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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

March 14-15, 1982

PPS-82-1

Graduate School of Management
University of Rochester

SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

March 14-15, 1982

PPS-82-1

Shadow Open Market Committee Members - March 1982
SOMC Policy Statement, March 14, 1982
Position Papers prepared for the March 1982 meeting;
The Politics of Uncertainty - Karl Brunner, University of Rochester
Fiscal Outlook, March 1982 and The 1983 Budget Testimony - Rudolph G.
Penner, American Enterprise Institute
Statement to the Subcommittee on Domestic Monetary Policy of the
Committee on Banking, Finance and Urban Affairs and Appendix H. Erich Heinemann, Morgan Stanley & Co., Incorporated.
The Behavior of the Monetary Aggregates: The Predictability of the Past
and Some Prognostications for the Future - James M. Johannes and
Robert H. Rasehe, Michigan State University
Sources of Financing for the Government Deficit - Robert H. Rasehe,
Michigan State University
Economic Prospects Through 1983 and Business Outlook-Monthly Update Robert J. Genetski, Harris Trust and Savings Bank
Economic Projections - Burton Zwick, Prudential Insurance Company of
America



SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. to 8;00 p.m. on Sunday, March 14,
1982.

Members:
PROFESSOR KARL BRUNNER, Director of the Center for Research in
Government Policy and Business, Graduate School of Management,
University of Rochester, Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial
Administration, Carnegie-Mellon University, Pittsburgh, Pennsylvania.
DR. ROBERT J. GENETSKI, Vice President and Chief Economist, Harris Trust
and Savings Bank, Chicago, Illinois.
MR. H. ERICH HEINEMANN, Vice President,
Incorporated, New York, New York.

Morgan Stanley & Co.,

DR. HOMER JONES, Retired Senior Vice President and Director of Research,
Federal Reserve Bank of St. Louis, St. Louis, Missouri.
DR. JERRY L. JORDAN, Anderson Schools of Management, University of New
Mexico, Albuquerque, New Mexico.*
DR. RUDOLPH G. PENNER, American Enterprise Institute, Washington, D.C.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State
University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York,
New York.
DR. BERYL SPRINKEL, Executive Vice President and Economist, Harris Trust
and Savings Bank, Chicago, Illinois.**
DR. BURTON ZWICK, Vice President, Economic Research, Prudential Insurance
Company of America, Newark, New Jersey,

*On leave from the SOMC; currently a member of the Council of Economic
Advisers.
**On Leave from the SOMC; currently Under Secretary of the Treasury for
Monetary Affairs.



POLICY STATEMENT
Shadow Open Market Committee
March 15, 1982

All the market economies of the world are in the throes of a persistent
decline in productivity growth that has produced stagflation everywhere. Now,
hesitant and uncertain steps to slow inflation have imposed a mild recession and
intensified the underlying problem. The peak-to-trough decline in output for
the United States during the current recession is likely to be below the average
for postwar recessions, and the recession seems likely to end in the next few
months. Yet, discussion of a worldwide depression has become common, and
proposals for the reinflation are widespread.
There are two principal reasons for this wide gulf between the facts about
the current recession and the rhetoric about a major depression. The first is the
position of major industries such as steel, autos, and trucks in all the
industrialized countries. The second is the pervasive uncertainty about the
future fiscal policy and current and future monetary policy.
High unemployment in autos, steel and related industries, can be found in
countries like France with expansionist policies and rising inflation and in
countries with declining inflation. All over the world these industries are
suffering more from declines in competitiveness than from the effects of
cyclical contraction. The problem for many countries is to shift resources from
declining to expanding industries. A return to stop and go policies is not a
solution.
Continuation of programs to reduce the growth of public spending and to
reduce inflation is the only lasting solution. We offer a program to lower rates
and reduce uncertainty.
A PROGRAM TO REDUCE INTEREST RATES
Pressures are rising, as in prior recessions, to pump up the money supply in
an effort to lower interest rates. Proposals of this sort will fail in 1982 as they




1

have in all prior business cycles. In fact, a return to rapid money growth would
quickly and inevitably lead to higher, not lower, credit costs.
The present level of interest rates does, indeed, represent a severe burden
on the economy. Interest rates must be reduced promptly in a non-inflationary
manner that sets the foundation for sustained real growth in the economy and a
lasting reduction in unemployment. To do so, we propose the following
program:
*

The rate of increase in Federal expenditures must be cut substantially
below the levels proposed by the Administration. To do this, cost-ofliving adjustments in Federal entitlement programs must be limited
and the growth of national defense purchases cut back.

*

Tax increases should be limited to Federal excises and/or a surcharge
on imported oil. The principal problem in the Federal budget has been,
and continues to be, excessive expenditures, not the reductions in tax
rates enacted last year.
* Stable, predictable, and believable reductions in money growth —long
promised by the Federal Reserve — must be implemented. Elected
officials can contribute to the achievement of this goal by insisting
that the Federal Reserve keep the money supply well within the
targets that have been announced.
Such insistence will lower
uncertainty and help to reduce the risk premium in interest rates.
*

The Federal Reserve should move promptly to stabilize the growth in
money along its preannounced path by implementing the procedural
reforms which this committee has long advocated and which are
outlined once again in this statement.

The four elements of this program are complementary and will reinforce
each other. All four work toward lower interest rates and sustained noninflationary growth of output.
They should be adopted promptly by the
Administration, Congress, and the Federal Reserve.
FEDERAL RESERVE POLICY
The main problems with Federal Reserve policy arise because, despite
statements full of good intentions and worthy goals, the Federal Reserve does
not make any of the changes that would improve monetary control and remove
current high risk premiums in interest rates. No one can have any confidence in
Federal Reserve statements that reaffirm its commitment to slower money
growth and lower inflation. The Federal Reserve misleads the public and the
Congress by talking as if its main objective were control of bank reserves and




2

money. In practice, the Federal Reserve seeks to hold the daily Federal funds
rate within a narrow range, and ignores the broad limits it announces.
The Federal Reserve continues to promulgate target growth rates for
several monetary aggregates without recognizing that such ranges are not
independent of one another. The Federal Reserve should either publish
consistent target ranges for the several aggregates or restrict targeting to one
aggregate, preferably M-l. There is no evidence that financial innovation,
apart from regulatory changes, has rendered the relative behavior of the various
monetary aggregates unpredictable. Currently, as in the recent past, a wide
gulf separates Federal Reserve statements and Federal Reserve actions.
Table 1 shows the discrepancy between Federal Reserve announcements
and achievements for the six years in which it has announced targets for money
growth.
TABLE 1
Money Growth 1975-1981

Percent Growth
Year
Ending in
4th Quarter
1976
1977
1978
1979
1980
1981
1982

(M-l)
(M-l)
(M-l)
(M-l)
(M-1B)
(M-1B)
(M-l)

Target
Announced
by Federal Reserve
4.5
4.5
4.0
3.0
4.0
6.0

-

ZiO

Target
Mid-point

7.5%
6.5
6.5
6.0
6.5
8.5

6.0%
5.5
5.2
4.5
5.2
7.2
4.0

""" D o O

Actual
5.8%
7.9
7.2
5.5
7.3
5.0

Error
-0.2%
2.4
1.9
1.0
2.0
-2.2

In four of the most recent six years, the Federal Reserve failed to keep
money growth within the preannounced target band. Since 1979, the Federal
Reserve has claimed to be more concerned about money growth, and has given
greater emphasis to money growth in its statements, but monetary control has
worsened. Annual errors have been larger, and short-term variability has
increased. Better procedures, endorsed by virtually all monetary economists,
including Federal Reserve staff, are available, but they have not been adopted.




