are
the influence of environmental
and safety regulations that divert
resources to uses not measured in the National Income and Product
Accounts, and the increase in the proportion of young and inexperienced
workers in the labor force.
22
37
RATIO OF CAPITAL STOCK
TO LABOR FORCE
Ratio scato, thousands of 1972 dollars par parson
12
1947-1967 Trend
10
i
I
I
'48
I
I
I
I
I
'53
I
I
I
I
'58
I
I
I
I
I
I
I
'63
I
I
I
'68
I I
I
I
I
I
I
'73
AVERAGE ANNUAL GROWTH OF CAPITAL STOCK
1962-1967
1967-1972
* Private nonresklential net capital stock measured in constant dollars
23
1972-1977
I
I I
'78
38
Section 5. Investment
Since the early 1960s, there has been a marked trend toward
slower growth of the stock of business capital in the United States.
Although real gross business fixed investment last year surpassed
the 1973 record, still stronger investment activity will be needed
if there is to be a sustained reversal of this trend.
In part this
merely reflects the arithmetic truth that unchanged absolute amounts
of investment translate into declining percentage increases in a
growing stock of plant and equipment.
Also important, however,
is the fact that it is net investment—that is, gross investment
less the depreciation of existing capital goods—that adds to the
capital stock, and real net investment has yet to reach its previous
peak level. Because the fraction of the capital stock in the form
of relatively short-lived equipment has been increasing in recent
years, a higher level of gross investment is now needed simply
to maintain the existing capital stock.
It also must be noted that even the figures for net investment probably overstate the contribution that capital outlays have
been making recently to the expansion of productive capacity.
A
significant share of plant and equipment spending has been undertaken
to meet Government pollution, health, and safety regulations. During
the past several years roughly 5 percent of total capital spending
has been for the purpose of pollution abatement, and some estimates
suggest that perhaps an additional 2 percent of investment has
been for improvements in health and safety conditions.
24
Although
39
these outlays may well yield important benefits to society, they do
not directly enhance productive capacity.
When an economy is near full employment, the commitment
of additional resources to capital formation will require some nearterm sacrifice of consumption by individuals or Government. However,
there is ample evidence that higher levels of investment effort can
enhance long-range economic growth and raise living standards.
The
increase in U.S. capital spending last year raised the ratio of real
gross business fixed investment to GNP to 10.2 percent—the first
time since 1974 that it reached the 10 percent level, but still somewhat
below the average of the late 1960s and early 1970s. Although international comparisons must be made with caution, owing to differences
in accounting and other technical problems, it is clear that other
major industrial nations have allocated greater shares of GNP to investment and, as a result, have enjoyed substantially faster increases
in productivity and output. While this does not lead to the conclusion
that the United States should attempt to achieve the same investment-toGNP ratios as prevail elsewhere, it tends to confirm the proposition
that this Nation would benefit from higher proportions of capital
spending to GNP than have been experienced in recent years.
25
40
INTERNATIONAL COMPARISON OF INVESTMENT SHARES*
1966-1976
Peccant
Japan
U.S.
*Real nonresidential fixed investment as percent of real gross domestic product; OECD data.
Includes Government purchases of capital goods.
Data for France cover the period 1970-75.
26
41
Section 6.
International Trade and Payments
From the mid-1960s through the early 1970s, the U.S. merchandise trade balance moved
Then, during
gradually from surplus to deficit.
the 1974-75 worldwide
economic slowdown
the United
States a suffered disproportionately sharp contraction, so that—
despite an enormous increase
U.S. trade balance swung
in our outlays for imported oil—the
into surplus in 1975. The surplus proved
temporary, however; the subsequent economic
recovery was stronger
here than abroad, and this played a major role in the steep increase
of our trade deficit from 1976 through early 1978.
The trade deficit in 1978 was $34 billion, slightly larger
than in 1977. But the deficit peaked at an annual rate of $45 billion
in the first quarter of 1978, and developments, in both exports and
imports contributed to a narrowing of the imbalance to a rate of
about $30 billion in each of the subsequent quarters.
The growth of exports accelerated in the second quarter.
The step-up was partly attributable to temporary causes—for example,
demand for U.S.
Southern
agricultural commodities was stimulated by poor
Hemisphere
harvests.
More
important, however, was a
strengthening of economic activity abroad and the improved competitiveness of U.S. goods resulting from the substantial depreciation
of the U.S. dollar that began in the fall of 1977.
The real volume
of non-agricultural exports increased 6 percent in 1978, and growth
picked up strongly in the second half of the year. Prices of exports
increased
in line
with
the general
27
pace of domestic
inflation,
42
U.S. CURRENT ACCOUNT AND
TRADE BALANCES
Billions of dollars
Current Account Balance
Trade Balance
International Accounts Basis
I I I
'65
'60
'70
'75
'78
ACTIVITY RATIO
1975=100
102
Ratio of Foreign Real GNP*
To U.S. Real GNP
100
98
96
I
1974
1976
* Weigh ted average of G-10 countries plus Switzerland
using total 1972—1976 average trade of these countries
28
1978
43
and the total value of merchandise exports rose 17 percent from
1977.
The relatively moderate rise, in the volume of imports
in 1978, following two years of very Icige increases, resulted primarily from a slower increase in nonoil import!, but it wf£ re irifcrced
by some decline in petroleum imports. Although total U.£« petroleum
consumption is estimated to have increased 3 percent, the higher
demand was more than met by increased Alaskan production rnd by
a drawing down of inventories from unusually high levels.
The
total value of imports increased 16 percent in 1978 with the gain
spread over most major commodity categories.
Almost half of this
increase was in volume terms as imports responded to the continuing
strength in U.S. economic activity.
Prices of nonoil imports were
boosted by the decline in the international value of the dollar.
The current account deficit in 1978, estimated at $17
billion, was slightly larger than in 1977. As in other recent years,
net receipts from service transactions provided a substantial offset
to the merchandise trade deficit.
Earnings, fees, and royalties
from foreign direct investments have shown a strong uptrend during
the 1970s.
In the period between the onset of generalized floating of
currencies in March 1973 and September 1977, the exchange value of
the dollar went through several phases of appreciation and depreciation.
The average value of the dollar increased sharply (nearly
15 percent) from October 1973 to January 1974, despite large sales
of dollars by foreign central banks. Continued large sales of dollars
29
44
NON-AGRICULTURAL EXPORTS
Ratio scale, annual rate
Billions of 1972 dollars
Ratio scale, annual rate,
billions of dollars
160
160
120
120
100
100
80
80
60
60
I
1974
1976
1978
OIL IMPORTS
Millions of barrels per day
Annual rate, billions of dollars
60
40
10
20
1974
1976
30
1978
45
by foreign central banks in 1974, later reinforced by the easing
of domestic interest rates associated with the U.S. recession, contributed to a decline in the dollar that began in the first quarter
of 1974 and did not end until the spring of 1975.
Thereafter, the
emergence of a large current-account surplus and a relative firming
of U.S. interest rates led to a substantial appreciation of the
dollar until the spring of 1976. The dollar subsequently held relatively steady until the fall of 1977.
The dollar began to depreciate markedly against most major
foreign currencies in late September 1977 as forecasts for 1978 suggested that theU.S. trade deficit would be no smaller than in 1977.
The decline continued through the end of 1977, despite large intervention purchases of dollars by foreign central banks. An announcement in January 1978 that the U.S. Treasury would join the Federal
Reserve in exchange market intervention in German marks, followed
by an increase in the discount rate, improved market sentiment only
temporarily, and by early April the dollar had declined about 10
percent on a weighted-average basis. Between early April and mid-May,
a relative firming of U.S. interest rates contributed to a recovery,
but the dollar declined fairly steadily thereafter in response to
continuing concerns about the size of the U.S. trade deficit and
increasing fears that U.S. price performance was deteriorating.
Although some depreciation of the dollar was justified
by the need to restore external balance in the face of differential
growth rates in the United States and major foreign economies and
31
46
U.S. INTERNATIONAL PRICE COMPETITIVENESS
March 1973*100
Relative Consumer Prices
Foreign*/U.S.
__
f
"X.
— t08
— 104
100
Foreign Exchange Value
Of the U.S. Dollar*
—
96
—
92
88
1974
1976
197a
* Weighted average aga*st other G-10 countries plus Switzerland using total 1972—1976
average trade of these countries
32
47
a relative worsening of U.S. inflation, by midsummer it was clear
that the dollar's decline was becoming excessive in trading that
was increasingly disorderly.
Consequently, in August the Federal
Reserve announced a 1/2 percentage point increase in the discount
rate and reduced to zero reserve requirements on borrowings by member
banks from the Eurodollar market. The Treasury subsequently announced
that it would increase the size of its regular monthly gold auctions.
These measures produced a brief rally and then a few weeks of stability
for the dollar.
However, the dollar's slide soon resumed. After
the President announced his wage-price program on October 24, the
decline steepened alarmingly, threatening to undercut
the anti-
inflation effort at home and to lead to further erosion of confidence
abroad.
By late October, the dollar had fallen 21 percent from
its September 1977 level.
Under
these circumstances, more
forceful action was
required. On November 1, the Federal Reserve increased the discount
rate by 1 percentage point and imposed a 2 percentage point supplementary reserve requirement on large time deposits. To increase
the availability of foreign currencies for exchange market intervention, enlarged swap lines were arranged with the central banks
of Germany, Japan, and Switzerland. The U.S. Treasury simultaneously
announced
its
intention
to draw on its reserve position in the
IMF, to sell SDRs, and to issue foreign currency denominated securities. In addition, the Treasury announced
of gold sales.
33
a doubling in its rate
48
The aim of these measures was to correct the excessive
depreciation of the dollar and thereby to counter upward pressures on
the domestic price level. When viewed in its entirety, the policy
initiative of the Administration and the Federal Reserve System
indicated that the United States recognized the need for an integrated
approach in addressing domestic and international economic concerns.
The announcement of these measures on November 1 produced a dramatic
jump in the dollar's exchange value.
On that day alone the dollar
advanced by 5 percent on a weighted-average basis. Heavy cooperative
central bank intervention over the following few weeks provided
support for the dollar as market participants tested the authorities1
resolve, but the need for such intervention abated in January.
As
of mid-February of this year, the dollar was more than 7 percent
above its October low on a weighted-average basis.
34
49
Section 7. Prices
Inflation typically has accelerated over the course of cyclical expansions in economic activity, and this upswing has proven no
exception.
However, the marked increase in the pace of price advance
during the past year was in large measure a consequence of forces
not directly related to an intensification of general demand pressures
on available productive resources. Government-mandated increases in
costs and special developments in the agricultural and international
sectors contributed substantially to the pick-up in inflation during
1978.
Inflation moderated during the first stages of the cyclical
recovery in 1975 and 1976. The earlier extraordinary pressures associated with the rise in oil prices, the sharp escalation in food
prices, a worldwide boom in other commodities, and domestic price
decontrol subsided, and the considerable slack in labor and product
markets restrained wages and prices. Inflation began to speed up
again in 1977, however, and prices then surged in 1978. The Consumer
Price Index, the Producer Price Index, and the fixed-weight price
index for gross business product all registered increases of around
9 percent during 1978, about 2 percentage points more than in the
preceding year.
The acceleration of inflation
last year reflected impor-
tantly the pressure of rising labor costs. Wage rates in the private
nonfarm sector increased
8-1/4
percent, compared with about 7-1/2
percent in each of the preceding two years.
35
A boost in the Federal
50
minimum wage contributed
appreciably
to
the accelerated rise
of wages; the impact was especially noticeable in the trade sector,
which has the largest concentration of lower-wage workers and saw
average wage increases of more than 9 percent last year.
Hourly compensation, which includes, in addition to wages,
the costs to employers of social insurance contributions and of
privately negotiated fringe benefits, rose 9-3/4 percent—about 2
percentage points faster than in 1977.
acceleration resulted
from increased
About one-quarter of the
Social Security taxes and
unemployment insurance contributions. In addition, private fringe
benefits continued to rise faster than wages.
Given
the weak performance of labor productivity, the
larger compensation gains were translated into rapid increases in
unit labor costs.
Unit labor costs in the nonfarm business sector
rose 9 percent during 1978 versus 6-1/3 percent in 1977.
As 1979
began, labor costs again were given an upward jolt by further increases
in the minimum wage and Social Security taxes.
Apart from the broad pressures exerted by rising unit
labor costs, the general level of prices was affected considerably
in 1978 by developments in the farm and food sector.
Retail food
prices rose 12 percent over the year—the largest increase since
1974.
The increases at the retail level reflected a rise of almost
20 percent in farm prices during 1978 following little change in
the preceding year.
Meat price increases were particularly rapid,
as beef production continued to decline.
36
51
UNIT COST INDICATORS
Change from year earlier,
annual rate, percent
Nonfarm Business Sector
Compensation per Hour
10
—
4
12
I
I
1975
1976
I
1977
37
1978
52
LABOR COSTS AND
PRICES
Change from year earlier,
annual rate, percent
—115
Nonfarm Unit Labor Costs
10
GNP Prices
Excluding Food and Energy
10
20
Energy
10
12
Total Prices
I
I
1975
1976
1977
38
1978
53
The decline in the foreign exchange value of the dollar
also aggravated inflation.
Aside from the direct impact of higher
prices for imported merchandise, the price-restraining pressure of
foreign competition was weakened for many domestic products. Large
price increases for domestically produced automobiles and other durable goods reflected both of these effects. The inflationary pressures associated with the steep depreciation of the dollar that
began in September 1977 appear to have accounted for about 1 percentage point of last year's rise in the Consumer Price Index.
At the producer level, the inflation of prices of capital
equipment accelerated considerably less than that for consumer finished goods. But crude materials prices, for both food and nonfood
items, increased sharply, and prices for construction materials also
rose rapidly. In the first month of this year the continuing strength
of inflationary
forces was demonstrated by a 1.3 percent jump in
the Producer Price Index; although consumer foods posted an especially
large increase, all of the major groupings of finished goods and
materials showed accelerated advances.
39
54
Section 8. Financial Markets
Interest Rates
Interest rates generally declined during the early part
of the current economic expansion. This departure from usual cyclical patterns probably was attributable in part to a diminution of
inflation expectations associated with the observed slowing in the
advance of prices and to the limited credit needs of businesses which
were pursuing cautious capital spending policies.
Interest rates
began to move upward in the Spring of 1977, however, as the Federal
Reserve acted to restrain accelerating growth in money and credit.
Over the course of 1977, yields on short-term market instruments
generally rose about 2 percentage points, while corporate and Treasury
bond yields increased around 3/4 percentage point.
With inflation picking
up, the margin of unutilized
resources narrowing, and the dollar under downward pressure in foreign
exchange markets, the Federal Reserve applied increasing restraint
to the expansion of money and credit in 1978.
This was reflected
in further increases of 3 to 4 percentage points in most shortterm rates over the course of the year.
short rates and heightened inflation
The combination of rising
expectations
resulted in
increases of roughly 1 percentage point in bond yields. By year-end,
a number of interest rates were near or above the peak levels of 1974.
Monetary Aggregates
The monetary aggregates have exhibited some unusual patterns of behavior during the past several years.
This has been
especially true with respect to the narrow money stock, M-l. During
40
55
INTEREST RATES
SHORT-TERM
4-6 Month Prime
Commerical Paper
1972
1976
1974
1978
LONG-TERM
Percent
11
Home Mortgage
Interest Rate
1972
1974
1976
41
1978
56
1975 and 1976, growth in M-l averaged just over 5 percent per annum.
Given the concurrent decline in interest rates, the sizable increases
in M-l velocity—that is, the ratio of GNP to M-l—were much larger
than would have been predicted on the basis of previous historical
relationships among money, income, and interest rates.
The moderation of the public's demand for M-l may have
reflected to a degree an unusually strong cyclical swing in confidence
and increased willingness to spend out of existing cash balances
as the economy recovered from a severe recession.
However, there
is also considerable evidence that other factors played an important
role.
The unprecedentedly high level reached by interest rates
in 1974 stimulated the creation and adoption of new cash management
techniques that permitted individuals and businesses to economize
on nonearning demand deposits. This development apparently continued
to exert a significant influence even after interest rates turned
downward, and it was reinforced by several important legislative and
regulatory developments and innovations affecting the payments system. These included the authorization of NOW accounts in all of
New England, of savings accounts for businesses and governmental
units, and of preauthorized third party and telephone transfer privileges for personal savings accounts.
By the beginning of 1977, the level of M-l was well below
that predicted by most standard econometric models of the demand for
money.
This downward shift in money demand abated in early 1977,
however, and growth of M-l generally conformed to historical patterns
until the final months of 1978.
42
M-l expanded 8 percent during
57
1977 and at about the same pace over the first three quarters of
1978; rising interest rates and slowing economic expansion worked
to moderate M-l growth over this span, but these influences were
offset by the effect of accelerating inflation on transactions requirements.
On a quarterly
average
basis M-l growth in the fourth
quarter of 1978 was at a 4.4 percent annual rate, but the average
level of the money stock in January was slightly below that for
October.
A portion of this weakness is the direct consequence of
the introduction of automatic transfer services (ATS) last November
1; many individuals have shifted their transactions balances
from
checking accounts to savings accounts from which funds are automatically transferred to cover checks. These shifts appear to have reduced
M-l growth rates by roughly 3 percentage points per month, on average.
Even after allowance for this, however, growth in M-l has been weaker
than might have been expected in light of the recent expansion of
income
and
spending.
It
may
be
that, as in 1974,
interest
rates have reached a high threshold level at which households and
businesses are induced to seek out and adopt cash management techniques
that permit major economies in demand deposit holdings. The advent
of ATS—which occasioned basic changes in the checking account pricing
policies of many
banks—undoubtedly
has caused many individuals
to assess more carefully the opportunity costs of holding noninterestearning demand deposit balances as compared not only with ATS accounts
but also with other highly liquid interest-earning assets.
43
58
MONEY SUPPLY GROWTH
M-1
Change from previous period, annual rate, percent
12
1975
i mm
i l il l l il i
1976
1977
1978
M-2
12
I •III I
1976 1977
1975
1978
M-3
12
I
1975
I
1976 1977
44
Illillllll
I
1978
59
The behavior of the interest-bearing components of the
broader monetary aggregates—M-2 and M-3—was generally in line
with historical patterns during the first three years of the economic
upswing, but there has been a marked deviation since last June.
Commercial banks and thrift institutions experienced rapid growth
of savings and small denomination time deposits until the latter
part of 1977. At that point a gap began to develop between interest
rates on short- and intermediate-term market securities and the
rates permitted on insured deposits by Federal regulations. As the
gap grew, inflows to savings and small time accounts gradually diminished through the spring of 1978. Commercial banks found it necessary
to rely more heavily during this period on large time deposits
and other managed liabilities to fund their lending activities, and
savings and loan associations borrowed heavily from Federal Home
Loan Banks.
To prevent a repetition of past episodes when markedly
reduced deposit inflows led to an abrupt curtailment
of credit
to home buyers and others reliant on the depositary institutions
for credit, the Federal regulatory agencies authorized two new time
deposit categories effective June 1.
One was an 8-year account
paying up to 7-3/4 percent at commercial banks and 8 percent at
thrift institutions. The other was a 6-month "money market certificate" (MMC) whose maximum rate varies weekly with the average
yield on newly issued 6-month Treasury bills. Given rate relationships , the 8-year certificate has not added significantly to over-all
45
60
OUTSTANDING BALANCES OF
MONEY MARKET CERTIFICATES
— 10
July
August
September
October
November
December
January
February
Chang* from previous period,
annual rate, percent
DEPOSIT GROWTH AT THRIFT INSTITUTIONS
20
1975
1976
1977
46
1978
61
deposit flows, but quite the contrary is true of the MMCs. During
the first 5 months of 1978, time and savings deposits subject to
rate ceilings at commercial banks, savings and loan associations,
and mutual banks grew at a 7.9 percent annual rate; since the beginning
of June, these deposits have grown at a 10.3 percent rate despite
substantial further increases in market interest rates. MMC balances
at the end of January totaled about $105 billion and accounted
for 7-3/4 percent of savings and small time deposits at banks and
almost 13 percent at thrift institutions.
The MMCs have greatly reduced the sensitivity of time
and savings deposit growth to changes in market interest rates,
but they have not eliminated it.
Indeed, inflows have moderated
during the past few months, at least partly in response to the
substantial further rise in interest rates. Increased noncompetitive
tenders in auctions of Treasury securities and record growth of
money market mutual funds are indications that recent interest rate
levels have been inducing some diversion of funds from savings
and small time accounts subject to fixed rate ceilings.
Credit Flows
Although accelerating inflation has tended to dampen the
impact of rising nominal interest rates on credit demands, there has
been a perceptible flattening of the over-all pace of borrowing in the
economy over the past year. Total funds raised in credit markets by the
private domestic nonfinancial sectors have expanded only moderately
47
62
FUNDS RAISED BY DOMESTIC
NONFINANCIAL SECTORS
Billions of dollars
400
Total
300
Private
200
Federal
Government
100
1975
1976
1977
48
1978
63
since the second half of 1977
after having
the earlier part of the economic expansion.
risen rapidly during
Although the liquidity
of depositary institutions has declined over the past two years, the
introduction of the MMC has prevented the disintennediation that
accompanied previous interest rate cycles and permitted banks and
thrift institutions to continue to account for a very .large share
of the funds advanced to ultimate borrowers.
Households, in particular, are heavily reliant on depositary institutions for credit, and their demands for funds have remained
strong.
Home mortgage borrowing in 1978 was slightly larger than
in 1977, and consumer instalment borrowing rose to a new record as
households financed purchases of autos and other large ticket items.
The aggregate flow of credit to households in 1978, at more than
$160 billion, was 15 percent greater than in 1977 and three times
the volume recorded in 1975.
The build-up of indebtedness by households over the last
three years has outstripped both the growth of this sector's financial
asset holdings and of disposable income. Repayment burdens have reached
record proportions.
Although loan delinquency data indicate that
families have not as yet encountered significant difficulty in meeting
their obligations for debt service, the diminished liquidity of household financial positions suggests a greater fragility and vulnerability to any deterioration of income flows.
The nonfinancial
business sector also experienced
decline in liquidity in the past year.
capital
spending and internal cash
49
some
The gap between corporate
flow widened, and
firms met
64
HOUSEHOLD DEBT REPAYMENTS RELATIVE
TO DISPOSABLE PERSONAL INCOME
Percent
23
22
21
20
1975
1976
1977
1978
NONFINANCIAL CORPORATIONS
Balance Sheet Ratio
Percent
Liquid Assets to
Short-Term Liabilities
34
30
26
1975
1976
1977
50
1978
65
a substantial portion of their external financing needs through shortterm borrowings—particularly from commercial banks. While commercial
mortgage borrowing increased and private bond placements remained
large, many of the big, highly rated industrial firms that have ready
access to the public bond markets evidently preferred to defer long-term
financings in the expectation that long-term rates would eventually
decline.
As a consequence, the aggregate ratio of liquid assets to
short-term liabilities in the nonfinancial corporate sector declined
over the course of 1978, to a level only slightly above the 1974
low.
State and local borrowing was about the same in 1978 as in
1977.
Advance refundings again accounted for a sizable share of tax-
exempt bond issuance, but such operations virtually ceased after August
owing to the combination of restrictive IRS regulations and rising
interest rates. Despite some rise in the past few months, the ratio
of yields on municipal bonds to those on taxable obligations has
remained relatively low by historical standards, reflecting in part
the continued demand for tax-exempt securities by casualty insurance
companies, commercial banks, and individuals.
Borrowing by the U.S. Treasury has declined over the past
year, reflecting the diminution of the Federal budget deficit. Government borrowing from the public totaled $59 billion in FY 1978, but
is projected by the Administration at about $40 billion in the current
fiscal year. The preponderance of the increase in outstanding Treasury
debt during 1978 was absorbed by State and local governments, which
purchased a large volume of nonmarketable Treasury securities with
51
66
proceeds of advance refundings, and by foreign official institutions,
which invested dollars obtained in exchange market intervention.
Commercial banks satisfied a substantial proportion of the
credit demands of households, businesses, and State and local governments during 1978. Total bank credit expanded 10.9 percent over the
course of the year, with loan portfolios increasing by 14.6 percent.
To meet loan demands many banks had to liquidate holdings of Treasury
securities and to borrow either from correspondents or in the open
market through the issuance of large CDs or nondeposit liabilities
such as Federal funds and repurchase agreements. Aggregate bank liquidity ratios declined appreciably, especially among the smaller and
regional institutions that have experienced the strongest business
loan growth during this expansion.
Thrift
institutions experienced
pressure during the
considerable cash
flow
first half of 1978, but they have been able
to rebuild their liquid asset positions since the MMCs began to
bolster deposit growth.
Thrift institution mortgage lending declined
moderately during 1978, although there was some upturn in the final
quarter in lagged reaction to the midyear pick-up in deposit inflows.
Outstanding loan commitments also rose during the second half, but
in December were slightly below the year-earlier level.
Life insurance companies and pension funds have continued
to experience
large inflows of investable funds.
In 1978, as in
previous years of the economic expansion, these institutions absorbed
52
67
the bulk of the net issuance of corporate bonds.
The insurance
companies also have supplied a large share of commercial mortgage
credit *
53
68
CHAPTER 2
"the objectives and plans of the Board of Governors and the
Federal Op'en Market Committee with respect to the ranges of
growth or diminution of the monetary and credit aggregates
for the calendar year during which the report is transmitted,
taking account of past and prospective developments in employment, unemployment, production, investment, real income, productivity, international trade and payments, and prices"
Section 108(a) Full Employment and
Balanced Growth Act of 1978
69
Section 1.
The Objective of Monetary Policy in 1979
The objective of the Federal Reserve is to foster financial
conditions conducive to a continued, but more moderate, economic
expansion during
1979 that should permit a gradual winding down
of inflation and the maintenance of the stronger position of the
dollar in international exchange markets.
Given the limited margin
of unutilized labor and industrial resources remaining in the economy,
it is critically important to avoid strong aggregate demand pressures
that would aggravate our already serious inflation problem.
At the
same time, the current condition of general balance in the economy
suggests that it should be possible to continue restraint to relieve
inflationary pressures without triggering a recession.
54
70
Section 2. Growth of Money and Credit in 1979
The Federal Open Market Committee has selected growth ranges
for the monetary aggregates that it believes will bring to bear an
appropriate degree of restraint in light of current outlook for fiscal
policy and the underlying strength of private demand in the economy.
Over the year ending with the fourth quarter of 1979, M-l is expected
to grow between 1-1/2 and 4-1/2 percent; M-2, 5 to 8 percent; and
M-3, 6 to 9 percent.
Commercial bank credit has been projected to
increase between 7-1/2 and 10-1/2 percent during the year.
The growth range for M-l calls for a marked deceleration
from the pace of recent years.
This reflects in part an expectation
that the shifting of funds to savings accounts with automatic transfer
facilities and to the NOW accounts recently authorized in New York
State will continue to depress the growth of demand deposits throughout
1979.
The Board*s staff has projected that such shifting will damp
growth in M-l this year by around 3 percentage points. Because there
has been only a brief period of experience upon which to base an
analysis of the attractiveness of the ATS accounts, this projection
carries a broad range of uncertainty.
The unexplained
flatness of M-l in recent months intro-
duced another uncertainty in the FOMC's deliberations regarding the
monetary growth ranges.
At this stage it is impossible to tell
whether the weakness of M-l relative to what would have been expected
on the basis of historical relationships among money, income, and
interest rates is a transitory phenonenon or one that is likely
to persist for some time.
The range for M-l assumes that the recent
55
71
weakness does in some degree reflect a change in the public's desired
allocation of funds among various financial assets that may persist
for some time ahead, though not so strongly as in recent months.
The breadth of the specified growth range for M-l recognizes
the considerable uncertainties that currently exist.
As subsequent
information begins to resolve those uncertainties, the range may be
adjusted. In the meantime, M-l may continue to be a somewhat ambiguous
indicator of monetary policy, and it will be especially important
to monitor carefully the behavior of other financial variables.
It may be noted that the Federal Reserve is studying possible redefinitions of the monetary aggregates. Among the proposals
made in a staff paper published for public comment in the January
Federal Reserve Bulletin is that M-l be redefined to encompass ATS,
NOW, and other similar transactional accounts.
While such a redefi-
nition would not eliminate the need to understand the behavior of
the various financial assets, it might produce an aggregate that is
more reflective of the public's need for transactions balances in
light of ongoing institutional changes.
The behavior of M-l was not the only puzzling development
confronting the FOMC early this month as it considered the appropriate ranges for monetary growth during 1979. There were questions
as well regarding the movements of the interest-bearing components
of the broader aggregates—especially the time and savings deposits
at commercial banks that, along with M-l, constitute M-2. Bank savings
56
72
deposits have declined appreciably in the past few months, despite
the influx of funds to ATS savings accounts. While savings deposit
inflows might be expected to exhibit weakness when market interest
rates are so far above regulatory ceilings, a large gap had existed
for a considerable time and it might have been expected that most
of the interest-sensitive funds had already moved into other instruments.
It is possible, however,
deposits—the recent
that—as perhaps with
demand
further sharp increase in interest rates to
historically high levels has prompted many people to seek out more
aggressively
alternative assets carrying market
yields. The M-2
range adopted by the FOMC reflects an expectation that growth of
the interest-bearing
component
will be somewhat stronger in the
months ahead, buttressed by further sizable increases in the large
denomination time deposits included in the total and abatement of
the recent unusually large withdrawals of funds from savings deposits.
The range for M-3 implies a continued substantial growth
of deposits at nonbank thrift institutions.
The money market certi-
ficates have proven a reliable source of funds. While some institutions
have reduced their promotion of MMCs, the certificates have continued
to be widely offered at ceiling rates—although there has been some
erosion of thrift institution earnings since mid-1978 as these relatively high
cost deposits have taken a growing share of thrift
institution liabilities.
The projected range for bank credit expansion reflects an
expectation that loan demands will be less intense in 1979 than in
1978, in line with the prospective more moderate growth of economic
57
73
activity.
Banks likely will have to continue relying heavily on
large time deposits and other money market liabilities to fund asset
growth, and this implies some further decline in traditional measures
of institutional liquidity.
58
74
Billions of dollars
M-1
360
-Actual
-Adopted Range
340
1978Q4-1979Q4
320
300
1975
1976
1977
59
1978
75
M-2
Actual
Adopted Range
1978Q4-1979Q4
— 70C
1975
1976
1977
60
1978
1979
76
of dollars
1700
-Actual
-Adopted Range
1400
1978Q4-1979Q4
1000
1975
1976
1977
61
1978
1979
77
Billion* of dollars
TI100
BANK CREDIT
10Vi%
• 1000
- Actual
-Adopted Range
1978Q4-1979Q4
900
800
1975
1976
1977
62
1978
1979
78
Section 3.
The Economic Outlook
Despite the surge in real GNP during
it appears that underlying economic
lead to a moderation
of economic
the fourth quarter,
and financial conditions will
growth
in the year ahead.
The
absence of the sorts of distortions and imbalances that have often
precipitated economic downturns in the past indicates that it should
be possible to slow the pace of expansion—and thereby relieve inflationary pressures—without prompting a recession.
However, any fur-
ther acceleration of inflation or the occurrence of severe shortages
of critical commodities, such as oil, would
imperil this dutcome.
The monetary restraint applied over the past year by the
Federal Reserve
is expected increasingly to affect the residential
construction sector.
Higher costs of credit will cause land developers
and builders to put aside marginally
combination of
higher
profitable projects, and the
house prices and
some families to defer home purchase.
mortgage rates will lead
Nonetheless, owing to the MMCs
and various institutional developments that have broadened the sources
of mortgage
shelter,
funds, as well as to the strong underlying
the
decline
in housing
activity
demand for
should be moderate by
comparison with past cycles.
Business
fixed
investment
likely will continue
during 1979, but at a slower rate than in 1978.
indication
to grow
There has been some
in the past few months of a slowing in the steep upward
trend of contracts
and
orders
for plant and equipment, and this
is generally consistent with surveys of capital spending plans which
63
79
REAL NEW ORDERS
REAL CONSTRUCTION
Billions of dollars
Nondefense Capital Goods
CONTRACTS
Billions of dollars
3-Month Moving Average
3.0
2.5
2.0
1.5
I
1976
I
1977
1978
PLANT AND EQUIPMENT
EXPENDITURES
1976
I
1977
1978
Change from previous period, annual rate, per cent
15
[projected*]
10
Nominal
1976
1977
1978
* Department of Commerce Survey of Anticipated Plant and Equipment Expenditures, December, 1978.
1979
80
point to smaller gains in outlays this year than last.
On the other
hand, the climate for investment can be expected to improve as business managers begin to perceive some progress in retarding inflation
and become more confident about the sustainability of expansion.
Government spending probably will post only a small increase
in real terms this year.
Indeed, real Federal purchases could decline
during the first half due partly to expected repayments of Commodity
Credit Corporation loans (which are, in effect, sales of agricultural
stocks).
financial
At the State and local level, slower
aid and the pressure
growth of Federal
for tax relief will
tend to hold
spending increases to small proportions.
Foreign demand for U.S. exports should tend to strengthen
during
1979.
Economic
expansion abroad
is generally
expected to
continue at its recent more rapid pace, and the effects of the substantial depreciation
of the
dollar
on
the
U.S.
trade position
should become more evident as the year progresses.
On balance, the aforementioned sectors are likely to provide a reduced impetus to income growth during
a consequence, consumer
spending
the year ahead.
As
is likely to grow less vigorously.
Moreover, the substantial debt repayment burdens faced by many households and generally reduced liquidity of the household sector could
prompt households
rate.
to increase their recent
relatively low savings
The demand for imports also should moderate this year, not
only because of the slower expansion of domestic income and
produc-
tion, but also because of the lagged effects of the 1977-1978 decline
65
81
GROWTH OF FEDERAL OUTLAYS
Percent
Fiscal Years
20
15
10
Percent
GROWTH OF FEDERAL RECEIPTS
Fiscal Years
20
15
FEDERAL DEFICIT
Billions of doli&rc
— 1C
— 30
50
I
1975
I
1976 1977 1978 1979 1980
Fiscal Years
Note: Projections for 1979 and 1980 are from The Budget of the U.S. Government.
66
82
in the international exchange value of the dollar.
Inventory invest-
ment is likely to be relatively flat in the projected economic environment .
With a slower growth of activity, pressures on productive
capacity should ease a bit. Industrial capacity utilization rates,
which in the manufacturing sector are not now far below past cyclical
peaks, should decline slightly.
In labor markets, the growth of
employment should moderate from its recent rapid pace.
Labor force
increases likely also will diminish, as the growth of the working
age population slows slightly and as labor force participation rates—
especially for youth—respond to the slackening in economic expansion. Together, the prospective changes in employment and the labor
force point to a small increase in the over-all unemployment
rate
during 1979.
The moderation of demand pressures in labor and product
markets will tend to slow the advance of wages and prices and thus
to reduce
the present, unacceptable rate of inflation.
However,
uncertainties will remain as a result of highly volatile and largely
exogenous influences such as farm prices and oil prices.
It now
appears that food prices will increase somewhat less this year than
last. Unfortunately, the price of imported oil will be boosted substantially this year as a result of the decisions taken by OPEC in
December, and the unsettled situation in Iran raises the possibility
of even larger price increases.
Setting aside these special factors, a key determinant of
the rate of inflation this year will be the performance of unit labor
67
83
costs.
Although there may well be some improvement in productivity
in the next few years as the work force tends to become, on average,
somewhat older and more experienced, there is little reason to expect
any marked acceleration of productivity growth during 1979.
quently, if
there is
to
be a noticeable slowing
Conse-
in the rise of
unit labor costs, compensation gains will have to moderate significantly.
Toward this end, the
Administration's wage-price program
can play an important role. By providing a standard for constructive
behavior on the parts of both business and labor, the program can
be a vehicle
compliance
for helping to brake the wage-price
spiral.
Broad
with the Administration's standards would make a signi-
ficant contribution to the slowing of
inflation. * Of course,
the
wage-price program can be successful only if there is complementary
restraint in monetary and fiscal policy—to contain aggregate demand
pressures
and to assure
the public of the Government's commitment
to the restoration of price stability.
68
84
CHAPTER 3
"the relationship of the [Federal Reserve's] objectives
and plans to the short-term goals set forth in the most
recent Economic Report of the President11
Section 108(a) Full Employment and
Balanced Growth Act of 1978
85
Section 1. The Short-Term Goals in the
Economic Report of the President
As specified by the Full Employment and Balanced Growth Act,
the President' s Economic Report, transmitted to the Congress last month,
lays out a detailed set of economic goals for 1979 and 1980.
The
discussion of the Act's requirements points out that the Administration's "short-term goals for [1979] and 1980 represent a forecast
of how the economy will respond over the next 2 years not only to
the budgetary policies proposed by the President for fiscal 1979 and
I/
1980 but to the anti-inflation program announced on October 24."
The Administration's goals, along with the comparable figures
for 1978, are summarized in the following table:
ftie President's Economic Goals
Item
1978
1979
1980
Level, fourth quarter
Employment (millions)
95.6
97.5
99.5
5.8
6.2
6.2
Unemployment rate (percent)
Percentage change, fourth quarter
to fourth quarter
Consumer prices
8.9
7.5
6.4
Real GNP
4.3
2.2
3.2
Real disposable income
3.3
2.8
2.3
Productivity
0.2
0.4
1.1
I/ Economic Report of the President, p. 108.
69
86
Section 2. The Relationship of the Federal Reserve's
Monetary Growth Ranges to the Short-Term Goals in
The Economic Report
The Full Employment and Balanced Growth Act directs the
Federal Reserve to assess the relationship of its plans for monetary
growth to the short-term goals in the Economic Report.
This task is
complicated by the fact that goals are specified for a variety of
economic variables, and monetary policy does not affect each of them
separately.
Monetary policy has its most direct short-term impact
on aggregate nominal GNP. Within the context of a particular nominal
GNP outcome,
the mix of real output gains and inflation, the growth
of employment, and the movements
importantly
in other variables are influenced
by conditions at the beginning of the period, by other
governmental policies, by the structural and behavioral relationships
in the economy,
and by developments outside the domestic economy.