3

Recent Federal Reserve policy has been more variable than in the past.
Sudden, sharp downswings in monetary growth were a principal cause of the two
recessions in 1980 and 1981-82. Wide swings in monetary growth from zero to
double-digit annual rates bewilder financial markets. The high variability of
annual rates of growth of total reserves, the monetary base, and money also
causes frequent revisions of the expected rate of monetary growth and future
inflation. These frequent revisions are reflected in interest rates at all
maturities. They produce high risk premiums and high rates of interest.
The relationship between the annual rates of growth of total reserves
and/or the monetary base and interest rates leaves little doubt that interest
rates rise and fall directly with growth in reserves and base money. While the
current level of interest rates is influenced by many factors, including the
prospect of deficits, recent changes in interest rates appear to be dominated by
changes in the growth of monetary aggregates.
The message of Figure 1 seems clear. Interest rates can be reduced and
stability of interest rates can be increased. To do so, the Federal Reserve must
stabilize the growth of monetary aggregates.
To control either total reserves or the monetary base, the Federal
Reserve must control the size of its balance sheet. This is not difficult, but to
do so the Federal Reserve must adopt the procedural changes that we and many
other economists advocate. These include elimination of seasonal adjustment,
an end to interest rate targeting, restoration of contemporaneous reserve
accounting, and simplification of the reserve requirement structure. Chairman
Volcker's recent statement to the Senate Budget Committee suggests that some
of these long delayed changes may finally be adopted.
Federal Reserve spokesmen repeatedly claim that money is difficult to
control. Recently the Vice Chairman of the Federal Open Market Committee,
in a widely publicized address, claimed that the growth of money substitutes
increases the problem of control in 1981. Such statements are without any basis
in fact. The problems that the Federal Reserve experienced in 1981 result,
mainly, from the use of inefficient and improper methods of control including
continued attempts to manage short-term interest rates.
At our September meeting, we urged the Federal Reserve to expand the
monetary base at a 5 percent annual rate in 1982 to reach $180-billion by fourth
quarter 1982. The annual growth rate of the base fell below our target in the




4




Figure 1
Bank Reserves and Short-Term Interest Rates

Left Scale Total Adjusted Bank R e s e n t s
Right Scale Interest Rale on Three-Month Trcasurv Bills
r 17.0"

6.00

15.6

4 75

14.2

s in

12.8

ion TTrTTrrrTTrrrnm'TTTTnTnnnt^^

i n 1111 r i ' " '
I'llsJ

Rcserw d a l a a n iuur-\si L k mu\ ing a\cra^i s
Sources

Ecnnah si Dala Bast . Morgan Sianlt \ Risiaic

5

fourth quarter of 1981, but the decline was short-lived. Since last Fall, growth
in the base and money has surged well above the levels consistent with
disinflation.
Slower growth of the base and money made an important contribution to
the reduction in inflation — and in the rate of money wage increases — that is
now widely recognized. The task for monetary policy is to keep the gains that
have been achieved.
We repeat our recommendation for monetary policy in 1982. The Federal
reserve should control the monetary base, return to a sustained 5 percent
growth path, and aim for a target of about $180-billion in fourth quarter 1982,
as we urged six months ago.
BUDGET POLICY
The Administration's budgets for fiscal 1983 and future years, when
combined with currently available guesses or estimates about future economic
activity and inflation and fears about future debt monetization, raise doubts
about the internal consistency of the fiscal program. These doubts are of two
kinds. One concerns the success of the promising effort to restore productivity
growth to its historic path and increase personal incentives by reducing current
and future tax rates. The other is the increased probability that the budget
deficit will rise at a faster rate than output, thereby reducing real capital
formation and generating increasing economic instability with rising real rates
of interest, falling productivity, and a chain of events that no one can foresee
accurately or predict reliably.
While no one can be confident about the effects of continuously increasing
deficits, the effects are unlikely to include any of the paths of stable growth
and declining inflation used by CBO, OMB, and private forecasters to generate
budget data for the next five fiscal years. There is therefore likely to be an
inconsistency between the projections for the economy and for future deficits.
The result may be deficits larger than forecast, leading to a decline in real
income and standards of living and an economic crisis. Or, the economy may
continue to limp along the path characterized by low productivity growth, rising
real transfer payments and a rising size of government.
If there are no changes in tax rates and spending levels, our projections of
possible ranges for total budget and off-budget financing are;




6

TABLE 2
Fiscal Year
1982
1983
1984
1985

Projected Range
On- Plus Off-Budget Deficit
$100 - 150-billion
150 - 200-billion
200 - 250-billion
225 - 275-billion

There is nothing certain about future deficits.
We have no prior
experience on which to base a reliable judgment because there is no example in
which a large economy — the largest economy — has incurred deficits of this
relative magnitude for an indefinite period. There is great uncertainty.
Prudence requires that this uncertainty be lessened promptly. Everyone knows
what needs to be done to reduce the deficit: We must spend less.
We continue to believe that the Administration's strategy is correct.
Reducing the growth of government spending, reducing the share of output
spent by government, and reducing tax rates is the best way to increase
incentives to save, work, and invest. The problem is not in the policy
conception or design but in its implementation. The Administration's reductions
in spending are too small relative to the projected reductions in tax collections.
To achieve the promised gains from tax reduction requires additional cuts in the
growth of spending. The principal reason is that current policy does not reduce
the share of output spent by government and may, instead, lead to increases in
that share.
While the share of output spent by government is a more reliable measure
of applicable tax rates than the revenue share, no single measure summarizes
the incentive and disincentive effects of government programs. Nevertheless,
when the Administration proposed its fiscal reform program, and when the
Congress adopted the Humphrey-Hawkins Act in 1978 and subsequently passed
the 1981 fiscal program, the intention was to reduce the share of output spent
by government to 20 percent of GNP or less. Currently, government spending
remains between 23 percent and 24 percent of output.
CONCLUDING COMMENTS
Current fiscal and monetary problems pose a challenge to representative
government. The problems are easy to state. Solutions are not hard to find.




7

None are easy to implement. None are costless. None can be chosen on
technical grounds alone. The problem is political; leadership is needed to gain
public approval of the changes that must be made.
At issue is the ability of representative government to put an end to the
current fiscal crisis and the rising instability brought about by the destabilizing
Federal Reserve operations. The alternatives to a change in policy are less
attractive. We run the risk of sliding into immobilism and instability or of
moving to some other less desirable solution that no one can now forsee.




8

THE POLITICS OF UNCERTAINTY
Karl Brunner
University of Rochester

I.