As required by the Full Employment and Balanced Growth Act,
the Federal Reserve at this time has established ranges for monetary
growth through the end of 1979.
It will reassess these and report
preliminary ranges for 1980 in July, unless developments in the months
ahead necessitate earlier reconsideration.
At this juncture, the
monetary growth ranges and the Administration's 1979 economic goals
appear reasonably consistent.
The Administration's forecast implies
an expansion in nominal GNP of around 9-3/4 percent from the fourth
quarter of 1978 to the fourth quarter of 1979.
FOMC's
growth
range
for
M-l is
The midpoint of the
about 6 percent after adjustment
for the expected impact of shifts of funds to ATS and NOW accounts.
70
87
This suggests an increase of M-l velocity on the order of 3-1/2 percent,
a figure somewhat above the longer-term trend, but reasonable in light
of the lagged effects of the recent substantial increases in interest
rates and the downward shift in money demand that has been occurring.
The upper and lower boundaries
of the M-l range, of course, allow
for the possibility of smaller or faster increases in velocity over
the year.
The output-price mix in the Administration's 1979 forecast
apr^ irs attainable if there is reasonable compliance with the wage-price
standards and as long as there are no untoward
unanticipated
productivity
surge in food or energy prices.
forecasts appear consistent
shocks such as an
The employment
and
with the output goal, and
the unemployment rate forecast seems consistent with reasonable assumptions about labor force growth in the projected economic environment.
Considerably greater uncertainties naturally are encountered
with respect to the Administration's goals for 1980, a period that is
still rather distant. Nothing in the monetary or economic projections
for 1979
suggests to us that conditions prevailing at yearend will
bar the achievement of the Administration's forecasted 9-1/2 percent
growth
in
nominal GNP during
1980.
At this time, however,
achievement of the output-price mix projected for 1980
the
appears to
be more difficult.
The Administration has
forecast a marked
acceleration of
real GNP growth in 1980 and a marked deceleration of inflation.
Such
an outcome is certainly attainable, but given the projected levels
71
of resource utilization—with the unemployment rate remaining around
6-1/4 percent—this result will require considerable progress in the
lowering of inflation expectations.
There will have to be broad
conformance to the Administration's wage-price standards, and Government will have to give careful attention to the potential cost-raising
impacts of its regulatory and legislative actions. Continued budgetary
restraint also will be necessary, both to build confidence in the
Government's commitment to avoid fiscal excesses and to minimize pressures on the capital markets.
Recognizing the risks and uncertainties that currently exist,
the Administration's 1980 forecast can serve as an appropriate goal
for Congress as it considers its budgetary plan for fiscal 1980.
If inflationary pressures subsequently should prove stronger than the
Administration has projected, then the prudent course for Government
policy would be to exercise a substantial degree of restraint even if
it risks less real growth in 1980 than the 3.2 percent goal.
Such
a policy would lay the foundation for balanced economic growth over
the years to come and help to maintain the integrity of the dollar.
72
89
The CHAIRMAN. Thank you, Mr. Miller, for an admirable report.
We will now examine under the- 5-minute rule.
My first question concerns your discussion of the money supply in
terms of the domestic (aggregates. What are the potential consequences
on monetary policy of massive shifts into this country of some of the
$700 billion floating around Europe and the Caribbean? What does
the Federal Reserve do to monitor this, and what would it do to offset
the inflationary effects of large-scale redeployments of dollars domestically?
Mr. MILLER. Mr. Chairman, should there be a large shift from those
markets into domestic markets, the Federal Reserve would respond
through the open market by absorbing excess resources and endeavoring to maintain the growth rates that we have indicated in our objectives for the yeiar.
I would expect that if there is a shift of dollars into this country,
that that would be advantageous to us long term.
As you know, the Eurodollar market generally represents deposits
in the form of CD's. If that money should shift here, it would really
not have an effect on Mj or M2 as much as it would involve some bank
credit; we certainly would have to take countermeasures.
The CHAIRMAN. You say you would endeavor to sop up the shift by
open market policy. Would not the possibility of using your reserve
power, assuming you are left with one, also be useful ? Mr. MILLER. It could well be.
The CHAIRMAN. If there were really a massive shift?
Mr. MILLER. I think we could well have to look at reserve policy, as
well as at the open market.
[Subsequent to the above colloquy, the following correspondence
was exchanged between Congressman Ron Paul and Chairman G. William Miller:]
90
CongresK of tlje ttlmteb
of £eprc$£ntattoe
ltutfjtnflton, 23.C. 20515
February 22, 1979
Mr. William E. Miller
Chairman, Federal Reserve Board
of Governors
Federal Reserve System
Twentieth Street and Constitution
Avenue, N.W.
Washington, D.C. 20551
Dear Chairman Miller:
For the record, would you answer one question raised by your testimony
before the House Banking Committee on Wednesday, February 21?
In your reply to Chairman Reuss's question about the $700 billion
Eurodollar market, you first stated that if substantial numbers of
Eurodollars were to enter the United States, the Fed would act through
the Open Market Committee to "sop up" the excess dollars. Then, after some
hesitation, you replied further that such an inflow of dollars would be
"advantageous" to us. Would you clarify your answer?
Thank you very much for your cooperation.
Sincerely,
Ron Paul, M.C.
91
BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 2Q55I
C. W I L L I A M MILLER
March 9, 1979
The Honorable Ron Paul
House of Representatives
Washington, D.C. 20515
Dear Mr. Paul:
Thanks for your recent request for further elaboration
of my reply to Chairman Reuss1 question on February 21 about the
potential consequences for monetary policy of shifts into the
United States of deposits now held in the Euro-dollar market.
A shift of deposits from the Euro-dollar market to the
domestic offices of U.S. banks would probably take the form of an
increase in large certificates of deposit issued by U.S. banks and
would probably be accompanied by a corresponding shift on the asset
side of banks' balance sheets. Such shifts could lead to conflicting
signals regarding the appropriate stance of U.S. monetary policy.
These signals would have to be assessed carefully. The Federal
Reserve's response would, of course, depend on the rate of inflation, the level of economic activity, and the conditions of
financial markets at the time the shifts occurred.
If these shifts led to inappropriate increases in the
rates of growth of the monetary aggregates or bank credit, the
Federal Reserve would take action to offset these effects. For
example, loans booked at domestic banks would tend to increase as
a consequence of a shift of Euro-dollar deposits to U.S. banks while
Euro-dollar loans booked at banks abroad would decrease. The total
amount of dollar loans would remain roughly unchanged. The need
for action by the Federal Reserve under such circumstances would
depend, in part, on the proportion of the total that consisted of
loans to domestic residents.
Turning to the more clearly advantageous aspects of any
such hypothetical shift of Euro-dollar deposits to banks in the
United States, several advantages might be involved. First, to
92
the extent that the shift would contribute to reduce concern over
Euro-currency markets, that would be helpful. Second, such a shift
would also be advantageous because it would lead to some improvement
in the information available to the Federal Reserve and thereby make
possible a more accurate assessment of financial developments
affecting the U.S. economy. Data on the assets and liabilities of
banks in the U.S. are more detailed and are collected more frequently
than comparable data on the assets and liabilities of banks operating
in the Euro-currency markets. Third, a shift of Euro-dollar deposits
to banks in the United States might lead to some appreciation of the
dollar; at a time of weakness for the dollar such an appreciation
would be an advantage.
I hope you find these further comments for the record
helpful.
Sincerely,
98
The CHAIRMAN. Further, in the international field, what assumption about the foreign exchange value of the dollar and the extent of
Federal intervention support was incorporated in your forecast for
monetary expansion given us here today ?
That is to say the exchange value of the dollar has a lot to do with
inflation and the balance of payments.
Mr. MILLER. In view of the relative stability of the dollar since November 1, and in view of the expected substantial improvement in the
trade and in the current account balances, the assumption for this
purpose is that the dollar will stay at the present level. If our position improves, as most of us expect, you could see some slight appreciation of the dollar, but for the purposes of this analysis, we have assumed
a stable dollar over this period.
The CHAIRMAN. Turning to the domestic scene, in your testimony
today and particularly in your testimony on January 30, before the
Joint Economic Committee, you dealt with the problem of structural
unemployment.
Am I right in inferring from what you have testified in the last few
weeks before the Congress, that any Congressman who, consistent with
the overall budgetary target containing the deficit at a figure of $29
billion, or even better than that, who can find funds elsewhere in the
budget to switch to a targeted program of combatting structural unemployment, would have your blessing?
Mr. MILLER. Very much so. I think the place in the budget that
needs to be protected is that area which is, in terms of the size of the
budget, relatively small, but extremely important: those funds flowing
to skill development, to aid to the transition of young people to the
world of work.
I would hope that Congress will not in any way impair those funds.
I think they need to be preserved. If anything, those programs need
to be strengthened and made more effective.
The CHAIRMAN. I trust nobody would impair them, but I wanted
you to talk about specifically adding to the funds. I take it that your
testimony here is that to the extent that that can be done without impairing the overall budgetary objective, you would view that as
favorable?
Mr. MILLER. Mr. Chairman, there is one pending supplemental request. As I understand it, there is an appropriation of $400 million to
fund a private sector initiative that would expand the work of the
local business-industry-community-labor councils, to target in on individuals in the community who are hard to employ and to get activity
at the grass roots—where it just isn't a broad brush, but deals with
identified individuals with needed skills and needed opportunities.
I hope Congress will act favorably upon that request. The program
was authorized in the last Congress, but the appropriation was not
completed; I hope that can be done.
The CHAIRMAN. That is a highly desirable supplement, I believe,
to the fiscal 1979 budget. Just to make sure of your testimony, let me
review a point with reference to the fiscal year 1980 budget. Your
testimony is that you would applaud efforts, consistent with the budgetary projections, with which you do not quarrel, to find other sources
of funds for an expansion of the attack on structural unemployment
94
over and above that produced by the present 1980 budget. Is that
correct?
Mr. MILLER. Absolutely.
The CHAIRMAN. Thank you very much.
Mr. St Germain?
Mr. ST GERMAIN. Thank you, Mr. Chairman.
Chairman Miller, a great many of us, and me, also, are very concerned about the long-term effects of the current high-interest rate
structure that we are facing.
Frankly, I question whether the economy or an individual consumer
can continue to sustain this burden.
Now, when you look at the interest rates for the figures, the national
average is one thing. But when you get down to individual consumers,
the burden becomes very staggering, and in many cases, it becomes
impossible.
Most American consumers, frankly, I don't think, can afford 10,11,
and 12 percent mortgages on their homes, even though it is spread over
30 years.
Does the Federal Reserve have an estimate of the number of home
buyers that are presently priced out of the market under the current
intrest rates?
Mr. MILLER. Mr. St Germain, I couldn't give you such an estimate. I
would say that we will price people out of the market if we continue
to have inflation escalating the price of housing. That is perhaps a
bigger factor in the ability to afford housing than the current interest
rates.
One of the problems with suggesting that we should create conditions
to expand the demand for housing is that it would put so much pressure
on the sources of housing and might drive up prices; that would do far
more damage to those who need shelter.
Housing would be better off by having less swings up and down, by
having more stability. I think that would bring the costs down more
than if we continue to go through the kind of cycles that, as I illustrated in these charts, have been so disruptive in the past.
People could benefit during the period of the trough, because interest
rates were lower. But they couldn't afford to buy houses if they were
uncertain of their futures, uncertain of their jobs; many firms went
bankrupt because of the denial of credit during the 1973-74 period.
Mr. ST GERMAIN. Well, you know, we look at the money market
certificates that are hailed as having accomplished goals, they have
averted disintermediation, and I look at your charts on page 26 on
outstanding money markets.
However, I think that in reality what is happening is consumers
cannot afford the high interest rates on mortgages, and the thrift institutions are not placing these funds where they are traditionally
supposed to be putting them, to wit, in housing, but rather they are
investing those funds in other areas, and as a result thereof, the prime
purpose and the purpose of the thrift institutions is being aborted
so to speak.
I am wondering on the one hand about the interest rate, but on the
other hand, I wonder if the certificates haven't contributed to very high
interest rates. It is one thing to say we are holding housing down to
a more stable level, we are avoiding the swing, but to the family out
95
there that needs a house, you know, do you think that that is the
answer that that family wants ?
And you say you are just going to have to put up with it, we are
trying to avoid the ups and downs in the housing markets, you are just
going to have to stay in your apartment, and double up on the bedrooms, and what have you?
Mr. MILLER. The other choice—denying funds to housing, not building housing—is not acceptable.
You say interest rates are high. Interest rates during the recession
period got down to 9 percent or so. They have gone up 1.5 percent
since then, even though inflation has gone up from 6 to 9 percent. On
every scale that I know of, that means that the interest rate, in real
terms, has gone down. It seems to me that the proof is that families
have been willing to pay those interest rates in order to buy shelter,
and that we have kept housing starts at a 2 million rate. Had we not
authorized money market certificates, in my view, there would have
been disintermediation; there would have been many less houses built.
To say that some families might have gotten a house at a lower mortgage rate is a very doubtful statement; just because you are building
fewer houses doesn't make the interest rate lower.
I will certainly concur with you that recently, and only recently,
there is evidence—and this is indirect, not direct evidence—that some
of the thrifts are not planning to commit the funds they have raised
through money market certificates to mortgages. They are uncertain
of the future; they are investing their funds without making new mortgage commitments because they are not certain what the rate may be
at the time of rollover. They don't want to make long-term commitments. But that is a fairly recent phenomena.
Mr. ST GERMAIN. Excuse me, Mr. Miller. We are also adding
other provisos, for example, "Have you had an account with us for
some period of time?" They are becoming very, very selective.
Mr. MILLER. Isn't this what the market system is about? Isn't that
why we have improved it? We are learning something here that we
ought to apply in a number of other areas; that is, that when the
market is allowed to operate, $105 billion flows into thrifts that otherwise would have been somewhere else. The thrifts are now going to
have to learn to gage how to use those resources, in order to support
their objectives.
It may be that for a temporary period, they will, in fact, be more
cautious and put in nonprice restraints to expansion. These, I would
think, would be consistent with our need to maintain a more moderate
rate of growth of our economy so that we do not unleash higher interest rates and carrying costs for housing in the future even more onerous to our families.
Mr, ST GERMAIN. My time has expired, Mr. Chairman. But I think
it is important that we do not rely on indirect information, but that
we monitor very closely and determine what is happening with these
funds in the thrifts, and whether the thrifts are going to continue
operating or functioning, as is their mandate, in the area of housing,
or are they just going to be investing in mony markets themselves.
Mr. MILLER. I think we will want to keep a close watch on that; I
agree with you.
The CHAIRMAN. Mr. Wylie?
96
Mr. WYLIE. Thank you very much, Mr. Chairman.
Chairman Reuss said we could avoid this if we had a strong membership bill, and that is why the thrift institutions would be in favor of it.
I have used that quote in many speeches before the thrifts.
The last time you were here, Mr. Miller, and this is an oversimplification, but you said that the economy is strong; that no recession
is in sight, and that we have reason to feel very optimistic about the
future.
Do you still feel that way ?
Mr. MILLER. I have said that economic expansions don't just die of
old age; you have to find some malady. It would seem to me that the
economy is well balanced, and the strategy that is being proposed—
that of slackening the rate of growth of the economy and keeping it in
a balanced condition—gives us the probability of continuing our progress without a recession during 1979.
I cannot predict what will happen in future years, because that depends not only on how successful we are with the current strategy,
but on unknowns, such as crop production, weather, international
events, dislocations in oil supply, and so forth.
But generally, I have, I hope, not been either optimistic nor pessimistic, but realistic in saying, "Let us look at the data, let us look at
the condition of personal income, housing, business investment, and
inventories, and assess other conditions."
As I see it, we have a very well-balanced economy with no really
significant overextension or underutilization, so the prospects are good
for reaching the general goals that have been set in the President's
economic plan; that is, lower growth rates but for a more sustained
period of time, using that more moderate growth as the way to work
off inflation.
Mr. WYLIE. The reason I asked the question is because I liked the
statement before our committee 2 days later, although it was a disconcerting statement to me. Dr. Everett appeared before the Budget
Committee, and she was not very optimistic. She said if interest rates
don't come down, we are ver^ likely to be in a recessionary period by
next year. I think that is a fair appraisal or analysis of what she said.
And a question which recurs in my mail, and I know this is not on
the high level that we have been talking about, but it is a very common
question among constituents of mine, is there anything we can do to
bring interest rates down, or is there anything that you can do, Congressman, to bring interest rates down ?
They say we need to worry about bringing interest rates down. It
is a problem from their point of view as far as the strength of the
economy is concerned.
In your opinion, is it an indication that recession is in sight if interest rates stay at the high level they are, or if they start to climb?
Mr. MILLER. If inflation declined and demand declined, but interest
rates remained high, then I think you could have a policy that impacts
the economy adversely.
But if inflation stays high, interest rates should be consistent; otherwise we just unleash further demand for another boom period that
adds to inflationary pressures and starts us on a worse cycle.
There is no way to solve our problem using the techniques of the
past. If we administer interest rates low, and let everybody have all
97
the credit they want, then we are going to have inflation. If we administer interest rates low, and then allocate credit—just tell people which
of them can have it—then we are into a control mode, which I believe
is a rather unhealthy mode and a very unwise mode for the United
States.
I think we should tend to restrain the overall availability of credit,
and let the choices of spending or saving be made by individuals and
businesses, rather than sit in judgment.
We have seen situations in the past where we have held the lid on
things. The tendency then is to steam up the economy; we have the
impression that we are containing inflation, while we are just kidding
ourselves.
Eventually the lid pops off.
I think we have to have the persistence, the discipline, the willingness to pursue austerity for a period, in order to make up for our past
excesses. There can't be a free lunch in this process; we just have to
pay the piper for what has happened over 12 years.
Mr. WYLIE. My time has expired, but I have one last question.
Why not just put control on the money available rather than increasing the interest rate?
Mr. MILLER. The trouble, Congressman Wylie, is people sometimes
have the impression that the two are unrelated; but they are related.
There is no market if you can reduce supply without the price
increasing.
It is the same with money as it is with wheat. If you made only so
many bushels of wheat available, the price would go up; if you made
more wheat available, the price would come down. That is what interest rates do in relation to the money supply. There is a bit of a misunderstanding here.
We are not trying to run the economy by pegging interest rates
artificially. The supply of money and credit is related to interest rates
as surely as can be, and that
Mr. WYLIE. I am not sure that I am developing my question very
well.
The last time that you were here, I asked whether the Fed would
not have greater success in controlling inflation if it sought to influence
the monetary aggregates directly rather than seeking to influence
them indirectly through interest rates, and I believe you replied in
essence that you would think about it, but you weren't sure.
Meanwhile, the Federal Eeserve issued its bulletin for January,
and on page 31 it says:
Thus, with a reserves operating target, control might be weaker over the
proposed aggregates than over the current aggregates, unless legislation were
approved extending reserve requirements to the monetary liabilities of nonmember institutions.
With an interest rate operating target, control over a monetary aggregate
depends on whether the demand for that aggregate is sensitive to changes in
short-term interest rates. A desired change in the quantity of a monetary aggregate is achieved by varying the attractiveness of holding the monetary aggregate
through changes in short-term interest rates.
There seems to be an inconsistency there to me, and I would hope
you could straighten that out.
Mr. MILLER. We could monitor policy techniques; our tools can be
used in different ways.
98
It is possible, in terms of trying to achieve the rate of growth of
aggregates that we have perceived to be appropriate, that we could
operate through a technique, such as controlling reserves, rather than
operating indirectly through interest rates. But the same result would
take place. If you restrict through direct action, interest rates will go
up. Whichever way we go, we are going to have the same consequences.
The only question, therefore, is what is a better operating technique.
As far as the issue of monetary control and universal reserve requirements, I think that is a different point. To the extent that deposits are
held outside of the Federal Keserve System that is, to the extent deposits move from accounts subject to reserves to accounts subject to
different reserves or subject to no reserves—an unpredictability is created ; the greater the unpredictability, the harder it is to operate, whatever way.
Believe me, whichever way you operate, you are going to affect both
the supply and the cost of money. But, you can operate more effectively
with a more complete coverage of the deposits that you are trying to
influence.
Mr. WYLIE. I respect your judgment. I am not sure that the interest
rate approach has worked all that well so far. That was the point I
tried to make.
Thank you very much.
The CHAIRMAN. Mr. Vento?
Mr. VENTO. Thank you, Mr. Chairman.
I appreciate your effort to try and build the position of the legislation. It is an ambitious goal and one that we will have to work together
on. Nonetheless, with respect to the monetary policy and interest rate,
I am pleased to see that you see a relationship between them.
Mr. MILLER. Even if I didn't see it, it would exist.
Mr. VENTO. There was reluctance by your predecessor to recognize
that fact. But there is a disturbing occurrence with regard to monetary
policy as exercised by the Fed.
In your judgment, isn't it possible that monetary policy under some
circumstances can be overextended in terms of what it is trying to do?
Mr. MILLER. Certainly, we should not seek to achieve our economic
goals relying solely on monetary policy. I have said this consistently.
We can expect monetary policy to carry too much of the burden, and
that, to my mind, is dangerous. It is very important that we have,
concurrently, fiscal policies, incomes policies, policies on the formation of capital, on investment, and on international trade that supplement and confirm the economic direction that we feel is correct to
achieve our goals.
Mr. VENTO. One of the problems has been, of course, you pointed out
the certificates of deposits that savings and loans and mutual savings
banks have been permitted to offer more recently on the market applies. You also pointed out in your report the increase in the consumer
debt. I might add that on a related subject, regulation Z, I know that
you put out a comment period for new rules and regulations, and you
have been very much involved in a regulatory capacity in terms of
truth in lending in extending that particular service. I will not ask
any questions about that.
I will just point out that the general nature of the rules, I think,
permit a more liberalized extension of credit by second mortgages.
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This whole phenomena seems to operate at counterpoint really to the
objectives of monetary policy. That is to say, that a second mortgage
on homes, the extension of credit, or the offering on CD's, for instance,
seem to resist the restraints that otherwise exist. The negative impact
on monetary policy on homes, as much as I abhor that, and the capital
which relates to productivity and so forth on the nonresidential side,
how do you explain that?
I don't know if it is just empirical theory that you have, or do you
have any data that indicate consumers are buying now because they
think there is going to be even greater inflation tomorrow. I have
heard that phrase before. There might be some other things including
a more liberal credit policy.
I would like to get your impression and the Board's response to that.
Mr. MILLER. Let me point out a couple of things. In the first place,
I think we have to be sure that we think about each of these issues
clearly. In dealing with the issue of open end credit secured by second
mortgages—this, by the way, is credit already being extended; we did
not create it—our purpose was not to expand aggregate credit. Our
purpose was to give consumers the ability to negotiate better terms.
We did not believe that a household would gain more credit; its capacity to repay won't be changed. It would merely mean better terms
because of the secured nature of the credit. Our purpose was therefore
to try to help families, in these difficult times, bargain for better terms.
Now, to the extent that we misjudged that—and to the extent that it
is anyone's judgment that that particular regulation would expand
credit—we put it out for comment. If, in fact, we perceive that there
are those who view it differently and they can persuade us, we will
look at that issue. We are trying to improve terms. Let's be sure we
don't relate that purpose to other issues, such as overexpansion.
The proper use of credit is not bad in an economy. Since we have
an innovative economy, the fact that over time we have developed
techniques to utilize credit to meet legitimate household and family
needs should not be criticized.
In fact, in terms of nonprice credit terms there has been an inventiveness, a creativeness in the system, in trying to adapt to rapid
changes in the financial marketplace.
We have not had in our lifetimes, before the 1970's, any extended
period of inflation in peacetime; we have never had that experience.
When we suddenly had that experience, automobiles jumped substantially in price—because of inflation and mandated requirements—and
families who felt they needed an automobile started saying, "I can't
make the payments in 3 years; I need some more time." And financiers
said, "I will give you a few more months, because you have got a good
record, and your automobile is better engineered." And so forth.
We ought to be cautious in judging that as being an overextension of
credit. Maybe it is just an adaptation through this period when we
want to find legitimate ways to keep the family progressing.
Mr. VENTO. The point is, though, that it does have an impact in
terms of what monetary policy does.
That seems to actually move it in the opposite direction. There are
actually actions by the Federal Home Loan Bank Board in conflict
with what you are trying to do.
One other point that was made here is the factor of capital investment in terms of its relationship to productivity.
100
Isn't it possible that we have hit a plateau in terms of capital input
and what we can expect back in terms of workers ? Isn't that a factor
in some industries, or could it be a factor ?
Mr. MILLER. I think not. I think that the uncertainties of inflation,
on cash flows, on future prices and markets, is the real factor at work.
The fact is, too, that a lot of capital expenditures have been put into
nonproductive areas; 5 to 7 percent of capital expenditures are now
going into areas that do not relate to productivity.
Mr. VENTO. That leads to another question. I believe that as money is
available, it goes into noncapital expenditures.
Has that historically been true in this country? Second have you
made an effort to monitor the amount of capital to be invested, that is,
productive capital, capital that goes for building plant and equipment,
into other areas? There is American capital coming in, and capital
coming from Europe, about $30 billion last year? But where is that
oing? What portion goes for capital investment? What portion goes
or consumer goods? That is, both from within this country and
without ?
Mr. MILLER. We keep close records as to what is actually going into
business fixed investments. That is what we are talking aoout here. If
you talk about financial instruments, you are talking about something
that doesn't show up in productivity. Many of the institutions' holdings merely go into short-term Treasury bills: we will have had a very
large growth in the foreign demand for Treasury bills, because of
direct intervention, which has resulted in many countries' official institutions holding large amounts of dollars that need to be invested. That
money is not going to flow into business fixed investment. The source
of capital, the availability of capital, the decisions to invest, this is a
different structure. Again, we have to separate those two issues.
Mr. VENTO. My time is expired, but I don't think my question was
answered, at least the last one. I hope we will get back to it.
Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Leach ?
Mr. LEACH. Mr. Miller, today in Bonn the United States is selling $2.5 billion worth of D mark denominated bonds.
It strikes me that this may be a good risk; but it is also a high stakes
game. In fact, it is a bit like playing Eussian roulette with U.S. taxpayers' dollars, because if the value of the dollar depreciates, the debt
derived from the obligations will be significantly increased by exchange
losses.
What intrigues me is that there has been almost no public discussion
of this issue. Furthermore, there has been no congressional debate on
this issue.
I am wondering if you, as Fed Chairman, advised the Treasury in
this regard ?
Mr. MILLER. Mr. Leach, the offering will be 2y2 billion D marks,
not $2% billion, just let me point that out.
Let me say that I am very much in favor of these issues of foreign
currency-dominated obligations.
The United States, whether we like it or not, has been running a
very large current account deficit that must be financed. If we continue to find it necessary to depreciate the dollar in order to attract
funds to finance that deficit, we are headed for deeper and deeper
f
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trouble in terms of inflation, for bigger costs to the taxpayer than
could possibly be involved in this important means we can use to
close our gap and buy us time.
For example, the depreciation of the dollar since September 1977
added 1 percent to inflation in 1978; that was equivalent to a tax of
$15 billion on consumers. Probably 1 percent more will be added to
inflation from that depreciation. We are going to do much more for
the taxpayer by stabilizing the dollar.
You point out that we issue foreign currency denominated securities; why would you assume that to have a greater risk than issuing
dollar denominated securities, in the sense that in either case there
must be a capacity to repay or refinance ?
When our Treasury borrows funds in Germany, the cost is far less
than borrowing funds in this country. Any risk of depreciation of the
mark is covered by a 4- or 5-percent differential in interest costs. Any
exchange loss should be looked upon, annually, as part of the carrying
cost of debt. If we save our dollar, save ourselves from the inflationary
impact of its depreciation, believe me, we won't be incurring any
further loss or risk. We will have done a great deal to stabilize the
total situation and to reduce the cost of our financing our goals.
Mr. LEACH. You make a strong case, but we know that in the last
few years alone, the U.S. Treasury has lost a spectacular sum of
money due to devaluation of the dollar and our obligation to pay back
some of our debt in Swiss francs.
The CHAIRMAN. I think we better be careful. The Roosa bonds go
back
Mr. LEACH. The Roosa bonds go back to 1961. We are still paying
them off. The devaluation of the dollar vis-a-vis the Swiss franc in the
last 4 years has caused a loss to the Treasury of substantial proportions—around a billion dollars—and this is admitted by the Treasury.
It is a simple fact.
Let me pursue this further. In recent months the Fed has taken
several significant steps to stabilize the dollar in foreign exchange
markets. However, Fed policy has not been clear-cut. In late January,
the Fed sold $1 billion in 1 week for Japanese yen.
Part of the rationale was that we wanted to keep the relative value
of the dollar to the yen about where it was.
In that regard, is there a desire on the part of the Fed not to allow
the dollar to appreciate significantly relative to other stronger currencies, in order to maintain a competitive edge in trade or otherwise ?
Mr. MILLER. I have too many questions here. I will have to take them
one at a time if I am going to be responsive.
I cannot accept the proposition that hundreds of millions of dollars
have been lost on the Roosa bond without looking at the underlying
realities. In the first place, what interest rate has been paid over the
years, and what interest rate would have been paid elsewhere? What
is the annual cost of carrying and paying that debt.
Unless you look through the life cycle of the security, you can get
inflammatory statements about its cost. But this is just not a factual
statement about the cost of carrying the debt.
The second issue is what was our other choice ? To sell gold. The
United States, by saving that gold, saved $1 billion. To look at the
reality, this process has benefited the United States;
102
Of course, I had nothing to do with those bonds. But I want us to
look at this realistically. We were in trouble in the world at the time
they were issued; our choice is to sell gold at $42 an ounce, and later
find that it is worth $250. I would gladly hold the gold.
Mr. LEACH. You are correct in taking the long-term point of view.
However, if you just examine the period of this administration, where
the dollar has depreciated substantially
Mr. MILLER. This administration hasn't lost money in these markets. So, either we are going to take it one way or the other. Either
Koosa bonds didn't lose us money or they did, but we haven't lost any
money. We haven't sold 1 billion dollars' worth of yen. The resources
that have been committed have been relatively modest. We have
stabilized the dollar. We are contributing to saving the American taxpayer billions of dollars.
Mr. LEACH. Let me quote Mr. Anthony Solomon of the Treasury
Department. He says the appreciation of the Swiss franc has created
large actual and accrued exchange losses.
The point I am making is that over a period of 2 or 3 years, we have
seen substantial losses clearly indicating that whenever you sell a foreign currency denominated bond, you are running a certain risk. That
risk is undeniable, and I think it should be fully understood by this
Congress, as well as the American people.
Simply arguing that there have been no losses is inaccurate. If you
take 1961 as a base year, the bonds may have a benefit. However, more
recently, the bonds have resulted in losses.
Mr. MILLER. I don't know where the loss is. Is the interest payment
we make on the national debt every year a loss ?
Mr. LEACH. That would be a liability to the American taxpayer.
Mr. MILLER. We should be careful not to mix up terms. The difference between the resources you get, and what you pay back in total—
interest charges and exchange costs—that sum has to be spread over
the life of the debt issues. That determines the total carrying cost,
which is the equivalent of interest.
If you call it interest, it doesn't sound bad. In fact, it is functionally
interest. The truth is, you know, that what you borrow Swiss francs
for—what you pay in interest this year—and what you have to pay to
buy those Swiss francs later to pay back, must all be taken into account
in figuring out the cost of carrying that debt.
An isolated statement that we have had exchange losses doesn't
specify those losses in terms of equivalency costs, or of the alternate
resources that would have had to have been expended by the Nation
to cover its financial obligations.
Unless you are willing to examine this that way, I am afraid you
may miss the impact of the major policy decision that was made on
November 1, a terribly important policy decision: the fact that in
order for us to stabilize the dollar, and to acquire the resources in foreign currency that we need, we gained access to the markets to those
resources, without expanding the money supply of Germany. This is
extremely important.
What we had been doing up until that time was relying entirely on
D marks acquired by expanding the money supply in Germany. That
creates problems and inflationary risks for the Germans.
By going to the market, and borrowing from banks, we eliminated
the prospect of expanding the money supply issued by the central
103
bank, yet the obligation to repay is no different than what we would
have had if we borrowed from the Bundesbank.
The CHAIRMAN. The gentleman's time has expired.
Mr. Cavanaugh ?
Mr. CAVANAUGH. Mr. Miller, in the past, you have provided the
committee with your own quantitative statements for prospective real
GNP growth, inflation and unemployment in the year ahead, and these
have differed from the forecasts of the administration.
This time, you do not provide us with a separate quantitative forecast. Does this mean that your best forecast and the administration's
goals are exactly the same ? And if not, where do they differ ?
Mr. MILLER. Mr. Cavanaugh, as you know, the report filed by us is
the report of the Board of Governors, and the Board of Governors as a
body has not been able or willing to try to make economic forecasts.
So, in the past, I have given my personal forecasts, and I would be
happy to indicate to you today what I see personally.
The President's economic goals for 1979 involve real GNP growth
of 2.2 percent, and consumer price growth of 7.5 percent. I would say
the likelihood is that the real growth rate would be slightly less, and
the inflation rate slightly more, with about the same nominal growth
rate.
Incidentally, I would see the economy slowing over the course of
1979, so that when I talk about the rate for the year as coming out a
little less than 2.2 percent, I am talking about a slowing toward the end
of the year.
I think the unemployment rate at the end of the year will probably
be fairly consistent with the outlook stated in the President's goals. I
do believe that over 1979, we will have about the same average rate of
unemployment as in 1978. But in 1978, we started higher and came
down; in 1979, we will start lower and go up slightly.
As to 1980, it is harder, of course, to look that far ahead, but I would
say that we could expect a slower growth rate in real terms than the
President's goal, moving up during the year; rather than moving
down, it will be moving up.
I would think, again, that consumer prices could be slightly higher
than forecast for 1980.1 don't see inflation coming down quite as fast.
I see real GNP growth slightly slower.
This forecast is on page 69.
Mr. CAVANAUGH. Right. I am on page 69.
For example, on consumer prices, by slightly higher, can you
quantify that ?
Mr. MILLER. Yes; in 1979, the administration's projection is shown
as 7.5 percent of inflation. I think a 7.5 percent rate would be the
bottom of my expectation. My expectation is that the rate would be
more like 7.5 to 8.25 percent, in that range, that would more likely
be the outlook.
Inflation could go down to 7.5 percent, but I think that is unlikely.
Mr. CAVANAUGH. Your growth, would you put that below 2, or at 2 ?
Mr. MILLER. I would think the growth could range for real GNP
from 1.75 to 2.25 percent.
Mr. CAVANAUGH. On page 55,1 would like for you to comment and
help clear up what appears to be a variance to me between page 55
and the bottom of page 56 and 57, where you are talking (about M t
growth, and the effect of automatic transfer facilities.
104
On page 55, you state that the board staff has projected that such a
shifting will dampen the growth in MI this year by about 3 percentage
points. And then at the bottom of 56, and the top of 57, you say bank
savings deposits have declined 'appreciably in the past few months
depite the increase of funds to ATS savings accounts.
How do you project in 1979 such an accelerated growth of ATS ?
What data do you have available now, as to what is the size of ATS
accounts now, and what do you expect them to be at the end of 1979 ?
Mr. MILLER. ATS, plus NOW accounts in New York—perhaps not
this week, but as of January—are about $5 billion combined—about
$4 billion in ATS, and about $1 billion in New York NOW accounts. That is amazingly consistent with the projection the staff
had made as to how rapidly ATS would grow.
Let me point out, just so we are clear, that MO. consists of currency
and coin in circulation, and demand deposits at commercial banks.
M2 includes savings and time deposits at commercial banks. The
point made is that while M2 has continued to grow, savings accounts
have been slowing; the difference has been made up by time deposits.
This is just a shift, internally—that is, within M2, among the type of
deposit, occurring because we assume that there is >a shift toward time
deposits with higher yields. People have been putting their money
where they can get more.
Mr. CAVANAUGH. Do you have a projection for the size of ATS accounts by the close of 1979 ?
Mr. MILLER. About $19 or $20 billion.
Mr. CAVANAUGH. From the current $5 billion ?
Mr. MILLER. Yes; once you get past this year, in 1980, we will be
looking at MI figures progressively comparable to past year figures.
We are going to go through one period where this adjustment to ATS
makes it necessary to give you a picture of what would have been, so
there won't be any confusion.
In the fourth quarter, our rate of MI growth, if we had noth^iLATS,
would have been 1 percent higher. For 1979, we expect, as you just
pointed out, that if we had not had ATS, our MI rate of growth would
be 3 percent higher.
Or, put the other way, it will be 3 percent lower than it otherwise
would have been.
Mr. CAVANATJGH. If I can go back to my original question.
You indicate that the Board set no goals, or determines no goals in
arriving at its monetary growth targets. Does that mean that these
goals related by the administration's goals are not the goals which the
monetary targets the Board has presented us are designed to achieve ?
Mr. MILLER. You recall that the Federal Open Market Committee is
a collegial body; believe me, to get 12 people to ever adopt or agree
on the precise numbers for a forecast of the economy is unlikely.
What we do, of course, is rely upon projections by our staff. Each
Governor and each president who is a member of the FOMC makes his
own evaluations in setting what are his or her responsibility, and that
is the monetary goals.
Now, our job under Humphrey-Hawkins, as we understand it, is,
once we have set those goals, to relate them back to the President's goals
and report on whether they are consistent or inconsistent. The President does decide, as one person can, on his national goals.
105
Because of the uncertainties of an economy as large and complex as
ours we have adopted a program, as other countries now have, of setting monetary goals in terms of ranges.
Once you have ranges, it is possible to have some fluctuation. What
we are saying in the report, of course, is that the ranges we have set
would be consistent with achieving the nominal rate of growth in
GNP that has been set by the President.
Mr. CAVANAUGH. Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Evans ?
Mr. EVANS. Mr. Miller, thanks for being with us this morning. I
know you were with Senator Proxmire's committee yesterday.
I am glad we have more here in the House of Eepresentatives than we
had in the Senate Banking Committee.