STRATEGY AND TACTICS DURING THE 1970'S AND THE RECORD OF
PERFORMANCE

On October 6, 1979 the Chairman of the Board of Governors of the
Federal Reserve System announced a change in tactical procedures. Monetary
policy was formulated since the later years of the 1960's in terms of a money
demand equation linking money stock (or monetary growth) with the federal
funds rate and the projected value of gross national product. This formulation
served the Fed for two alternative monetary strategies. It could guide a
strategy of interest control but also be exploited, as the Fed maintained, for the
purpose of a monetary control strategy. The tactical operations centered in
either case on the federal funds rate. The two strategies differed essentially in
terms of the role assigned to the federal funds rate. This rate and its expected
relation to other interest rates formed the immediate centerpiece of an interest
control strategy. A monetary control strategy, in contrast, used the federal
funds rate as an instrument producing the desired path of monetary growth.
The formulation organizing the Fed's policy process was thus consistent
with either strategy. It allowed subtle and rapid shifts in strategic emphasis
difficult to recognize by outside observers. The conception was moreover well
designed to protect the heritage of "discretionary policymaking". It offered an
effective defense against increasing pressures for a commitment to a
predictable policy of systematic monetary control. The analytic framework
provided the appearance of monetary targeting, whenever desired, and still
offered an opportunity to pursue the old conceptions and adhere to the
accustomed pattern of a "discretionary policy". Lastly, it yielded an important
and useful source for the supply of excuses on the political market. The
consequences of neglecting a monetary control strategy, or of failures in the
actual execution of such a strategy, could always, and usually were, attributed




9

to unexpected shifts of an essentially unstable money demand. A poorly
informed Congress and ignorant media could hardly be expected to cope
effectively with such "explanations" advanced by "authority". This policy
conception increasingly operated with an inflationary bias in response to the
political realities emerging over the postwar period. It produced the record of a
rising and erratic inflation accompanied by rising interest rates. This dismal
record was "enriched" by repeated declines of the dollar on the foreign
exchange markets.
II.

THE APPEARANCE OF A CHANGE IN POLICYMAKING

The international response to the failure of the dollar ultimately forced
the Federal Reserve Authorities to reexamine its policy in the fall of 1979. The
Chairman's statement acknowledged the Federal Reserve's ambivalent strategy
over the past decade. It also acknowledged that tactical procedures need be
modified in order to assure a more reliable monetary control yielding more
success in the battle against inflation. The new procedure claims to use nonborrowed reserves as an instrument directed to the control of monetary growth.
The policy conception corresponding to the new procedure can be
described by an analytic framework consisting of two relations. The first is the
money demand equation which expressed for years the previous strategic and
tactical situation. But this money demand equation was supplemented with a
reserve equation, relating the sum of non-borrowed and free reserves with
required reserves.
The volume of required reserves in any week are
predetermined under current arrangements by the money stock prevailing two
weeks earlier. The volume of free reserves depends on the other hand on the
current federal funds rate, the Fed's discount rate and the institutions governing
the "discount window". This dependence of free reserves (or essentially
borrowed reserves) coupled with the predetermination of required reserves by
the past characterize the crucial features of the Fed's "new" policy conception.
They involve a remarkable revival of free reserves in the Fed's thinking. These
reserves form according to the new framework a centerpiece in the Fed's
conception of the control process.
The steps required under the new operational procedures may be described
as follows: First, a monetary target need be set. This in conjunction with the
projected value for gross national product determines in the context of the




10

money demand equation a federal funds rate consistent with the targeted
monetary growth. This federal funds rate can be fed subsequently into the
reserve relation in order to project the expected volume of free reserves. The
Fed may frequently just extrapolate however the most recent value of free
reserves for their tactical purposes. This expected value together with the
predetermined volume of required reserves determines the required amount of
non-borrowed reserves needed to produce in the average the planned monetary
target.
The new framework and its associated procedures substantially
strengthens the Fed's political defenses. It defines a control process involving,
in contrast to the earlier tactical procedure, the possibility of using a reserve
magnitude as an instrument for the execution of control. But this possibility
need not be exploited. The modified framework still allows the Fed to slip into
an interest control strategy or to fall back on the federal funds rate as the
actual instrument of monetary control. These options are all subsumed under
the new framework. It allows thus in particular shifting combinations of
reserve and federal funds targeting. The amended framework introduced after
October 1979 thus serves the political purpose of the Fed even better than the
prior concentration on the money demand equation. It combines the opportunity
to emphasize the possible use of a reserve instrument in the monetary control
process with the actual pursuit of the traditional pattern of a "discretionary
policy" expressed by ambivalent strategies and shifting tactical combinations.
The new framework and the related operational procedure yield thus no clear
promise bearing on the course and nature of monetary policy. It emerged as a
natural evolution of the Federal Reserve's traditional strategic thinking and
tactical executions in response to public critique and the votes of no confidence
cast by exchange and financial markets. But the very fact that it appears to
offer better and more subtle justifications for the Fed's traditional commitment
to undefined "discretionary policies, flexibility and judgment" should warn us
that the basic problem posed by our policymakers in the Fed persists to this day.
III.

THE FED'S TRADE-OFF THESIS

The framework used by the Fed supplemented by a standard Keynesian
analysis implies that a closer control of monetary growth would have "to be
purchased" by greater variability of interest rates. The Fed traditionally main-




11

tained that there occurs a trade-off between the variability of monetary growth
and the variability of interest rates. Two major flaws in the Fed's traditional
analysis condition this view. The response structure of the system is assumed to
be invariant under changes of the policy regime or changes in the behavior
patterns characterizing a Central Bank. Moreover, the shocks operating on the
economic or financial system are usually treated as transitory events. The
implications bearing on a possible trade-off are crucially affected by these
assumptions. A different pattern emerges once we recognize the sensitivity of
behavior patterns governing financial markets to variations in the policy regime
and the operation of shifting mixtures of permanent and transitory shocks. A
credible policy of monetary control, effectively executed and thus lowering
substantially the variability of monetary growth, will not raise under these
circumstances the variability of new interest rates over the maturity spectrum.
The remaining variability will be understood to occur as a transitory event and
thus hardly affect interest rates beyond the short end of the yield curve. The
adjustment of financial behavior to this regime can be expected furthermore to
moderate also movements of short rates over periods beyond one or a few days.
Lastly, even a larger variability of daily short rates poses no serious economic
problem when agents fully understood their transitory character. Recent
developments in monetary analysis thus deny the relevance of the Fed's tradeoff thesis.
IV.

THE RECORD UNDER THE NEW REGIME AND THE POLITICS OF
UNCERTAINTY

The experience made under the Fed's new operational procedure offers
remarkable clues about the fundamental problem afflicting our policymaking.
Two crucial patterns emerged over the past two years contrasting sharply with
the trade-off thesis. We note first that both monetary growth and interest
rates exhibit a substantially larger variability than in previous periods.
Secondly, the correlation between interest rates over the maturity spectrum
was significantly higher than in earlier times. The Federal Reserve authorities
explained this variability in market rates of interest with the change in tactical
procedures. They add that this variability was the cause of the prevailing
uncertainty and confusion exhibited by the financial markets. The causation




12

asserted by the Federal Reserve's view thus runs from the shift in operational
procedure over an increased variability of interest rates to more pervasive and
larger uncertainty.
V.