I commend you, sir, for your courage, as I have done on previous occasions, in the exercise of restraint in monetary standards.
I would like to take this opportunity this morning to ask you some
questions relating to a couple of charts.
Page 23. It seems to me a very relevant fact in fighting inflation
would be to stimulate capital formation, and those charts are somewhat
alarming, but if not alarming, they underscore the need to do more to
stimulate capital investment. Last year we extended the investment tax
credit, which I think was a step in the right direction, on a more permanent basis, so that business would know what to expect in the future,
they could make decisions with reasonable certainty, and that is good.
We also reduced the tax rate on capital gains.
What further might we do?
Mr. MILLER. Mr. Evans, I have felt that the most effective policy of
the Federal Government would be to stimulate business fixed investment through higher rates of depreciation.
Business enterprises make their decisions on major investments based
upon projections of markets, sales, costs, profits, the return on investment, and the discounted cash flow.
In making those decisions, the opportunity to write off investment
more rapidly has a significant effect on the estimate of risk. Or, to put
it another way, the faster a business recaptures capital, the less it is exposed to risk and, therefore, the more likely an enterprise would be willing to finance and to make an investment.
From the point of view of the Federal Government, accelerated depreciation also works to give us the greatest bang for the buck, in my
opinion, because it does not represent a forgiveness of tax; it represents
a deferral. If you give an investment tax credit, you may have to go to
higher figures before you get an investment.
So looking at it from the point of view of the Treasury, you can create a credit for business investment through depreciation at lower
cost to the Government. The Federal Government looks upon the cost
of its money in terms of raising funds in the market, while businessmen look at a higher yield on their capital; and depreciation makes
that spread more favorable.
I would very much hope that the Congress, in due course, would be
starting on a phased in program toward liberalization of depreciation;
that would go a long way toward eliminating this problem.
Mr. EVANS. I was glad to see the attention focused on capital
depreciation.
106
But I agree with you that is a very relevant factor. But, unfortunately, too many people view that as a loophole.
Mr. MILLER. It never should be considered a loophole.
Mr. EVANS. I agree with you.
Mr. MILLER. If we create conditions for a flow from the savings of
Americans through the enterprises of America—investment in the
means of production that create jobs for Americans—that should not
be looked upon as a loophole. Eather, you should give out medals for
that kind of action.
Mr. EVANS. I couldn't agree with you more.
Turning now to another chart on page 38. Excluding food and energy, there would seem to be two very relevant factors in the high rate
of inflation that we have.
What do you consider aside from those as major inflationary factors
today?
Mr. MILLER. Putting food and energy aside, we are trying to illustrate that increased unit labor costs are a very serious, underlying cause
of inflation.
Mr. EVANS. Can I interrupt at this point and ask a question about
wages.
It seems to me that it is rather inconsistent to pass a minimum wage
bill as the Congress did in 1978, especially without a differential, a
youth differential, to have such a high unemployment rate among teenagers and minorities, that in itself is an inflationary factor.
Would you agree that we should do something to go back to minimum wage in 1979 ?
Mr. MILLER. Yes; I have pointed out that an increase in the minimum
wage, whatever may have been its original purpose, has, in this situation, had a significant impact on inflation.
In 1978, we could trace four-tenths or one-half percent of inflation to
the minimum wage increase; this year that will be less because the
increase is less.
It would be desirable for Congress to defer that increase, but I don't
think that has been very acceptable so far. The alternative of a youth
differential, I think, would be well worth enacting; that would make it
very helpful with regard to this process of closing the gap as to
teenagers.
Mr. EVANS. I see that my time has expired.
When you were here testifying before on the Federal membership, I
indicated that I would like to get together with you.
Mr. MILLER. Very good. Excellent.
Mr. EVANS. Thank you, sir.
The CHAIRMAN. Mr. Stanton?
Mr. STANTON. Thank you, Mr. Chairman. Chairman Miller, I apologize to you for my absence here in the last 45 minutes. I made an
appointment and felt obligated.
Mr. MILLER. Somebody has to work in Washington.
Mr. STANTON. I thought your statement was certainly very fair and
very equitable.
You know, the Board of Governors, and also the committee is implementing for the first time what we refer to as the "Full Employment and Growth Act of 1978." I wonder if you had had any problem
at all in fulfilling the requirements in this particular legislation, and
still maintaining an independence of the monetary system.
107
Mr. MILLER. Mr. Stanton, we have found this procedure worked out
in the Full Employment and Balanced Growth Act to be, I think,
quite satisfactory from our point of view.
Let me just remind everyone that when this act was being considered
last year and being brought near to final dispensation, we worked very
closely with this committee, and with your companion committee
in the Senate, to find language that would be workable, that would
look at what we really could do and should do as an independent
agency. I want again to thank this committee for its understanding,
and for its help in developing that language. I think it has brought
us to the point where we can give a useful report.
I hope it is a report that will -show consistency over the years and
make a contribution to the interaction of monetary and fiscal policy;
but we are not and should not hold ourselves out as a single separate
authority for the committee. We are a monetary authority, not the
economic authority for the Nation.
So, I have found this personally—and I welcome any suggestions or
observations from the committee—a very workable format. We organized along the three mandates that were listed in the act, and it
seemed to work very well from my point of view.
Mr. STANTON. This is mostly again out of curiosity. You spoke in
your statement that the board had been studying the possibility of
redefining the monetary aggregate, published in the January Federal
Reserve Bulletin.
Have you set any particular target date to make up your mind?
Mr. MILLER. Mr. Stanton, my personal target date—and this is not
a target date for the Governors—is to make a decision by the end of
the year.
Perhaps that sounds rather conservative, but I have felt that the
redefinition of the aggregates is a very important procedure, that we
should not rush it; that we should have input from this committee and
its staff, from the academic community, and from business economists
and business people and financial experts; and that we should digest
all of that and have as complete an exchange of views as possible.
We are not looking to win a race. We are looking for a substantive
contribution to understanding the money supply, for which we need
all the input that we can get.
At least, I would prefer to do this patiently and do it well, rather
than to rush through in a couple of months and find out that people
hadn't had a chance to run through their own calculations and see
how it works. We depend a good deal upon responses from those who
see our effort. We cannot, of course, force people to study this and
respond. We just hope the process will attract enough attention and
be important enough that we get intellectual input of high quality.
The CHAIRMAN. Mr. Green ?
Mr. GREEN. Mr. Miller, I think in your response to Mr. Vento,
you mentioned nonproductive investment and we have also had a discussion of Government-induced inflation.
I would like to know to what assumptions you all make, in setting
your monetary targets, as to what would happen in terms of further
Government-induced inflation, and to what extent you will have to
change your targets if there is a series of events such as the President's proposal to raise sugar prices, for example.
108
Mr. MILLER. All of those factors get cranked into our projections
of prices. As you know, when you deal with materials, quite apart
from those which are influenced by Government actions, it is very
difficult to project, with precision, how price actions will operate. Food
is particularly difficult to estimate.
As to Government factors, we have put them all in. We have included the effects of the new minimum wage; we do look at the price
support programs, and what they mean; and so forth.
I just would warn you that this is not an exact science, so all we can
do is continue to recognize any bias built in.
We try, quite often to slice the pie in different ways. That is, we
can project from the point of view of overall compensation gains, or
overall materials increases; or, we can cut it another way and look
at productivity, or some other factor.
Mr. GREEN. I guess if I could try to pin you down a little further:
What assumptions have you made as to what is going to happen in
terms of governmental regulations over the next year in reaching the
monetary targets? Or have you simply assumed that the system now
will stand still on the basis of existing legislation.
Mr. MILLER. In general, the latter. We have not recognized any
major new initiatives on the part of the Government. We have recognized the continuing impact of existing legislation. We have not
assumed any major, new changes; we have merely been extrapolating
from the present program. I hope there won't be any new additions.
Mr. GREEN. Let me ask you one final question. If you had your
choice of the matter, at what level would you like to see the Federal
deficit for the fiscal year 1980 ?
Mr. MILLER. I have been a proponent of adjusting our economy to
a slower growth mode, on a gradual basis, so we don't shock it, don't
create dislocations, don't interrupt the process of investment in a way
that would trigger a serious recession.
Therefore, I have favored a process of bringing the Federal deficit
down from $50 billion to the $35 billion it is likely to be this year,
when we get through with it, to half of that in 1980, and to as nearly
balanced as possible in 1981.
If I were drawing a straight line, I would say that something in
the $20 to $25 billion range would be more ideal for 1980. But I can't
quarrel with $5 billion more or less in an economy of this size. I don't
find myself faulting an objective of $29 billion; I think it is in the
right range. The important thing is to keep going in the proper direction, which would mean that we get much nearer to a zero deficit
in fiscal year 1981; certainly in 1982.
Mr. GREEN. Thank you.
The CHAIRMAN. The Humphrey-Hawkins Act requires that you
"take account of the past and prospective developments in employment, unemployment, production, investments, real income, productivity, international trades and prices." You have done this in your
report without quantifying your terms. Would you be able to provide
the committee, for the record, with the quantitative assumptions for
these estimates? I say that because in the past you have given us your
estimates of the growth of GNP.
Mr. MILLER. Yes, I would be pleased to do so, Mr. Chairman.
109
[Chairman Miller subsequently submitted the following table for
inclusion in the record responding to a question of Chairman Keuss:]
PERCENT CHANGE IN REAL GROSS NATIONAL PRODUCT AND RELATED ITEMS
1975-IVto
1976-IV
Gross national product
Business fixed investment
Residential structures
Net exports *
Total employment..
Real disposable income
Output per hour3
Gross national product deflator
Unemployment rate3
4.6
8.6
23.6
-9.1
._
3.3
3.3
2 6
4.7
7.7
1976-IV to
1977-1 V
5.5
9.1
15.3
-10.0
4.4
5.4
1.3
6.1
6.6
Projection—
11977-1 V to 1978-IV to
1978-IV 1979-IV
4 3
8.3
-.8
7.9
3.8
3.3
.8
8.3
5.8
l%io2M.
2j| to 3&
8££ to 9>£.
4^ to 7.
\V* to 2%.
% to 3M% to 1M.
7H to 8K.
6 to 6H.
1
Net change.
'3 Nonfarm business sector.
Level 4th quarter.
The CHAIRMAN. Finally, for me, in your current Federal Eeserve
statistics released on February 8, 1979, you have a footnote to your
special supplementary table on automatic transfers and NOW accounts in New York State, which says the survey-collecting data on
outstanding balances is scheduled to be conducted weekly through
March 1979. Why just through March? Shouldn't this one be kept
going for awhile ? My staff tells me it would be helpful for us to have
it, and I should think for you, too.
Mr. MILLER. I think we will want to extend it. We don't want to
lose track of this, because we do want to know how we adjust so as to
compare previous figures.
The CHAIRMAN. So you will continue it past March as long as
needed.
Mr. MILLER. Yes.
The CHAIRMAN. Mr. Paul ?
Mr. PAUL. Mr. Miller, I read recently that the amount of cash held
outside of the banks was as high as $98 billion. Given a population of
220 million, that comes out to $445 per individual, and for a family
of four, $1,800. I have a family of eight. That means I should have
$3,600, and I don't have it. I checked with my wife. She said she
doesn't have it. She said she would spend it, if she did.
In light of the recent news stories about the underground economy,
would you care to speculate on the location and possible use of this
much cash?
Mr. MILLER. Excuse me ?
Mr. PAUL, I am just wondering where that cash is and whether it
could be used in an underground economy, since this is money outside
the banks.
Mr. MILLER. It has been interesting to me to see the growth in the
per capita amount of currency in circulation, and it makes us wonder
if there isn't a growing cash economy. It may not be an underground
economy, just a growing cash economy that would be of concern.
Now, we don't know enough about this. It could well be that some
of that currency is literally lost, destroyed over years. Some of it
could be like Eisenhower dollars, hoarded for reasons of its curio
value rather than its monetary value. Or, it could be that there is a
larger growth in the cash economy.
110
It is a riddle for which we do not have an answer, but one that
makes us worry, as you do, as to whether it has some underlying significance.
I have a suspicion that, in times of high inflation, you will see more
transactions outside of any recorded process. Once again, anything we
can do to eliminate inflation will undoubtedly return us to a more
healthy atmosphere in that regard.
Mr. PAUL. You mentioned earlier that we benefited by holding gold
in the sixties rather than selling gold at $35 an ounce. Does this mean
that you might think it would be of value to us to hold the gold now
and suspend the monthly Treasury sale of gold?
Mr. MILLER. No, I don't think so. I think in terms of the dollar
amount and what the alternates for its use over time would be, that
this is a good time to sell gold in order to lessen the inflationary or
the speculative value of gold as an alternate asset for holding wealth.
It also reduces our importation of gold for use in the industrial and
jewelry processes, and therefore contributes positively to our balance
of payments situation; and, to a more modest degree, it relieves the
Treasury from borrowing. But our main purpose is to help in stabilizing the dollar and reducing our trade deficit.
I think it is a good time to liquidate the supply of gold; it is a much
better time than when gold was at $42 an ounce.
Mr. PAUL. It may go higher before it is all over.
Mr. MILLER. I am illustrating my confidence that we are going to
get inflation under control.
Mr. PAUL. You mentioned in your report that the Mx figures for the
last few months are unexplainable.
Now that you have been in the job for awhile, do you believe that
the institution of the Federal Reserve can regulate this money supply
as you see fit, or do you think this is something that we can't possibly
control.
Mr. MILLER. I think over time—over a reasonable time—the Federal
Reserve can do the job. On a week-to-week basis, at least when we have
so great a percent of deposits outside of the Federal Reserve System,
the money supply is more difficult to predict. But, overall, I believe we
can do the job. I don't think there is anything unusual or mysterious
about the behavioral patterns of people; they try to economize on
noninterest bearing forms of money in times of high interest rates.
What we lack are precise measuring techniques for the mix of
population and the alternative uses of resources in differing life
cycles.
The main thing is that we should be realists, and be practical. We
should not, for example, start to ease money prematurely just because
there has been low growth recently. First, we are making up for some
growth higher than we would have liked a little earlier. Second, we
have got to judge whether the shift in the demand functions of money
is such that we have to adjust before we start any relaxation. Those
factors aren't that hard to judge, if one is patient and looks at what
is really happening in the economy, instead of being mechanistic.
Mr. PAUL. This week, Milton Freidman criticized you rather severely in Newsweek for not increasing the money supply fast enough.
This question also does come up: When do you decide to increase the
money supply? Can you give me any objective point that you would
Ill
use in order to turn the money supply faucet back on ? Is it an unemployment figure that is in your mind, or just what is it that you use as
an objective criterion?
Mr. MILLER. It is a whole series of criteria.
One of the most reassuring aspects of the present monetary stance
is the fact that both the Keynesian and the monetarist viewpoints feel
it is time to ease up on monetary restraint. That is very assuring. The
fact that they are both on the same side of the fence probably means
that we should not ease up.
The Keynesians take the view that the full employment budget—
which depends upon what you assume full employment means—is creating conditions for a fiscal drain which would exacerbate a recession.
Therefore, they feel we should ease up, based on the fiscal drain.
The monetarists take the view that the aggregates have not been
going very well recently, and we should ease up.
Both fail to take account of what has actually been going on in the
economy and the fact that there is no constant star in the sky to guide
these things. Things are shifting, and we should look at the realities
before we make decisions that are very far reaching.
Mr. PAUL. My time is up.
The CHAIRMAN. Thank you. Mr. Vento?
Mr. VENTO. Mr. Miller, in looking at some of those underlying
realities, yesterday before the Senate Banking Committee you said you
did not expect a large external shock to hit the economy from the oil
producers in general, and Iran in particular.
Suppose there were such a shock, large increase in oil prices, for example. An increase in oil prices has two effects. It adds directly to inflation, and I guess to the OPEC. The National Journal reports that
there is seven-tenths of 1 percent increase in the Consumer Price
Index.
Of course, it also acts like a tax—I guess worse than a tax because
we don't get any feedback from it.
The implication from our monetary policy is that it is very ambiguous. How can monetary policy respond to those realities that we face ?
You said that monetary policy shouldn't and can't do everything by
itself, and I heartily agree with you. I think we should do our part. I
will get back to that in a minute. I am interested in what your reaction
is. It is very likely that this sort of circumstance can occur this year,
unfortunately.
Mr. MILLER. I hope what I said yesterday is that it is not possible to
predict what can happen in the oil situation, and that that is a risk
factor. If there should be a disruption in supply, then the goals we are
looking at could be subject to some degree of uncertainty.
Let me hasten to point out that my first preference, in terms of the
oil supply situation, is to suggest that monetary policy is not the appropriate policy. We can either continue to restrain the overall amount
of money and, therefore, if money shifts to oil, it will have to be denied
someplace else; or, we can accommodate increases and create more
inflation.
Either alternative is unattractive. What we need to do to respond to
energy issues is an energy policy. It would take only a 2 or 3 percent
reduction in the demand for oil in the world to solve the whole problem.
112
Why shouldn't it be more possible to get a more vigorous, more intensified, and more understood conservation program in this country ?
I am sure that everyone in this room could use 15 percent less gasoline
than they used last year and do no harm to their standard of living.
I could do it, and I am sure you could do it. If we would all do that,
we wouldn't have to worry about monetary policy doing something
we are not willing to do ourselves.
Mr. VENTO. I think the reality, though, since 1973, is that it hasn't
occurred. I don't know what it is going to take to make it occur. There
are certain forces. We have been successful in raising interest rates, and
increasing, and accommodating it, through inflation, I guess, is what
has happened. So that is likely what is to happen in the future. I hope
that we can develop a comprehensive policy, or at least one that makes
some sense in terms of providing some alternatives. But the alternatives especially represent long-term type goals.
The other question I have, Mr. Miller, is that for consideration of
the budget in fiscal year 1979, we tried to work in coordination—I
think we worked effectively in terms of the fact that we dealt with the
deficiency, of some $40 billion, and the interest rates caused it to rise
some $2 billion as a result of that, which is not affected by the decisions
of the Board of Governors.
Second, \ve tried to keep the tax bill in the range that we talked
about. After we left and finished our work in mid-October, toward the
end of the month, a crisis occurred, and it seemed as though some of
the work we had been doing in trying to coordinate, that is, in keeping
interest rates down, keeping the deficit down within a certain range,
was negated. Some of these actions contradicted what we had been
working for, which was to see a kind of balanced approach as a solution ; I know the events that occurred were beyond your control. But
how can we avoid such a situation, or can't we avoid that in the future ?
Mr. MILLER. The interrelations that you talk about depend very importantly upon our success in abating inflation. If we don't succeed in
doing that, I don't think it is possible to expect interest rates to move
down.
Now, if the economy slows, as we expect and as everyone expects—
I guess the only question is whether the slowing down will be a recession technically, or merely a lower rate of growth; we happen to believe it will not be a recession—then a couple of things will happen.
One is that there will be less income and therefore less revenues to the
Treasury from taxes.
And, to the extent there is a slowdown, there may be more Government expenditures brought about by unemployment or some other
need. Therefore, 'Congress will have to work even harder to maintain
its budget deficit objective at $29 billion.
Likewise, if the economy slows down, the demand for money and
credit will slow down and there will be a tendency, all things being
equal, for interest rates being too loose. Neither you nor I can control the fact that if there is some reason for inflation to accelerate—
be it war, a revolution in Iran that affects oil supply, or a crop failure
somewhere—if then, unfortunately, we can't control the interactions
in financial markets, we can only work on the scenario probabilities,
and hope that more times than not we will be right.
113
I think our strategy is correct. Those things that we can control,
I think, have been working in remarkable harmony. I think the Congress, the administration, the Federal Reserve, have been in better
harmony in recent months than I would have expected. That is very
much to be commended. But none of those three bodies can control
the Iranian situation, for example.
Mr. VENTO. I appreciate your response. Thank you for your
attention.
The CHAIRMAN. We want to thank you, Chairman Miller. We will
now stand in adjournment until 10 o'clock tomorrow morning, at which
time we will hear further witnesses.
[Whereupon, at 12:25 p.m., the hearing was adjourned, to reconvene
at 10 a.m., on Thursday, February 22,1979.]
CONDUCT OF MONETARY POLICY
(Pursuant to the Full Employment and Balanced Growth
Act of 1978, Public Law 95-523)
THTTBSDAY, FEBRUARY 22, 1979
HOUSE OF REPRESENTATIVES,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10:05 a.m. in room 2128 of the Rayburn House
Office Building, Hon. Henry S. Reuss (chairman of the committee)
presiding.
Present: Representatives Reuss, St Germain, Minish, Hanley, Blanchard, LaFalce, Cavanaugh, Watkins, Wylie, Hansen, Kelly, Evans
of Delaware, Green, Paul, Bethune, and Hinson.
The CHAIRMAN. Good morning.
The committee will be in session to continue our hearings on the
conduct of monetary policy. We meet in the fifth year of sustained recovery from the recession of 1974-75, in a climate of substantial doubt
that there will be a sixth. As the economic expansion ages, the twin
risks of accelerated inflation and renewed recession continue with us;
as time passes, we are less and less certain that we can continue to
maneuver between them.
Yesterday we heard testimony from G. William Miller, Chairman of
the Federal Reserve Board, and received into the record the Federal
Reserve's first report pursuant to the Full Employment and Balanced
Growth Act of 1978. In that report, the Federal Reserve promised
to aim for moderate rates of monetary expansion. Chairman Miller
testified that such a policy can work to squeeze out inflation over 6 or 7
years, while avoiding recession and the stop-go pattern that has
crippled anti-inflation policy in the past. He testified that the administration's economic goals for 1979—7.5-percent inflation, 2.2-percent
real growth, 6.2-percent unemployment, are achievable, but that they
hinge on a greater success for the President's voluntary wage-price
policy than Chairman Miller is willing to predict.
Our witnesses today are operating under a slight disadvantage, in
that they have not had much time to study the Federal Reserve's report. Nevertheless, I should like to ask each of them, as he testifies, to
bear in mind three questions about the conduct of monetary policy:
One, is the policy of the Federal Reserve, as announced this week
for calendar year 1979, consistent with the economic goals specified
by Humphrey-Hawkins?
(115)
116
Two, is the present and recent past behavior of the Federal Keserve,
particularly the high level of short-term interest rates and, apparently,
the lack of growth of Mx since September, consistent with the Federal
Reserve's announced policy and with the administration's forecast of
a no-recession economic path for 1979 and 1980, which the Federal
Reserve has largely endorsed ?
Three, are the goals of Humphrey-Hawkins, as specified by the
administration for 1979 and 1980 and by law for the period through
1983, themselves mutually consistent and obtainable without changing
the present predominance of aggregate fiscal and monetary policy in
the policymaker's arsenal ? If not, what combination of policies would
be required to achieve them?
We have scheduled four distinguished witnesses for today. They
are: Dr. Karl Brunner of the University of Rochester; Prof. Martin
Feldstein of Harvard; Prof. Robert Lekachman of Lehman College,
City University of New York; and Dr. Lester Thurow of MIT.
I am told that because of weather conditions Boston is isolated and
that MIT and Harvard are not able to be with us. Professor Lekachman is also not able to be with us.
Statements have been received from those who could not make it,
and they will be entered, in full, into the record.
[The statements of Professors Lekachman and Feldstein appear at
the end of the proceedings of this day.]
So Dr. Brunner, we are delighted to have a person of your distinction with us, and I know I speak for Congressmen St Germain,
Watkins, Lowry, Wylie, Kelly, Paul, Bethune, and Hinson, as well as
for all members of the committee, in welcoming you. Would you now
proceed, Dr. Brunner, to either read your statement or summarize it in
any way you please.
STATEMENT OF DR. KARL BRUNNER, PROFESSOR, UNIVERSITY OF
ROCHESTER, ROCHESTER, N.Y.
Dr. BRUNNER. I appreciate very much the opportunity to present
my views to this committee and to talk about how to best achieve the
goals laid down in the Full Employment and Balanced Growth Act of
1978.
The goals, as I understand them, are to bring down inflation by 1983
to 3 percent and by 1988 to squeeze it out of the economy, and in a
similar way that unemployment should be brought down to 4 percent
for the age group of those over 16 years old.
Now, if you look at the drift of our events and the U.S. economy over
the past 14 years, we have seen that the inflation has been drifting
up consistently intermittently with some declines of location, and also,
basically, the unemployment rate has been drifting up over this period.
I think it is important to understand that this drift in inflation and
unemployment was not simply the result of mysterious social forces,
that basically what happened is a result of the trend in our policies
which we have pursued essentially since 1965. We have in the past
had periods of amazing stability in our economy. From 1960
to 1965 our price level was essentially level. Possibly, if we make
proper measurements in terms of prices actually paid, our price level
may have actually declined over this period.
117
We also have this stability: We have the stability in terms of economic expansion; we have the stability in terms of interest rates.
The prime rate was 4i/£ percent for 4 or 5 years; it was not lli/2
percent.
Now, what happened is essentially that in terms of our monetary
policy we have engaged in the past in the postwar period since 1965
on a basically inflationary course, a very persistent inflationary course,
and that is the difference in our policymaking now than before.
Now, given this background, what can we do about it? In my
statement I indicate this in section 3, the general program of monetary
policy that should be laid out. Essentially, in order to cut out inflation
or in order to get down the inflation, what we have to do is that the
growth rates in the monetary base, instead of being at 9 percent, approximately the rate it was last year, it should be brought down to 2
percent.
Now, around 2 percent, if you take account also with the trend of
the monetary multiplier, the trend in monetary velocity, and get to
the average about an increase, a trend increase in nominal gross national product of about 3 percent with a normal growth rate of approximately 3 percent, this would deliver about a stable pricing.
Of course, there are all sorts of estimation errors in that, but the
estimation errors involved are comparatively small, relative to the
inflation rate which we have inherited at the moment.
The crucial aspect of the program is the gradual decline in monetary
growth. The shadow open market committee has over the past years
repeatedly recommended such a policy. It would be important, however, that the Federal Reserve authorities would really maintain such
a program over the next 5 years. We should also acknowledge that our
economy will suffer a temporary recession on this new track. I wish I
knew, or others would know, how to lower monetary growth to a noninflationary level without causing any social costs. But it seems most
important, just in view of the potential social costs, that a credible
policy program be formulated beyond this year which covers the
period mentioned in the Full Employment and Balanced Growth Act
of 1978.
Now, having stated the general outline, we still have to face the
problem of implementation, how to implement this goal from 9-percent
growth in the monetary base to a 2-percent growth in the monetary
base. Of course, there are immediately at least two major alternatives.
You say why can't we go immediately from 9 percent to 2 percent?
The consequence of that would be rather definitely that we would have
a recession, and not just a very mild or minimal recession, we would
have a recession certainly of the magnitude of about 1948-49 or 195354 or 1957-58, of this magnitude.
I still would like to indicate that even if it would go immediately
that way, it would still be a substantially smaller retardation in the
growth of the monetary base than we had experienced in 1920-21 or
1937-38, where the retardation by our monetary policy assumed some
brutal proportions, which we certainly don't want to imitate anymore,
I hope, in the future.
Now, an alternative procedure is the following: An alternative
procedure is to say, "Well, all right, according to the Full Employment and Balanced Growth Act of 1978, we have to get our inflation
118
down systematically over the next 3 years." And I think, in terms of
the uncertainty which we face, how exactly the reactions of the economy are, that we suffer some uncertainty indeed in this respect, and
that to play a sort of game of minimizing that social cost of transition, it seems to me best advised to distribute the reduction in the
growth rate of the monetary base over time, to instruct the Federal
Eeserve to go down, say, from last year to this year, possibly by 2
percent and then subsequently every year thereafter by 2 percent or
simply each year by 1 percent—I would not want to die on the barricade about that diiference—but essentially to go down each year by
1 percent until we reach 2 percent; and that the Federal Reserve
should be instructed to announce that very loud and very clear, so to
make the strongest, clearest commitment to this course of action as
to gradually hopefully to gain some credibility as to what it plans to
do and hold on to what it plans to do over the longer run and not
jump around every few quarters in a new direction as we have experienced in the last 14 years.
We had four aborted attempts at anti-inflationary policies in the
last 14 years. In 1966, when we had the minirecession and there prices
responded very aptly, the price inflation rates dropped by 50 percent
within less than 1 year—within 8 months. Again, we tried it in 1969,
and then we gave up again in January 1970. In January 1970, after
8 months, the Federal Reserve reversed itself again.
And then we got again on track in August 1971 to April 1972. Well,
gentlemen, I am sure you all know the sad sorry of 1972. And then
again we tried to get on track in 1975, but the Federal Keserve
abandoned this again in 1976, and more than almost trebled over the
2,1/2 years of growth rate the money stock and essentially increased
rapidly also the growth rate of the monetary base.
That is, basically, the Federal Eeserve would really have to stay on
track and hold onto this track.
Now, the next point which I wish to emphasize in this context are
a few more points which need to be considered; namely, the implementation, which I indicated, has also some further consequences in
terms of Federal Keserve procedures. In order to carry through this
program, the Federal Keserve would have to change substantially its
internal procedures and also the prevalent conceptions about monetary
policy and how to go about it, which it has held up and maintained
over many, many decades.
Together with my friend, Alan Meltzer, I had occasion 15 years ago,
in 1964, to submit to this committee the detailed report on Federal
Reserve policymaking, where we essentially brought and emphasized
that the internal procedures, implementation procedures of the Fed,
the way they are structured, as well-designed to make an adequate
monetary control possible, that they contribute basically to the instability in our monetary growth, and they contribute to the instability in the performance of our economy; once we had initiated an
inflationary thrust, they would contribute to reinforce this inflationary
thrust in the long run.
So, the Fed would have to be instructed to change these implementation procedures and to develop procedures appropriate for the control
of the monetary aggregates which are required if we want to get Out
of inflation.
119
Other central banks were able to do so. I don't see why the Fed
should not be able to do so. It can be done. The Swiss National Bank
has shown it. The German National Bank has shown it. The Spanish
National Bank has shown it. If it were so permitted by the political
process—again, there have been some changes there in recent years—
even the Bank of England has learned the lesson and is shifting to
another attitude and another stance, quite explicitly, in this respect,
and it is remarkable to see that.
Now, another aspect of this context which is important is the
following: We need also attention, in order to improve the policymaking which is required for anti-inflation purposes, to the arrangements, to the institutional arrangements in our monetary system. Some
of them create problems in terms of inadequate controls. I simply
refer to the reserve requirements, the way we have them structured
at the moment, over the last 10 or 11 years, are not well designed for
this purpose.
The Federal Eeserve has their direct immediate opportunities to
change it. It could also propose changes which are more adequate
which require legislation in this respect, and all that would help to get
to better monetary control which is necessary for our purposes.
Another point which is very important at this stage: We have
become increasingly subjected to measurement error. The data, particularly in MI and M2, suffer under a very serious measure of error.
I think the measurement errors might reach up to 10 percent at this
stage for M±. Also, therefore, we have a serious problem to assess
what is really going on in terms of our monetary growth, measured in
terms of M± and M2.
Now, there is nothing in here that is technically impossible to get
an accurate picture. It is very important that the Federal Reserve
follow up on the recommendations of the Bach committee in order to
carry through the necessary work on the data so that it knows what
it is doing in terms of the task assigned to it by Congress and the
general nature of our political process.
Now, this is, incidentally, the reason why for the moment I formulated my proposal in terms of the monetary base, because we do not
have the measurement problem there. The Federal Reserve controls
every dollar of the base if it so wishes to do. And, in addition, we do
know that in the average over time the thrust which the monetary
base exerts will push through in the behavior of the monetary aggregates. There is no need to wait until there have been new committees or new studies made by the Fed on MX and M2, the proper measurements of MI and M2, to implement the proposal. We can get started
immediately this year. And, meanwhile, the Fed should also do the
work on the data so that we have better information.
Now, there are various objections that have been raised against the
proposal. One of them is that the cost, the social cost, of transition is
too high. Another one is that monetary policy has nothing to do with
inflation. The third one is that, "Well, we need various supplementary
actions."
Let me indicate only quickly this: In terms of the social cost, we
do have probably a social cost of transition. I simply do not know how
to avoid that. I wish I knew. I wish that somebody knew. But the
fact of the matter is we don't have the necessary detailed, very spe-
120
cific knowledge of the detailed reaction structure of the economy.
So, the best we can do through a gradual process to minimize this
social cost of transition. What is important to realize is that this is
a temporary cost, but still it exists.
The crucial point, however: What is the social cost of the alternative? The alternative is a permanent inflation, and permanent inflations, well, we know how they work. We have 100 years of experience
in Latin America; this is highly rapid inflation. Highly rapid inflation would also be the fate of the United States if we continue. This
rapid inflation would mean continuous—again, a drop in output between intermittent surges in unemployment and, over 10 or 15 years,
that would mean a social cost which is a vast multiple of the social
cost affecting coming out of inflation once and for all.
Now, the second, point in terms of monetary policy has nothing to
do with inflation. Well, the answer there is very simple: All we have
to do is look at any inflation we experience. There simply was never
any inflation without preceding excessive monetary growth. And
whenever and wherever in medieval times, in ancient times, in modern times, in the 19th century, the United States or Yugoslavia or
Turkey or whatever, if monetary growth declines consistently, inflation will drop and ultimately disappear.
We had many experiments made again in the last years. Switzerland lowered its inflation rate from 13 percent to zero by just getting hold of monetary growth, lowering monetary growth from 20
percent to 4 or 5 percent on the average. Other countries have done
it. We can also.
Now, the next point is in terms of supplementary measures. The
supplementary measures, for instance, of income policies, orchestrated action of this and that as a means to do something about inflation, are simply essentially irrelevant and do not contribute anything
in terms of inflation. They actually sidetrack attention from what we
really have to do in this respect.
It is contended sometimes that general measures, monetary policy,
fiscal policy, have failed, but that is simply not true. That is exactly
the story, like, suppose somebody sits in a car, fumbles with the ignition or confuses the brake and the accelerator, the car doesn't work,
and then he says, "There you see, Detroit has done a lousy job. The
car has broken down."
You have to know how to drive a car, and that is essentially what
we have: We have not tried to carry through an anti-inflationary
policy in this country so far; and if we do, it will work like in any
other country, but we have to be patient. That is a crucial point in
this respect.
Now, fiscal policy, I simply wish to emphasize that this does not
play, by itself alone, the crucial role for the inflation problem. It
plays an important role in terms of our real growth in the future,
whether we absorb a lot of resources from the capital markets and
finance the deficit and so on, but in terms of inflation it only plays
an indirect role in terms of the political pressure. The large deficit
imposes upon monetization of the deficit by the central bank, so lowering the deficit helps. It will contribute to stay on the course of a
noninflationary monetary policy.
121
Lastly, what about unemployment and growth, as indicated by the
Full Employment and Balanced Growth Act of 1978? The point is
simply this—that we have to recognize that monetry policy cannot
solve all the problems. Monetary policy can solve the inflation problem, but monetary policy cannot lower the measured unemployment
rate under our present institution to 4 percent for the age group indicated, or the 3 percent to the other age groups.
There are many things that can be done: The changing of institutions in a variety of ways that would contribute to the lowering of
the unemployment rate. I regret very much that Martin Feldstein is
not here, because he has actually through his work over the past 5
years elaborated in some detail on what could be done in this respect
to lower the unemployment rate.
But to use monetary policy to force unemployment down will only
create a vast failure. The unemployment will stay high. It will actually drift up under the permanent rapid inflation. We will get more
inflation.
So, the course I propose, we do get in at least one respect nearer
to the goals of full employment and balanced growth.
Thank you.
[Dr. Brunner's prepared statement follows:]
PEEPABED STATEMENT OF DR. KARL BRUNNER
1. THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978
I appreciate the opportunity to present my views to this Committee concerning the course of monetary policy best designed to promote the goals of the
Full Employment and Balanced Growth Act of 1978. This Act establishes medium and long term goals for both inflation and unemployment. Inflation should
be lowered to 3 percent p.a. by 1983 and completely vanquished by 1988. Unemployment for individuals aged twenty and over need be reduced to 3 percent
and among all persons aged sixteen and over to 4 percent. These unemployment
levels should be realized by 1983 and subsequently maintained into the future.
The Act also declares Congressional intentions addressed to capital formation,
rising productivity and increasing real income per capita. Congress rejects
thus the prospects of permanent stagnation advanced by assorted groups advocating a "non-growth economy". Congress also rejected the views advanced
with increasing frequency that we should accept a permanent inflation and
accommodate our policies to this fate.
2. THE INFLATIONARY HERITAGE OF PAST POLICIES
The apparent interest of Congress in price-stability and economic growth at
least as expressed in the Act of 1978, should stimulate concern about the performance of our economy in the 1970's. The drift in inflation and unemployment was
not produced by blind fates beyond our reach. We contribute to this drift with
the dominant trend in our economic policies. This fact holds most particularly
for the case of inflation. The differences in the behavior of the general price-level
between the period 1960-1965 and the 1970's and similar differences in other countries or between countries are not determined by mysterious social forces. Nor is
the relative intractability of recent inflation in the USA particularly surprising.
The level and persistence of our inflation is essentially the product of our monetary policy pursued since 1965. This policy produced a monetary growth pushing
nominal gross national product at a rate of expansion exceeding the average rate
of real growth. Economic agents in the private sector unavoidably adjusted their
price and wage setting to this nominal expansion maintained over many years by
the Federal Reserve Authorities. The sequence of abandoned attempts at an antiinflationary policy (1966, 1969, 1971/72, 1974/75) confirms prevalent expectations
of a persistent inflationary policy. Wage- and price-setters show little inclination
under the circumstances to adjust their behavior to a temporary reduction in mon-
122
etary growth and to the passing retardation of nominal demand. Both our current
inflation and its apparent intractability result from the pattern of policies cultivated by our monetary authorities.
3. A GENERAL PROGRAM OF MONETARY POLICY
The recognition of the underlying cause driving our inflation determines the
course of policy pushing the economy nearer to the goals expressed by Congressional legislation. A stable price-level requires that the Federal Reserve hold the
growth rate of the monetary base to around 2 percent p.a. The combination of
this growth with the expected trend in the monetary multipliers and monetary
velocity produced by a gradual diffusion of institutional innovations determines
approximately a trend growth of 3 percent p.a. in nominal gross national product.
This implies under the circumstances a normal rate of growth in real output of
about 3 percent p.a. arid a stable price-level. With a different normal real growth
or a different trend in multiplier and Velocity than implicitly used in the previous
assessment suitable revisions in the medium term growth rate of the monetary
base yield closer approximation to the stability of the price-level required over
time. A well managed Federal Reserve Authority with a definite commitment to
its public responsibility would learn from experience as the situation evolves the
approximate magnitude of the non-inflationary growth rate of the monetary base.
At the moment and on the basis of our available information it seems quite adequate to use 2 percent as a benchmark for 1988 or even somewhat earlier. The
probable errors are small relative to the magnitude of the current inflation. The
path of the monetary base determined by its initial position (around 9 percent
p.a. in 1978) to the benchmark level set for 1986-1988 would assure an unambiguous reduction of the rate of inflation to a small fraction of the inflation emerging
during the winter 1978/79.
4. THE IMPLEMENTATION OF THE PROGRAM
The implementation of this general program requires some attention. The
non-inflationary level can be approached in many different ways. If we knew
with certainty the economy's complex dynamic structure and the patterns of
changing expectations induced by new information the move to a non-inflationary
state could be realized under optimal conditions in terms of the social costs associated with the transition. The revisions of expectations would moreover induce
rapid changes in price-wage setting in case the new policy is (miraculously) accepted by the public with full confidence as an expression of a determined and
sustained effort. The social costs of the transition would be lowered to a minimal
level under the circumstances. Unfortunately we do not possess this information
and we must grope for a path in a murky fog. An immediate reduction of the
growth rate of the base from 9% to 2% induces most likely a recession with losses
in output and employment. The low credibility attached at this time to any sustained anti-inflationary monetary policy raises the social cost of the transition as
it lengthens the time required for the adjustment in price-wage setting behavior,
It should be noted however that the moderation in the growth of the base required
for our proposal is substantially smaller than the retardation observed in 1920/
21 or in 1936/37. It would be somewhat larger than the retardation imposed by
the Fed in 1948/49 and other postwar recessions. The loss in output and employment resulting under the circumstances fosters most likely political pressures
forcing a reversal of monetary policy onto a renewal of the inflationary game. I
know of no way to determine a path for the monetary base which will assure us
the absence of any social cost of transition or promise that we move along an optimal trajectory in terms of social cost. My best suggestion under this uncertainty
shared by all of us indicates a gradual approach explicitly announced and well
articulated to the public. According to this approach the Fed should announce once
and for all in a manner conveying a convincing commitment that it plans to lower
the growth rate of the monetary base each year by one percentage point until we
achieve a stable price-level.
This policy need be announced now and initiated for 1979. The White House
should also commit its prestige, as it is, in support of this policy and make clear
that it will not tolerate any deviation from the announced path.
5. THE IMPLEMENTATION OF THE PROGRAM : CHANGES IN PROCEDURES AND CONCEPTIONS
GOVERNING THE FED'S POLICYMAKING
The simple proposal involves no technical complications and difficulties. The
Federal Reserve Authorities possess all the technical means for an effective execu-
123
tion of such a policy. It will require however somewhat of a revolution in the conception and procedure of the Federal Reserve's bureaucracy. The Federal Reserve continues to formulate and implement policy according to an old pattern.
This pattern, and its consequences with respect to economic stability, has been
described in detail in a study on Federal Reserve Policy Making jointly prepared
for this Committee in 1964 by myself and Allan H. Meltzer. The Shadow Open
Market Committee also commented repeatedly in recent years on this problem.
The Fed's traditional procedure seriously impairs the control of monetary growth
and the growth of the monetary base. It obstructed in the past four years the
realization of Congressional intentions expressed by HC 133 (March 1975) and
the recent revisions of the Federal Reserve Act. This obstruction was reenforced
by the Fed's conception traditionally dominating its views of monetary events
and monetary processes. The conception inherited by the Fed'-s bureaucracy essentially denies the relevance of monetary aggregates and blinds the Fed to the
crucial role of monetary growth in the inflation process. The internal procedures
combined with the old conceptions explain the fact why the Fed so miserably
failed to satisfy the Congressional intentions over the past four years.
6. THE IMPLEMENTATION
OF THE PROGRAM : INSTITUTIONAL REFORM OF ADEQUATE
INFORMATION
The change in procedures and conception of the Fed's bureaucracy must be
supplemented with two other groups of measures in order to improve our policymaking in a manner better suited to achieve Congressional goals. Some of the
institutional arrangements in the US monetary system are not well designed for
an effective control over monetary growth. The prevailing structure of reserve
requirements and the ceiling on interest rates imposed on* checking and time
deposits produces under inflationary circumstances serious distortions in the
measured monetary aggregates. These distortions lower the information content
of the data and impair any rational assessment in policymaking. These distortions
have recently been aggravated by increasing errors impounded into the traditional measures of Mi and M2. Institutional innovations (AFT accounts, NOW
accounts, broker and money market fund checkable accounts and overnight repos)
in the financial industry erode the meaning of the published data. There remain
however some questions concerning the adequacy of the published date even in
the absence of the evolving institutional innovations. Several years ago a special
Committee constituted by the Federal Reserve Authorities recommended several
modifications in the assembly and preparation of data for the measurement
of monetary aggregates. It seems most urgent at this time that the Federal
Reserve Authorities be advised that their responsibility denned by the Federal
Reserve Act and the Full Employment and.Balanced Growth Act requires a
systematic reexamination of their measurements. Inadequate measures increase
the uncertainty confronting policymakers and economic agents. They also offer
opportunities for useful exploitation by the Fed's bureaucracy in order to produce
sufficient verbal smog to obstruct the movement to a noninflationary path of the
relevant monetary magnitudes.
It is important to emphasize in the present context however that we need not
suspend any relevant action until the studies of new Committees or the enquiries
made by the Fed are terminated. The Fed can immediately initiate the necessary
changes in implementation proposed by the Shadow Open Market Committee in
recent years, modify some arrangement (e.g. reserve requirements), actively propose some other modifications (structure of reserve requirements, interest ceilings
on deposits) and most particularly announce a commitment to lower the growth
rate of the monetary base by one percentage point each year in the manner
indicated above. We note in passing that the monetary 'base suffers at most
vanishing measurement problems. It suffers on the other hand under the Federal
Reserve's systematic refusal to recognize its central position in the money supply
process.
7. THE SIGNIFICANCE OF FISCAL POLICY
My statement concentrated thus far on monetary policy. A short comment
bearing on the role of fiscal policy need be added at this point. The direct effect
of budget and deficit on the rate of inflation is comparatively negligible. An
expansion of government expenditures on goods and services tends indeed to raise
the price-level. But such expansions contribute (directly) little to our inflation.
A similar situation holds for the deficit. The direct effect of the deficit on the
rate of inflation vanishes in comparison to the importance of the mode of its
financing. The deficit exerts however an indirect effect of some importance on
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the inflation motor. The nature of the political proces lowers the likelihood of a
non-inflationary monetary policy under the circumstances of a persistent and large
borrowing requirement by the Federal Government. It would thus seem advisable
that fiscal policy contribute with a balanced budget to the goal addressed by
Congress. The comparative irrelevance of the direct effect of budget and deficit
on inflation does not imply however the irrelevance of these fiscal magnitudes
in terms of our welfare. A large and increasing budget absorbs resources by
the government sector. These resources are used less productively and more
wastefully in this manner than in the private sector. Rising government expenditures on goods and services
lower in the average real investment and real
consumption and lowrer over time our economic welfare. Rising government
expenditures in any form expand moreover the power and reach of the bureaucracy. The citizen's control over an ever expanding government sector forms a
major problem for our political future beyond the threat of permanent inflation.
8. THE OBJECTIONS TO ANTI-INFLATIONAEY MONETARY POLICY
The program submitted in my statement is hardly uncontested. It is opposed
on the grounds that the social cost of transition to a stable price-level is too high.
The argument asserts in particular that the social cost of permanent inflation is
small when compared to the social cost of an anti-inflationary policy. This discrepancy in social costs determines that policy should rationally accommodate
a persistent inflation built into the economy. Another objection contends that
inflation involves a social process essentially independent of monetary growth.
A reduction in monetary growth produces under the circumstances a permanent
loss of output and employment. It is useless and harmful in this view to tame
inflation by means of monetary control. Lastly, one may concede some usefulness
to monetary-fiscal restraints but argue that such "general measures" be supplemented by "specific and structural" measures.
(a) The social cost of anti-inflationary policy
The case for a permanent inflation in terms of the social cost of anti-inflationary policy involves essentially an irrelevant comparison. It compares the transition to a stable price-level with a stable and fully anticipated inflation. But
this comparison is hardly relevant for our purposes. It assesses an anti-inflationary policy against the standards of Never-Never-Land. Permanent inflation actually means an erratic inflation with large variations in the spread between
expected and actual rate of inflation. A policy of permanent inflation induces
thus substantial variations in output and unemployment. The cumulative loss of
output from intermittent recessions whenever inflation abates exceeds probably
the social cost of a once and for all transition. Permanent inflation imposes
additional social costs beyond this cumulative output loss resulting from intermittent "stagflationary" recessions. The erratic course of permanent inflation increases the uncertainty confronting economic agents. The higher level of uncertainty shortens the horizon of investment projects, curtails the average pay-off
period, and tends thus to lower the rate of investment in human and non-human
capital. These repercussions are further aggravated by our tax structure. Permanent inflation typically fosters furthermore intermittent controls over prices,
wages, and interest rates. Every new wave of inflation encourages the formation
of new agencies and watchdogs "supervising" prices or fosters extended powers
to already existing agencies. The bureaucracy expands and the power of government increases. The resources invested in this manner by the government sector
hardly affect the ongoing increase in costs and prices. They do provide however
substantial incentives encouraging a wasteful and distorted use of our productive opportunities. These repercussions lower over time the trend growth of
normal output.
(&) Irrelevance of monetary policy and monetary growth?
The second objection against an anti-inflationary monetary policy implicitly
argues that the social cost imposed by such a policy is indefinitely high. This
follows from the view that inflation evolves irrespective and independently of
monetary growth. This theme has become quite fashionable in wide circles. Its
attraction follows to a large extent from the political message implicit in the
view. It offers some further justification for massive social engineering and most
particularly for the replacement of markets with political institutions. The evidence accumulated from a wide array of inflationary experiences drawn from
many different historical circumstances and countries thoroughly refutes how-
125
ever this contention. No inflation ever emerged without an excessive monetary
growth usually produced by the government. This holds for the French inflation
in the middle of the 14'th century just as well as for the Latin American inflation
of the last 150 years, or the Italian, English, Turkish, Spanish, etc. inflation of
the past ten years. We find in particular that every major or persistent acceleration of monetary growth is followed by rising inflation. Substantial variations
over time within any given country or differences between countries at any
given time in the level of monetary growth are clearly reflected by prevailing
magnitudes in the rate of inflation. But the evidence shows more. It also reveals
that inflation disappears whenever monetary growth subsides to a level determined by normal real growth and the trend in velocity. Recent experiences in
West Germany, Switzerland and the United Kingdom offer remarkable instructions for our purposes. West Germany and Switzerland were more exposed to
the real shocks produced by OPEC and the failure of agricultural crops than
the USA. They still managed by a determined reduction of monetary growth
below the excessive rates reached in 1972 to lower inflation to vanishing levels.
There are many other cases from other periods and other countries which
exhibit unambiguously that a persistent and sufficient decline of monetary
growth effectively reduces the rate of inflation. Any contention that inflation
proceeds irrespective of monetary policy and independently of monetary growth
finds no support in the reality of inflation experiences.
(c) A need for supplementary measures f
Lastly, it is argued on occasion that general measures based on monetary and
fiscal policy cannot form the sole instruments of an anti-inflationary policy. They
need to be supplemented by "specific and structural" measures. But this position
is fundamentally untenable and contradicted by the facts summarized by the
previous paragraphs. In particular, the contention that general policy measures
have been unable to lower inflation is simply false. The failure observed over
fourteen years in the USA is not due to price movements being disconnected in
a "new world governed by new social structures" from falling monetary growth
produced by unstinting efforts of our Federal Reserve bureaucracy. The facts
are very different. Our monetary policy never settled on such an effort and never
showed any determined attempt to reduce monetary growth to the levels required
for a noninflationary growth. One might just as well attribute the failure of
a car to move because the driver confuses brake and accelerator or fumbles with
the ignition to a breakdown of the car. An emphasis on supplementary measures
lowers the likelihood of an effective anti-inflationary policy as it directs attention
away from the basic requirement to lower monetary growth. The Federal Reserve
bureaucracy essentially rejected in the past years and still rejects this very
notion of monetary control for the purpose of taming inflation.
Supplementary measures are basically useless as anti-inflationary devices. "Income policies", "social contracts", "orchestrated approaches" or simple coercion
all failed to contain inflation. We need not invoke ancient history and the futile
exercise of Diocletian, Julian the Apostate, Jean Valosis II of France, Edward
III of England and others. The experiences of the postwar era are quite sufficient
to reveal that such measures may modify somewhat the shorter-run path of inflation with little longer-run effect in the face of a persistently excessive monetary
growth. Moreover, the measures mentioned above -hardly contribute to raise the
credibility of a new attempt at anti-infllationary moneary policy. The uncertain
and unreliable record of policymakers will not dissolve with the cultivation of
irrelevant and ineffectiveness measures. Even under the best circumstances when
they initiate a more efficient use of our resources the effect of specific or structural
measures on the rate of inflation is minimal. It is quite illusory to cope with an
8% p.a. rate of inflation in such terms. It should be noted -however that the
irrelevance of supplementary (structural) measures with respect to inflation
does not imply their irrelevance in terms of their cumulative effect on our general
welfare. But I also wish to emphasize that some of the supplementary measures
occasionally proposed are more likely to foster price increases and a wasteful
use of our resources.
9. UNEMPLOYMENT AND GROWTH
The Full Employment and Balanced Growth Act 1978 imposes joint goals for
inflation and unemployment. Policymakers are thus addressed to pursue a course
of action lowering both inflation and measured unemployment. This course should
also foster economic growth. Some clarification of the role of monetary policy
in this context may be useful in view of many prevalent confusions. The case
126
for an effective anti-inflationary monetary policy is frequently dismissed as
expression of "Republican values" favoring higher unemployment and lower
inflation. This argument misrepresents unfortunately the actual issues confronting us. The choice is not between lower unemployment and higher inflation on the
one side or higher unemployment and lower inflation on the other side. Our choice
lies between a temporary increase of unemployment in the present above its
normal level in conjunction with a return to the normal level and no inflation in
the future on the one side, or, on the other side, permanent inflation with intermittent spurts of unemployment beyond its normal level augmented very likely
by an increase in the normal level. It is unfortunate that we do not possess a sure
way out of inflation without suffering most likely some temporary increase in
unemployment. But there is really no alternative. All attempts to avoid lower
monetary growth, exemplified by my proposal in a previous section, which insist
on a variety of "specific or structural" measures are committed to failures. They
will produce an apparently more and more intractable inflation and the final
"Latin-Americanization" of this country. And most importantly, the country will
move even further away from the goals declared by Congress.
A determined and generally understood sustained effort to reduce monetary
growth does remove inflation. It will not raise the normal level of unemployment
but neither will it lower this level significantly at this stage of our inflationary
heritage. The normal level of unemployment settled probably around 6% under
the current institutions. Any effort to lower this level moves our attention beyond
monetary policy. Monetary policy could lower the measured unemployment rate
substantially below 6 percent only for a short period and would unleash thereby
accelerating inflation. A reduction in the normal level of unemployment must be
accomplished by major changes in our social institutions, (among others: minimum wage, the modus of food stamp plan and unemployment compensation or
benefits). Government policies reenforced in the USA the upwards drift in the
normal (and measured) unemployment rate beyond the range due to demographic
trends in our labor force. A similar pattern holds for the fall in the rate of real
growth observed in the USA. The proper approach to lower unemployment and
higher real growth involves under the circumstances a systematic reassessment
of a wide range of inherited government policies and regulatory procedures. This
reexamination with appropriate actions should indeed be welcomed and encouraged. Our society would benefit and general welfare rise. But our political
process may not produce this result and Congress may prefer to continue the
prevailing arrangement. But this also means under the circumstances that one
should rationally accept the consequences expressed in terms of unemployment
and growth rate. In particular, these consequences offer no justification for an
"expansionary" monetary and fiscal policy intended to force a lower rate of
unemployment and higher rate of real growth. Monetary policy will not deliver
this result. It would only yield on this course accelerating and erratic inflation
with unstable output and rising level of normal unemployment. And lastly, any
attempt at curing the problem of low growth and high measured unemployment
with larger doses of the "specific and structural" measures which produced these
problems contributes to accelerate the trend into stagnation and permanent
inflation.
The CHAIRMAN. Thank you very much, Dr. Brunner. As always,
you have given us a very clear position.
In essence, what you describe, what you and the Shadow Open Market Committee passed, which is: you have as a target for the money supply, MI or M2, an annual decrease of about 1 percentage point. Stick
with it.
With reference to Chairman Miller's and the Fed's 1979 targets, as
you probably know, their MI target is really a band of 4i/£ to Y%
percent. It was phrased as "1% percent to 4% percent," but then there
is a 3 percent add-on to that because of automatic transfer savings
accounts and NOW accounts.
Would you have felt good about a Federal Reserve position which
said, "All right, for the coming year, 1979, our band will be 4% to 7%
percent, of which the middle is 6 percent. Thereafter, we are going to
5 percent in 1980, 4 percent in 1981, 3 percent in 1982, 2 percent in
127
1983, ad infinitum." Would that kind of a statement have been what
you were looking for ?
Dr. BRUNNER. That indeed goes in the direction toward which I and
my friends are looking for. It is really a 4% to 7^ percent, really,
the way it was presented, and I think we should look at it this way.
That certainly would be a retardation in the direction where we have
to go relative to what we had previously. And it would also imply,
I think—and I think we should face up to it—the fact that it really
carries it through.
We will have a beginning of the economy during that track, and
as I said, I wish I knew how to get around it, but I simply don't know
and I don't see that anybody could know how we could avoid that.
Now, and again, like you said, we should continue, definitely. The
announcement should be supplemented that this is continued each
year by a further percentage reduction of both boundaries so that the
ultimate zeroing in of the monetary gross, say, for example, and one
should be about 2 or 3 percent at the most by about the middle of tjhe
eighties.
The CHAIRMAN. Toward the end of your paper and toward the end
of your discussion you talk about the need for supplementary
measures. You say, no, let's not have any "specific structural" measures. You then go on to talk about and to dismiss wage-price-incomes
policies, however clothed they may be. I certainly don't have any
difficulty philosophically with that position. But the word "structural"
certainly means to me a great many things other than wage-priceincomes policies, meek or brutal.
I want to bear down on this a bit with you. Don't you think the
structure of our economy, most of it, government-induced, I will grant
you, has a lot to do with inflation, and if your monetarist ideas are to
succeed, it really would be wise to do something about the structure?
Let me just tell you what I am talking about. Look at the composition
of our 9-percent current consumer price index inflation. Food is a very
large part of that. As you came in here today, you noticed our friends
from the agricultural regions of this country who are down here saying
that they want higher price supports.
People point out to them, the farmers, that they are in trouble very
largely because the price of land has been bid up by the capitalization
of existing price support levels and by their being overextended at
the bank and that to raise the price by governmental fiat will just
make matters worse, and so the ratchet will go on indefinitely.
Isn't structure thus very important and isn't your monetary light
at the end of the tunnel going to be snuffed put if we leave the ramshackle structure of our economy as it is? First, let me say that the
answer to me in terms of our farm prices would be to cease the everincreasing mandated, man-made, Government-made farm prices, and
instead to compensate family farmers by whatever direct payment
the Government felt necessary in order to keep people on farms. What
do you think of other methods such as the Homeowners Loan Corporation which is intended to reduce human tragedy when a bank starts
to foreclose on a mortgage because the price of land doesn't continue
to go up fast enough at the local level. Land costs deeply affect both
food production and housing.
128
What do you think of the way our localities tax land and homes and
factories with an artificially low land valuation and a correspondingly
too great valuation on improvement ? In the minds of some of us neoHenry Georgites, we would be much better off if we changed the mix
and got the same revenue from the local real estate taxes we now do,
but upped the tax on raw land and downed the tax on improvements.
I give you two examples of structural conditions as I ask you: Do
you really believe structure is irrelevant?
Dr. BRUNNER. There are several aspects I have to deal with. Really,
there are several questions involved which you raised. Let me indicate
in one fashion—I think we really have to differentiate—and that is
what you are really bringing out in your elaborations, several meanings of structure which are relevant in this context.
There are at least about two, and I want to address myself to them.
One of them I can best describe if I indicate the experiences of a few
other countries. Last week I just happened to be in Italy and Turkey
in order to work out some problems there with some friends. The
inflation problem in both countries is to a large extent the structural
problem in a very specific sense.
Look at, for instance, Turkey. They have not only the traditional
range of the Government, but then the large part of the remaining
economy is the state enterprise system. The competition between the
two major parties prevents to adjust the prices on the state enterprise
system to the reality, to the market reality.
The result is that the state enterprise is a—has a permanent deficit
which is financed by the central bank. So there is in a way the structural problem there related to that, to the political process, which
explains why we have an excessive monetary growth in Turkey. But
this inflation is the result of this excessive monetary growth.
Your question and argument involves several issues and we need to
discern several aspects or strands in the "structural problem." One important aspect bearing on the inflation problem came to my attention at
the occasion of a recent visit in Italy and Turkey. The latter country's "political-social structure" is indeed a major factor in the large
inflation—about 60 percent in 1978—observed there. The political process produced a vast state enterprise system and also obstructs adjustments of the price charged by state enterprises to the realities of the
market place. The massive deficit of this "extended political sector"
is financed by the Central Bank. The political forces shaping this social
structure thus induce the monetary expansion pushing the price level.
The "structural strands" of the Turkish society do not, per se, directly create the observed inflation. Their relevance for the inflation is
conditioned by their effect on monetary expansion. If the Turkish Central Bank would lower monetary growth and refuse accommodation of
the deficit, inflation would stop. The so-called "sheltered system" of the
Italian society contributes in a similar vein to the Italian inflation via
involvement of the Banca d'ltalia in the money-producing business.
But your question addressed substantially some other aspects of a
"structural problem." You mentioned increasing land values and the
resulting pressure to raise the support level of agricultural prices. We
should recognize in this context that land values essentially reflect the
inflation unleashed over the past 14 years by our monetary policy. Real
estate and land are probably the best hedge against inflation ror the
129
individual investor. The resulting pressure on support prices for agricultural products just forms a further consequence of the inflationary
£>licies pursued by our financial authorities. It is also noteworthy that
e occurrence or nonoccurrence of these structural elements do not
discriminate between countries which effectively lowered and those
which raised the rate of inflation. The support programs for agricultural products are in West Germany and Switzerland at least as extensive as in the United States, but these countries still managed to
lower inflation. The structural problems mentioned in your statement
certainly affect the efficient use of our resources and our welfare. They
hardly affect, however, the ongoing rate of inflation. We should avoid
the pervasive confusion of the inflation problem with aspects bearing
on relative prices of different goods and services. The observed increase
of any price in the economy is the sum of a component common to all
price increases and a specific component. The common component reflects the inflation problem and measures the ongoing rate of inflation.
The specific component expresses specific supply and demand conditions associated with particular goods or services. The specific component of different types of goods, fuel, and so forth, vary quite
substantially over time relative to the common component. Unfortunately, public attention often confuses these gyrations of the specific
component in particular price increases with the inflation problem
and attributes inflation to the special supply-demand constellation in
a particular market. "Structural" consideration addressed to the evolution of the specific component may well be appropriate in terms of efficient resource utilization but will never cope effectively with the inflation problem.
The CHAIRMAN. Thank you very much. My time is up. Before calling on Representative Kelly, I want to welcome Dr. Thurow, and I
guess I will ask Dr. Brunner his preference. After Mr. Kelly has an
opportunity to ask you some questions, would you prefer that we continue with our committee questioning of you and then go to Dr.
Thurow, or if your time permits, I would then call on Dr. Thurow.
Is that all right?
Mr. BRUNNER. That is fine.
The CHAIRMAN. But I think you do have to go, Mr. Kelly, so I will
recognize you.
Mr. KELLY. Thank you, Mr. Chairman.
Dr. Brunner, I would like to ask you, do you think that in the order
of things the monetary and fiscal policy as it is controlled by the Fed
and by the Government probably has an overwhelming impact on the
question of whether the economy is inflated or not as compared with
activity in the private sector and otherwise ?
Dr. BRUNNER. I had a little difficulty to hear you. You seem to ask
whether monetary and fiscal policy has an overwhelming effect in
which respect?
Mr. KELLY. That the overwhelming cause of inflation is created by
the monetary and fiscal policy as it is controlled by the Fed and the
Government; do you agree with that ?
Dr. BRUNNER. Yes; indeed. That is my central thrust.
Mr. KELLY. According to your testimony, over the last 15 years, the
Federal Reserve for its part has not controlled the monetary policy
consistent with that which is required in order to avoid inflation.
Let me ask you this: Is that a fair statement ?
130
Dr. BRUNNER. The Federal Reserve essentially produced the monetary expansion experienced since 1965. It has shown little interest ever
to understand the issue and to overcome its confusion.
Mr. KELLY. Then for whatever reason, the conduct of the Federal
Reserve Board with regard to properly controlling the monetary policy has just been inadequate. It has not done what was necessary to
avoid initiation, for whatever reason.
Dr. BRUNNER. That is exactly the point.
Mr. KELLY. Now, to the extent that fiscal policy also makes a contribution to inflation, the fiscal policy also has not been consistent
with maintaining a level of economy as opposed to inflated economy.
Would you agree with that ?
Dr. BRUNNER. When we speak about the role of fiscal policy we need
to remember the following: First, fiscal policy importantly affects
our welfare and the development of our resources but exerts little direct
influence on inflation. Second, there is however an indirect effect of the
deficit on inflation via the political pressure on the central bank to
monetize the deficit.
Mr. KELLY. Then when one considers the impact of the activity, the
pricing activity of the private sector, as a cause of inflation compared
with the cause by the monetary and fiscal control of the Government,
it is a relatively minor part. In other words, it probably plays even
less a part than the fiscal policy and substantially less than the monetary policy.
Dr. BRUNNER. Well, the pricing behavior of the private sector is
simply an adjustment to the monetary and fiscal policies pursued.
Mr. KELLY. So it is simply a response to what is established by the
monetary and fiscal policy ?
Dr. BRUNNER. That is exactly the point. That is why we find these
differences between the various countries.
Mr. KELLY. Then let me ask you this: Can we then really have any—
can the American people, the people that are realy paying the price
for all of this nonsense, present and prospective, can they really hope
for any relief with the President's voluntary guidelines? Isn't that
more a diversionary tactic to just draw attention away from the real
causes than anything? It is sort of a public relations-type of thing as
far as it having any real impact on inflation.
Dr. BRUNNER. Indeed, guidelines of any kind, voluntary or mandatory, misdirect our attention from the central aspect of inflation. They
form a sort of handwaving to obscure the basic responsibility of the
Government. They cannot cope with inflation but damage our economy.
Mr. KELLY. If I understand you then, that this will have no impact
on the rate of inflation ?
Dr. BRUNNER. That is right.
Mr. KELLY. There has been a pretty substantial effort or sentiment
expressed here in the Congress that in order for us to get our act together for a sound economy in America, what we need to do is to have
a little more political control over the monetary policy so that there
won't be any inconsistencies between the monetary policy and the
fiscal policy so that the same people that are controlling the reins of
the fiscal policy will also be able to control the monetary policy so that
they can go in unison.
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My question to you: It is the failure of the Fed to perform with any
kind of courage and consistency their obligation to control the monetary policy in a way that would create a sound economy which endangers the strongest argument for independence of the Federal
Reserve System.
Would you agree with that ? In other words, if the thing isn't working, what difference does it make whether it is independent or controlled or whatever? But if it does work, there is a strong argument
for its independence.
Dr. BRTJNNER. The crucial issue confronting us is really the public
accountability of the central bank. The central bank is a political institution which need be made accountable for its action. This accountability hardly exists in any relevant sense in this country. The persistent
obfuscation cultivated by the Federal Keserye bureaucracy protected
the Fed from the accountability really required in a democratic government. The Fed invested a massive political effort to obscure the fact
of its responsibility for the large depression from 1929 to 1933. It
again used all the political mechanisms available to obscure its responsibility for the inflation in recent years.
It is interesting to compare the Fed with the Swiss National Bank
in this respect. The latter actively mobilized a tacit but powerful coalition including most of the political spectrum to support a noninflationary course of monetary policy. This coalition suffered last year a
serious setback and at the time the survival of a noninflationary policy
is really on the line.
Our major problem currently is to find a procedure which forces the
Fed against its entrenched bureaucratic instincts to a pattern of meaningful public accountability. Congress could assume an important role
in this respect by insisting that the Fed provide useful data that specify unambiguously the monetary target conducive to a stable pricelevel by 1985 or so and that the Fed be held responsible in public to
satisfy their obligation.
And in this respect, appropriate measures should be taken.
Mr. KELLY. Dr. Brunner, my time has expired, and I thank you for
the opportunity to inquire.
The CHAIRMAN. Dr. Brunner, we will now hear from Dr. Thurow,
and then we will resume our questioning.
Welcome. We appreciate your long wait through difficult conditions.
STATEMENT OF DR. LESTER THUROW, PROFESSOR OF ECONOMICS
AND MANAGEMENT, MASSACHUSETTS INSTITUTE OF TECHNOLOGY, CAMBRIDGE, MASS.
Dr. THUROW. I apologize for being late but the Washington airports
weren't open either last night or this morning. So I spent several hours
in the air.
At the moment, all forecasts, Government and private, call for a
sharp slowdown in the pace of economic activity late in 1979 or early
in 1980.
Unemployment rises under all forecasts and a technical recession
occurs in most of the private forecasts. While there has been an argument as to whether a recession will actually occur, this argument should
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not be allowed to obscure the consensus on a sharp slowdown and a rise
in unemployment.
If you remember that monetary and fiscal policies only affect the
economy with a time lag, there is a real question as to whether current
and planned monetary and fiscal policies are appropriate. These
policies should now be adjusted to prevent a recession or slowdown
from occurring. To be forced to adjust the policies to fight a recession
during a recession is to engage in a policy action that cannot work
because of time lags.
Under the pressure of rising unemployment, policymakers are also
apt to adopt monetary and fiscal policies that will be too strong with
respect to long-run inflationary problems. A recession by definition is
not good for unemployment and it is, as I shall argue in a minute, also
not good for inflation.
Instead of being moderated now to prevent the expected recession
at the end of the year, both monetary and fiscal policies have recently
been tightened and are expected to be tightened further. This is completely inappropriate and will only make the recession or slowdown
at the end of the year worse.
Since September the money supply, M2, has risen at an annual rate
of 4 percent and short-term interest rates have risen by 2 percentage
points. Over the last iy2 years interest rates on commercial paper have
risen by 5 percentage points.
This tight monetary policy is not necessary to counteract loose fiscal
policies. Fiscal policies are now tight and scheduled to get tighter. With
the Federal Government now paying 25 percent of all State and local
government bills, government budgets have become integrated and it
is no longer possible to judge the tightness of fiscal policies by looking
at the Federal budget.
In the last three quarters, State and local governments had a $27billion surplus—at annual rates—the Federal Government had a
$22-billion deficit, and was at the same time giving State and local
governments $78 billion.
Overall Government has been running a $5-billion surplus for the
past three quarters and it is scheduled to keep running a surplus unless a recession occurs and lowers revenues. Under the proposed Carter
budget, this surplus will rise by $7 billion to $8 billion in 1979 and
another $6 billion to $7 billion in 1980.
Thus, both fiscal and monetary policies are tight and fiscal policies
are scheduled to tighten further at precisely the time when a recession
or slowdown is predicted to occur. This hardly seems like monetary
and fiscal policies coordinated in the way in which the Full Employment and Balanced Growth Act of 1978 intended.
In addition, the economy is going to be hit by the full deflationary
shock of the scheduled OPEC oil price increases—and price increases
induced by the Iranian shutdown—in late 1979.
An increase in the price of oil is equivalent to a domestic sales tax
in oil. At one and the same time it raises the price of energy and reduces the demands for other goods and services. More of our income
is now diverted to Government, in this case a foreign government, and
less is available for the purchase of other goods and services.
While history never exactly repeats itself, I think that we are
setting ourselves up for a replay of 1974. High inflation became the
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sole concern and in the process monetary and fiscal policies were tightened to the point where they caused the sharpest recession since the
Great Depression. We have not yet tightened monetary policies to
1974 levels, but we are headed in that direction. Throw in a run on the
dollar and you can easily imagine the Federal Keserve Board devastating the economy as it did in 1974.
Let me turn for a moment to the causes and cures of inflation.
Like generals condemned to fight the last war, the Federal Keserve
Board does not seem to realize that the experience of double-digit inflation and recession in 1974-75 has altered the characteristics of the
economy. A mild recession or slowdown would have moderated the rate
of inflation in the fifties and sixties, but by the end of the seventies,
it does not work. Mild tightenings of monetary and fiscal policies
have lost their ability to control inflation since the economy has indexed
itself.
This is not the place to go into detail on the evidence as to how
the private economy has indexed itself or to recount the number of de
facto and de jure cost-of-living escalator clauses that appear in private contracts or Government programs, but it is the place to remind
ourselves of the consequences of indexing.
What happens if the economy is heavily indexed ?
Suppose that inflation is running at 8 percent in a 10-percent indexed
economy. With indexing, all wages and prices go up by 8 percent in
year 2 to counteract the inflation of year 1. But if all wages and prices
go up by 8 percent, the rate of inflation is 8 percent. Hence, wages and
prices go up by 8 percent in year 3, et cetera. In a fully indexed world
only two things can reduce the rate of inflation: one, favorable international events such as a fall in oil prices, or two, a basic wage settlement which is for less than the rate of growth of productivity.
Monetary and fiscal policies can be tightened in an indexed world,
but they only produce unemployment and idle capacity. They do not
produce a reduction in the rate of inflation.
It is possible to argue that a truly dramatic recession and rise in
unemployment would drive the indexes and the expectations out of
the economy, but this would require an enormous cost in terms of lost
output and unemployment. Exactly how high and how long the unemployment would have to last is a matter of controversy, but no one
thinks that a mild short recession will work.
It does not have the necessary shock value.
The current acceleration in the inflation rate was not caused by
overstimulating the economy and it will not be cured by slightly deflating the economy in 1979 and 1980. If you look at the causes of the
acceleration during 1978, it can be traced to food price increases,
half caused by Government policies, a fall in the value of the dollar,
an increase in the minimum wage, a rise in social security taxes, an
increase in the costs of homeownership, half caused by rising interest
rates, and a variety of other factors such as steel reference pricing.
If excess demand played any role at all, it was very limited and in
such specific sectors that it cannot be controlled by general economywide policies.
If you look at the 1978 causes of inflation, most are apt to be repeated in 1979. Meat prices are still going up, with the increase in the
price of oil the dollar is apt to fall further, the minimum wage will
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once again rise, social security taxes went up in January, the full
effect of rising interest rates has not yet been felt in the costs of homeownership in the indexes.
In addition, oil prices are going to rise very rapidly. The Council
of Economic Advisers predicted in its report that the rate of inflation in the implicit price deflator for the GNP would fall from 8.3
percent in 1978 to 7.5 percent in 1979. I think that this is highly
unlikely. Inflation will be as high or higher in 1979 as it was in 1978.
Indexing will cany most of the 1978 inflation into 1979 and we are
going to add to this inflation with the set of actions just mentioned.
If a solution to inflation is to be found, it must be found in either
a workable incomes policy or a sector-by-sector attempt to redua,
prices, the deregulation of trucking, the abandonment of steel and
agricultural price supports, and so forth.
A policy of sustained, modest rates of real growth can contribute
to this effort, but stop-go economics and a mild recession or slowdown
are not going to solve the problem.
Let me talk for a minute on defending the dollar. To some extent,
monetary policies are now focused on supporting the price of the
dollar. I have no objection to supporting the price of the dollar if it
can be done, but I am afraid that the Federal Keserve Board is making the U.S. economy hostage to an untenable position. One cannot
defend the indefensible. Defending the dollar only makes sense if the
equilibrium value of the dollar is as high or higher than the -current
value of the dollar. If this is not true, it is only a question of tinpte
until the defender is beaten.
In the process of being beaten, the U.S. taxpayer will take large
capital losses on the foreign currency borrowings that have been made
in his behalf, but an attempt to defend the dollar can be even more
costly if it leads to tight monetary policies during a period of slow
economic growth such as that which we are now facing.
Tight money and a recession already underway produced the collapse of the U.S. economy in late 1974. With rising oil prices, the
pressure on the dollar is apt to be most acute in late 1979, but this is
exactly the time when a recession may be underway. Defending the
dollar may well collapse the economy.
As a result, I think that this committee should ask for the technical
studies showing that the equilibrium value of the dollar, given current
and expected oil prices, is as high or higher than the current price of
the dollar. If the Federal Keserve Board cannot present such evidence, it should not be in the business of defending the dollar. Without such evidence, it is doing something that is in neither the short-run
nor the long-run best interests of the U.S. economy.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Dr. Thurow.
It is, incidentally, a very active confrontation generated by your
testimony and that'of Dr. Brunner's, which I am sure can be explored
during questioning. In your testimony you place considerable store
on getting some reforms in the structure of our economy: whereas,
Dr. Brunner takes the view that while that may be desirable for reasons of income distribution or equity, it doesn't have much of anything
to do with inflation.
So we return to that.
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But I, having had my initial round of questioning, will wait until
others have had a chance to examine.
Mr. Lowry?
Mr. LOWRY. Thank you, Mr. Chairman.