AN ASSESSMENT OF THE RECORD OF UNCERTAINTY

The explanation offered by the Fed naturally corresponds to its basic
positions. It also fits well with the usual political defense of "discretionary,
flexible and judgmental policy". It fails however to account for the joint
increase in the variability of both monetary growth and interest rates. The line
of causation argued is moreover difficult to reconcile with the remarkable
correlations between interest rates observed over the whole range of
maturities.
The explanation of recent patterns observed on financial markets does
indeed involve the element of a pervasive and diffuse uncertainty. This uncertainty is however of a very different nature than suggested by the Federal
Reserve Authorities. Our financial markets suffered over the past two years
under an increasing uncertainty about the future course of our financial
policies. The announcement of October 1979 was difficult to interpret
unambiguously. Its meaning remained vague, most particularly when it was
considered in the context of supplementary interpretations offered by various
Federal Reserve officials. By this time agents on financial markets had also
learned since 1965 that all promises of an anti-inflationary policy were usually
broken within a short time. Such promises were usually followed over the
subsequent one or two years by even more prounced inflationary policies. By
late 1979 the credibility of the Fed had already sunk to low levels and the
October announcement deepened the confusion on the markets. The response of
the bond market to the announcement at the time revealed this state quite
clearly.
Subsequent events enlarged the uncertainty and made the markets'
expectation even more diffuse. The increased variability of monetary growth
raised more questions about the Fed's longer-run policy. We frequently hear
that larger accelerations (or decelerations) of the money stock lasting at most
six months can be disregarded and impose no problem on the economy. In the
absence of credible policymaking larger variability of monetary growth
entrenches however the prevalent uncertainty even further.
It is this




13

uncertainty which fosters the overheated attention to weekly data. Under a
diffuse uncertainty agents grope for every possible clue and sign yielding some
information about the future course of policy. The observed variability in
monetary growth contributed thus to sudden and irregular shifts in the
distribution of expectations among market agents.
One last element contributed to broaden the prevalent uncertainty.
Speeches by Federal Reserve officials made over the past two years on various
occasions reflected the persistent commitment to a traditional policy
conception attuned to the Fed's political interests. These speeches, most
significantly exemplified by President Solomon's speech delivered in early
January 1982, signal a strong opposition to an effective strategy of monetary
control. The general uncertainty produced by our monetary policymaking as a
result of the history of broken promises, larger variability of monetary growth
and the often revealed preference for the traditional "discretionary flexibility"
dominated the behavior of interest rates over the past two years. The observed
levels and variability cannot be explained in terms of the basic real rate on
default-risk free securities or the inflation premium. The large real rates
emerging in the recent past contain a substantial risk premium which hardly
ever entered in the past history of our financial markets. This risk premium
reflects the prevailing uncertainty imposed by our policymakers on the U.S.
economy. This uncertainty explains both the level and the recent variability of
nominal interest rates. Rapidly moving signals and clues watched by market
agents induce shifts in expectational patterns expressed by sudden changes in
interest rates. An array of signals suggesting adherence to an anti-inflationary
policy induces a fall of interest rates over the whole spectrum. A wave of
opposite clues produces rising interest rates. This pattern explains the positive
association observed between monetary growth and interest rates. The market's
behavior essentially denies the assertion that monetary expansions will produce
lower interest rates.
VI.

THE ROLE OF THE BUDGET DEFICIT

Our explanation of observed market behavior disregarded thus far the
European's and "Wall Street" favorite villain. It is frequently argued that the
behavior of interest rates is dominated by the budget deficit. The prevalent
argument asserts such a connection irrespective and independent of monetary




14

policy. But the argument is fundamentally flawed. The budget deficit, per se,
cannot explain the observed behavior of interest rates. One strand of the
argument derives the behavior of interest rates directly from an interaction
between savings and the government sector's deficit. This view is however
inconsistent with the core of economic analysis. Interest rates (or prices) on
the bond and money markets emerge minute to minute from the interaction
between the existing stock of securities and the private sector's stock demand
(i.e. willingness to hold in portfolios). The latter is conditioned by the public's
wealth and current or expected market conditions. The assessment of future
market conditions substantially influences and frequently controls the shifts in
the public's stock demand dominating the rapid changes of interest rates. These
expectations are moreover crucially influenced by the public's evaluation of the
future course of financial policies.
Budgetary deficits operate on interest rates under the circumstances not
via any direct mechanism linking savings, investment and deficits, but via the
public's assessment of future market conditions. This means in particular that
sustained deficits are expected to raise over time the stock of securities to be
absorbed in portfolios. This expectation tends to lower the current price of
bonds and consequently raises the current interest rates. Savings on the other
side raise wealth and expand over time the stock demand for securities. This
tends to raise their expected price and will be discounted partly in the current
price of bonds.
The correction of the prevalent argument bearing on the mechanism
determining interest rates also affects the relevant order of magnitudes. We
need to recognize first that savings and deficits modify the nominal rate of
interest along the lines traced above by changing the real rate of interest. This
elementary fact should warn us about the fallacy involved in the standard
argument.
The latter essentially discounts the inflation premium which
dominated over the past years the average level of interest rates.
We also note that neither the magnitude of last year's deficit nor the
existing real volume of Federal (marketed) debt can explain the observed
nominal rates of interest. The deficit is comparatively smaller (relative to
gross national product) than in 1975 and the real debt outstanding absorbed in
private portfolios is still smaller than in the 1950's. These facts cannot be
reconciled with the contention of a dominant deficit effect expressed by




15

interest rates over the past two years. There is however still the potentially
large deficit of an intractable budget accumulating over the next four to six
years. Suppose that the real Federal debt in the context of a really bad
scenario increases by 70 percent per unit of output over the next three years.
How much would the basic real rate on default-risk free securities be raised as
a result? Such estimates must be advanced with great caution and reservation.
The empirical examinations accumulated over the past decades yield however
no support for assertions claiming increases of the basic real rate by more than
three percentage points. This figure seems already an improbably large upper
bound on the relevant responses. An increasing volume of research suggests
that the response to the government's financial decisions, given the magnitude
of the budget and the expenditure programs, is substantially smaller. It follows
that the removal of the inflation premium, achieved by a credible and sustained
anti-inflationary policy, would dominate the increase in real rates due to budget
deficits persisting over the next five years. The decisive strand in the future
movements of interest rates is thus the monetary policy pursued by the Fed.
This does not quite exhaust our story bearing on budget deficits. The
increasing uncertainty about the budget contributed and reenforced the uncertainty produced by monetary policy. The financial markets became increasingly
apprehensive over the past two years about the future course of our budgetary
policies. We do not know at the moment how much expenditures will be
curtailed or what taxes will be raised. We do not know to which extent "the
inflation tax" will be reinstated as large budget deficits persist. Neither do we
know what combination of other taxes will be favored by Congress. But
different combinations of taxes affect asset prices on capital markets very
differently. The inflation tax raises the inflation premium and a variety of
other taxes affect the gross real rate of interest. A diffuse and shifting
uncertainty about the budget thus contributes directly to the uncertainty about
monetary policy and reenforees the effect of this uncertainty on interest rates.
VII. THE CRUCIAL POLICY ISSUE;
UNCERTAINTY

THE INSTITUTIONALIZATION OF

The assessment of the problems confronting us in the recent past and at
the moment directs our attention to the crucial policy issue. We know at this
stage that the Federal Reserve actually has, in the average over the past two