Dr. Thurow, my question isn't really directly to all of the things
you have touched upon, but what we are facing here, fiscal policywise
in this Congress, are requests for a decrease in the rate of the increase
of the deficit from $10 to $20 billion, perhaps.
What do you think as far as the effect on inflation, of decreasing the
annual deficit would have, say, if we ended up with a $15- or $20billion annual deficit this year, as opposed to $40 billion ?
Is that a definable effect on inflation ?
Dr. THUROW. Well, one of the things I would want to refer to that
comes back to my testimony, is I do think that the American economy
has heavily indexed itself.
Now Brazil has legal indexing, which means that the Government
passes a law that says that every contract, implicit or explicit, has a
eost-of-living escalator clause in it.
The classic objection to legal indexing is if you do it, it means that
neither monetary nor fiscal policies can have the impact on prices
that they otherwise would have.
Now we have a good hunk of legal indexing, indexes that have been
put into government programs. But we, the private economy, haven't
indexed itself in both wages and industrial contracts.
Now in an indexed world, modest tightenings of fiscal policies and
modest tightenings of monetary policies don't have any substantial
effect on the rate of inflation. All they do is produce a little bit higher
unemployment.
Now if you are willing to go whole hog and have really a dramatic
recession, then, since these indexes are put into the economy by the
private decisionmakers, they just won't be honored and will be taken
out of the private economy. But raising the unemployment rate from
6 to 7 percent doesn't cause indexing to leave the economy.
The other thing 1 would want to say is whatever you think the
right degree of fiscal tightness is, you can no longer look at the
Federal budget with this huge amount of grants-in-aids. We just have
changed the structure of the American economy and we have a government budget which is Federal, State, and local, and you can only
judge fiscal policies in terms of the surplus or deficit in that government budget. You can't look at one fraction of it.
Like, take the last 9 months where, as I mentioned, the States have
had a $27-billion surplus, the Federal Government a $22-billion deficit,
and the Federal Government was giving the States $78 billion.
Well, as a bookkeeping measure, you could reduce grants-in-aid to
the State and local governments by $27 billion. If that doesn't cause
any changes in their plans, they then would have a balanced budget.
The Federal Government would have had a $5-billion surplus. But
that wouldn't change anything in terms of the economy.
The fact of the matter is, government has had a surplus for the
last 9 months.
And you can make an argument that perhaps that total surplus
ought to be bigger, and that is a discussion I would be willing to have
but I think it is completely inappropriate to look at the Federal
136
budget by itself and try and decide whether fiscal policies are good or
bad.
Mr. LOWRY. There is, of course, a lot of discussion that the psychological impact of the Federal Government making that obvious effort
to tighten would have an impact on the economy and on inflation.
Do you think that holds water ?
Dr. THUROW. There are two ways to look at it: One, you can think
of the economy as being indexed—and in that case, let us say that
the rate of inflation has already started and you have indexes in the
economy. Then the rate of inflation essentially gets propagated because, given that inflation was 8 percent last year, the indexes carry
it forward as 8 percent this year.
To some extent, expectations play a role and I would not want to
deny that.
But the real question is: Can modestly tightening, let us say this
total government budget, so instead of having a $5-billion surplus,
you have a $15-billion surplus, is that going to change anybody's
expectations?
I doubt it.
If you) were willing to stand up and say, look, I am really going
to crack the American economy. I am going to have really severe
monetary and fiscal policies, and I am just going to tolerate whatever
level of unemployment and whatever level of disruption that causes,
then you might buy something in that round.
But I think that there is a real argument as to whether the kind
of modest tightenings in the current world really have a payoff.
Mr. LOWRY. Thank you. Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Green.
Mr. GREEN. Dr. Brunner, I wonder if you would care to comment
on the argument that indexing frustrates the monetary or fiscal approach to dealing with inflation ?
Dr. BRUNNER. Let me see if I understand correctly. Would I comment on the arguments made now by Professor Thurow ?
Mr. GREEN. Well, I understood Professor Thurow to be arguing
that, in fact, fiscal and monetary policy were hopeless in the face of
an economy which has as much indexing, contractual or legal, as that
of the United States.
Dr. BRUNNER. Two issues require our attention here, the asserted
uselessness of monetary policy in the context of indexing and the
more or less implicit suggestion that we need "structural reforms"
which would be nothing more than another variation on the old price
control theme.
The assertion that monetary policy is powerless to cope with inflation in the context of inflation is simply false. Brazil was thoroughly
indexed and still, the large variation in monetary growth produced
corresponding waves in the rate of inflation. Professor Thurow has
no analysis to back up his claim.
The claim for controls is also fallacious. We have acquired some
experiences over 2,000 years which governments are always willing to
disregard. I draw your attention to the description in Barbara Tuchman's book, "A Distant Mirror." She describes how the French King
produced inflation in the middle of the 14th century with his persistent
tampering with the coinage. And in a fashion most typical for our
137
times also, after creating inflation he promptly accused the private
sector and imposed statutes preventing increases of wages and prices.
But these statutes had little effect on inflation. The world has changed
in many respects but not in this. If we continue on the track of an
inflationary monetary policy with the excuse of indexation, we will
experience rates of inflation up to 20 percent per annum and a stagnating economy in 10 years.
Mr. GREEN. Can I just press that point a little further? You have
argued that wage and price controls won't work, but you haven't
really responded to the argument that the monetary and fiscal policy
won't work, and that because of the indexing built in
Dr. BRUNNER. I was certainly surprised to hear that indexation
condemns monetary policy to impotency. There is simply no economic
analysis supporting such a contention. We should also note that the
extent of indexation depends on the course of inflation. With a persistent fall in the rate of inflation, the extent of indexation declines.
Indexation expands on the other hand with accelerating inflation. But
with or without indexation, the rate of monetary expansion determines
the ongoing rate of inflation. I have already referred to Brazil. Beyond the point previously mentioned should be noted that we learn
from Brazil that the cost of transition to a widely indexed economy
is not trivial.
Mr. GREEN. I would be happy to give Professor Thurow a chance
to respond.
Dr. THUROW. One, I was not advocating incomes policy because I
think the preferred strategy is essentially to take the sector-by-sector
approach, like the deregulation of trucking, and wherever that allows
prices to go down, you then want to have tighter monetary policies
because I am also not arguing that monetary policies are hopeless.
They can make the situation a lot worse, and I think we should
have monetary restraint.
What I am basically arguing is that we should aim for monetary
and fiscal policies which keep the economy growing at a positive real
rate, around 2 or 3 percent a year, because I think if we let them
tighten so far that we cause a recession, then for political reasons, and
other reasons, we are going to have to let them go very easy for a
period of time, and that is worse than keeping the economy growing
at that modest rate during that period of time.
Mr. GREEN. Are you persuaded that we can fine tune the economy
tightly enough to make that distinction between 2 or 3 percent growth
and zero growth, for example ?
Dr. THUROW. I am sure that we can. We may not be able to succeed,
but we don't deliberately pump monetary policies into the economy
that will cause that kind of a recession to occur.
Let me say one thing about the slowdown in the Swiss rate of inflation because as long as we are going to have a controversy here, we
might as well have it full blown.
Imagine the following world. Now, these are not the Swiss numbers, but this indicates the Swiss situation. Imagine that you have a
domestic rate of inflation of 10 percent and a rate of inflation in every
country in the world of 10 percent, but you import 50 percent of your
GNP and your currency goes up 20 percent in value.
138
Now, what does that mean happens to the cost of your imports?
They are going down 10 percent. Y ou get minus 10 percent rate of inflation on half of your GNP, plus 10 percent rate of inflation on half
of your GNP, and you have a zero rate of inflation.
And a big part of the downturn in both the German and the Swiss
inflation have to do with an appreciating currency in economies that
have very large imports.
Now, let me say one further thing on indexing.
It isn't a matter of analysis; it is a matter of simple logic. And I
don't know any American economist who would argue that if the
world is 100 percent indexed—noW, we can argue about whether the
world is 100 percent indexed, but if it is 100 percent indexed, then
monetary policies lose a lot of their power because legally, every wage
and price goes up in the following year because the rate of inflation
was 8 percent last year.
And in that kind of a world, as I mentioned, there are only two
things: If everybody has 100 percent indexing, that will cause the
rate of inflation to slow down; favorable international events or a
basic wage settlement which is less than the rate of growth or productivity ; that is, 1 percent in our economy at the moment.
There is nothing else that will work.
Now, you can say, well, the economy isn't 100 percent indexed. I
would admit that it is not 100 percent indexed, but it is very close to
it. If you look at labor contracts, they are close to 100 percent indexed.
Now, you can say, well, ony 20 to 25 percent of the American labor
force belongs to unions. But if labor contracts are indexed, then General Motors is going to give the same increase to its white-collar
workers who are not unionized. If General Motors is giving the costof-living escalator increase, then nonunion companies like Xerox are
going to have to do it to keep their labor force, or to keep unions out.
If large corporations are giving cost-of-living increases, then small
companies have to do it or they lose their best workers.
I do a fair amount of speaking to business groups, and I have taken
to asking the rhetorical question, how many people in this room would
sell the commodity that they produce for delivery a year from now
with a contract without the protection of a cost-of-living escalator
clause.
I have never gotten a single hand raised. And I think this economy
is very highly indexed, even if it is not 100 percent indexed.
Dr. BRUNNER. Mr. Chairman, may I comment?
The CHAIRMAN. Yes; Mr. Green's time is up, but surely, you may
comment.
Dr. BRUNNER. Thank you very much.
The rise in the Swiss franc was neither a gift of the gods nor a
curse imposed by demons. It resulted from the radical difference between the monetary policies pursued in Switzerland and in other
countries. It was this policy which induced the rise in the Swiss franc
and lowered import prices in francs.
We should however also examine movements in domestic prices.
There is hardly an item more domestic or "nontraded" than building
materials. It is noteworthy that building material costs mostly fell
since 1975.
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Lastly, I do not wish to pursue a technical discussion of indexation,
inflation, and monetary policy before Congress. But I do invite Professor Thurow to present a paper with an analysis supporting his
contention. I guarantee him that I will publish it in the Journal of
Monetary Economics for the public inspection by the profession.
The CHAIRMAN. Thank you.
Mr. Wylie?
Mr. WYLIE. Thank you very much, Mr. Chairman.
Dr. Brunner, I am glad to see you again. I am just sorry you are
not still at Ohio State and a constituent of mine, as you once were.
I 'apologize for having to leave for a moment, but I had to look into
the Federal gas plant closing in Columbus.
You mentioned the Swiss situation, and I know your feeling on that,
having talked to you about it before.
Is Switzerland really an analogous situation that we can look to for
guidance ? There are only about 6^ or 7 million people in Switzerland
and we are talking about 220 million people in the United States. And
they have a fiscal policy which says that if a welfare program is to be
increased, they have a plebiscite for the program in Switzerland to
see if the voters want to pay for the increase in welfare expenditures.
I know you make frequent trips there. Are you still teaching at the
University of Berne?
Dr. BRUNNER. Yes.
Mr. WYLIE. Do you really think there is an analogy that we can look
to as far as the fiscal and monetary solution to the problems are
concerned ?
Dr. BRTJNNER. The trends in the government budget and fiscal policy
in major Western countries do show some remarkable analogies. The
Shadow European Economic Committee has repeatedly emphasized
this point in recent years. In all cases the expansion of the budget did
not result from the government's purchases of goods and services but
from an explosion of transfer payments.
This also happened in Switzerland. However it is also worth noting
the taxpayers' and voters' reaction to the legislators and the administrations largess. The referendum provided by the Constitution offers
the voters a veto power over Parliament. Budgetary bills proposed by
the administration and approved by Parliament were repeatedly rejected with a large margin by the Swiss voters. This political mechanism worked effectively as a brake on budget expansion and deficit.
Mr. WYLIE. The point I am making is that in Switzerland, they
don't run substantial budget deficit like we do.
Dr. BRUNNER. They have. They have a budget deficit.
Mr. WYLIE.. What is the percentage of gross national product?
Dr. BRUNNER. It is probably less in proportion to gross national
product than in the United States.
Mr. WYLIE. You are a monetarist and you feel that fiscal policy
doesn't mean all that much, as I gather from your statement.
Dr. BRUNNER. For inflation. It means a lot for many other things.
Mr. WYLIE. But not as far as inflation is concerned ?
Dr. BRUNNER. Right.
Mr. WYLIE, What do you think about the bill which provides for a
constitutional amendment to say that we don't spend more than we take
in except in time of war or economic necessity ? Now some 26 States
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have ratified a resolution calling for a constitutional convention to
prohibit deficit spending.
Dr. BRUNNER. I certainly am in favor of some form of constitutional
limitation on the Government's budget. But we need to ponder somewhat about the form of such limitation. A constitutional requirement
to impose a balanced budget seems least desirable in my judgment.
Limitations on the magnitude and growth of spending, taxing, and
indebtedness seem to me more useful. We should be concerned however
about the potential escape mechanisms. Government may be instance
delegate tasks and powers to more or less autonomous public corporations and grant them the right of independent indebtedness or offer
extensive financial guarantees. The limitation on spending should explicitly cover the current value of all liabilities arising under various
forms of financial guarantees. This should certainly include the current
value of the implicit obligation imposed on the Federal Government
by our social security system.
Mr. WYLIE. I will want to read the record back and develop a better
understanding of your answer to that. But what do you think of the
decline in Fed membership ?
Dr. BRUNNER. The decline of Federal Eeserve membership is essentially a result of inflation. I apologize to sound like Cato.
Mr. WYLIE. From your viewpoint as a monetarist, is that a serious
problem ?
Dr. BRUNNER. Inflation drove interest rates to high levels and raised
thus the cost of membership. The revenues forfeited as a result of the
comparatively high reserve requirements imposed on member banks
rose with the level of interest rates.
The decline in membership poses by itself no problem to monetary
policy. All the computations I made on several occasions clearly indicate that the changes in the proportion of the membership have no
relevant effect on the controllability of monetary growth. The extent of
membership affects the political clientele of the Fed but not the execution of monetary policy.
There is really a simple solution to satisfy the Fed and encourage
membership. All we need to do is to abolish the reserve requirements.
No case has ever been made over 200 years in support of the contention that reserve requirements contribute to a better control of monetary growth. Monetary policy does not need reserve requirements.
Once they are abolished this particular cost of membership vanishes.
Mr. WYLIE. I have been given a note that my time has expired. I
wonder if I might ask one more question.
The CHAIRMAN. Without objection.
Mr. WYLIE. Because it refers to his testimony; on page 6 of your
statement you list institutional innovations in the financial industry,
that erode the meaning, of published data, as you put it; do overnight
repos constitute the bulk of repurchase agreements? That is one
question.
And if you were asked to state a given percentage of distortion
introduced into the estimates of traditional measures of the money
supply, such as MI and M2 by the institutional innovations which you
have mentioned on page 6, what would that percentage be for all of
the innovations, and what would it be for the repurchase agreements
alone?
141
Dr. BRUNNER. Some rough computations were prepared for the
March session of the Shadow Open Market Committee. These computations suggest that the retardation of measured Mx by 11 percentage
points experienced in the last 4 months seems to overestimate the true
retardation by somewhat more than 4 percentage points. The error
appears to be smaller in the case of M2. In either case Congress and the
public are confronted by a serious information problem. The published
data for MI and M2 are quite inadequate. Until the Fed has clarified
our data base, monetary policy should best be formulated in terms of
the monetary base.
Mr. WYLIE. Thank you very much. I do have one more question that
1 asked the Chairman of the Federal Eeserve Board, Mr. Miller, and I
ask you to respond to if you will, please. And I ask that for the record.
The CHAIRMAN. That will be submitted to you, Dr. Brunner, and if
you could perhaps respond for the record, I know it would help Mr.
Wylie very much.
Dr. BRUNNER. I would be glad to do that.
[Congressman Wylie's questions and Dr. Brunner's response
follow:]
QUESTIONS SUBMITTED BY CONGRESSMAN WYLIE TO DK. BRUNNER
Question. My question is essentially the same one that I asked Chairman
Miller, and it is in two parts. First, do yon believe the Federal Reserve would
have greater success in controlling inflation if it controlled the monetary aggregates directly rather than by operating indirectly through interest rates? Second,
in light of the fact that the Federal Reserve uses interest rates rather than monetary aggregates as a basis for its operating targets, do you believe it is necessary,
as the Federal Reserve has argued it is, for Congress to pass legislation extending
reserve requirements to the monetary liabilities of nonmember institutions?
REPLY RECEIVED FROM DR. BRUNNER
Answer. The answer to your first question is indeed in the affirmative. The
existing implementation of policy based on setting a target range for the Federal
Funds rate produces a poor control over monetary growth. This point has been
made by many economists and over many years. The Fed has never supplied
an adequate justification of its traditional procedure. An effective anti-inflationary policy requires that the Fed specify first meaningful targets for monetary
growth. This target need, secondly, be translated into a required growth rate
of the monetary base. This involves appropriate estimates of the monetary multiplier. Thirdly, the requirement growth of the monetary base must be translated
into specific instructions to the account manager in terms of the volume of net
purchases to be carried out over a month and quarter. The procedure has been
presented in more detail in various position papers of the Shadow Open Market
Committee. I also refer to the technique developed along these lines at the Swiss
National Bank. This new procedure should be supplemented by simplification
of reserve requirements. All interest ceilings imposed on any bank liabilities
should, moreover, be abolished. We can expect that under the circumstances the
efficacy of monetary control would be substantially improved. The Fed's traditional procedure and conception contributed in the past on frequent occasion to
aggregate our problems. It produced an accelerated monetary growth during
expansions or in periods of rising inflation and lowered monetary growth during
recession. The Fed's procedure is well designed to destabilize the economy. Other
Central Banks have learned their lesson. Could we not expect even the Fed's
bureaucracy to learn from the experience of others in this respect?
Concerning the second question the Fed has shown little interest in reserve
requirements beyond their effect on the Fed's political clientele. My work bearing on these mutters shows that the differentiation between member and nonmeinber banks exert comparatively small effects on the behavior of monetary
aggregates and particularly on their degree of controllability. The existing structure of reserve requirements imposed on member banks produces actually larger
142
problems. An extension of the arrangement covering member banks to non-member banks would hardly raise the level of monetary control. It is more probable
that this extension worsens the potential degree of monetary control. It should
be noted here that no systematic case has ever been presented to that reserve
requirements contribute to improve monetary control. The Fed's own behavior
over the past supports this contention. It never used changes in reserve requirement for purposes of monetary policy over the postwar period. Every single
change in requirements was usually offset to a large extent by open market policies. Requirement policy thus was essentially a tax policy applied to banks with
out Congressional consent. The best solution would be no reserve requirements
to play with by the Fed. The next best are uniform (and low) requirements on
liabilities of all financial institutions. The requirements should be fixed by law
and not be subject to manipulation by the Fed. As a third best, I suggest, a small
range for possible manipulation without any discrimination however between
institutions or magnitude of deposits. Such discriminations tend to complicate
the problems of monetary control.
The CHAIRMAN. Mr. Paul.
Mr. PAUL. Thank you, Mr. Chairman. Professor Brunner, you mentioned in your testimony that you think we should pay more attention
to the monetary base, and I have observed that most economists
usually talk only about MI and M2.1 would like you to comment on the
reasons for that, and also comment on how M! and M2 and interest
rates would be affected if the Fed concentrated only on the monetary
base?
Dr. BRUNNER. I have to apologize. I have to ask again. I do have for
a few days a pressure on my ears which makes a bit of a problem. Can
I have it again, that the problem is how to explain
Mr. PAUL. I observed that many economists are interested only in
watching Mj and M2, and you mentioned in your paper that you are
interested in the monetary base. I was wondering why and how you
think that concentration on the monetary base would affect MI and M2
and interest rates.
Dr. BRUNNER. The issue is not that the monetary base is everything
and the end of our consideration. The monetary base is a major
determinant of the monetary aggregates and is free of the measurement errors currently embedded in Mx and M2. I conjecture that the
movement of the true measures for MI and M2 over the past months
is much closer to the path followed by the monetary base than indicated by the currently available data. We also observe that the velocity
of the monetary base exhibits a remarkable regularity. This fact and
the reliability of the data pertaining to the monetary base determine
my proposal. If the Fed lowers over the next 5 or 6 years the growth
rate of the base to 2 percent per annum, inflation will be lowered to a
trivial level. We can attend to this program irrespective of our current
difficulties with the available data on Mx and M2. I most definitely
would object to any overreaction so frequently shown by the Fed. The
year-over-year growth rate of the base has already descended from an
average of 9.5 percent, for the 7- and 12-month periods ending in June
1978 to December 1978, to 8 percent for the 12-month period ending
February 1979. This is sufficient for the moment. The goals of the Full
Employment and Balanced Growth Act would be best served with an
8 percent growth this year followed by a 1 percentage point decline in
each subsequent year until the base grows by about 2 percent per
annum or a bit less.
So in this respect what I am aiming at essentially, that we should
control the monetary growth, and that is what we have to do over the
143
next 5 or 10 years. Now, my emphasis on the monetary base at the
moment is essentially simply this: at the moment we have, for instance,
a very large retardation in MI and M? jointly since last October.
It is not very clear at the moment, given the measurement errors, to
what extent this is associated with measurement errors that, for instance, the overnight repos have ballooned in the last years with
interest rates on certificates of deposits, to which extent it is essentially
a transitory event of the certificates of deposits and similar things, and
the retardation in the monetary base has so far been relatively
moderate.
It has gone down from about 9 percent to 7 percent, the retardation
in the last 3 months. So the issue is therefore to focus on what we
know with certainty. This is the growth rate in the monetary base and
direct attention by the Fed that it should move along a path as indicated, and at the same time shape up its information pertaining to
the monetary aggregates.
And the justification I gave is that the movement of the monetary
base, whatever the measurement errors are in MI and M2 will ultimately prevail in whatever the true measures of M1 and M2 are; not in
a week, not in a month, not in a quarter, but certainly in the average
over a year.
Mr. PAUL. Also you mentioned that in 1972 and 1976 the Federal
Reserve abandoned all monetary restraint. Is it a coincidence that
these were also election years ?
Dr. BRUNNER. Well, the concern I have in this respect—and possibly
I mean our concerns overlap here with Professor Thurow—is the
following: namely, that the Federal Eeserve in realizing now that it
has to do something about inflation moves too fast and too far.
The way it is usually done, very frequently done in the past, I
definitely would not want the Federal Reserve to lower monetary
growth, say for instance, to 2 or 3 percent this year. I would not want
the Federal Reserve to immediately lower the monetary base, from an
average growth rate of 8 to 9 percent to 2 to 4 percent, not until the fall
of next year.
I think in my judgment that the social cost of transition would
immediately loom fairly high and particularly as a result of that, the
probability of the Federal Reserve reversing itself again next winter
would be very, very high because the economy would start weakening
rapidly late this year. And, well, there is a presidential election year
coming up, and the pressures on the Fed will mount under the circumstances, in my judgment, and reverse itself.
So we are simply starting the old path again and 'again of these
circumstances.
Mr. PAUL. Thank you.
The CHAIRMAN. Thank you. Mr. Bethune ?
Mr. BETHUNE. Thank you. Dr. Thurow, I was privileged to hear
you at Harvard, and I was impressed with your presentation then.
Now on listening to you today, it seems that there is some difference
in the presentation, at least my perception of the presentation; you
seem to be suggesting that there are alternatives to fiscal and monetary
restraint, yet when we get to the point concerning the alternatives, I
don't find much help. And I was a little frustrated when we got to that
point in your presentation.
144
You mentioned workable incomes policies, and then twice you relied
on deregulation of trucking as having some potential for price relief
to reduce crisis. And I would like to propound this question to you:
Are you relying there on the experience in the airline industry as some
evidence that there would be price relief in the trucking deregulation
proposition ?
Dr. THUROW. One, I think you slightly misinterpret me because I
think we should have fiscal and monetary restraint. Without those
nothing else works. And in the last statement made by the other
witness, I think we are very close because if you assume that the
monetary base has been growing at 8 percent and since the fall it has
been growing at 4 percent, then I say that is is too low. And the other
witness also said that is too low.
We may very well be able to compromise at 6 or 7 percent and both
agree that that is the appropriate thing to do from different perspectives. The strategy I think we need to follow in fighting inflation is to
have modest fiscal and monetary restraint because I think fiscal policies have some impact on the system or can at least make the system
worse.
But if you want to have any noticeable reduction in the rate of inflation, you have to do other things along with those modest fiscal and
monetary policies; making them too tight I think will do exactly
what was mentioned in the last question. The pressures will build up
to overstimulate the economy again. And so I think a recession is
really counterproductive, and to deliberately cause one is doubly
counterproductive, not just with respect to getting people reelected
but with respect to having a good economy.
And if you think about—essentially I am not in favor of incomes
policies as a solution because I think they are very difficult or impossible to make them work for any extended period of time in the
American economy.
If you think about the sector-by-sector approach, the argument is
that there are many things which the Government does where it could
lower the rate of inflation or lower prices in some area, and by lowering
prices in that area, if the economy is heavily indexed—let us just
say, for example, that by deregulating airlines you reduce airline prices
and that reduces the Consumer Price Index from 7 to 6y2 percent. Then
under the cost-of-living escaltor clause, the next year, instead of giving
7-percent wage and price increases, people only get 6i/£» percent, and
so you have bought something in the long run, if you have monetary
policy that accommodates along with that reduction in the rate of
inflation.
Now, if Professor Houthakker at Harvard a few years ago listed,
I think, 50 some such areas—for example, agricultural price supports—and I don't remember whether your district has a lot of farmers or not—half were classified food inflation last year, and that makes
some difference in the system.
Steel reference pricing added $40 to a ton of steel. Maritime subsidies add a lot to the price of sea transportation and maritime regulations. Trucking regulations add a lot to the price of trucking. Now,
if we could go down that road of getting rid of some of those things,
they would be good in and of themselves, and they would also allow
the Fed to have tighter monetary policies without making unemploy-
145
ment higher because I think the unemployment thing is one of the
things you have to think about seriously, and that is one of the differences between Switzerland and the United States. I don't remember
how many people the Swiss sent home, but the West Germans sent V/%
million Yugoslavs, Turks, Italians, and Spaniards back to those
countries.
If you can export your unemployment, then you don^t worry about
unemployment so much because you just send it back to Yugoslavia.
But the problem in the United States is we don't send the unemployed
back to Yugoslavia. They are Americans. And in Switzerland and
Germany, a lot of the unemployed were foreigners who were sent home.
And so I think we have to take the whole unemployment thing
much more seriously than the West Germans or the Swiss do because
they can export it directly.
Mr. BETHUNE. Dr. Thurow, we very frequently look to these other
propositions that you mentioned and assume that there can be some
relief from high prices, and we just categorically say, well, we need to
deregulate trucking, and that is going to provide some relief from inflation. The airline industry had some success with this because prices
there are sensitive to demand or demand in that area is sensitive to
price reduction because you are dealing with passengers, and they are
more liable to fly when the price gets lower.
I am, however, persuaded that the demand in the trucking industry
is not necessarily as sensitive to prices as the general economy.
Dr. THUROW. I think you are probably right. The demand elasticities
in trucking are not high, and so there is a big difference between
deregulating trucking and deregulating airlines.
Deregulating airlines was good for airline profits. Deregulating
trucking would undoubtedly be bad for trucking profits. But the thing
to remember is that when we talk about trucking regulation, the
big thing we are not doing is protecting the trucks against the railroads.
They don't need any protection against the railroads.
What we are doing is protecting the interstate trucking company
from farm trucks, many of which are unused a large fraction of the
year, and farmers could set up little trucking lines and be carrying
goods at much lower prices. And so the real threat to the big interstate
trucking companies doesn't come from the railroads; it comes from
underutilized farm trucks.
I don't think there is any doubt that the price would go down. I also
think it would be very devastating to the position profitwise and any
other way you would like to think of it, of existing large interstate
trucking companies. I don't think they would benefit the way the airlines have.
Mr. BETHUNE. I would like to pursue this with you, but my time
has expired. Thank you.
The CHAIRMAN. Dr. Brunner, since last September the growth of
M! has been flat, nonexistent. It is today at the level where it was at
the end of September. In the light of what you have said this morning,
is it your view that the Federal Reserve has now done too much of a
good thing and that it should relent a bit on the supertightness of MI,
both for its own sake and lest it be tempted with the terrible temptations of presidential election years to offset its present tightness with
too much of a swing in the other direction.
146
What is your view, if in 6 months there is no growth of MI ?
Dr. BRUNNER. The data on Mx and M2 since last September are
indeed troublesome. There is no question that the growth rate of the
monetary base declined by a substantial margin. But the decline in
the growth of MI and M2 exceeded the decline of the growth of the
base by a factor of 3 for Mx or more than 2 for M2. If this movement expressed the relevant monetary thrust and would also persist
I would be quite concerned. But there are good reasons to think that
some portion of the apparently excessive declaration is due to temporary factors—Treasury funds, CD expansion, currency drain—and
that another portion reflects increasing measurement errors of both Mx
and M2. After all these corrections were made there probably still
remains a retardation corresponding to the decline in the growth rate
of the monetary base. Everything depends now on the Fed's further
behavior. A continuation of the retardation would endanger in my
judgment the long-run program required for the final goal of pricestability. I would urge that the Fed prevent any further decline in
the growth of the base and the true measures of MI and M2. It should
in particular maintain for the next quarters a growth rate of about
8 percent per annum in the base.
The CHAIRMAN. Well, let me try to recapitulate what I think you
have said, but you may correct me. I think you have said that the flatness of M! over the last 4 or 5 months, while somewhat disturbing to
you, may be explicable by other factors which you have named. Therefore, you are not quite ready to say that the Fed has gone too far in Mi
tightening. However, it is also your view that if MI doesn't pick up
pretty soon, then you would feel that the Fed is going too far and
should loosen.
Is that a reasonable statement ?
Dr. BRUNNER. That is correct.
The CHAIRMAN. Turning to a more cosmic subject, it is indeed fortunate for this committee that we have an eminent monetarist and an
eminent nonmonetarist ranged side by side here. This committee always grasps pathetically at whatever chance there may be to reconcile
the apparently inharmonious testimony of witnesses.
I empathized with Dr. Thurow here a moment ago when he said,
look, Dr. Brunner, we may not be so far apart. Of course he was not
here earlier when you and I had our little exchange about the structural elements.
When I asked Dr. Brunner if getting rid of high agricultural
price supports and substituting something else in their place, income
supports for the family farmer, a system of avoiding financial
tragedy by some sort of a Homeowners Loan Corporation approach
to overstretched farmers; when I asked if these actions were a good
approach to take, his answer, again subject to his correction, was,
well, those things might be desirable in and of themselves, but that
it wouldn't really have any impact on inflation. He said money alone
was really important for inflation because doing something about
bringing farm prices upward, which is what the farmers assembled
here in Washington want, would be at the expense of somebody else's
prices and thus would not affect inflation.
I would have tried, if we had endless time, to answer that by saying,
well, I am not so sure because the other's prices don't go down; they
147
are ratcheted. Hence, I don't think I agree with Dr. Brunner's point
on that. But be that as it may, he is unwilling, I believe, to make the
step toward a joint monetarist-nonmonetarist national policy. Let me
inquire how willing you are, Dr. Thurow, to make such a gesture. You
have said that, of course, you need monetary and fiscal tightenings
in moderation; that aH is lost unless we do this. You have then added,
however, don't make them too tight or the cure will be worse than the
disease. Furthermore, tightness is not going to work, even moderate
tightness, unless you accompany it by structural methods, which you
define as a workable incomes policy, and attention to agricultural price
supports, trucking regulations, tax policies, and many, many other
things.
My question is: Would you sail for your policy of attacking the
commanding heights of price increases by direct methods such as
you have described? The forms would include fiscal policy among
them, and also you would make a proprietary bow toward the monetarists by saying, all right, Dr. Friedman, Dr. Brunner, and the business community and the banking community, as far as that goes, we
will sail for a Federal Eeserve statement backed by the administration
of MI targeted growth for 1979 of 6 percent, as the Federal Eeserve
suggests.
Good fellow that you are, would you go for that?
Dr. THUROW. I am always the great compromiser. I would certainly
be the first one to say that none of these other policies will work if
you don't have a Federal Eeserve Board doing sensible things at the
same time. And I think "sensible things at the same time" means a
money supply rate of growth. I think M± has kind of lost all meaning,
given the recent change in banking institutions. So, I don't even like
to talk about Ma any more, but let us say we are talking about M2,
that you have to have some modest, slow deceleration in the rate of
growth of M2 or the money base or whatever you want to look at.
I think, however, that if you think about the structural policies,
what the structural policies allow the Federal Eeserve Board to do
is tighten monetary policies further and faster without producing
unemployment than they otherwise would. Because I am with you.
I am on the ratchet effect. If you had a perfectly competitive economy,
it is quite right, as long as you kept the money supply constant, every
time some price went up, regardless of whether it was due to monopoly
power or a Government program or anything else, some other price
would go down by an equally equivalent amount, and the cost-of-living
index would not change.
But I just don't think that is our econonry. Where are these sectors
where prices will fall when agricultural prices go up? Where are
these sectors that will fall when we raise the price of steel $40 a ton
with reference pricing? I just don't think they exist to any substantial
extent, and, therefore, you have to worry about these actions that raise
prices, because the Fed—let us say you take one of these actions, like
steel referencing prices and raised the price of steel $40 a ton, the Fed
then has two choices: If it doesn't let the money supply grow, the rate
of unemployment goes up; if it lets the money supply grow, it is
essentially monetizing the price increase and making the rate of
inflation worse.
148
And it just seems to me that in a democracy, if we put the Fed in
that choice, we know what the Fed is going to do: It is going to monetize the price increase, because it is and should be a political animal
in a democracy. And, therefore, I really think the structural policies
are an important part of allowing the Federal Reserve Board to lower
the rate of growth of money supply below what it otherwise would be.
Dr. BRUNNER. Mr. Chairman, could I comment on one point?
The CHAIRMAN. Take as long as you want, because I think we are in
an interesting area here.
Dr. BRUNNER. Thank you very much.
Professor Thurow asks, "Where are the other prices which have
fallen if agricultural prices are pushed up ?" The point at issue is really
very simple and some of my previous comments extend to the present
case. I indicated before that all price changes are the sum of a common and a specific component. I repeat that the common component
represents the rate of inflation and the specific component is composed
of all the particular supply and demand factors for this market. Professor Thurow's comment should properly be addressed to the specific
component alone and not to the actual change in price. The larger the
inflation rate—that is, the larger the common component in the array
of price movements—the less frequently you will encounter falling
prices. Professor Thurow thus misdirects our attention to an irrelevant
aspect. The relevant movements for our purposes involve the fact of
falling relative prices or the occurrence of a negative specific component in the price change.
There is a further problem implicit in Professor Thurow' statement.
He appears to suggest that general price movements are determined by
the most rapidly increasing relative prices. This view, quite frequently
encountered, is simply false. It implies, for instance, that the velocity
of the monetary base accelerates and decelerates with the rate of inflation. An inspection of the data yields no support for this contention.
Dr. THUROW. I think it is a great mistake to go back to 1965 and
say in 1965 some price fell, because I think the key thing to note is
that in 1973-75, when we were hit with double-digit inflation and
almost double-digit unemployment, the structure of the economy
changed.
Kecently, as Mr. Bethune down there knows, I have gone through
and I have looked at relative wages—I haven't done it in all relative
prices—trying to figure out where have relative wages fallen in this
economy, given that you have high unemployment rates.
Now, you would expect, given these enormous unemployment rates
for teenagers, that if you went out and looked at the wage rates for
teenagers who were working, you would find some fall in the relative
wage rate. The fact of the matter is you don't. It even went up slightly.
The relative wage rates of teenagers for those employed went up
slightly from 1972 to 1977, and it has nothing to do with the minimum
wage since the average wage rate for this group is well above the
minimum wage.
Massive unemployment just has not had the effect on the relative
earnings of teenagers that it should have had.
Dr. BRUNNER. Well, I don't know whether I can comment.
The CHAIRMAN. Please do.
149
Dr. BRUNNER. There appears to me an important issue at this stage.
The Brookings group tends to relate accelerations or decelerations of
inflation to some measure of a "market gap." Much of our work and
the work of others indicate that the ongoing inflation in the context
of perceived monetary expansions is highly insensitive to the
magnitude or change in "market gaps."
Dr. THUROW. Let me interrupt. I wasn't talking about the rate of
inflation; I was talking about real relative wages.
Dr. BRUNNER. I let you finish your point and you surely can grant
me the courtesy to finish my point. The dominant issue is inflation and
the fact that we should not expect any moderation of price movements with the pervasive perceptions of unabated monetary
expansion.
Dr. THUROW. All I am saying is I did not say one word about the
rate of inflation. I said the high youth unemployment has not reduced
the relative wages, the wages of young people relative to the wages
of adults, since 1972. If this was the kind of competitive economy
that you are imagining, 20-percent youth unemployment rates for
whites, 40-percent youth unemployment rates for blacks, 30-percent
youth unemployment rates for Hispanics, that would lower their relative earnings; it simply hasn't.
Dr. BRUNNER. Well, Professor Thurow, I am very happy to look at
the facts. Until then I must suspend judgment.
The CHAIRMAN. Returning to my wistful guest here, Dr. Brunner,
while you tend to brush aside structural reforms as a method of inflation-fighting, you favor, do you not—as a descendant of Adam
Smith, which I take it you are—the elimination of structural
stickiness and structural impediments as a step toward a free economy ?
Dr. BRUNNER. Many "structural measures" are quite important in
terms of their effect on our welfare. We have become an "overregulated
and overgoverned society." Professor Houthakker has assembled a
long list of measures which would contribute to better use of our
resources. But all these measures, however important their cumulative
effect in terms of our welfare, constitute no relevant approach to inflation. We should not sell them on the political market place with the
promise to curb inflation. If we do that and disregard monetary policy,
as President Carter did, we will just invite failure. I am also concerned
that a "structural emphasis" in matters of anti-inflationary policies
opens the door to new controls and income policies under new names
and disguises.