16

years, pursued an anti-inflationary course. We never knew it during these past
months, neither did most of the agents operating on financial markets. Nor do
we know at this point in time with any sense of certainty that the Fed will
effectively deliver an anti-inflationary policy. If a large segment knew this
with any sense of conviction interest rates would behave very differently
indeed. Their behavior is after all the best indicator of the prevalent
uncertainty. So far, the Federal Reserve Authorities made no clear and
unambiguous commitment to a strategy of monetary control coupled with an
effective tactical procedure. Our progress remains under the circumstances, at
the very best, slow and erratic. The transition to a non-inflationary state of the
economy will therefore be associated with comparatively high social costs, the
most important contribution to be made by the Federal Reserve Authorities at
this point in time is a convincing and generally understood commitment to an
effective tactical procedure for the execution of a strategy of monetary
control. This would be the most useful political measure to remove the burden
of uncertainty on financial markets. It does not require any Congressional
actions with the uncertainties facing the battle about the budget. The Federal
Reserve Authorities can initiate an institutionalization of monetary control by
their own initiative and political decision.
The Shadow has urged such a policy for almost nine years. If our
monetary authorities had accepted our proposal in 1975/1976 or followed the
recommendations repeatedly advanced by Congress or Congressional
Committees, inflation in the past two years would have been low indeed with
interest rates substantially below 10 percent. But the Federal Reserve
disregarded all these urgent proposals and persisted with a policy producing both
inflation and increasing uncertainty about its course. There is really no excuse
for such a policy. We have formulated our tactical procedure on previous
occasions and the Federal Reserve Authorities know our proposal. The proposal
has moreover been tested over several years by James Johannes and Robert
Rasche. The results of these tests have been published and were also included
every six months in the minutes of the Shadow Open Market Committee. The
record is very clear. It shows that monetary control over one year with a
tolerance band not more than plus or minus one percentage point is technically
quite feasible. This tolerance band is really quite small relative to the order of
magnitude of the problem inherited from past years of monetary
mismanagement. Even within the year an improvement over past performance
seems feasible.




17

The tactics proposed would require that the Fed set a target path for M1B (or M2) lowering monetary growth to a non-inflationary benchmark level
(about 2 percent p.a.) over the next three years. This target path is maintained
by suitable adjustments in the monetary base in the light of the expected profile
for the monetary multiplier linking base and money stock. The studies prepared
by the Federal Reserve Board's own staff establish that monetary control with
an adequate tolerance level relative to the size of the problem is technically
feasible. These studies thus confirmed the Shadow's argument and proposal.
Axilrod, among others, recognizes moreover in the last issue of the Federal
Reserve Bulletin that the monetary base is fully controllable by the monetary
authorities. Any change in the base reflects dollar for dollar actions of the Fed
changing its total assets or modifying its non-money liabilities. Its control over
its balance sheet determines the Fed's potential control over the monetary base,
the frequent allusion to the proportion of currency in base money outstanding is
thus quite irrelevant in this context.
Beyond the record of the statistical tests presented by the Shadow lies a
mass of evidence from "disinflationary policies" produced by various countries
on different occasions. They all involved in one form or another a radical
change in the regime governing the behavior of the monetary base. Such
changes in regime are quite accessible to the policymakers, if they so desire.
The central issue becomes thus the political will and the political interest of the
Central Bank. But the political market offers unfortunately little appeal to
reveal this interest so directly. The protection of inherited positions and
interests (i.e. discretionary policies) is more effectively assured by a supply of
judicious sounding reservations about monetary control and our proposal in
particular.
None of these reservations or objections survives any closer
examination. My position paper cannot address however the whole array of
imaginative objections advanced. A few major arguments need to suffice for
our purposes.
Federal Reserve officials maintained on repeated occasions that our
procedure anchored by the monetary base involves substantially more slippage
than their tactical procedure developed since October 1979 and centered with
non-borrowed reserves. This statement is particularly remarkable, as it is not
supported by the Board's empirical examination of this issue. The empirical
results produced by Johannes-Rasehe established furthermore that the




18

instrumental use of the monetary base for purposes of monetary control yields
more reliable results and a smaller tolerance level than the instrumental use of
non-borrowed reserves. We understand of course that our tactical proposal
involves a radical break with the Fed's traditional strategic conception. We
noted above that the tactical arrangements made in recent years should be
understood as a political adaptation to existing pressures with corresponding
adjustments in rhetoric without sacrificing an opportunity for the exercise of
discretionary policies.
Financial innovations including claims about an increasingly unstable or
unpredictable money demand are abundantly cited in arguments opposing
monetary control. Financial innovations seem to make monetary control either
impossible, irrelevant or both. My tentative survey of all these arguments
found little, if any, analytic or empirical support for these contentions. Moreover, these contentions are usually advanced without any reference to the
literature which has actually explored this issue, and apparently without any
knowledge of these scholarly investigations. All the contentions in question can
be expressed in one way or another as statements about the behavior of the
monetary multiplier (i.e. link between monetary base and money stock) or
velocity (i.e. link between money stock and gross national product). They assert
in particular that financial innovations substantially modified the pattern
exhibited by either multiplier, velocity or both.
Such conjectures are
fortunately assessable in terms of the observed data. The reports regularly
prepared by Robert Rasehe for the Shadow, included in all the minutes made
publicly available, present evidence thoroughly disconfirming any assertions
claiming changes in multiplier patterns. This result supports in particular our
view that the Fed's emphasis on money demand shocks is misleading and false.
Whatever money demand has done, there is no evidence in the multiplier
patterns observed until this year that they eroded monetary control. There is
also no evidence supporting President Solomon's (Federal Reserve Bank of New
York) allegations that the relative movements of M-1B and M-2 observed in
1981 describe "actually a unique situation". Robert Rasehe shows in his
statement prepared for our current session that the new observations are quite
consistent with the patterns observed over previous years.
The last
observations introduce no problem for monetary control. The same multiplier
patterns also demonstrate that many other contentions invoking the Euro-dollar
market or addressing other phenomena to claim erosion of monetary
controllability are similarly unfounded.




19

Consider lastly the range of assertions claiming radical changes in
velocity behavior. A preliminary investigation based on time series analysis
offers so far no support for the contention of an increasing "looseness" of the
link between money stock and national income. The stochastic term in the
velocity process, i.e. the so-called innovation, exhibits for M-2 velocity an
increase of 10 percent in its standard devision in the 1970's compared to the
1950's. The velocity associated with M-1B shows in contrast a decline of about
30 percent in the standard deviation of its innovation over this period. Lastly,
the standard deviation of the innovation of base velocity declined over the same
period by about 10 percent.
An investigation of the years 1979-1981 usefully supplements our
evaluation. We can compute the probabilities associated with the most recent
observations beyond the sample used to infer the properties of a velocity
process. Very low probabilities under the maintained hypotheses would suggest
that we accept the conjecture of a shift in velocity patterns. We find that the
recent observations of base velocity should be expected one out of ten times
under a maintained hypothesis. The corresponding results are slightly more than
four out of ten times for M-1B velocity and also for M-2 velocity. These
probabilities offer no support for the dramatic assertion about the changes in
velocity behavior. These results do not deny the occurrence of financial
innovations, but their effects on various aspects of the velocity process may
hardly justify .the reservations and objections voiced without much supportive
evidence. The tentative and preliminary evidence suggests no problems for
monetary control beyond the range of our experience. There is, once again, no
substantive reason for the continued refusal of our monetary authorities to
commit their policy to a predictable and effective strategy of monetary
control. We have experienced the consequences of their game for the past
decade and the most recent two years. The American public surely deserves
better service.