The CHAIRMAN. For example, while I am sure you sympathize with
the social plight of the embattled farmers that you see here, you do
not advocate the kind of rise in the Government-mandated price support for their products, largely feedgrains, which they are asking,
do you ?
Dr. BRUNNER. Government price support for what ? Which economic
branch were you referring to ?
The CHAIRMAN. I am talking about the farm movement, which is
now encamped here in Washington. What they want is higher price
supports on wheat, corn, barley
Dr. BRUNNER. I am quite dubious about the farm support program.
If the voters and Congress wish to grant income transfers to farmers
150
there are much better ways to achieve this end than with the aid of
price support and production controls. I would suggest that the
present support system be abolished.
The CHAIRMAN. Good for you. Your views, as just stated, are very
like what I think Dr. Thurow's views are, and they are certainly like
my own.
That being so, wouldn't the Nation be well off if the President and
the administration would announce a two-pronged anti-inflationary
program: One, your kind of monetary program—and I won't repeat
it because we have repeated it several times this morning; and, two,
a 10-year long attack on the structural problems, which we have already adequately defined.
Such a program would be 50-percent satisfactory to a monetarist
believer, like yourself, whom I respect. You may be right. I have never
been able to make up my mind—and all you would be asked to add
to your monetarist dream program is some structural activity, which
you favor anyway, though on other grounds.
Equally, I ask the question to Dr. Thurow, the antimonetarist, who
believes that structure is the real central approach but that monetarism
cannot be disregarded, both on its merits and because it is a view
deeply felt by a wide segment of Americans and thus should not be
dismissed lightly. Dr. Thurow would have to sit still for a program
half of which he thought was great and the other half of which he
thought was of decidely less importance.
Why isn't it perfectly possible for both sides of this "War of the
Roses" to disarm ?
Dr. THUROW. I am disarmed.
The CHAIRMAN. Would you, in this spirit, go to Jerusalem, too?
Dr. BRUNNER. I certainly would support it. There remains, however,
the need for clarification about the meaning of "structural policy."
My support is full and clear in case this means abolition of many
unnecessary and dubious regulations and Government maintained
monopoly positions. But I oppose "structural policies" imposing new
constraints and inducing new patterns of waste in our resources.
The CHAIRMAN. Like what?
Dr. BRUNNER. I still suffer from an uneasy sense that "structural
policy" could easily subsume, whenever political circumstances demand, any measure involving new types of income policies or controls.
Professor Thurow speaks about a "sectorial approach" and I have
difficulty to understand what that means. I would appreciate a
clarification.
Now, I may be mistaken, but if it is that, then I would have reservations about that.
Dr. THUROW. For example, it seems to me what we did in January
with respect to the rate of inflation in terms of the social security tax
and the income tax was crazy. Let us imagine the two increases and
decreases were equal in magnitude—they weren't, quite—but we raised
a tax which, by the way the indexes are constructed, show up in the
cost-of-living indexes, which means it is going to get built into all
those escalators. We lowered a tax which is not in the indexes, given
the way the indexes are constructed.
So, in real terms, people are equally well off: One tax goes up,
another tax goes down. But the indexes show it has an increase in the
151
cost of living, which then gets built into the escalators, and so forth,
in the economy. That is the kind of action I just don't think we ought
to be taking if you are serious about fighting inflation.
Dr. BRUNNER. Thank you.
The CHAIRMAN. Do any other members have additional questions?
Mr. Paul?
Mr. PAUL. I have one short question.
Professor Brunner, we mentioned a little while ago that monetary
policy sometimes varies in an election year, and we also talked about
the Swiss franc doing quite well.
Do you think that the fact that there is some legal requirement for
the Swiss central bank to have gold reserves has helped? Do you think
gold reserves are a legitimate guidance for monetary policy ?
Dr. BRUNNER. Let me see if I understood you correctly. You seemed
to inquire about the background of Swiss monetary policy ?
Mr. PAUL. I was saying that the Swiss central bank is required to
have gold reserves, and we commented earlier that the monetary policy
of the Swiss was rather restrictive and provided for a strong Swiss
franc. Do you think that we could give any credit for the fact that
they were required to restrain their monetary policy to the fact that
they had to hold a gold reserve?
Dr. BRUNNER. No; the legal requirements bearing on the assets on
the Swiss National Bank play no role. The Swiss National Bank abandoned a policy of fixed exchange rates for the simple reason that this
policy produced in the early years of this decade a rapid acceleration
of price movements. Inflation reached to 13 percent per annum in
1972-73. The Swiss National Bank moved at the time to a noninflationary policy with the full political support of the large majority of
Swiss. The inflationary experience from 1970 to 1972 shaped the political basis for the noninflationary policy introduced in 1973 and
maintained until late 1977.
Mr. PAUL. Thank you.
The CHAIRMAN. Mr. Lowry ?
Mr. LOWRY. Dr. Thurow, at Harvard you also told a delightful story
about economists, but we have here before us legislation designed to
correct the declining membership of the Federal Reserve. How important do you believe the membership of the Federal Reserve, as far as
most of the commercial banking institutions, is to having the type of
monetary policy out of the Federal Keserve tha^ we need?
Dr. THUROW. I think it is undoubtedly true that even if nobody belonged—no banks belonged—to the Federal Reserve System, through
the open market operations that the Federal Reserve Board could conduct its policies. Undoubtedly, it is somewhat easier if they do, because then, in addition to open market operations, you have various
kinds of administrative disciplines that you cannot apply to the banks,
too.
And so, I think that the falling number of people in the Federal
Reserve System is not a serious thing with respect to having whatever
you think the appropriate degree of monetary restraint is. I do think,
however, when you think about reserve requirements and regulation Q,
I think I would be supporting Dr. Brunner here, that I think that both
of those things could be gotten rid of. Getting rid of one without the
other, I think, is terribly unfair. But if you were willing to get rid of
152
regulation Q and force banks to pay competitive interest rates for all
the money they borrow, then I don't see any need to have reserve
requirements!
Mr. LOWRY. Thank you.
The CHAIRMAN. Returning to the matter of Federal Reserve monetary policyy we are most grateful for the wide-ranging discussion you
have both conducted this morning. I think it has been a fascinating session, one of the best we have had. It makes a real contribution to the
difficult task of this committee; namely, to provide a report to Congress, telling our colleagues wherein we should walk in the next few
years.
Thank you both very much.
We now stand adjourned.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]
[The statements of Professors Lekachman and Feldstein referred
to by Chairman Reuss in his opening statement follow:]
STATEMENT OF PROF. ROBERT LEKACHMAN
Possibly because I prepared these brief remarks in ignorance of Chairman
Miller's testimony before this committee yesterday, I record a measure of sympathy for him and his colleagues on the Federal Reserve Board. Not for the
first time in its history, the Fed appears to be operating the only game in town.
Whatever disposition Congress ultimately makes of President Carter's budget proposals, fiscal policy is not now operating against inflation. Even if one accepts
the administration version of the prospects for the wage-price guidelines, they
will have minimal impact upon inflation. At present rates of inflation, in excess
of 17 percent compounded, prudent Americans are saving very littlt of their income, assuming a heavy burden of installment debt, and bidding home prices up
to new speculative heights weekly. Why shouldn't they ? Inflations reward grasshoppers, not ants.
Only the Fed is so situated as to respond swiftly, effectively,—and calamitously. That redoubtable critic of monetary policy, Milton Friedman, only last
week expressed fear that according to precedent the Fed would go too far. In
his February 19 Newsweek column, Dr. Friedman uttered these monitory words:
''Past history demonstrates that the danger of unduly restrictive policy is not
an idle one. That is exactly what occurred in 1974, as it has repeatedly, during
the whole of the Fed's history. The golden mean has had a way of escaping the
Fed, which has tended to be extremist—either pumping up the money supply too
rapidly, or holding it down too rigidly."
On the record, Mr. Miller fears recession more than his predecessor. The danger is nevertheless substantial that in the absence of other responses, the Fed
will further tighten credit, raise interest rates, inflict customary damage on small
businessmen, local governments, and home buyers, and precipitate the economy
into recession.
%
Although milk once spilled cannot readily be rebottled, it is a pity that Jimmy
Carter as President did not adhere to the position on mandatory controls that
he held as a mere candidate. Two years have been wasted during which an
inflationary psychology has begun to distort business and consumer decisions.
The hour is perilously late. I much fear that unless Congress or the White
House takes a new initiative, a year from now unchecked inflation will be combined with rising unemployment, deepening recession, and panic-stricken resort
by a discredited administration to measures that ought be taken immediately
without a day's further delay.
What ought to be done is naturally easier for me to prescribe than Congress
to enact and the executive branch to administer. Let me sketch the bare essentials
of an anti-inflationary program into which monetary policy will fit as a part, but
only a part of a coherent whole.
PRICE-WAGE POLICY
A sixty or ninety day general freeze is essential. It should be followed by selective controls over key prices and wage bargains in concentrated industries, hous-
153
ing, and the health sector. No need to regulate retailing, a genuinely competitive
sector of the economy.
In the interests of equity and, despite the technical difficulties involved, other
forms of income besides wages should be subject to limitation—rent, dividends,
interest, and executive compensation. It cannot be reassuring to trade unionists
nagged by Alfred Kahn and their employers to accept 7 percent wage improvements, that COWPS has apparently abandoned any attempt to set standards for
bank profits.
Charity impels me to say no more about present "voluntary" guidelines than
this: they stand on shaky legal ground, they exclude items which comprise a
large proportion of family budgets, and they operate inequitably. They are
otherwise splendid.
ENERGY
Probably no single measure would be more reassuring to our friends and
thought-provoking to our antagonists than some hard evidence of collective willingness to restrict consumption of gasoline and fuel oil. In the wake of the
Iranian cataclysm and the spreading wave of new increases in the price of crude
petroleum, we should move to gasoline rationing. Coupons issued to the owners
of registered vehicles should be freely transferable on white markets.
MONETARY POLICY
Here the crucial policy is allocation. Rather than allow credit stringency to
damage the most valuable borrowers, we should substitute effective limitations
upon consumer credit and reasonable flows of funds into the hands of small
business borrowers. I note that that astute observer Alfred Neal, former president
of the Committee for Economic Development, urged credit controls some months
ago.
Two concluding observations. No control program is exempt from the tangles
of bureaucracy, but exemption of the retail sector greatly simplifies administrative tasks. Economists routinely complain that controls distort market signals. Their criticism is appropriate w'here markets are competitive. Where they
are not, the market signals are already distorted. Offered a choice, I'd rather
have public bureaucrats, subject to congressional and media oversight, administer markets in concentrated industries than anonymous private bureaucrats
responsible only to corporate management.
Finally, the goals of Humphrey-Hawkins are valid and indeed essential to
the health of this society. We stand at this moment in the gravest danger of
discarding them as we cope with inflation by ensuring serious recession. I note
an ominous inclination, reminiscent of the 1950's, tacitly to redefine acceptable
levels of unemployment. The current Economic Report states with apparent
neutrality that "The evidence suggests that under current labor market conditions the danger of accelerating wages begins to mount as the rate of unemployment falls significantly below 6 percent." (page 65) Tremblin in the air is the
connotation that we dare not pursue the 4 percent Humphrey-Hawkins target.
We dare not pursue it. But unless, Congress or the President, and preferably
both respond with appropriate vigor to this inflation, Humphrey-Hawkins will
become one more failed promise.
STATEMENT OF PROF. MARTIN FELDSTEIN*
MONETARY POLICY FOR 1979 AND BEYOND
Thank you, Mr. Chairman. I am very pleased to have this opportunity to
participate in this first set of hearings on monetary policy under the new procedures that were mandated by the Full Employment; and Balanced Growth Act
of 1978. Although the report that the Board of Governors submitted to you
earlier this week was not available to me when I prepared this statement, I
will be happy to comment on the Board's report during our general discussion.
Before turning to the details of my analysis, I can summarize briefly my basic
conclusions: It is now unusually difficult to judge the tightness of existing
monetary conditions on the basis of either interest rates of monetary aggregates.
* President, National Bureau of Economic Research, and Professor of Economics,
Harvard University. The views expressed here are my own and should not be attributed
to any organization.
154
It is, however, clear that the level of real aggregate demand is excessive. We
need to slow the growth of real demand below the potential growth of the economy in order to reduce the prevailing inflationary pressures. The appropriate
policy for the Federal Reserve is therefore one of greater monetary tightness.
It is particularly important that this tightness be seen as part of a longer-term
strategy of monetary deceleration. Although it is difficult to set short-term goals
for monetary aggregates, I think the middle of the 5 percent to 9 percent range
for the M2 growth rate (that the Board announced earlier this year) in on
balance a good compromise for the coming months.
In recent years, economists have grown increasingly aware of the difficulty of
evaluating the ease or tightness of monetary conditions. At the present moment,
monetary conditions are particularly ambiguous and hard to judge. Although
some economist have pointed to the high interest rates and the slow recent
growth of the monetary aggregates as indicating monetary tightness, my own
analysis does not lead me to this conclusion. I will begin by considering the
high interest rates and then turn to the sluggish growth of the money supply.
Interest Rates
Most interest rates reached new highs in 1978 and now stand at two to three
times their levels of 15 years ago. It is, however, now widely recognized that
these high nominal interest rates reflect primarily the high expected rate of
inflation and do not represent high real interest rates. Indeed, when you consider the tax deductibility of interest expenses, it is clear that the high nominal
interest rates will not deter investment.
The implication of tax deductibility is seen most easily in the demand for
owner-occupied housing. A married couple with $20,000 of taxable income faces
a marginal federal income tax rate of 28 percent. A 10 percent mortgage interest
rate implies a net-of-tax rate of only 7.2 percent. A borrower who anticipates a
6 percent rate of inflation over the life of the mortgage is borrowing for a real
net-of-tax cost of only 1.2 percent ! * Fifteen years ago, the mortgage interest
rate was 6 percent, implying a net of tax rate of 4.3 percent. Since a reasonable
estimate of inflation would have been less than two percent,2 tne real net interest,
rate presumably appeared higher in 1963 than it does today. The apparently3
high cost of mortgage borrowing is unlikely to deter the demand for mortgages.
For corporate borrowers, the analysis is somewhat more complex because
inflation changes 4the effective tax rate on investments as well as the real net-oftax interest rate. With a 46 percent corporate income tax rate, the 10 percent
interest rate on commercial paper and long-term bonds represents a net-of-tax
cost of only 5.4 percent, clearly less than the short-term expected inflation and
probably less than most firms' intermediate range inflation forecasts. However,
historic cost depreciation reduces substantially the after-tax yield on investments in plant and equipment. The balance between the lower real net interest
cost and the lower real net return on investment depends on the corporation's
debt-equity ratio and the difference between the yields that must be paid on
debt and on equity funds. In a preliminary analysis of this, Lawrence Summers
and I concluded that the rise in the nominal interest rate caused by inflation is
less 5than the rise in the maximum interest rate that the firms could afford to
pay. Although the high rate of inflation and its uncertainty may independently
reduce firms' willingness to invest, the high nominal interest rates as such are
not a deterrent.
Two final comments reinforce the point that current interest rates do not
represent tight money. In the past, high interest rates—even high nominal
rates—could check aggregate demand by drawing funds away from housing;
the new money market certificates and the secondary mortgage market have
now insulated housing from such supply side constraints. It is also worth noting
1
Recall that the CPI inflation has averaged 6.1 percent over the last 8 years and that
most
mortgages remain in force for no more than that period of time.
2
The CPI inflation rate averaged 1.8 percent for the previous 8 years and exceeded 2
percent
in only 2 of those years.
3
Individuals may be deterred by the cash flow required for the high monthly payments
but even this will be avoided by variable repayment mortgages in which the monthly
payment rises with time.
*In the case of homeowners, I ignored any tax on the nominal capital gain on the
house. Such a tax, if any, is levied at the lower capital gains rate, is f ostponed, is only
on 3 the excess over $100,000, and may be avoided if the property is bequeathed.
See Martin Feldstein and Lawrence Summers, "Inflation, Tax Rules and the LongTerm Interest Rate," Brooking Papers on Economic Activity, 1978, especially Table 3
155
that short-term interest rates have turned down since the beginning of the year
during the period of apparently constant nominal loan demand.
Slow Monetary Growth
I turn now to the argument that the slow growth of the money supply during
the past year implies that money conditions are tight. The slow growth of M2
since last year is unquestionably quite striking. Between 1970 and 1977, the M2
veolocity (i.e., the ratio of GNP to M2) remained in a narrow band between 2.35
and 2.43 without any discernible trend. It has climbed steadily since then: from
2.43 in the first quarter of 1978 to 2.50 in the next two quarters, and 2.54 by the
fourth quarter of 1978. With nominal GNP growing at about 10 percent and M2
up only 0.3 percent between the end of November and the end of January, the
current month presumably began with an M2 velocity of approximately 2.6.
This represents an increase of 7 percent in one year.
A strict monetarist interpretation, based on the view that the velocity must
return to its old level, implies that we are headed for a substantial fall in nominal
GNP. Since prices are relatively slow to adjust, this fall in GNP would be primarily a fall in real output with a corresponding rise in unemployment.
I do not accept the view that there is a fixed long-run velocity to which the
economy will necessarily return. I believe that the rise in velocity over the past
year represents the combined effect of higher interest rates and new institutional
developments. Recall that money market interest rates rose 50 percent between
the 7 percent level prevailing in the beginning of the year and the 10.5 percent
level at the end. There was a dramatic rise in the funds invested with money
market mutual funds to take advantage of these rates. Thrift institutions used
the new Money Market Certificates to attract funds and then often invested
these funds in large CD's or commercial paper, thereby extending the range
of institutions meeting the financing needs traditionally met by commercial
banks. The secondary mortgage market also grew during the year, tapping the
resources of insurance companies and pension funds to meet demands that
would otherwise have been directed to banks. Consumer credit continued its
rapid expansion, further reducing household demand for Ml. Moreover, many
of these practices and institutions that have developed in response to high
nominal interest rates are likely to continue after interest rates fall. The economy
is likely to have achieved a permanent increase in velocity.
On balance, I am therefore inclined to believe that the rise in velocity does
not represent a temporary departure from a fixed norm but a natural movement
to a new equilibrium level. Further support for this view that money is not tight
is the fact that short rates have recently fallen even though there seems no reason
to believe that expected inflation during the first quarter of 1979 is lower than
it was six months ago.
Excess Real Demand
Although I believe that the evidence does not favor the view that money
is tight, I should again emphasize that the evidence is difficult to judge. Because
of this ambiguity about monetary conditions, it is particularly important to
look at the real side of the economy. Here we have evidence of tight labor markets
and an increasing rate of price and wage inflation. The number of employees on
payrolls grew more than four percent during 1978. Average hourly earnings rose
8.8 percent, up from 7.7 percent the year earlier despite the growth of new
entrants. Non-union wages are rising as fast or faster than union wages, a key
indication of labor market tightness. And the manufacturing layoff rate is as
low as it has been in the past 20 years.
The current inflation is likely to persist until there is a sustained period of
slack in labor and product markets. The record shows that a fall in the rate
of wage inflation is preceded or accompanied by an increase in the rate of unemployment. Monetary policy should therefore lean in the direction of slowing
the growth of demand. A slowdown in real demand growth in 1979 and 1980
should be welcome and should not be resisted by expansionary monetary or fiscal
policy.
It is not contradictory to emphasize, as I have, an inability to measure how
tight money is and yet to counsel monetary restraint. A perspiring man may
not know the temperature in the room, but he knows he will be more comfortable
if the thermostat is turned down. We may not be able to measure monetary
tightness but the inflation rate tells us that we will be more comfortable if the
economy is cooled down.
156
Most economists now agree that there will be some slowdown in 1979. The
rapid expansion of labor force participation experienced in 1978 cannot be
sustained. Housing demand has already shown some decline. The General Motors
strike that is expected later this year will have a widespread depressing effect
on inflation. But there is also a general consensus among economists that the
slowdown later this year or early next year is likely to be both small and shortlived, and then to be followed by a vigorous expansion in 1980. Whether the
slowdown will be substantial enough to meet the NBEEi standard of being a
recession, obviously cannot now be determined. But few if any serious forecasters are expecting this slowdown to turn into another recession of the sort
experienced in 1973 through 1975.
Monetary Policy
Unfortunately, a very short slowdown of the type predicted will reduce employment and output while having relatively little effect on inflation. To bring
the inflation rate down permanently, we need a more sustained period of economic slack. The 1973-1975 gains in fighting inflation were quickly lost by
reflating too soon and too much. The expectations developed because of the
experience of 1973-1975 will mean that the inflation response to the current
slowdown will be even smaller. But if we sustain market slack for a few years—
enough slack to keep the unemployment rate about one percent above the level
at which wage and price inflation starts accelerating—we will succeed in gradually bringing down the rate of inflation. As the policy is seen to be working,
expectations will shift and the inflation rate will come down more rapidly. This
in turn will be reinforced by a strengthening dollar which will reduce the cost
of imports and the dollar value of potential exports.
It is important to bear in mind that a sustained but temporary period of
slack demand will achieve a permanent reduction in inflation.8 Failure to accept
greater slack in the next few years merely postpones the problem or leave us
committed to a permanent higher rate of inflation. Moreover, if we do not eliminate the current inflation, every new shock will be regarded as the beginning of
further inflation and will merely add to the existing rate of inflation.
The knowledge that we can achieve a permanent reduction in inflation by
accepting a temporary period of slack should reinforce the widespread public
sentiment that reducing inflation is the number one priority for macroeconomic
policy. Despite this, maintaining slack for a long enough period will require
significant political courage. Fortunately, our unemployment compensation system will eliminate much of the personal hardship that would otherwise accompany cyclical increases in layoffs.7 Moreover, it is possible to proceed with
labor market policies that reduce the unemployment rates of young people
and other high unemployment groups at the same time that macroeconomic
policies maintain slack in the demand for experienced skilled workers.
It is difficult to say what specific monetary policy is needed to keep the un^
employment rate at 8about one percent above the rate at which wage inflation
begins to accelerate. In addition to the ambiguity of the changing institutions
to which I have referred, there are also uncertainties about fiscal policy and
about the changes in aggregate demand. If the federal deficit is limited to the
$30 billion proposed by the administration and there are no surprises in the
other sources of exogenous demand, a growth rate of M2 in the middle of the
5 to 9 percent range should be suitable for the next few months. To be effective,
this monetary restraint must be seen as part of a longer term strategy to decelerate the growth of liquidity. In the context of such a strategy, a generally
tight monetary policy in the months ahead may be the beginning of a permanent
fall in the rate of inflation.
8
See M Feldstein, "The Welfare Cost of Permanent Inflation and Optimal Short-Run
Economic
"Policy," NBER Working Paper No. 201.
7
See M. Feldstein, "The Private and Social Costs of Unemployment," American Economic
Review,
Proceedings,
1978.
8
With no change in other labor market policies, this target would now correspond to
an unemployment rate of approximately 7 percent.
APPENDIXES
ADDITIONAL MATERIAL SUBMITTED FOR INCLUSION IN THE KECORD
APPENDIX I.—BRIEFING MATERIAL SUBMITTED
U.S. HOUSE OF REPRESENTATIVES,
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS,
Washington, D.C.
BRIEFING MEMORANDUM, HEARINGS ON THE CONDUCT OF MONETARY POLICY PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978, PUBLIC
LAW 95-523
(Prepared by the staff of the Committee on Banking, Finance and Urban Affairs)
MONETARY POLICY AND THE ECONOMY
Growth, Inflation and Unemployment
Real Gross National Product (GNP) grew by just under 4.3 percent from
the fourth quarter of 1977 through the fourth quarter of 1978, according to
preliminary estimates. This is in the midrange of the personal projection of 4
to 4.75 percent growth presented to this Committee in March, 1978 by Federal
Reserve Chairman G. William Miller. It is somewhat better than the consensus
of business and professional economic forecasts for the same period, as reported
in December, 1977 by the American Statistical Association and the National
Bureau of Economic Research. Unemployment averaged 5.8 percent in the fourth
quarter, also within Chairman Miller's projected range of 5.75 to 6 percent.
Inflation, measured by the GNP price deflator, was more rapid than anticipated
by Chairman Miller: 8.3 percent from the fourth quarter of 1977 through the
fourth quarter of 1978, as compared with a forecast range of 6.5-7 percent. In
short, while Chairman Miller's forecasts of real growth and unemployment,
presented to this Committee a year ago, have proved accurate, his forecast of
the inflation rate turned out to be understated.
Money
1978: IV marked the sixth consecutive quarter in which the growth of the
money stock (currency plus demand deposits at banks) exceeded the upper
limit of the target range established a year previously by the Federal Reserve.
More broadly defined monetary aggregates, M2 and M3, have been within the
ranges of growth forecast for them. These facts suggest that the growth
ranges presented by the Federal Reserve to Congress in the past 10 quarters
(from 1976: III to the present) for Ml, M2 and M3 (which imply, for instance,
a much more rapid growth of time and savings deposits in banks than of demand deposits and currency) have not been mutually consistent. To the extent
that the announced ranges of growth of Ml receive a disproportionate share of
attention from Members of Congress and observers of the monetary oversight
process, it may also be that the unrealistic ranges of growth that have been
announced for this variable have generated public misunderstanding of the
Federal Reserve's true policy.
The growth rate of Ml, while above target, has been declining, from a peak
rate of 8.2 percent in the year ending in 1978 :II, to an annual rate of increase
equalling 7.3 percent in the year ending in 1978 :IV. Moreover, these annual
figures mask a sharp deceleration in annual rate of new money creation from
the third to the fourth quarter of 1978: from 8.4 to 4.4 percent. Looking at
weekly data, it appears that the absolute level of the money stock peaked in
(157)
158
mid-October 1978, and has fallen from 364.3 billion dollars then to 357.6 billion
as of the last week in January, 1979.
The significance of this deceleration is unclear. It is not reflected in the quarterto-quarter growth rate of more broadly defined monetary aggregates, such as
M2 (Ml plus time and savings deposits other than large negotiable CD's). The
annual growth rate of M2 from the third to the fourth quarter was 8.0 percent,
just under the annual average growth rate for the year as a whole (8.5 percent).
Looking at weekly data, M2 did decelerate in the past 16 weeks pari passu with
Ml. But, when large negotiable Certificates of Deposit are included with M2, as
in the very broad aggregate M4, no major deceleration is apparent even on a
weekly basis. This suggests that, while there has been a substantial shift away
from money and demand deposits toward interest bearing securities, e.g. from
"money" to "near-money", and especially so among large depositors, the high
interest rate policy of the Federal Reserve has not yet had the effect of depressing transactions-related balances taken as a whole. The very significant increases
in the Income Velocity of Ml, Ml-f, and M2, as shown in the attached charts,
would tend to bear out this impression.
Interest Rates
Short term interest rates rose sharply in the second half of 1978. The Federal
Funds rate led the way, jumping from 7.6 percent on average in June and 8.45
percent on average in September, to about 10 percent in December, at which
level it remained through January, 1979. Persistent reports that the funds rate
has peaked, abetted by hints from the Federal Reserve, have yet to show up in
the data.
Long-term interest rates continued to rise in the second half of 1978. Now
home mortgage yields, a prime component of the cost of housing, rose by 56
basis points, from 9.46 percent in June to 10.02 percent in December. This followed a similar rise in the first half of the year, which was the first increase
in mortgage rates since 1974. The prime rate charged by banks rose even more
sharply: by 312 basis points, from 8.63 percent in June, 1978 to 11.75 percent
in January, 1979.
Government Deficit
As a percentage of Gross National Product, the Federal deficit continued to
decline in 1978. On a National Income Accounts basis, the federal deficit in
calendar 1978 amounted to 1.4 percent of GNP ($29.4 billion) compared with
2.5 percent in 1977 ($48.1 billion). (It is the national income accounts basis
that gives the truest measure of the impact of federal spending and taxation
on the economy.)
Investment and Capacity Utilization
Gross Private Domestic Investment rose at a brisk rate in 1978. Nonresidential
fixed investment rose by 8.3 percent in real terms. Residential investment did
not rise over the year as a whole, but did remain stable at a high level: housing
starts exceeded 2 million units at an annual rate in every month after March.
Inventory/sales ratios remained stable throughout the year.
Most indices of capacity utilization climbed substantially in 1978, but remain
below the peak levels achieved in 1973. The Federal Reserve's capacity utilization index for total manufacturing rose from 83.0 to 85.9 percent from December,
1977 to December, 1978, and averaged 84.2 for the year as a whole, compared with
an average figure of 87.5 in 1973.
Balance of Payments
The balance of payments deficit on current account stood at $3.1 billion in
1978:11 and $3.8 billion in 1978:11, down from about $7 billion in the two
preceding quarters. The gain is attributable to a rise in exports of about $4.5
billion between the first and second quarter: the merchandise trade deficit fell
from $11.1 billion in the first quarter to about $7.7 billion in the second, and
held steady at that level for the rest of the year.
Foreign Exchange
After falling by over 10 percent in the first 11 months of 1978, the value of
the U.S. dollar, on a trade-weighted basis, stabilized in November, December
and January in response to a policy of massive coordinated intervention.
159
MONETARY POLICY AND THE HUMPHREY-HAWKINS ACT
Section 108 of the Full Employment and Balanced Growth Act of 1978 (Public
Law 93-523) prescribes new and expanded requirements for the Federal Reserve's
reports to the Congress on the conduct of monetary policy. A copy of the legislative language is appended. On January 31, 1979, in a letter to Chairman Miller,
Senator Proxmire and Congressmen Reuss, Hawkins and Mitchell spelled out
their understanding of the intent of Congress in imposing these new requirements. They said:
"According to the new law, the written reports that are to go to the Banking
Committees are to discuss three related items:
"1. Recent developments affecting economic trends in the nation;
"2. The objectives and plans of the Board and the Federal Open Market Committee with respect to the ranges of growth of the monetary and credit aggregates for the calendar year during which the report is transmitted, taking account of past and prospective developments in employment, unemployment, production, investment, real income, productivity, international trade and payments,
and prices; and
"3. The relationship of the Federal Reserve's objectives and plans to the shortterm goals (for the current year and for the next year) set forth by the President in his most recent Economic Report and to any short-term goals approved
by the Congress.
"In order to evaluate the Federal Reserve's intended policies, the Congress will
need to make informed judgments about the relationship between those policies
and the nation's economic goals. Thus, it is important that the Federal Reserve's
reports to the Congress be in a manner that is conducive to understanding that
relationship. The information to be presented should be in a form consistent with
that used to set forth the short-term goals in the Economic Report. The monetary
policy plans and objectives should be specified in terms of growth rates fourth
quarter to fourth quarter.
"The Federal Reserve's discussion of the relationship between monetary policy
plans and the President's short-term goals must be clearly and carefully stated
if the Humphrey-Hawkins Act is to make a meaningful difference with regard
to the role of monetary policy in the achievement of our economic goals. The
Board and the Senate Banking Committee agreed to specific language in the
report on the legislation to clarify the intent of the word 'relationship'. The purpose of that legisaltive history was to make explicit the expectation of the Congress that the Federal Reserve would provide both a qualitative discussion and
a quantitative analysis of the linkage between intended monetary policy and
established goals. The legislative history says:
" 'In explaining the relationship of the Board's objectives and plans to the shortterm goals established by the President in his Economic Report and any subsequent goals established by the Congress, it is expected that the Board would
provide the Congress with a full discussion concerning the extent to which the
Federal Reserve's intended policies would help to achieve those goals.'
"Our interpretation of this agreed upon language is that the Board's written
report will be structured in a manner that wil lindicate in explicit and deailed
terms: (1) whether and to what extent the numerical monetary growth targets
adopted by the Board and the Federal Open Market Committee will achieve
numerical economic goals for the current year and the next year that have been
established by the President; and (2) whether the numerical economic goals
themselves are mutually consistent and obtainable through the combination of
fiscal policies proposed by the President and the Federal Reserve's proposed
monetary growth targets."
Tables on pages 9 and 10 of the attached background material from the Congressional Research Service report the Administration's goals in 1979 and 1980
under the Humphrey-Hawkins Act for employment, unemployment, consumer
prices, real gross national product, real disposable income, and productivity. The
CRS has also provided, at our request, comparable forecasts for these items by
three prominent private econometric forecasting groups: Chase Econometrics,
Data Resources, Inc., and Wharton Econometric Forecasting Associates. We
expect the Federal Reserve to provide this Committee with a detailed, substantive analysis of the relationship between the monetary growth ranges it will be
promulgating and the economic goals of the Administration.
160
REPORTING REQUIREMENTS UNDER THE FULL EMPLOYMENT AND BALANCED GROWTH ACT
OF 1978
SEC. 102. (a) Section 2A of the Federal Reserve Act is amended by striking
out the second and third sentences and inserting in lieu thereof the following:
"In furtherance of the purposes of the Full Employment and Balanced Growth
Act of 1978, the Board of Governors of the Federal Reserve System shall transmit to the Congress, not later than February 20 and July 20 of each year, independent written reports setting forth (1) a review and analysis of recent developments affecting economic trends in the Nation; (2) the objectives and
plans of the Board of Governors and the Federal Open Market Committee with
respect to the ranges of growth or diminution of the monetary and credit aggregate for the calendar year during which the report is transmitted, taking
account of past and prospective developments in employment, unemployment,
production, investment, real income, productivity, international trade and payments, and prices; and (3) the relationship of the aforesaid objectives and
plans to the short-term goals set forth in the most recent Economic Report of
the President pursuant to section 3(a) (2) (A) of the Employment Act of 1946
and to any short-term goals approved by the Congress. In addition, as a part
of its report on July 20 of each year, the Board of Governors shall include a
statement of its objectives and plans with respect to the ranges of growth or
diminution of the monetary and credit aggregates for the calendar year following the year in which the report is submitted. The reports required under the
two preceding sentences shall be transmitted to the Congress and shall be referred in the Senate to the Committee on Banking, Housing, and Urban Affairs,
and in the House of Representatives to the Committee on Banking, Finance and
Urban Affairs. The Board shall consult with each such Committee on the reports
and, thereafter, each such Committee shall submit to its respective body a report
containing its views and recommendations with respect to the Federal Reserve's
intended policies. Nothing in this Act shall be interpreted to require that the
objectives and plans with respect to the ranges of growth or diminution of the
monetary and credit aggregates disclosed in the reports submitted under this
section be achieved if the Board of Governors and the Federal Open Market
Committee determine that they cannot or should not be achieved because of
changing conditions: Provided, That in the subsequent consultations with, and
reports to, the aforesaid Committees of the Congress pursuant to this section,
the Board of Governors shall include an explanation of the reasons for any
revisions to or deviations from such objectives and plans."
(b) The amendment made by subsection (a) takes effect on January 1, 1979.
NOTE ON MONETARY STATISTICS
The Federal Reserve's present estimates of the narrowly-defined money stock
(Ml) are considered by many observers, including the Federal Reserve Board
itself, to be unreliable guides to policy at the present time. In recent weeks,
growth of the money stock has undergone a very sharp apparent deceleration.
If past relationships between measured Ml and the economy hold true (e.g.,
if velocity does not rise to offset the deceleration of Ml), then this deceleration
could augur a severe recession in mid-1979. On the other hand, it may be that
institutional innovations and inadequacies in the reporting system have destroyed the correspondence between measured Ml and "real money"—actual
transactions balances available to individuals and companies in the economy.
In this case, the observed deceleration of Ml would be an illusion from which
no policy implications should be drawn.
There are four principal sources of possible distortion in the estimation of
Ml:
1. Repurchase agreements. Many private corporations routinely withdraw
their checking balances just before bank closing time and buy an overnight
loan, redepositing the funds the following morning. This practice is mutually
beneficial to company and bank: it allows the company to earn market interest
rates on its deposits, and it allows the commercial bank to evade reserve requirements. Such borrowings are not reported as part of Ml, and they are
not regularly or accurately monitored by the Federal Reserve. On the basis
of December 1977 data, the total of these borrowings was estimated to be $27
billion nightly. It is probably much greater today, as high interest rates reinforce the incentive for this kind of behavior.
161
2. Money held in banks that do not report regularly to the Federal Reserve.
Twenty-seven percent of all deposits are held in banks that are not members of
the Federal Reserve System and that therefore do not make frequent reports
of their deposits to the Fed. Misestimation of lending by these small institutions can badly distort the reported money supply, and such errors are corrected only when call data comes in on a quarterly basis.
3. Near-money. Checkable accounts in thrift institutions, automatic transfers
from savings to demand accounts in commercial banks, checkable money-market,
and other new transactions-related instruments are coming into increasing use.
The Federal Reserve now publishes estimates of some of these items, but weekly
reports are not available, and the estimates are somewhat unreliable.
4. Seasonal adjustment. Faulty seasonal adjustment procedures have plagued
Federal Reserve money supply estimate—and many others as well—for years.
They may be responsible for some inaccuracies now.
BRIEFING MATERIALS PREPARED FOR THE QUARTERLY HEARING ON MONETARY POLICY
BY THE SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
Exhibit 1.—Exhibit 1 breaks the 1954-1977 period into eight consecutive 3-year
periods: 1954-1955, 1957-1959, etc. For each 3 year period, Chart 1A relates
average Ml growth to the average rate of rise in the CPI (inflation) ; Chart
IB relates average Ml growth to the average rate of interest on 3-month Treasury bills; and Chart 1C relates average Ml growth to the average rate of unemployment.
The exhibit shows that there is a close positive relationship between money
growth and inflation (Chart 1A) and between money growth and the rate of
interest (Chart IB). It shows that as money growth increases, so do both inflation and the rate of interest. However, it also shows that there is no relationship between the rate of money growth and the rate of unemployment
(Chart 1C). This belies the Phillips Curve theory that inflation is inversely
correlated with unemployment.
The closeness of these relationships is denoted by the lines which were fitted
in between the points on the graphs. Note the straight lines which were easily
drawn in Charts 1A and IB. It was impossible to fit one line into Chart C.