20

FISCAL OUTLOOK, MARCH 1982
Rudolph G. Penner
American Enterprise Institute

In place of my usual report I am attaching my testimony before the Senate
Budget Committee. The CBO estimates, discussed there, use economic assumptions that are only slightly more optimistic than those that will be used by the
SOMC.
The attached testimony, of course, discusses what should be done and does
not attempt to guess what will actually be done. This year's politics are as
volatile as the economics.
While there may be a small chance of putting a majority coalition
together behind a Domeniei-Hollings type proposal, it would be necessary to do
that quickly to save much money in fiscal 1983. For example, any change in the
social security cost of living adjustment must be decided by the end of April to
allow time to reprogram the computers for the July check. Accomplishing that
will be quite a trick without Presidential support. Indeed, accomplishing
anything will be quite a trick without Presidential support. Therefore, I assume
a do-nothing policy for the following estimates while feverently hoping that I
am wrong.
A do-nothing policy plus the SOMC economic assumptions provides something like:
FISCAL YEARS
1981 actual

1982

1983

Outlays

660

745

816

Receipts

603

625

645

Unified deficit

58

120

171

Off-budget deficit

21

20

19

Total deficit

79

140

180




21

THE 1983 BUDGET
TESTIMONY
before the
SENATE BUDGET COMMITTEE
March 5, 1982

I would like to thank the Committee for this opportunity to testify. The
views expressed in this testimony are my own and do not necessarily reflect the
views of the staff, advisory panels, officers or trustees of the American
Enterprise Institute.
I shall base my analysis of the 1983 budget on Congressional Budget Office
(CBO) documents which are more realistic in their economic assumptions than is
the Administration and in their estimates of spending rates and program costs
for any given economic outlook.
ADJUSTED BASELINE DEFICIT
The CBO begins the analysis by projecting spending commitments and the
tax laws as they existed at the end of 1981. Their analysis assumes that all
programs are adjusted for inflation, including those that are not explicitly
indexed.
To view the problem as it must be viewed by the Congress, I shall make
three adjustments to CBO figures. First, the President's recommended defense
program will be added to the outlay figures. Second, inflation-adjustments to
non-indexed non-defense programs will be subtracted. I do not believe that the
Congress has ever presumed that such programs must be held constant in real
terms. After these two adjustments the budget projections through fiscal 1985
are as follows:




22

FISCAL YEARS
(billions of dollars)
1981 actual

Outlays
Receipts
Unified deficit
Off-budget deficit
Total deficit

1982

1983

1984

1985

600

740

806

885

972

603

631

952

701

763

58

109

154

184

209

21

20

19

18

18

79

129

173

202

227

While the CBO economic assumptions are more reasonable than the
administration's, they do assume a rather high rate of nominal income growth if
the Federal Reserve System carries out its enunciated monetary policy and
gradually slows the rate of growth of the money aggregates. For example, if
the top end of the Fed's target range for M-l growth of 5.5 percent for 1982 is
lowered by one-half of one percentage point per year and if the amount of
economic activity that can be financed by a given money supply continues to
grow at the same rate experienced since 1970, the nominal GNP in 1985 would
have to be lowered by slightly over 5 percent. If all of that reduction was the
result of lower inflation, the 1985 deficit would have to be increased by about
$15 billion. To the extent that real growth is also slower than assumed by CBO,
the deficit increase would be larger.
I shall not attempt to make a precise adjustment for the relatively small
change in economic assumptions suggested by the above analysis, but will
instead use the following ranges for the horrendous on-plus off-budget deficit
problem faced by the Congress.
FISCAL YEAR
1982
1983
1984

ON PLUS OFF-BUDGET DEFICIT RANGE
$100 - $150 billion
150 - 200 billion
200 - 250 billion

1985

225 -

275 billion

It should be re-emphasized that these estimates depend crucially on the
assumptions regarding monetary policy. Monetary policy and fiscal policy are
intimately entwined. Inflation can be used to raise tax burdens and to reduce
deficits. That will be true even if personal tax brackets are indexed after 1984,
but, of course, much less true than it is today.




23

OPTIONS FOR CUTTING OUTLAYS
The size of the future deficit problems suggests that the Congress will
have to alter the old saw, "tax, tax, tax, and spend, spend, spend," to "tax, tax,
tax, and cut, cut, cut."
This short paper cannot explore all of the possible options for taxing and
cutting, but will have to confine itself to discussing a few main points and basic
principles. When confronting the spending side of the budget, it is necessary to
begin with the unpleasant fact that defense, social security (OASDI), and net
interest outlays will comprise almost 60 percent of the 1982 budget. Without
some reduction in defense and social security growth, prospects for controlling
total spending in the long-run look bleak. Unfortunately, in both cases, large
immediate reductions would be either unwise or unfair. But the emphasis must
be on the long-run because the deficit is now a long-run problem.
With regard to defense, it is necessary to be cautious about compromising
the readiness of our forces. Savings should be focused on long-run weapons
procurement and military retirement pay. The CBO has suggested eleven
options for defense cuts, all of which appear reasonable. For example, the B-l
program would be scrapped in favor of the advance technology bomber. Naval
forces would be deployed somewhat differently than envisioned by the
Administration and production runs of the M-l tank would be limited in favor of
the much less expensive M60A3. Retirement pay would be restructured in a
number of ways to compensate for overindexing in the past. Admittedly, the
savings from the CBO options are negligible in 1983 and 1984 but rise to $10
billion in 1985 and $15 billion by 1987. Perhaps more dramatic cuts could be
found, but the modesty of the CBO suggestions is, at least, interesting in an
area where many believe that cuts could resolve a high proportion of the deficit
problem.
Social Security presents an enormous challenge to our political system. It
is an extremely popular program and the smallest change in the benefit
structure is perceived to be a threat to the entire system by the program's
multitude of constituents. Yet, because of the system's huge size, even small
reductions in its growth rate would save massive amounts in the long-run.
Moreover, it is hard to justify holding social security benefits sacrosanct when
the recipients have recently been faring better than the average worker and we
have been significantly cutting other less affluent recipients of government
transfers.




24

One change which may be saleable politically would be to index benefits
to the lower of wage or price increases. I do not believe that the population
thinks it fair for social security recipients to do better than wage earners. It
could be understood that if this technique caused a significant shrinkage in real
benefits over the long run, there would be periodic upward discretionary
adjustments in benefits. If the same principle were applied to the indexing of
the formula determining future benefits (the formula is now linked to wage
growth), large amounts could be saved in the long-run. Again, it must be
emphasized that it is the long-run which counts. It is not short-run deficits
which are scaring financial markets. It is the fear that they will continue to
rise for the forseeable future that is so troublesome. If some signal could be
given that social security, the most important component of the non-defense
outlay growth problem, was being controlled, it would, in my view, have a
significant impact on expectations.
The precise savings implied by the above options depends on the relationship between wages and prices which has been erratic in the recent past. If the
system had been in effect between 1975 and 1981, the savings in the latter year
would have been $10 billion, largely because of a significant fall in real wages in
1980.
Other indexing options have been suggested and are reasonable given that
recent cost-of-living adjustments have been excessive due to upward biases in
the CPI. Martin Feldstein has suggested that cost-of-living adjustments
compensate for only that inflation in excess of 2 percent per year. Given CBO
inflation assumptions this option would save $10 to $15 billion in 1985. Others
have suggested delaying the cost-of-living adjustment to September 1. That
would save over $3 billion in 1985. The savings would expand significantly if the
same options were used in all the other indexed programs of the government.
The suggestions made above imply that relatively minor changes in social
security indexing might save $15 billion or more by 1985. To provide some
notion of the enormous size of social security relative to other transfer
programs, it can be noted that $15 billion in 1985 will be sufficient to finance
the entire food stamp program.
The CBO has outlined options for over $25 billion in cuts of non-defense,
non-social security programs. All deserve serious consideration. The Administration has suggested further efficiencies in medicare and medicaid which are
also worthy of note because without some economizing these two programs will