162
CHART lA
1954 - 1977
...J
•
AVEF^C-ES IN 3-vEw. Nor:-ovr?^A?F:j;s ?E=JODS
Or Ml C?OWTH
t,
THE FJ»T£ OF C?CW-H IN
>
THE CO:;SL-;-_E:P. PRICE INDEX
^77" 77
„
>x^
,/^
-
/,-
3.3 -
3.4
4.6
HI P«^-cwnl Srcvlh
6.S -I
7.8
AV-?^GES IN 2-YZAK NOi:-0\'Z?I.\??IS5 --E31ODS
OF Ml G?.OWTH
t THE 2-YZAJl T?ZASC?.Y 3IL.L
?A7Z,
1954 - 1S77
s.s-
i.S
3.S
4.6
5.7
.11 P^c-nt Erovlh
8.8 -I
CHART 1 C
vr?^s£s is S-YSAH ::o!:
Cr Ml GROWTH
:S54
-
«
THE
1577
-
I!.'3 .-IF.IODS
Z:;T. PATE
75-7K
7.8-
t e.a •
| 6C-6Z
\ .•.
s B \. "
I -
=7 S9
3.3
•*•
3.S
.11
»»wc
4.6
•^l
=rcwlh
S.7
6.8
163
ExhiUt 2.—In April 1977, Ml growth hit the top of the target range. In July
1977, it burst through the top of the range, and continued to accelerate faster
than the announced target growth range until September 1978. Since then Ml
growth has decelerated sharply whether defined inclusive or exclusive of ATS
accounts.
The April 1977-September 1978 rapid acceleration helps account for the recent
upsurge of inflation. The essentially flat profile that has occurred since September, especially coming as it does in the wake of rapid acceleration will trigger
another recession if continued much longer.
EXHIBIT 2
M-1 MONEY SUPPLY CSA)
ACTUAL & TARGET LIMITS
'
TARGETS ARE QUARTERLY
ACTUAL IS MONTHLY
Adjustment for ATS Accounts
(S)
333-r-
3G0-;-
I
•330 21
164
Exhibit 3.—Ml growth measured between the same months of adjacent years
(for example January 1947 to January 1948), cycled down and up seven times
between the end of World War II and 1978, and now after a prolonged upsurge
appears to be headed down once more.
Our economy's performance in the post World War II period is mirrored in
this chart of money growth. Inflation was broken after World War II and again
after the Korean War by sustained low money growth. It was rekindled after
1964 by upsurges in money growth in the late 1960s, 1971-73 and 1977-78.
Recessions, which are delineated by the vertical lines on the time axis, occurred
in the wake of decelerations in Ml growth, as the chart shows.
The chart indicates that we are now headed for another recession. It is not,
however, too late to avoid another recession. It can be done if year-over-year
money growth this year is held in the 6-7 percent range.
EXHIBIJ 3
NARROWLY DEFINED MONEY SUPPLY, M-1
PERCENT CHANGE, YEAR TO YEAR
MONTKt V
165
Exhibit 4-—Exhibit 4 plots the percentage changes in the CPI measured between
the same months from one year to the next and the Federal funds rate—the
overnight inter-bank interest rate—in the last month. It shows that monthly
movements in the Fed funds rate occur very closely together with changes in the
inflation rate measured from the same month a year ago. It also shows that at
times, as in recent weeks, Federal Reserve tightening can cause the funds rate to
exceed the rate of inflation.
EXHIBIT 4
CPI, PERCENT CHANGE YEAR TO YEAR
vs
FEDERAL FUNDS RATE C A T J N . Y . BANKS)
;V
Z
U
'.)
8-
' ~ 7 I ' 7 2
I
73
' 7 4
MDNTHI Y DATA
77
« 7 8
'
78
166
THE LIBRARY OF CONGRESS,
CONGRESSIONAL RESEARCH SERVICE,
Washington, D.C., February 16,1979.
BRIEFING MATERIALS FOR MONETARY POLICY OVERSIGHT
(By F. Jean Wells, Robert S. White, Specialists in Money and Banking;
William Jackson, Analyst in Money and Banking, Economics Division)
This briefing document has been prepared to assist the House Committee on
Banking, Finance and Urban Affairs in monetary policy oversight conducted
pursuant to Public Law 95-523. It includes selected indicators for the economic
setting in which monetary policy operates as well as presenting indicators of the
direction of monetary policy itself. Assistance in preparing this report was obtained from Valerie L. Amerkhail and Gregg A. Esenwein of the Quantitative
Section of the Economic Division.
INCOME VELOCITY OF MONEY (Ml)
PERCENT CHflNGE FROM SflME QURRTER, PREVIOUS YEflR
1973
1974
1975
1976
1977
1978
2/13/79
SOURCES' B0RRD BF G0VERN0R5 0F THE FEDERRL RESERVE SYSTEM
DEPT. BF COMMERCE. BURL-RU ar ECONOMIC RNRLYSIB .
PREPRRED BY CBNGHE5SIQNRL RESEARCH SERVICE. LIBRRRY BF CONGRESS
INCOME V E L O C I T Y OF MONEY ( M l * )
PERCENT CHflNGE FROM SRME QUflRTER. PREVIOUS YEflR
T8
8-1
-4
• 1973
1974
1975
1976
1977
SOURCES > BBRRD'BF GOVERNORS BF THE FEDERRL RESERVE SYSTEM
DEPT. DF COMMERCE. BUREFIU OF ECONOMIC RNRLY5I5
PREPRRED BY CBNGRESSIQNRL RESERRCH SERVICE. LIBRRRY BF CONGRESS
1978
2/13/79
167
INCOME VELOCITY OF MONEY ( M2)
PERCENT CHRNGE FROM SRME QURRTER. PREVIOUS YERR
LU
O
1974
1973
1975
1976
1977
1978
2/13/79
SOURCES» BBRRD Qr GOVERNED QF THE FEOERRL RESERVE SYSTEM
DEPT. OF COMMERCE:. BURERU QF ECBNBMIC RNRLYSIS
PBEPflHED BY CONGRESSIONAL RESERRCH SERVICE. LIBRRRY 3F CONGRESS
INTEREST RRTES
FEOERRL FUNDS RRTE ( L I N E )
RVERRGE YIELD ON 6 MONTH TRERSURY BILLS ( D O T )
EFFECTIVE YIELD ON NEW HOME MORTGflGES (DRSH )
14
A
12
12
/\
10
10
V
LU
8
8
1973
1974
1975
1976
1977
1978
1979
2/13/79
SOURCES i BQRRD QF GOVERNORS OF THE FEOERPL RESERVE SYSTEM
DEPT. OF THE TREH5URY HND THE FEDERRL HOME LORN BRNK BBRRD
PRCPRRCO BY CQNGRE55IONRL RESERRCH SERVICE. LIBRARY OF CONGRESS
168
FEDERAL RESERVE SYSTEM 1-YR TARGET RANGES AND ACTUAL GROWTH RATES FOR MONETARY AGGREGATES
[Growth rates in percent]
M-ll
Period
Target
March 1975 to March 1976
1975:
Q2tol976:Q2
Q3to 1976: Q3
04 to 1976: 04..
.
1976:
Ql to 1977: Ql
02 to 1977: Q2
03 to 1977: 03
04 to 1977: 04
1977:
Ql to 1978' Ql
02 to 1978- 02
03 to 1978: 03
.
04 to 1978: 04
1978:
§to 1979: Ql
to 1979: Q2
to 1979" Q3
M-22
Actual
5. 0-7. 5
.„
. .
M-3«
Target
Actual
Target
Actual
5.3
8. 5-10. 5
9.7
10.0-12.0
12.2
5.0-7.5
5 0-7 5
4.5-7.5
5.3
4.6
5.8
8. 5-10. 5
7. 5-10. 5
7. 5-10. 5
9.6
9.3
10.9
10.0-12.0
9.0-12.0
9. 0-12. 0
12.1
11.5
12.7
4.5-7.0
4 5-7 0
45-65
4.5-6.5
6.5
6.8
8.0
7.9
7.5-10.0
7.5-9.5
7. 5-10. 0
7.0-10.0
11.0
10.8
11.1
9.8
9.0-12.0
9.0-11.0
9.0-11.5
8.5-11.5
12.9
12.5
12.7
11.7
45-65
4.0-6.5
4.0-6.5
4.0-6.5
7.7
8.2
8.1
7.3
7.0-9.5
7.0-9.5
6.5-9.0
6.5-9.0
8.8
8.6
8.6
8.5
8.5-11.0
8.5-11.0
8. 0-10. 5
7.5-10.0
10.5
10.0
9.6
9.4
4.0-6.5
4.0-6.5
2.0-6.0
8( )
6.5-9.0
6.5-9.0
6.5-9.0
7.5-10.0
7.5-10.0
7. 5-10. 0
( }
(4)
4
1
* Private demand deposits plus currency.
Ml plus bank time and savings deposits other than larg e negotiable CD's,
M2 plus deposits at mutual savings banks, savings and loan associations, and credit unions.
Not applicable.
2
3
4
Notes: Actual growth data are based on seasonally adjusted money supply series of the Board of Governors of the
Federal Reserve System as revised in February 1979. Target ranges are those announced before House and Senate Banking
Committees beginning in May 1975 according to procedures developed under H.. Con..Res..133 of the 94th Cong,, and Public
nges will
eginning in 19
1979, target ranges
wi be announced in accordance with provisions of Public Law 95-523.
Law 95-188. Beginning
MONETARY AND CREDIT AGGREGATES
[Percentage change, seasonally adjusted annual rates]
19751
Monetary aggregates:
M— 1
4.6
M-13
88
M-2
8.4
M-3
11.1
Deposits at nonbank
thrift institutions- 15.6
4.1
Bank credit 4
Reserves:
—5.9
Required
Nonborrowed.
—2.7
7.6
Monetary base
19761
19771
19781
5.8
12 6
10.9
12.7
79
93
9.8
11.7
7 3
53
8.5
9.4
15.6
8.1
14.5
11.2
.1
.2
8.4
3.8
1.2
8.8
1977' IV 2
Federal
Reserve
targets:
3d quarter
1978
1Q7R tn 3ri
|2
112
1112
IV2
(quarter 1979
75
68
8.1
10.5
69
51
7.2
8.3
95
74
8.6
8.7
84
62
10.3
10 8
44
2 5
8.0
97
20-60
40-65
6. 5-9. 0
7 5-10 0
10.6
11.5
13.8
10.1
10.0
10.6
8.8
15.9
11.5
11.3
12.2
8.3
NA
8.5-11.5
11.0
11.1
9.6
6.4
3.5
9.3
8.7
15.4
10.4
6 7
—.1
8.2
90
6.7
9.7
20 0
23.8
10.1
NA
NA
NA
1 From 4th quarter of previous year to 4th quarter of year indicated.
From previous quarter.
M-l-f=M-1 plus savings deposits at commercial banks, NOW accounts at banks and thrift institutions, credit union
share draft accounts, and demand deposits at mutual savings banks.
< Total loans and investments at commercial banks.
2
3
Sources: Board of Governors of the Federal Reserve System and Federal Reserve Bank of St. Louis.
169
SELECTED INTEREST RATES, 1975-79
1978
1979
3-mo treasury bills (new issues)
10-yr treasury securities (constant
maturity)
Corporate Aaa bonds (Moody's)
Prime commercial paper, 4 to 6 mo._
Prime rate charged by banks
New home mortgage yields, FHLBB
series
Federal Reserve discount rate
Federal funds rate
1975
1976
1977
1<)78
March
June
5.84
4.99
5.26
September
1December
January
7. 22
6.32
6.71
7.84
9.12
7 99 7 61 7 4? 8 41
8. 73
8.83
8.43
8.02
5.35
6.33
5.60 7.,99
7.86 6.84 6.82 9 06
8.04
8.47
6.80
8.00
8.46
8.76
7.63
8.63
8.42
8.69
8.44
9.41
9.01
9.16
9.10
9.25
10.43
11.55
10.32
9 01 8 99 9 01 9 54
7. 52
5.50 5.52
5 8? •> 05 •i 54 7 93
9.26
6.50
6.79
9.46
7.00
7.60
9.63
10.02
7.75-8.00
6.25
8.45
9.35
11.75
NA
9.50
9.50
10.03
10.07
Sources: Board of Governors of the Federal Reserve System, Federal Home Loan Bank Board, and Moody's Investors
Service.
FUNDS RAISED IN U.S. CREDIT MARKETS
[In billions of dollars; quarterly data are seasonally adjusted at annual rates]
Total funds raised, by instrument
Investment company shares.. _
Ottnr corporate equities
Debt instruments
U.S. Government securities
State and local obligations.
Corporate and foreign bonds
Mortgages
Consumer credit
_ _ _
Bank loans, n.e.c
Open market paper and Rp's l
Other loans
__
1978(1)
1978(11)
1978(111)
438.2
491.3
454.5
428.4
.9
5.5
-.2
1.2
-.9
2.1
395.6
430.9
490.2
453.3
428.3
84.3
29.2
36.1
91.7
25.0
40.1
105.1
22.2
29.9
92.9
35.8
33.7
97.5
37.6
34.2
134.0
152.4
137.3
137.9
143.2
35.0
32.2
19.8
25.1
36.2
30.9
15.0
39.6
38.0
67.3
50.8
39.7
51.6
33.5
36.7
31.1
43.4
26.6
21.4
24.5
1976
1977
220.2
301.3
399.4
-1.0
12.4
-1.0
11.2
4.8
209.1
289.8
98.2
15.6
36.4
57.2
88.1
19.0
37.2
87.1
23.6
j
9.4
_
__
1977(IV)
1975
-13.9
-2.4
8.7
6.4
13.3
15.3
-1.8
1.8
i Repurchase agreements.
Source: Board of Governors of the Federal Reserve System.
1979 ECONOMIC FORECASTS AND ADMINISTRATION GOALS
Administration goals
Chase
forecast
DRI
forecast
Wharton
forecast
HUMPHREY-HAWKINS ACT GOALS
Level, 4th quarter 1979:
Employment (millions)
Unemployment rate (percent)
_ _ _ _ _
Percent change, 4th quarter 1978 to 4th quarter 1979:
Consumer prices
Real gross national product
Real disposable income
. _ . _
Productivity total economy: *
Private business
Private nonfarm__
97.5
96.5
96.9
97.4
6.2
7.3
6.8
6.3
7.5
2.2
2.8
.4
NA
NA
7.6
-.6
1.7
NA
.4
-.7
8.1
0
2.8
NA
NA
.1
7.9
1.9
3.4
NA
1.3
NA
NA
NA
NA
5.2
6.7
7.7
3.1
7.0
4.9
6.7
9.6
MONETARY POLICY VARIABLES
Money supply (M-l)
Money supply (M-2).
Level, 4th quarter 1979: Federal funds rate (percent). ..
10.3
170
1980 ECONOMIC FORECASTS AND ADMINISTRATION GOALS
HUMPHREY-HAWKINS ACT GOALS
Level, 4th quarter 1980:
Employment (millions)....
Unemployment rate (percent)
Percent change, 4th quarter 1979 to 4th quarter 1980:
Consumer prices
Real gross national product
Real disposable income.__
Productivity total economy:*
Private business
Private nonfarm
99.5
6.2
99.0
7.3
98.8
6.8
98.7
7.0
6.4
3.2
2.3
1.1
NA
NA
6.1
4.1
3.1
NA
3.3
2.9
6.9
5.4
4.2
NA
NA
4.5
7.1
1.3
2.6
NA
1.0
NA
NA
NA
NA
6.2
9.7
6.4
5.8
9.7
9.3
7.3
8.6
8. 7
MONETARY POLICY VARIABLES
Money supply (M-l)
Money supply (M-2)
Level, 4th quarter 1980: Federal funds rate (percent)....
i Based on total real GNP per hour worked.
Source: U.S. Council of Economic Advisers; Economic Report of the President, Washington, U.S. Government Printing
Office, 1979, p. 109; Chase Econometric Associates, Inc., standard forecast of Jan. 25,1979; Data Resources Inc., control
forecast of Jan. 22,1979; Wharton Economic Forecasting Associates Inc., control forecast of Feb. 1,1979.
SUMMARY OF ADMINISTRATION'S ECONOMIC GOALS CONSISTENT WITH THE OBJECTIVES OF THE HUMPHREYHAWKINS ACT i
Year
Goal forecasts
Item
Level, 4th quarter:
Employment (millions)
Unemployment (percent)
Percent change, 4th quarter to 4th quarter:
Consumer prices
Real gross national product
Real disposable income..
Productivity2
Goal requirements
1979
1980
97.5
99.5
1981
1982
1983
6.2
6.2
102.6
5.4
105.5
4.6
108.3
4.0
7.5
6.4
3.2
2.3
1.1
5.2
4.6
4.4
1.8
4.1
4.6
4.4
2.0
3.0
4.2
4.0
2.0
2.2
2.8
1 "The short-term goals for 1979 and 1980 represent a forecast of how the economy will respond over the next 2 yr not
only to the budgetary policies proposed by the President for fiscal 1979 and 1980 but to the anti-inflation program announced
on Oct. 24. The medium-term goals for 1981 to 1983 are not forecasts. They are projections of the economic performance
that would be required to reach the 1983 unemployment and inflation goals specified in the act." Ibid., pp. 108-109.
2 Based on total real GNP per hour worked.
Source: U.S. Council of Economic Advisers; Economic Report of the President, Washington, U.S. Government Printing
Office, 1979 p. 109.
FEDERAL BUDGET RECEIPTS AND OUTLAYS
[In billions of dollars]'
Fiscal year or period
1975
1976
Transition quarter
1977
1978
_
1979 (estimates) 2
1980 (estimates) 2
Cumulative totals 1st 3 mo:
Fiscal year 1978
Fiscal year 1979.
1 Unified budget basis.
Estimates from Budget of the U.S. Government, fiscal year 1980.
2
Source: Economic Indicators, January 1979.
Budget
receipts
Budget
outlays
Budget surplus
or deficit
281 0
300.0
326.2
366.4
81.8
94.7
357.8
402.0
456.0
502.6
402.7
450.8
493.4
531.6
-45.2
-66.4
-13.0
-45.0
-48.8
-37.4
-29.0
84.5
99.4
113.3
123.2
-28.8
-23.8
171
TRADE BALANCE i CURRENT ACCOUNT BALANCES AND TRADE-WEIGHTED EXCHANGE VALUE OF THE
U.S. DOLLAR 3
[In billions of dollars; quarterly data seasonally adjusted]
1978
1975
Trade balance
Current account balance
Index of the weighted-average exchange value of the U.S. dollar
9.0
1.7
1976
1977
1978*
IV
1
—9.4 —31.1 —34.2 —10.2 —11.1
18.4
98.34 105.57
4.3 —15.3
103.3
93.14
II
—7.7
III
IV <
—7.0
—6.9
—3.1
—3.8
—8.0
—7.4
100.4
95.9
95.2
90.6
87.81
NA
1
Merchandise, excluding military, on balance of payments basis (adjusted from census data for differences in timing
and coverage).
2 Merchandise trade balance plus net investment income, military transactions, travel and transport receipts other
services, remittances, pensions and other unilateral transfers.
3
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries and Switzerland.
March 1973 17.6=100. Weights are 1972-1976 global trade of each of the 10 countries.
* Preliminary.
Sources: Trade balance and current account balance, Economic Indicators, January 1979.
Trade-weighted exchange value of the U.S. dollar, Board of Governors of the Federal Reserve System.
APPENDIX II.—STATEMENTS OF ASSOCIATIONS
NATIONAL RETIRED TEACHERS ASSOCIATION,
AMERICAN ASSOCIATION OF RETIRED PERSONS,
February 28, 1919.
Attention: Mr. Robert Auerbach.
Subject: Hearings on the conduct of monetary policy held pursuant to the Full
Employment and Balanced Growth Act of 1978.
Hon. HENRY S. REUSS,
Chairman, Committee on Banking, Finance and Urban Affairs, U.S. House of
Representatives, Rayburn House Office Building, Washington, D.C.
DEAR CONGRESSMAN REUSS : Our Associations with a combined membership in
excess of 12 million persons, believe that if full employment and low rates of inflation are to be achieved the value of the U.S. dollar will have to be stabilized.
That we think will require that monetary policy be conducted in a manner very
different from that of the recent past.
We wish to see an end to the "stop-and-go" monetary policies of the 1970's that
emphasized stable interest rates and other short term goals and deemphasized
the importance of long-range planning of money supply growth. We wish to see an
end to monetary policy heavily guided by political expediency. We believe that
monetary policy during the 1970's has been disruptive: it has accentuated economic boom and recession. Monetary policy is currently heading the country into
another recession, after playing a heavy hand in restoring double-digit inflation.
In our statement for the record of the hearings, our Associations propose that
monetary policy be conducted on the basis of planned, long range goals for money
supply growth. The planning period should cover 5 years. The rate of money supply growth should be guided by realistic expectations for the growth of real Gross
National Product during the period. Much weight should be given to those private
sector forecasts of GNP, which tend to assess properly the influence of such factors as declining productivity, declining investment in productive assets, and rising costs of energy. We believe that real GNP in the early 1980's will not be growing by much more than 3 per cent a year; this growth rate should also be the target rate for the growth of monetary expansion.
In the most recent quarters, the Federal Reserve Board has sharply reduced
the money supply expansion rates from the peak rates reached during 1977 and
1978; we believe this policy will produce a recession and then be reversed to pull
the country out of it and create a boom.
We propose that a plan for phasing down past excessive rates of monetary expansion be adopted, effective this year. Based on the Ml money aggregate, we
would establish a growth rate of 6 per cent for 1979 (over the 4 quarters) to be
reduced by 1 per cent in each succeeding year until Ml expansion is no greater
than the rate of growth of real GNP. At that time a new long range forward plan
172
for money expansion would take effect based on realistically anticipated GNP
growth rates.
Our Associations are well aware of the fact that the Ml money aggregate has
altered significance because of changes in bank and savings institution lending
practices during 1978 and the current year. Our testimony has not discussed
these complications in detail; the text emphasizes the importance of long range
planning for monetary expansion. If your Committee will accept the principle of
long range, planned monetary expansion we are satisfied that the tools and guidelines are available to do the job.
Sincerely,
PETER W. HUGHES,
Legislative Council.
STATEMENT OF THE NATIONAL RETIRED TEACHERS ASSOCIATION AND THE AMERICAN
ASSOCIATION OF RETIRED PERSONS ON THE CONDUCT OF MONETARY POLICY
THE ASSOCIATIONS AND THE ELDERLY
The National Retired Teachers Association and the American Association of Retired Persons have a membership in excess of 12 million persons. This is a significant portion of an elderly population that is increasing very rapidly. In 1950 there
were 18.5 million persons age 60 and over. By the year 2000, there will be 40.6
million.
The 75 and over segment of the elderly population is increasing even faster. In
1950, there were only 3.9 million persons in that age category. But by the year
2000, there will be about 13.5 million—3^ times more than there were in 1950.
The Associations have been leading proponents of the idea that the elderly
should, to the extent possible, be encouraged to remain productive and useful
members of our society. We feel that the proportion of the elderly who are working is much too small; only 1 out of 5 men and only 1 out of 12 women 65 years of
age and older are now working. But even if this proportion is significantly in
creased (as it must be if the elderly are to enjoy a reasonably adequate standard
of living in the future), the majority of the elderly will be either fully retired or
working only part time. Thus savings and private and public pensions will continue to be the primary sources of income for most persons in their later years
of life.
Yet these primary income sources are seriously threatened. The rapid decline
in the value of the dollar during the past decade has drained away a significant
portion of the income of many of the elderly in real terms. Our Associations are
convinced that the monetary policy pursued during this period was a major contributor to the weakening of the dollar and the price inflation that account for
that loss.
Congress has the power to promote long range monetary policies that would
gradually reduce the currently high (and rising) level of inflation. Regrettably,
much time has already been lost. There has been a refusal over the past decades
to face the fact that the money supply has been excessively expanded year-afteryear. The lack of discipline in controlling the expansion of money has been obscured by much discussion of the details of money markets and general macroeconomic objectives, and by an increasing acceptance of the idea that "money does
not matter".
The levels of persistent ("hard core") inflation have been rising over the past
decade. For this phenomena there is no single or simple explanation; yet too often
academic and government economists have attributed it to "exogenous" shocks
of various kinds, which the economy cannot shake off or to a number of microeconomic factors (the majority of which have long been in existence but failed to
raise the rates of inflation significantly before the 1970's).
THE 1970'S : ECONOMICS IN DISARRAY
The 1950's and the 1960's were years of rapid and sustained real wage and
economic growth in this country. In contrast, the years of the 1970's afford little
comfort to any sector of the economy. The decade began with prices tending to
rise so fast that mandatory controls on wages and prices became a component of
the economic stabilization policy of the U.S. Government (August 1971 to April
1974). This experiment was followed by accelerated inflation: in 1974 prices increased at an 11 percent rate in the United States and at even higher rates
173
abroad. In late 1974 and early 1975 the deepest recession of the post-war period
set in. While the rate of inflation moderated, it still remained high but was now
accompanied by high rates of unemployment. The conjunction of these two
factors, formerly thought to be largely mutually exclusive, led to the popularization of the word "stagflation".
The economic recovery, which began in 1975, has been long and is continuing.
However it has been marked by declining productivity, declining rates of investment and stabilized unemployment levels that are relatively high (between 6 and
7 percent). In addition, the annual inflation rates have been high and persistent.
Because of the sustained inflation levels more and more families have found it
necessary to have both husband and wife working to attain any significant increase in living standard or just to maintain what they already had. Real wages
have risen little if any during the 1970's. For the elderly living on relatively
fixed income—and especially for the elderly middle class—these years have been
a disaster.
Economic disarray has not been confined to this country. Stagflation has become endemic in many of the older, industrial countries. However, although
prices have been rising abroad, the United States has found that it has been
losing its ability to compete with many of the products of foreign industry like
steel, electronic equipment and textiles.
It can be argued, with some force, that much of the economic disarray on the
international scene dates from the August 15, 1971 suspension of the convertibility of the dollar into gold for international settlements. This, in effect, ended
the Bretton Woods agreement under which exchange parities between currencies
had been fixed and during the life of which post-war trade had flourished.
The second devaluation of the dollar (February 12, 1973) suspended the
Smithsonian Agreement. This was the death knell of any serious attempt, on a
world-wide basis, to reestablish fixed parities among the major currencies. Since
the collapse of this agreement, international conferences have brought little
order to the international monetary scene. As the currency of the dominant freeworld power, however, the U.S. dollar continues to be the reserve currency of
most countries and provides much of the liquidity needed for international
transactions.
Unfortunately, the dollar has continued to decline in value against such major
currencies as the German mark, the Japanese yen and the Swiss franc. Unless
the U.S. begins to pursue tough anti-inflation policies, this decline is likely to
continue, contributing further to instability abroad and exacerbating inflation
at home.
There have been many who have felt that the U.S. dollar has been undervalued and that the falling value of the dollar in the foreign exchange markets
should be treated with "benign neglect". However, as long as foreigners see U.S.
productivity declining, inflation running apparently out of control and the U.S.
money supply expanding too briskly, they are likely to continue to discount the
dollar.
The dollar's abrupt decline in the foreign exchange markets during 1977 and
1978 prompted the government's rescue attempt last November. But while the
government's intervention in the exchange markets has halted the slide in the
dollar's value, this type of intervention—as the British found in their many
post-war attemps to support the pound sterling—is only a palliative. The attack
on the dollar will cease when we mend our economic ways and that entails a
"disciplining" of money supply expansion.
Also in the 1970's an important change has occurred with respect to this
country's balance of payments. Not only have trade deficits appeared, but they
are persistent and increasing in size. During 1977 the deficit was $26.7 billion.
This was four times larger than the previous 1972.record and demonstrates how
far we have drifted from the trade surplus situation which prevailed prior to
1971. The problem is not just due to the cost of energy imports (now running in
excess of $40 billion) but also to an increasing trade deficit in manufactured
goods. The international competitive environment has changed; several countries
(notably Japan) have become more productive and innovative in manufacturing
than we have and the governments of those countries support their exports trade
more aggressively than we do.
If it seems that we are unfairly painting the decade of the 1970's as chaotic in
the United States (and abroad), we would point out that the 1978 "Economic
Report of the President" carried a detailed discussion of the "Origins of the
Current World Economic Disorder." Cited as the principal sources of disorder
174
were prolonged inflation, rising unemployment and large current account imbalances. While the report cites the strong expansionary polices existing everywhere in 1972, the rising rates of inflation were attributed to non-monetary
factors: the demand for raw materials and grains during the early years of the
decade, OPEC's quadrupling of crude oil prices in 1973, and the wage/price
momentum which had become institutionalized in the economics of any industrialized states. The Council of Economic Advisors, which prepared the
report, has, in our view, however under-estimated the contribution that overly
expansive monetary policy has made to the economic instability of the 1970's.
In an October, 1978 Boston interview the well-known Cambridge economist,
Joan Robinson, spoke of the capitalist world's arriving at a deep crisis, with the
foundations of its economies shaking loose. She thought that the capitalist world
was up against the limits of its resources, with no easy way out of the mess.
Americans, she said, were "bastard Keynesians" in that they believe that the
capitalist economies were essentially stable and that government spending could
bring unending growth and prosperity.
During the 1950's and early 1960's, this country experienced unparalled prosperity. If the foundations are now coming apart, perhaps it is because we have
tried to follow Keynesian economic prescriptions too closely since the mid-1960's.
According to this school of economics, it is not enough to give counter-cyclical
fiscal help; the economy must be perpetually fine-tuned. An emphasizing of income stream manipulation has lead to a deemphasizing of money value stabilization. Increasingly, the value of money has ceased to matter.
In fact, however, money matters a great deal in a capitalist society (and to
the elderly in such a society). If money is not reasonably stable, savings, investment, and enterprise are at a disadvantage. If money becomes highly unstable,
substitutes must be found, or industry will grind to a walk.
RESTORING ECONOMIC ORDER
The Associations believe that a fundamental (but by no means the only)
cause of the economic disorder of the 1970's had been the lack of stability of the
dollar. If economic order is to be restored in the 1980's the dollar must be stabilized in a dynamic sense by assuring that over the long run the rate of growth
in the money supply is tied to the rate of growth in real (non-inflationary)
Gross National Product (GNP). The Council of Economic Advisors should set
real GNP growth rate targets for five year periods. These targets and the statistics that accumulate during the period should be forwarded to the appropriate
Congressional Committees so that long term plans for the money supply as proposed by the Federal Reserve, can be closely coordinated.
Because present law requires the Federal Reserve Board to submit a statement of its policy only for the one year period for which the report is written, the
scope of the policy in terms of the time period covered is much too short. What
are we proposing is a five year plan, which will, of course, be subject to annual
review and adjustments. We think a plan of this length is needed so that the rate
of expansion of the money supply, to the extent it exceeds the rate of real GNP
growth, can be brought down gradually and systematically, without generating
a serious recession.
The rationale for our proposal is this. The country's economic machine will
apparently be capable of only an annual real growth rate of between 2 and 3%
percent during the coming years. Therefore the money supply growth rate ought
to be brought down gradually to this same range. Obviously, the monetary expansion policy we call for is quite the opposite of what has been pursued in the
recent past.
A simple comparison between the growth of Ml money stock and the growth
of real GNP reveals that in the first
two decades after World War II Ml grew
at a slower rate than real GNP.1 However, for the 9 years from 1967 through
1976, real GNP grew at an annual rate of only 2.6, while the money stock grew
at a 5.8 percent annual rate. In the following pages we cite much refined analysis
of post-war money supply growth to support what appears from a superficial
examination of the data—money stock growth rates have become so high that
they are supporting elevated rates of inflation.
We recognize that enabling legislation would be needed to carry out our proposal for gradually reducing the money supply growth rate and ultimately coordinating that growth rate with the real GNP growth rate planned over a five
1
See Table I in Appendix, infra.
175
year period. Immediately, however, the Federal Reserve Board can commence a
phased reduction in the money supply growth rate without any new legislation.
The Banking Committees ought to use the consultation process with respect to
the monetary policy proposals (that the Federal Reserve Board must present each
year under last year's Humphrey-Hawkins legislation) to make sure such a
gradual reduction is undertaken.
A PHASED REDUCTION IN THE GROWTH OF MONEY
STOCK
If any significant progress toward price stability is to be made, the uncharacteristically high Ml growth rates of the 1970's must be substantially lowered.
To avoid a serious recession, the reduction should be at a steady rate, phased in
over a period of years.
A careful econometric examination of the possibilities of this approach was
made 2by Peter I. Berman, recently a senior economist with The Conference
Board. Dr. Berman investigated the usefulness of a number of measurements
but dermined upon the Ml money stock for his final, econometric model, about
which he had this to say:
"The correct specification for the Ml model is a stable 10 quarter distributed
lag with uniformly sized weights. Since 1956, this model explains about 70 percent/>f the variability in inflation. For the 1963-1971 period R2 increases to 80
percent and the normally distributed residuals imply that, stochastically, money
growth completely explains inflation,
i.e. the real sector price effects are adequately captured in the trend term."3
Mr. Berman assessed the effects of increases in the Ml money stock as follows:
" . . . a permanently maintained 1 percent increase in Ml growth will eventually
increase inflation by 1.4 percentage points provided there is no change in the net
influence of the real sector on 4the price level. By inference, the quantity theory
may not hold in the near term."
The value of the model of course must be based on its ability to forecast. On
this subject Dr. Berman had the following to say:
"An out-of-sample forward simulation beginning in mid-1971 gives impressive
forecasts. For 1976 and 1977, the average forecast error is only 0.5 percentage
point, and the forecast errors do not show any sign of progressive deterioration.
. . . Only one quarter 1977/2 has a forecast error exceeding two standard errors,
1.6 percentage points. At the very least, the Ml model is a useful forecasting
tool."5
According to Bernan, a phased reduction of 1 percent a year in the Ml growth
rate would reduce inflation by about 4.5 percent over a five year period. A 1^
percent a year reduction would reduce inflation by 4 percent over a 4 year period.
A 2 percent a year reduction—a "crash" program—would reduce inflation by
41/£ percent in 3 years.6
The Associations would be satisfied with any phase-down program (like the
ones cited in the above paragraph) that could be adopted without generating a
major recession. Because of changes in banking practices, Ml may have to be
redefined; M2 might be a better aggregate to serve as a standard for the phasedown. The main thing, as we see it, is to slow down the growth of the money
stock in a gradual and systematic fashion. This recommendation calls for a
gradual slowing of the money supply growth rate until it is brought into line with
the rate of growth in real GNP. This recommendation also requires that GNP
be targeted for monetary policy purposes. In other words, the target GNP real
rate of growth figures must not be made so large that more inflation is promoted.
Recommendations that monetary policy focus on planned money stock growth
over a five-year period and that the size of the money stock be disciplined in
accordance with the needs of an expanding (or contracting) real GNP are recommendations which represent substantial change from monetary policy as practiced
in the past. The proposed policy would be focused on changes in monetary aggregates rather than on changes in interest rates. We think such a shift in focus
is called for. The fact is that the dollar is now an inconvertible paper currency.
Thus, we cannot afford to continue to give in to popular demands for cheap money
and abundant supplies of money because this makes the growth of the money
supply, and the inflation such growth facilitates, a secondary consideration for
the central bank.
2
3
P. Berman, Inflation and the Money Supply in the United States, 1956-1977 (1978.
Id. at 6.
*Id.
5
Id.
«Id. at 120.
176
A STABLE ECONOMY VS. STABLE MONEY MARKETS
With the adoption of House Concurrent Resolution 133 on March 24, 1975
the Congress began to emphasize the importance of money stock aggregates,
requiring the Federal Reserve Board to propose ranges of growth of monetary
aggregates for a twelve month forward period. Historically, however, the primary
objective of central bankers including our own Federal Reserve has been to keep
"the financial structure on an even keel" and the ideal situation for them has been
financial stability, with interest rates stabilized.
Our objection to having interest rate stability as the primary focus of monetary
policy is that supplies of bank credit and money became determined by the demand for them. Because changes in money supply are induced by changes in
private demands for money and credit, a rate stabilizing policy results in money
supply changes which tend to amplify business fluctuations, rather than countering them. Expanding the money supply in order to moderate increases in interest
rates is effected at the cost of increasing price inflation. The correct approach
it seems to us, is to keep the money supply growing at a relatively steady rate
in accordance with the needs of an expanding or declining real GNP. Interest rate
fluctuations should then be no cause of great concern, since they would not be
indicators of either an excessively deflationary or an excessively inflationary
policy. The history of the monetary policy of the 1970's—a disaster in terms of
its inflationary consequences—has led us to conclude that pre-occupation with
interest rates as the primary guide for monetary policy is just not the correct
course to follow.
Because this country has had a history of low inflation rates, we are only
now beginning to appreciate the significance of the inflation premium that is being
added to real interest costs. Expanding the money supply to keep down interest
rates only yields temporary success; lenders soon perceive that they will be
paid back in a devalued dollar and thus must include an inflation premium in
their rate of interest. The long-term result is a rise in interest rates. As expansionary monetary policy to keep interest rates down will, if it contributes to
more inflation, lead to even higher interest rates in the future.
REDUCING THE MONEY STOCK GROWTH RATE: WILL IT BRING ON A RECESSION?
We have proposed a phased reduction in the rate of growth of the money
stock over a period of years to bring it into line with real GNP growth rates.
One question that will be raised is whether or not this course of action will
eventually produce a recession. We think it will not. A gradual slowing of the
money stock growth rate has not produced recessions in the past. As the chart
in the appendix on page 34 indicates, the gradual money stock growth rate
reductions that occurred in 1955, 1962, 1965, 1971 and 1976 did not spawn
recessions. Only when the reductions were very sharp, as they were in 1959, 1969
and 1973, did they tend to bring on recessions.
A sharp reduction in growth rates will not be needed and a serious recession
can be avoided if a phased and systematic reduction isi pursued in the years immediately ahead The sharp reduction in money stock growth rates in the 4th
quarter of 1978 and the 1st quarter of 1979 is likely to provoke a recession, if
continued into the 2nd quarter of 1979 This abrupt restraining of money supply
growth might not have been needed if monetary policy had been oriented since
1976 to steady growth, rather than to interest rate stability.
Since the last quarter of 1976, when Ml grew at a rate of 7.7 percent on an
annual basis, and up until the last quarter of 1978 when the present restraint
began, the Ml growth rate has dipped below 7 percent only once—during the 1st
quarter of 1978. These high and sustained growth rates have virtually
institutionalized inflation in the 6 to 8 percent a year range.