25

grow by about 14 percent per year between 1981 and 1985. The Administration
has also suggested numerous reasonable options for cutting housing assistance
and other programs. It would be a shame if the admittedly serious estimating
problems within the President's budget prevented any of it from being taken
seriously.
There is, however, one category of Administration cuts which should be
rejected. The Reconciliation Act of 1981 concentrated its welfare cuts on the
working poor. Many of the Administration's 1983 proposals in the welfare
programs would go further in this direction by increasing the rate at which
benefits fall as earnings rise. The end result is little incentive for one to work
oneself off welfare. The Administration would substitute regulations requiring
work for economic incentives. Such regulations have not been effective in the
past, and it can be noted that in all other areas of policy the Administration has
emphasized increased economic incentives and reduced regulation.
While there is no shortage of options for cutting defense, social security,
and other spending, it is difficult, given political and time restraints, to imagine
cutting more than $50 billion from 1985 outlays by examining the options one at
a time. It would take an effort comparable to that enacted in the
Reconciliation Act of last year, and that seems implausible two years in a row.
Because a $50 billion cut would leave a 1985 deficit in the range of $200
billion given my economic assumptions, more extreme action is desirable. Such
extreme action generally involves a set of arbitrary cutting rules.
Senators Domenici, Hollings, and others have suggested various
combinations of generalized rules and freezes which have considerable appeal.
While it must be admitted that any general rule is bound to create numerous
inequities and inefficiencies, a generalized approach may be the only practical
way to make a severe dent in the strong upward trend in spending which was
barely affected by the strong measures of last year.
If all that is possible on the outlay side is $50 billion or less in cuts, it is
my judgment that about $100 billion in receipts increases are required to start
bringing the deficit down to tolerable levies by 1985. By tolerable levels, I
mean something in the range of $100 billion. Obviously, even this is nothing to
brag about and a lower deficit would be preferable, but unless some action on
the outlay side more dramatic than anything undertaken in past history occurs, I
see no way of getting there from here which does not involve extremely
disruptive tax increases.




26

Again, all of this assumes that the Fed adheres to its targets. While
inflation can be used both as an implicit tax and as a means of raising explicit
taxes, most observers would agree that inflation is the worst possible approach
to deficit reduction.
OPTIONS FOR INCREASING RECEIPTS
If we are embarking on a path involving $100 billion in extra revenue, it
would be desirable, in the ideal, to follow certain basic principles in raising that
much money. First, if it can be avoided, there should be no tax increase in
calendar 1982. the economy is in a tenuous position and significant tax
increases this year increase the risk that the recession will deepen and that the
initial stages of the recovery will be sluggish.
Second, increases in the tax burden should take the form of broadening the
tax base instead of raising marginal tax rates. Moreover, base broadening
measures should be aimed at enhancing economic efficiency. Some examples of
such base broadening efficient measures are as follows; Tax employer paid
health insurance to reduce the incentive to buy inefficient insurance (raises $6
billion in 1985). Eliminate the interest deduction on consumer loans other than
mortgages ($8 billion in 1985). Tax workman's compensation and unemployment
insurance to reduce the work disincentives inherent in those programs ($6 billion
in 1985). Other examples can be found in the CBO report on Reducing the
Deficit.
Third, base broadening measures should avoid increasing the tax on capital
income. There is one important exception to this rule. The depreciation law
passed last year becomes very much more generous in two steps scheduled for
1985 and 1986. Given the inflation and interest rate assumptions inherent in
this analysis, the tax burden on new equipment investments will become
negative, i.e., the tax system will provide outright subsidies for investing. This
goes too far. Those two steps should be eliminated unless inflation and interest
rates rise above current levels. That would raise about $2 billion in fiscal 1985,
$10 billion in fiscal 1986, and $20 billion in fiscal 1987.
Fourth, there are good, long-term national security reasons for increasing
the taxation of the consumption of energy in this country. In particular, recent
weaknesses in the price of oil may dampen our conservation efforts and should
be countered. This could be accomplished with a tax on imported oil which




27

aimed at eliminating reductions in the real price of oil. If nominal prices
remain constant, a tariff of about $5 per barrel could be justified in 1985. This
would bring in about $17 billion including its impact on windfall profit tax
receipts. Alternatively, raising the gasoline tax to 10 cents per gallon would
raise about $5 billion by 1985.
Fifth, whenever practical, user fees should be charged to the beneficiaries
of government goods and services. CBO suggests options which would raise $6
billion by 1985.
Although the principles suggested above could be used to raise large
amounts of revenue by 1985, the step-by-step approach on the tax side faces the
same practical problems as the step-by-step approach on the spending side. A
score of legislative changes would be required and each would involve an
enormous political battle over a few billion. Since there is a pressing need for
more receipts and quick action is required, it may be necessary to eliminate the
10 percent tax cut in personal income taxes scheduled for July 1, 1983 and to
delay indexing one year. This violates my second principle that marginal rate
increases be avoided. But only one political battle would be required and if
successful, it would raise $52 billion by 1985.
It may be time to begin a debate on a brand new tax such as a value added
tax or a national sales tax. Every rate point would raise $10 to $15 billion if the
base was kept fairly broad.
I would prefer to avoid such a tax, since once implemented, it would be
too easy to increase. However, absent a drastic reduction in the deficit
following the outlay cutting and receipts raising approaches discussed above, a
new broad based tax may be essential.
THE IMPACT OF DEFICITS
Why is it so important to reduce the deficit? Even if deficits approach
$250 billion in 1985, that will only amount to about 6 percent of the GNP and
other countries have continued to grow and have controlled inflation while
running such deficits.
In my view a deficit of that size has four negative impacts. First, there is
the traditional crowding out effect. Usually, it is discussed as though the only
important crowding out involves business capital investment. It is said further
that that will be mitigated by increased personal savings inspired by the tax cut




28

and by an inflow of foreign saving. However, things are not quite that simple.
First, the prospective deficits are very large relative to personal saving.
Personal saving was only $100 billion in fiscal 1981. It may be increased greatly
by the tax cut, but it will also be increased by the deficit itself as higher
interest rates crowd out consumption, especially spending on interest-sensitive
durables such as autos.
In other words, crowding out is a widespread phenomenon and does not
only affect capital formation.
For example, inflows of foreign saving will require the development of a
current account deficit since the balance of payments has to balance. This will
be accomplished by bidding up the value of the dollar which will crowd out
export and import competing industries. Again autos get clobbered. Housing is
also very sensitive to crowding out and the recovery of that sick industry will
also be delayed by larger deficits.
In any case, it will be a close race to see whether personal saving catches
up with the deficit. If they remain approximately equal, it means that all
capital formation must be financed using business saving which, while increased
by the tax cut, is being hurt by low profits during the recession; state and local
saving, which will be hurt by the recession and major cuts in grants; and foreign
saving which has the negative impacts discussed before.
The second negative effect of the deficit involves inflationary
expectations. Deficits are not inflationary unless the Federal Reserve System
buys Treasury bonds by creating new money. This is called monetizing the debt.
There is no technical need to monetize, but the political pressures to do so are
enormous as people complain about the high interest rates caused by the
deficits. In fact, several empirical studies suggest that money creation has
tended to accelerate in the past whenever deficits rise. Even if investors
believe that there is only a small chance of that happening in the near future,
the results of monetization would be so devastating that investors increase the
risk premium demanded on loans. Thus real interest rates may be raised by
more than the amount which would result from the crowding out effect working
alone.
Third, there are adjustment problems involved in suddenly adjusting to a
high deficit strategy. In part, we shall suffer some costs because we have been
a relatively low deficit country in the past. Suddenly, investors must be