MONETARY POLICY FOR 1979
This Committee has responsibility for reconciling the short term goals of the
President's Economic Report with the short term goals and targets of the
Federal Reserve Board and its Open Market Committee. The Committee will
be receiving proposals for various ranges for the monetary aggregates from the
Board for the coming quarters and proposals for interest rates to be established
for Federal Funds. We hope the Committee agrees with one of the main points
of this statement: the Federal Reserve system cannot, at this juncture, adequately control both monetary aggregates and interest rates; if the focus is on interest
177
rate stabilizations, control of money stock growth will be sacrificed; if the focus
is on the monetary aggregates, interest rates will fluctuate. Our recommendation
is to abandon the past emphasis on interest rate stabilization and concentrate
instead on control of money stock growth in the context of a longrange—preferably 5 year—plan.
It follows from our recommendation that we believe the Committee should
relate the proposals of the Federal Reserve Board for the control of monetary
aggregates to the expected growth of real GNP for the coming years. The
President's January
25 Economic Report has estimated the real GNP will grow
at a rate of only 2x/4 percent during calendar year 1979. This is optimistic when
compared to the —0.1 to 1.9 percent real GNP growth rate which the Congressional Budget Office projects for the period 1978:4 to 1979:4. The CBO estimates
real GNP growth for 1979:4 to 1980:4 in the range of 2.7 to 4.7 percent. While the
Economic Report speaks of monetary restraint, there are no specifications whatsoever for restraint under the discussion of "Policies to Control Inflation." This
failure to be specific about monetary restraint by relating money stock to the
needs of the economy as measured by real GNP is puzzling. Could it be the Administration1 has failed to recognize the connection between the economic disorder
of the 1970's and the undisciplined expansion of the U.S. money supply?
It appears that an annual four percent real economic growth rate is not attainable in the immediate future. Declining investment, declining productivity,
rising energy costs and other factors appear to preclude that. Politicized goals for
real GNP growth cannot be trusted as a guage for the expansion of the money
supply. The Wharton School's econometric projection of real growth in GNP
for the 5 years ending with 1985 is an annual average rate of 3.2 percent. As a
long range goal, we think an average annual rate of growth in the money stock
of 3 percent would be appropriate and non-inflationary. However, we ought to
move toward this optimum growth rate over a period of years to avoid bringing
on a severe recession by decelerating too quickly from the very rapid growth
rates of the recent past.
For simplicity we are specifying our plan for reducing money stock growth in
terms of Ml. Nevertheless we recognize that changes in the ways banks and
thrift institutions handle accounts may make it necessary to restate the resulting
Ml stock aggregates in nominal currency. If so, the Federal Reserve Board is
fully capable of making such a re-statement. Alternatively, the Federal Reserve
might wish to use another aggregate such as M2. But the objective is to arrive, in
a systematic manner at the end of a period of years at a money supply rate of
expansion that is no greater than the rate of growth of real GNP.
The phased reduction that we propose would proceed in accordance with the
following schedule.
Year:
1979
1980
1981
1982
Average Mi money
stock growth
4 quarters
(percent)
6
5
4
3
If this schedule does not reduce the inflation rate to 2 percent a year, a further
reduction in the growth of money stock could be made in 1983, so that annual
inflation is reduced to this rate.7
The adoption by Congress and the Federal Reserve system of a disciplined
method for controlling the expansion of the money stock should begin to dampen
inflationary expectations immediately. The world will be put on notice that this
country intends to defend the value of the dollar on a long range basis. Persistent,
elevated rates of inflation should gradually fall. Vigor should be restored to our
capital markets, both in equity offerings and in fixed securities, since lenders will
be able to calculate real long range returns with reasonable accuracy. New
enterprise should be promoted with the elimination of the uncertainties affecting
the return on investment created by fluctuating, elevated rates of inflation. The
return of relative stability to the dollar should eliminate the enormous inflationary burdens that the social security system would otherwise have to bear. Finally,
the growing elderly population should be better able to sustain themselves
through savings.
7
P. Berman, supra note 1, at 14, 20.
178
EMPLOYMENT AND INFLATION
We know the Committee will be reviewing short term monetary policy against
the economic goals set forth in The Full Employment and Balanced Growth Act
of 1978. The Associations have expressed on many occasions our support for
counter-cyclical action by the Federal Government to promote employment and
business activity during the declining phase of the business cycle. However, we
are much opposed to the Federal Government's pursuit of stimulative monetary
and fiscal policies as full employment is approached. We believe that the pursuit
of stimulative policies in both good economic times and bad has been another
major factor contributing to the lifting of the inflation rate levels. The Federal
Reserve system has found itself obliged during recent quarters to try and brake
the inflation rate which has once again risen to double digit levels by freezing the
expansion of the money stock and by raising the Federal Funds rate to very high
levels. This action is certain to promote uncertainties of all kinds in the business
community and to induce a severe recession if continued.
We hope the Committee will agree with the point of view of our testimony
that monetary policy ought not to be used to expedite short term economic goals
but instead should focus on the long term goal of expanding the money supply
in accordance with the rate of expansion of real GNP. Because many researchers
have found that the money supply tends to act slowly on prices and business
activity, monetary policies should not be changed on an ad hoc basis from
quarter-to-quarter or even from year-to-year; underlying all changes in policy
should be sound long range planning. The failure to follow a long range policy
of expansion has made for stop-and-go policies (even during the present economic recovery) that have had damaging effects on employment and on the rate
of persistent inflation.
The Humphrey-Hawkins bill was intended, in the eyes of some of its sponsors,
to be a blueprint for economic action by the Federal Government. However, not
only do we consider its goals to be rather "dated", but we have also found that
the methods of control implied by the bill—fine-tuning of the economy—work
poorly as evidenced by the results of the past decade. Full employment goals in
the 3 to 4 per cent range fail to take account of important changes in the working
population. Phillip Cagan of the American Enterprise Institute has estimated
that full employment at which inflation neither increases nor decreases is somewhere between 5.9 and 6.3 per cent. We believe that the goals of full employment
and low inflation for the United States can best be promoted by stabilizing the
value of the dollar by methods we have outlined in the previous paragraphs.
MONEY : THE QUANTITY MATTERS
The thesis of our statement is that the quantity of money issued by government is an important determinant of the exchange value of that money and to
stabilize its value, long range monetary policy should center on a planned expansion of the money stock in accordance with the expansion (or contraction)
of GNP in real terms.
While we have referred to certain studies in previous paragraphs, we would
like to conclude our statement with descriptions of two more, one by the Federal
Reserve Bank of St. Louis, and one by the Brookings Institute. Both find a close
association between money supply expansion rates and rising price levels. However, before proceeding to these, we would like to refer to an older study of
great depth, which was done by Milton Friedman and Anna Jacobson Schwartz,
"The Monetary History of the United States 1867-1960." One of their most
important findings is summarized in the following quotation from that study:
"Throughout the near-century examined in detail we have found that:
1. Changes in the behavior of money stock have been closely associated with
changes in economic activity, money income and prices.
2. The interrelation between monetary and economic changes has been highly
stable.
3. Monetary changes have often had an independent origin; they have not
been simply a reflection of changes in economic activity."
Although it is nearly twenty years since these conclusions were formulated,
we have no reason to believe that they are other than fundamentally sound.
In saying this we are not trying to make money stability the touch-stone of
economic prosperity. We are simply affirming again that money changes—which
are long range in their effect on economic activity and on prices—are important—
so important that they must be made according to a long range plan. We simply
179
can no longer affor^ "stop-and-go" monetary policies or policies that shift with
the political winds.
MONETARY GROWTH AND
PRICES
A December 1978 study by the Federal Reserve Bank of St. Louis demonstrated that there is a simple monetary guide to the rate of inflation: the rate
of change in prices over the next year will be about equal to the average rate
of growth of the money stock over the previous five years.8
As shown in Table II of the appendix (page 33), over the nineteen year
period 1953-71 the average difference between the actual rate of inflation and the
rate indicated by the past rate of monetary expansion was only 0.2 of a percentage point. In two-thirds of the years the error in the predicted rate was 0.5
of a percentage point or less. It was found that although prices oscillated around
the trend rate on a quarter-to-quarter basis, the rate of change of prices returned consistently to that dictated by the rate of monetary expansion.
Also during this period it was found that the five-year trend in the growth of
money accurately indicated changes in the year-to-year rate of inflation, up or
down. For example, as the trend in the growth of the money slowed in the period
1958-63 the rate of inflation slowed down. Over the next eight years the trend
in the growth of money accelerated steadily from around 2 per cent a year to
5 per cent and this corresponded with a rise in the annual inflation rate from,
2 to 5 per cent.
Over the short run the level of prices may be strongly influenced by factors
other than the trend in the growth of the money supply. However, after the
effects of the non-monetary factors (frequently described as shocks) have been
absorbed into the economy the level of prices tends to revert to the trends
indicated by the past growth in the money supply. Table II shows that prices
in 1974 and 1975 rose far higher than what would be indicated by the past fiveyear growth in the money supply. The shocks that raised prices over the trend
lines were the two separate dollar devaluations of 1973, which raised the costs
of imports in the following years, the worldwide food shortages of 1973 and
1974, the four-fold increase in world crude oil prices dating back to mid-1973,
and raw material shortages. Price levels in those two years were probably also
boosted by widespread expectations of inflation. But in 1976 and 1977 the inflation rates reverted to those indicated by past growth in the money supply;
the 1977 inflation rate of 5.9 per cent was only 0.1 percentage points off target.
We do not cite this study as proof that there is a mathematically verifiable
relationship between the level of prices and the growth of the money supply;
it remains possible that other factors could account for the apparent relationship between price levels and past money supply growth rates. However, elaborate econometric models of the economy have been failing to forecast the rate
of inflation with reasonable accuracy since the rates began to accelerate in the
late sixties. The money stock method for predicting inflation rates ought at least
to be deemed a useful tool. In addition, it raises the possibility that more elaborate demonstrations may prove a casual relationship between money supply
changes and changes in the rates of inflation.
WORLD INFLATION AND MONETARY ACCOMMODATION
An important econometric study of the sources of inflation in this country and
several other industrial countries
was described in the "Brookings Papers on
Economic Activity, 2: 1977." 9 The Report was supervised by Robert J. Gordon
of Northwestern University. The research was supported by the National Science
Foundation. The period analyzed covered the years 1958 to 1976.
The major alternative explanations for the acceleration in the rate of inflation
since 1965 and the advent of world wide inflation have been monetary expansion,
(an increase attributable primarily to the excessively expansionary monetary
policy of the United States) and wage-push inflation, promoted by the strength
of labor unions. The paper assumes that in the long run inflation is a monetary
phenomenon, confirmed by many studies on the connection between the growth
of world money and prices. However, this is to be regarded as an initial step
in the understanding of the inflation process, because the sources of change in
the money supply remain to be explained. In other words, we may correlate
8
Albert E. Burger "Is Inflation All Due to Money?", Bulletin of the Federal Reserve
Bank
of St. Louis (December 1978).
9
R. Gordon, "World Inflation and Monetary Accommodation in Eight Countries", Brookings Papers on Economic Activity (1977).
180
world prices and money but we do not rule out wage-push as a source of world
monetary growth. We ought not to regard the behavior of the monetary authorities and wage-push factors as competitive explanations for inflation, because the
monetary authorities may be expanding the money supply to accommodate wagepush and other causal factors like fiscal deficits, supply shocks and the countercyclical monetary reaction function. Thus, if we are analyzing why the monetary
authorities are expanding the money supply at certain rates, we must investigate the various factors that may be affecting their judgment. The reason that
wage-push factor assumes so much importance is that central bank must—for
political reasons—expand the money supply so that it is adequate to ratify any
given level of money wages, regardless of how the wage levels are determined.
If they fail to do so, excessive unemployment may be the consequence.
Econometric analysis of the relative importance of the various sources of inflation is a difficult task. The results of the study can only be accepted with reservations. Nevertheless, the study is solid in one respect: the growth of the money
supply was found to be a critical factor in determining the inflation rate and
control of money supply growth was found to be essential to control of inflation.
The importance of this conclusion is such that we quote this particular summation as set forth in the study.
"Is the control of the money supply sufficient to control inflation?" Money
growth has a significantly positive impact on wage growth in four major countries making up 72 percent of the 1976 GNP of the eight countries considered
here. Not only does this tend to deny the contention of some wage-push proponents that wage claims are numbers "picked out of thin air," but it also supports
the international-monetarist position that control of world monetary growth is
a crucial requirement in the determination of the world inflation rate. A qualification is that in the remaining four countries the effect of money on wages is
weak or nonexistent. A further qualification is that the estimated elasticity of
wages with respect to money is small, and that of prices with respect to money
is smaller still. Finally, this effect of money on prices apparently operates in
conjunction with the effect of money on output."
TABLE I.—POST-WORLD WAR II TRENDS IN NOMINAL AND REAL GROSS NATIONAL PRODUCT AND IN MONEY
STOCK (Ml AGGREGATE) 1947/1977
[All figures in billions]
Year
1947
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
30 yr average annual growth rate (percent).
_
Nominal
GNP
Money stock
M-l aggregate
Real GNP in
1972 dollars
$232.8
259.1
258.0
286.2
330.2
347.2
366.1
366.3
399.3
420.7
442.8
448.9
486.5
506.0
523.3
563.8
594.7
635.7
688.1
753.0
796.3
868.5
935.5
982.4
1,063.4
1,171.1
1,306.6
1,413.2
1,516.3
1,692.4
$113.1
111.5
111.2
116.2
122.7
127.4
128.8
132.3
135.2
136.9
135.9
141.1
143.4
144.2
148.7
150.9
156.5
163.7
171.3
175.7
187.3
202.2
208.8
219.6
233.8
255.3
270.5
283.1
294.8
311.9
$468.3
487.7
490.7
533.5
576.5
598.5
621.8
613.7
654.8
668.8
680.9
679.5
720.4
736.8
755.3
799.1
830.7
874.4
925.9
981.0
1,007.7
1,051.8
1,078.8
1,075.3
1, 107. 5
1, 171. 1
1,235.0
1,214.0
1, 191. 7
1,265.0
7.1
3.6
3.5
Note: Ml growth rates: 1947/1957 -1.9 percent; 1957/1967 -3.3 percent; 1967/1976 -5.8
rates: 1947/1957 -3.8 percent; 1957/1967 -4 percent; 1967/1976 -2.6 percent.
percent. Real GNP growth
Source: Date from various Government sources as given in the 1977 Economic Report of the President.
181
TABLE II.—MONETARY GROWTH AS AN INDICATOR OF INFLATION
[In percent]
Period
Growth rate
of money
Growth rate
of prices
Period
(2)
(1)
1947-52
1948-53
1949-54 ..
1950-55
1951-56
1952-57
1953-58
1954-59
1955-60
1956-61 .
1957-62
1958-63
1959-64 .
1960-65
1961-66
1962-67 .
1963-68
1964-69
1965-70 .
1956-71
1967-72
1968-73
1969-74 ..
1970-75
1971-76
2.3
2.7
3.2
3.3
2 7
1.8
15
2 0
13
1.5
1.8
2 2
2.2
31
36
4.0
4 8
5 2
5.1
5.5
61
6.2
6.1
6 2
6.0
Col. (1) minus
Col. (2)
1953
1954
1955
1956.
1957
1958
1959
1960
1961
1962
1963....
1964
1965
1966
1967
1968
1969
1970
1971.
1972
1973
1974
1975..
1976
1977
1.5
1.4
2.2
3.1
3.4
1.6
2 2
1.7
.9
1.8
1.5
1.6
2.2
33
2.9
4.5
5.0
5.4
5.1
4.1
5.8
9.7
. .
9.6
5.2
5.9
.8
1.3
1.0
.2
1
'.2
7
.3
.4
-.3
.3
.6
0
2
.7
—.5
-.2
o'
1.4
-3! 5
-3.5
1.0
.1
Source: Table reproduced from p. 9, December 1978 Review of the Federal Reserve Bank of St. Louis, "Is Inflation All
Due to Money?"
182
Trends and Fluctuations of Money, Prices, Output, and Unemployment
9fe i96/ 1968 1969 19 JO 19? 1 19/2 1973 1°?4 1975 1976 197? 19» 1979
183
APPENDIX III
Union Calendar No. 11
1st Session
f
\
No. 96-32
REPORT ON MONETARY POLICY FOR 1979
MARCH 12, 1979.—Committed to the Committee of the Whole House on the
State of the Union and ordered to be printed
Mr. REUSS, from the Committee on Banking, Finance and
Urban Affairs, submitted the following
REPORT
together with
SUPPLEMENTAL VIEWS and DISSENTING VIEWS
Submitted herewith is the first report of the Committee on Banking,
Finance and Urban Affairs pursuant to Public Law 95-523, the Full
Employment and Balanced Growth Act of 1978. This legislation
amended the Federal Reserve Act at section 2A to require the
following:
MONETARY POLICY
SEC. 108 (a) "In furtherance of the purposes of the Full
Employment and Balanced Growth Act of 1978, the Board
of Governors of the Federal Reserve System shall transmit to
the Congress, not later than February 20 and July 20 of each
year, independent written reports setting forth (1) a review
and analysis of recent developments affecting economic
trends in the Nation; (2) the objectives and plans of the
Board of Governors and the Federal Open Market Committee with respect to the ranges of growth or diminution of the
monetary and credit aggregates for the calendar year during
which the report is transmitted, taking account of past and
prospective developments in employment, unemployment,
production, investment, real income, productivity, international trade and payments, and prices; and (3) the relationship of the aforesaid objectives and plans to the short-term
goals set forth in the most recent Economic Report of the
President pursuant to section 3(a) (2) (A) of the Employment Act of 1946 and to any short-term goals approved by
the Congress. In addition, as a part of its report on July 20
184
of each year, the Board of Governors shall include a statement of its objectives and plans with respect to the ranges of
growth or diminution of the monetary and credit aggregates
for the calendar year following the year in which the report
is submitted. The reports required under the two preceding
sentences shall be transmitted to the Congress and shall be
referred in the Senate to the Committee on Banking, Housing, and Urban Affairs, and in the House of Eepresentatiyes
to the Committee on Banking, Finance and Urban Affairs.
The Board shall consult with each such committee on the reports, and thereafter, each such committee shall submit to its
respective body a report containing its views and recommendations with respect to the Federal Reserve's intended policies. Nothing in this Act shall be interpreted to require that
the objectives and plans with respect to the ranges of growth
or diminution of the monetary and credit aggregates disclosed
in the reports submitted under this section be achieved if the
Board of Governors and the Federal Open Market Committee determine that they cannot or should not be achieved because of changing conditions: Provided, That in the subsequent consultations with, and reports to, the aforesaid committees of the Congress pursuant to this section, the Board of
Governors shall include an explanation of the reasons for any
revisions to or deviations from such objectives and plans.",
(b) The amendment made by subsection (a) takes effect on
January 1,1979.
Our economy has been expanding continuously since the spring
of 1975. However, the expansion has been marred by accelerating inflation, a deteriorating dollar abroad and difficult structural unemployment problems. Today, moreover, continuation of the expansion
is threatened by a variety of factors including feedback from accelerating inflation. The committee takes the view that monetary policy
should persistently promote economic stability rather than alternating between stimulus and restraint. Alternating between fighting unemployment and inflation has failed to achieve either full employment or price level stability.
a. Anti-inflationa^ policies must not cause a recession
The committee recognizes that reducing inflation will require persistent, measured monetary and fiscal restraint. Policies which attempt
to break inflation quickly would lead to recession and high unemployment and defeat themselves. Such policies would not stop inflation because they are too costly in terms of lost output and employment. As
a result, they would be abandoned before they were in place long
enough to stop inflation and replaced instead by policies designed to
fight unemployment which would rekindle inflation.
The committee notes with concern the many economic forecasts, including those of the administration and the Federal Eeserve, that
project higher unemployment for later this year. Many economists
go further and forecast an outright recession by early 1980. Kecent
economic events land some support to this pessimistic view:
The sharp slowdown in the growth of the monetary aggregates
since October 1978.
H.R. 32
185
The sudden slowdown in housing starts in January, from an
annual rate of 2 million in December to 1.7 million.
The increases in oil prices, past and expected, which have the
effect of draining purchasing power from our economy.
Because of the danger of recession, the committee cautions the Federal Reserve to pursue monetary restraint with special prudence in the
year ahead.
&. The Federal Reserved target ranges for monetary growth are
appropriate
On February 21, G. William Miller, Chairman of the Federal Reserve Board, testified that :
As required by the Full Employment and Balanced Growth
Act, the Federal Reserve at this time has established ranges
for monetary growth through the end of 1979. It will reassess these and report preliminary ranges for 1980 in July,
unless developments in the months ahead necessitate earlier
reconsideration. At this juncture, the monetary growth
ranges and the administration's 1979 economic goals appear
reasonabl consistent.
Specifically, the ranges established are as follows: Ml, l1/^ to
percent; M2, 5 to 8 percent; M3, 6 to 9 percent; commercial bank
credit, 7^ to 10i/£ percent.
Regarding the target for Ml, Chairman Miller told the committee
that:
The growth range for Ml calls for a marked deceleration
from the pace of recent years. This reflects in part an expectation that the shifting of funds to savings accounts with automatic transfer facilities and to the NOW accounts recently
authorized in New York State will continue to depress the
growth of demand deposits throughout 1979. The Board's
staff has projected that such shifting will damp growth in
Ml this year by around 3 percentage points.
The committee believes that the target ranges for the growth of the
monetary and credit aggregates as established by the Board of Governiiors and Federal Open Market Committee of the Federal Reserve System are appropriate. If achieved, they will promote the objectives that
we desire—reducing inflation while avoiding a recession. If, however,
it should appear in the course of 1979 that the switch to automatic
transfer and NOW accounts is not proceeding at a rate equal to 3 percent of Ml, as the Board's staff projects, then the Ml growth target
should be revised and the revision reported to Congress.
More generally, if during 1979, measurements reveal that the Federal Reserve's target ranges for the growth of the other monetary and
credit aggregates are not being met, the Federal Reserve should take
immediate corrective steps and report to this committee on its actions.
c. Overnight repurchase agreements must ~be monitored
One institutional innovation that has caused some concern in recent
years has been the growth of short terni securities sales by commercial
banks to large depositors with agreements by banks to repurchase them.
When the agreement requires repurchase the next business day, the
transactions could bias downward the measurement of Ml. The Federal
Q
H.H. 32
186
Reserve should begin immediately to montior such agreements and
report totals on a weekly basis so that their importance can be
ascertained.
d. Monetary restraint must be accompanied by measures to salve structural problems
It is widely recognized that monetary restraint, however necessary
to reduce inflation, will not solve our economy's difficult structural
problems.
Your committee agrees that special initiatives are needed to reduce
structural unemployment. Structural unemployment reflects poor
schooling, lack of job training, high job-search costs to both employers
and the unemployed, and excessive regulation. These problems can be
remedied at the same time that monetary restraint is being used to reduce inflation.
Your committee further agrees that structural measures to improve
productivity, reduce regulation and increase competition could greatly
assist in the battle against inflation.
In summary, as a necessary accompaniment to monetary restraint,
the administration and the Congress should actively pursue structural
policies to reduce inflationary biases in the economy, and to eliminate
structural unemployment.
e. Long-term.' monetary growth targets should be adopted
The Humphrey-Hawkins Act calls for achieving 4-percent unemployment and 3-percent inflation by 1983 and zero inflation by 1988.
Achievement of the interim 1983 goals would be promoted by steady
deceleration in the average annual rate of monetary expansion over
the next 5 years. Specifically, the annual growth of Ml, measured inclusive of automatic transfer and NOW accounts, would be reduced to
3 percent by 1983 (assuming a continuation of the present approximately 3 percent yearly velocity growth trend). Ml grew by 7.6 percent
from the fourth quarter of 1977 to the fourth quarter of 1978. The midrange of the Federal Keserve's growth path of Ml (adjusted for the
new automated transfer accounts) in 1979 is 6 percent. This should
be achieved, and thereafter, deceleration of Ml growth by 1 percentage
point per year through 1982 should be the aim. Commensurate longrun targets should be established for the other monetary and credit
aggregates.
Recommended percent growth J^tK quarter to. 4th quarter Ml
1978-83x
1978
1979
1980
1981
1982 _
1983
_
_
Percent
7.6
_
_ _
_
(adjusted)
60
50
4.0
3. 0
3. 0
/. The strength of the international dollar depends on that of the
domestic dollar
The committee affirms that the strength of the U.S. dollar in foreign
exchange markets depends fundamentally on the purchasing power
1
Assuming continuation of the present approximately 3 percent velocity growth trend.
187
of the dollar within the United States. The policies recommended by
this committee are consistent with a fundamentally strong dollar
abroad. By restroing stability domestically, these policies will, over
the long run, improve confidence in the dollar abroad.
The committee recognizes the possibility of transitory instability in
foreign exchange markets. However, we caution the Federal Reserve
to stay on the long-run track during these ephemeral episodes. Monetary policy should not be made more restrictive than it is at present
in the interest of propping up the dollar.
g. Conclusion
Economic stability depends strategically on moderation and consistency in monetary policy. The Federal Reserve promises moderation
of monetary growth in 1979. Your committee notes that the Federal
Reserve has made this promise before, but has been either unwilling
or unable to keep it perhaps because of actual or preceived congressional pressures. We hope that this first report, pursuant to the
Humphrey-Hawkins Act, will make it clear to all, at home and abroad,
that the House and the Federal Reserve are in agreement on the
necessity for persistent moderation in the conduct of monetary policy.
188
ADDITIONAL VIEWS OF HENRY B. GONZALEZ
Monetary policy is a crucial and much neglected part of this country's economic policy. The diligence and concern of Chairman Reuss
makes it possible for this committee and the Congress to at least provide coherent views on the subject, though control of monetary policy
remains with the Federal Reserve. The country is truly indebted to
Chairman Eeuss for his efforts to provide meaningful participation
by Congress in the conduct of monetary policy, which heretofore has
been the exclusive province of appointees, rather than elected officials.
The current report of the committee, like its predecessors, could, be
much improved by the addition of a discussion of what the recommended policy is expected to do, and what alternative policies might
be expected to do.
It is one thing to endorse a Federal Reserve policy that is aimed at
reducing the rate of growth of the money supply, and quite another
to explain clearly what the consequences will be. The report should
explain in plain terms what the policy it endorses will dp to interest
rates, what it will do to the rate of employment, and how it will affect
overall economic performance, including the rate of inflation. The expected impacts need to be set forth as clearly as possible, so that there
can be no mistake about what the committee is recommending.
Likewise, the report should spell out what the alternatives may be
and how they would affect the economy.
Information of this kind would not only enable the committee to
make more intelligent choices; it would also enable the public to better
understand what has been done and why. Only if we provide this kind
of information can we ever hope to bring the importance of monetary
policy into the consciousness of the general public and thereby end
the long neglect of this subject.
*
The report, as far as it goes, provides a needed and useful service.
I hope that in the future we can improve the product and make it much
more useful to ourselves and the public at large.
HENRY B. GONZALEZ.
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189
SUPPLEMENTARY VIEWS OF PAEEEN J. MITCHELL,
WALTEE E. FAUNTEOY, AND EOBEET GAECIA
This Is not a dissent. The points we want to make are complementary
to the committee's report.
In general, we share the committee's views and recommendations on
monetary policy. In October 1977, one of us, Congressman Mitchell,
acting as chairman of the Subcommittee on Domestic Monetary Policy,
expressed concern about the high money growth policy the Federal
Eeserve had been pursuing for nearly a year. There was apprehension that this policy would accelerate inflation, and it has. Last summer,
Congressman Fauntroy joined Congressman Mitchell in recommending that the Federal Eeserve play its part in our quest for economic
stability by reducing Ml growth 1 percentage point a year over the
next 5 years. All of us are delighted that the committee now recommends essentially the same strategy.
Although sharper deceleration of money growth would court recession, as the committee has cautioned, there is little to fear from a slow
persistent cutting back of monetary growth to a rate "commensurate
with the economy's long run potential to increase production," as is
required by law. The facts show that faster money growth is fully
dissipated within 2 to 3 years in faster inflation and higher interest
rates, and this lays the groundwork for recession and higher unemployment. Thus the strategy for monetary policy which the committee
recommends, and which we support unequivocally, will not impede
achieving the employment goals of the Humphrey-Hawkins Act, and
should help to achieve these goals.
However, as our colleagues understand, the employment goals of the
Humphrey-Hawkins Act cannot be achieved by monetary policy alone.
We need direction in fiscal policy as well as prudence in monetary
policy. And direction in fiscal policy means expanding public service
and other job programs and subsidies, and also training programs and
subsidies. There is absolutely no reason why, at the same time as the
Federal Eeserve is slowing money growth, fiscal policy cannot be directed to employing the jobless, especially long term unemployment
persons in the black and Spanish speaking inner-city communities,
and training 16 to 19 year olds throughout the Nation who need and
want job training. It would only take about $3 billion a year to fully
employ 500,000 persons at the minimum wage. Another $3 billion annual fiscal expenditure would provide on-the-job training opportunities
for all or nearly all youngsters who need and want initial training and
skill development. In short, we can make substantial progress in solving our unemployment problem with minimal additional Government
spending, while at the same time using monetary policy to reduce inflation. As Prof. Martin Feldstein put it, in testimony received by the committee, paraphrasing, we can pursue microeconomic policies that reduce
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190
the unemployment rates of high unemployment groups and prepare
young people for work while at the same time proceeding with macroeconomic (monetary) actions that slowly reduce nominal or dollar
aggregate demand growth to our economy's long run potential for real
growth. We can and we should do both.
PARREN J. MITCHELL.
WALTER E. FAUNTROT.
ROBERT GARCIA.
191
SUPPLEMENTAL VIEWS OF MR. BAKNARD
I concur with the committee that a moderate and consistent monetary policy is necessary to reduce inflation and promote sound economicgrowth, but I want to stress that it must be accompanied by a responsible fiscal policy.
Far too often, Congress has overreacted to shifts in the growth of
the economy with deficits that are higher than necessary. To make matters worse, we have continued massive deficits far past the point that
there has been any economic justification for them. In future recessions,
Congress must carefully consider what action that it can take that will
improve the situation without overreacting. Just as the Federal Reserve must be careful to follow a moderate monetary policy, Congress
must follow a moderate fiscal policy and return to a balanced budget
as soon as possible.
Restrained and responsible fiscal policy does not mean a reduction in
all efforts to solve the structural problems of the economy, but rather
a careful examination of all spending priorities in light of the state of
the economy and likely benefits of a program, and making hard
choices. We do not help solve structural problems when we add inflation on top of them.
In summary, with my colleagues I support the Federal Reserve's
goals of a moderate and consistent monetary policy and recognize the
need for continued programs to remove structural problems in our society. However, if they are accompanied by a fiscal policy that is too
expansionary and has too high a deficit, the result will 'be continuedinflation. Monetary policy cannot end inflation or recession by itself;
it must be accompanied by a moderate restrained fiscal policy, and int
most circumstances this means a balanced budget.
DOUG BARNARD^ Jr..
192
MONETARY POLICY REPORT MINORITY VIEWS
We are in general agreement with the broad thrust of the committee's Report on Monetary Policy for 1979. However, we believe there
are substantive matters which deserve fuller development.
No one can deny the importance of a proper monetary policy to the
resolution of our current economic problems. Nor can anyone deny the
ultimate constitutional responsibility of Congress for monetary policy.
The duty that Public Law 95-523 imposes on this committee relative
to this report is a serious one, to be approached with due deliberation.
The committee's report rightly recognizes that a stable monetary
policy alone cannot be expected to carry the full burden of curing all
our economic ills. But we think this point could be further clarified by
a more complete discussion of what else is required. We take occasion
here to examine only a couple of these matters.
We are particularly worried by the recent behavior of American
productivity. If the goals of the Humphrey-Hawkins Act are to be
realized, the decline in productivity growth that has characterized the
American economy during the 1970's must be reversed.
The Board of Governors of the Federal Reserve System noted in
their Monetary Policy Report to the Congress (February 20, 1979)
that:
During the period from 1947 to 1967, productivity in the
nonfarm business sector rose on average by 2% percent per
annum. * * * Since 1967, the rise in output per hour has
slowed, with average gains of only 1.2 percent recorded
since 1973.
Growth of productivity is essential if standards of living are to rise
without inflation. Growth of productivity in turn is significantly related to capital formation.
The inescapable conclusion is that government policies—both tax
and regulatory as well as monetary—must address the issues of productivity and capital formation more aggresively. Congress made a
start in that direction with passage of the so-called Steiger amendment
to the Revenue Act of 1978. We must do more.
Elimination of large Federal deficits during periods of economic
expansion would be extremely helpful, since such deficits have tended
to be monetized by the Federal Reserve to avoid politically unacceptable "crowding out" of the private sector. Treasury borrowing on the
scale encountered in the last several years has created enormous pressures on credit markets. Each and every consumer, business, school
district or local government that seeks to borrow money pays higher
interest rates as the price for the Treasury's overwhelming competition for the saver's dollar. In short, fiscal polcy is an important source
of inflationary pressures in this country via credit markets, and the
resulting monetization insures constantly advancing prices. We in
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193
Congress must cooperate with the Federal Stable fiscal policy working
with stable monetary policy would result in stability in the capital and
money markets, particularly after such policies have reduced inflationary pressures. The reduced uncertainty in the investment
environment would greatly encourage capital formation and thus
productivity.
More generally, we agree that establishment of a stable monetary
policy is necessary to the control of inflation, and we agree that structural reforms—especially with respect to government-induced inflationary pressures—are also necessary. But we believe further that
inflation is inherent as big government increases and that no final solution to the inflationary problem can succeed until the growth of government is arrested.
Specifically, we believe that excessive monetary growth is but the
means by which inflationary pressures are financed and that those
pressures, particularly runaway government spending, must be rerestrained if prices are to be dependably stabilized. As desirable and
even necessary as a stable monetary policy is, the restraint of all government, particularly as measured by government direction of resources, must be achieved if inflation is to be defeated.
J. WILLIAM STANTON.
CHALMERS P. WYLIE.
STEWART B. McKiNNEY.
GEORGE HANSON.
HENRY J. HYDE.
KICHARD KELLY.
JIM LEACH.
TOM EVANS.
BILL GREEN.
KON PAUL.
ED BETHUNE.
NORMAN D. SHTJMWAY.
CARROLL A. CAMPBELL.
DON HITTER.
JON HINSON.
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DISSENTING VIEWS OF RON PAUL
While I applaud the committee's recognition of the fact that "reduring inflation will require persistent, measured, monetary and fiscal restraint," I believe that the committee is still looking at the Federal Reserve through rose-colored glasses. Throughout its 65 year
history, the Federal Reserve has pursued a policy of deliberate inflation and manipulation of the money supply, a policy which has caused
numerous recessions, massive unemployment, double-digit price inflation, international exchange crises, and the largest and longest depression in our national history. The committee does note that the
Federal Reserve had promised moderation and consistency in monetary
policy before, but that it has been either "unwilling or unable" to keep
its promise. I concur with the committee's view of the importance and
necessity of the Federal Reserve keeping its promises on monetary
policy, but I am skeptical nonetheless. One need only look at the record
of the Federal Reserve, which I have briefly recapitulated above,
in order to understand my skepticism. The only permanent and practical solution to the problem of inflation—the only way to implement
the Federal Reserve's and this committee's goal of persistent monetary
restraint—is to decouple money and politics altogether, removing control over the money supply from any governmental or quasi-governmental institution. The deregulation of money, not simply a slowing
in the growth of the money supply, must be our goal. The committee
is looking in the right direction, but it has not yet seen the correct
destination.
There seems to be a growing consensus among economists that the
American people will suffer through another government-caused recession later this year or early next year. The committee takes note
of this view and expresses its concern. What it does not seem to realize,
however, is that the persistent policy of monetary inflation pursued
by the Federal Reserve makes these recessions inevitable. The timing
of the next recession may be a matter of gu&sing; the fact of the
next recession is not. In view of this fact, it is not enough to express
concern and then declare that the Federal Reserve's monetary growth
targets are appropriate. They are not. If we intend to pursue a genuine
anti-inflationary policy, it is not appropriate to endorse a growth in
the money supply. Nor is it appropriate for the committee to endorse
even greater inflation should "measurements reveal that the Federal
Reserve's target ranges for the growth of the other monetary and credit
aggregates are not being met."
The committee is correct in demanding monetary restraint from
the Federal Reserve; the problem is that it does not demand enough
restraint and allows the Federal Reserve to exercise entirely too much
discretion in its control of the money supply. Thus, of course, is not
to argue for congressional control of the money supply, but it is to
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argue that discretionary and arbitrary control over the money supply by any governmental agency must be abolished. If any responsibility is granted to the government with respect to money, it should be
to insure that the value of the money is maintained, not systematically
destroyed through a policy of deliberate inflation. In medicine there
is a term for diseases caused by physicians: iatrogenic. Inflation might
•correctly be called politicogenic, for it is caused by the politicians
(including the officers of the Federal Eeserve) who for 65 years have
declared that they intend to cure inflation.
One hopes that the Federal Eeserve abides by its promise to decrease
the rate of monetary growth; it definitely should keep its word. But
its past record is not encouraging, and the committee should consider
legislation to curtail the Federal Reserve's discretionary powers and
to begin the process of depoliticizing money althogether. Fiat money,
with which we have been forced to live, requires extensive control
and management at all times, with the hope of not disrupting the
functioning of the economy too greatly. As the failure of the money
managers becomes more and more apparent, other programs will be
declared "necessary" and "required" by those same managers: Price,
and wage controls, rationing, import controls, capital market controls,
and so on. All these programs will be imposed on the people at the
sacrifice of personal freedom and the destruction of a market economy,
should our present policies of monetary management continue. Sound,
honest money needs no managers. The integrity of our leaders should
insure money of real value. If this were so, inflation would disappear
and our economy could be put on the road to recovery.
RON PAUL.
@FedFRASER