29

persuaded to increase their holdings of government debt at a much higher rate
than was experienced in the past. Investor habits and perhaps some institutions
will have to be changed. For example, imagine that we can hold debt creation
to the $150 billion per year level in the period 1983 through 1985. The Fed
would have to buy about $8 billion per year to implement their targets. Debt in
the hands of private investors would have to rise at 16 percent per year or about
8 1/2 percent in real terms given CBO inflation assumptions.
Nothing
approaching this rate of increase has occurred since World War II. The previous
high occurred in the '72-'76 period when the nominal debt rose at 11 percent per
year or about 4 percent in real terms. Persuading investors to begin absorbing
this much debt suddenly may take a larger rise in interest rates than if they had
been absorbing it at such levels over a long period.
The last impact of the deficit involves the interest bill itself. With high
deficits it becomes a driving force on the outlay side of the budget. Net
interest will already constitute 12 percent to 13 percent of outlays in 1983
compared to about 7 percent ten years earlier. The increase in the interest bill
between 1981 and 1983 will far exceed all of the budget cuts occuring in 1981.
Interest payments may not have the same negative impact on the economy as
other government spending but they do have to be financed'and they can be
expected to keep growing.
CONCLUSION
We face an extraordinarily difficult situation. The long-run tax cuts of
last summer mortgaged our future because they were not countered by
sufficient budget cuts.
The prospect of huge deficits is causing much
uncertainty which, in my view, is delaying recovery from the current recession.
It is important quickly to show some resolve in reducing the deficit. At this
point, we should not waste much time debating the fine points about exactly the
right kind of spending cut or tax increases. Speed is important because there is
a considerable risk of entering a British type recession if interest rates are not
brought down quickly. The recent substantial fall in long rates is reassuring. A
more sensible fiscal policy would help greatly to maintain and extend that
decline thus increasing the chances of a healthy economic recovery beginning
before mid-year. If we wait to see more economic data before taking
unpleasant actions that data itself may be very unpleasant.




30

STATEMENT TO THE SUBCOMMITTEE ON DOMESTIC MONETARY
POLICY OF THE COMMITTEE ON BANKING, FINANCE AND
URBAN AFFAIRS, UNITED STATES HOUSE OF
REPRESENTATIVES
March 4, 1982
H. Erich Heinemann
Morgan Stanley & Company, Incorporated

Mr. Chairman, members of this distinguished Subcommittee; I am pleased
to have the opportunity to present my personal views on the conduct of
monetary policy. The Subcommittee is to be congratulated on its line of
inquiry. The way in which we as a nation deal with the issues you have raised,
while they are admittedly technical, will have an important effect on our
quality of life. The definition of the money supply, the manner in which bank
reserve requirements are established, the impact of changes in the financial
system must all be dealt with in our quest to eliminate inflation and to
reestablish sustainable real growth. At the same time, they should also be seen
within a larger public policy context. Most critical, we must recognize that
fiscal policy is now, as always, inextricably intertwined with the conduct of
monetary affairs. However, taxes and spending are not the subject of these
hearings; therefore, to the best of my ability I will resist temptation and not
dwell on such matters.
In my judgment, analysis of the issues concerning monetary control that
are to be considered in these hearings should include the following points:
*




The Congress and the Administration have no practical alternative
other than to support the efforts of the Federal Reserve system to
achieve a credible, stable, and predictable deceleration in the long-run
rate of monetary expansion. Indeed, elected officials can make a
great contribution to economic stabilization and lower interest rates
by insisting that the monetary authorities actually implement their
announced anti-inflationary goals. This process has not been, will not

31




be, cannot be, cost free. But the costs will be far lower — in terms of
lost output and the potential threat to the workings of a democratic
society — than would be the case should the adjustment be delayed.
Any sustained or systematic effort to push interest rates down by
pumping up the money supply would quickly and inevitably backfire.
Anticipated and, eventually, actual rates of inflation would soon rise,
thus confirming the worst fears of participants in the financial
markets. Interest rates would rocket far higher than at present, and a
major crisis would be threatened. As it is, the cost of credit today
represents a severe disequilibrium both for the domestic and the world
economy. Tight money, and only tight money, will bring interest rates
down to establish the foundation for stable expansion in the real
economy.
Financial innovations — which Chairman Fauntroy in his very kind
letter of invitation indicated are to be the primary concern of these
hearings — are in my opinion simply a normal and expected market
response. They reflect the interaction of high inflation, high nominal
interest rates, and counterproductive governmental controls on deposit
interest rates.
If, as, and when inflation and interest rates are reduced, and the
controls are eliminated, the dominant role played by these innovative
practices will quickly diminish. Financial innovation, which is an
ongoing process, will not cease, but its pace and importance should be
attenuated. In the meantime, money market mutual funds, NOW
accounts, the all-savers certificate, IRA accounts, and the like appear
to have had little or no effect on the basic monetary process.
However great the difficulties these changes may have posed for the
statisticians who must measure the money supply, the underlying
linkages have not been seriously disturbed. Sustained movements in
the monetary base, which is the only aggregate the Federal Reserve
can control directly, continue to be reflected in the money supply
(measured as M-l) and, after a lag, in the behavior of total spending
and prices. The level of short-term interest rates, by contrast, has
proven to be unreliable as a guide for Federal Reserve policy actions.

32




This Subcommittee should take the lead in reexamining the basic
premises on which the present scheme for the maintenance of bank
reserves has been founded. Ultimately, Congress should consider a
simplified, uniform reserve requirement applied equally to all
liabilities of all financial institutions. The Depository Institutions
Deregulation and Monetary Control Act of 1980 established new
ground rules governing the way in which financial organizations hold
reserves against their deposits. Reserve requirements, of course, lie
at the very core of the monetary control process. The specific form in
which this legislation was adopted has been little debated — either
before or after its passage. The present procedures may in fact prove
to be a retrogressive step that could ultimately weaken the basic
linkage between Federal Reserve, actions, the money supply, and the
economy. My own preference, which I will outline in my testimony
today, would be for an approach to bank reserve requirements that
would emphasize the twin principles of uniformity and simplicity —
neither of which are characteristic of the legislation that is now being
gradually placed into effect.
Short-run variance in reported rates of monetary growth represents a
significant problem with which the Federal Reserve ought to deal. But
the nature of the concern is almost certainly different from the
popular impression. Significant and unpredictable changes in the
money supply have, of course, been commonplace. As a case in point,
the reported level of M-l declined slightly between April and October
last year but rose at an annual rate of roughly 18 percent between
November and January. All this occurred within the context of a
policy "committed to restraining growth in money and credit to exert
continuing downward pressure on the rate of inflation."
Market
participants have learned from bitter experience that unstable
monetary policy can lead to wide swings in inflationary expectations,
big changes in both short- and long-term interest rates, shifts in the
pace of real economic activity, and large social costs. To be sure, in
theory short-run changes in monetary growth should be ignored by the
marketplace and should have no impact on the economy. The problem
lies in the fact that the volatile pattern in the money stock has been

33

far from random, but rather has had a systematic inflationary bias.
Thus, when the money supply took a big jump in the first week of this
year, market participants quickly extrapolated this change into a longterm trend.
It is for this reason that I have long advocated — along with the other
members of the Shadow Open Market Committee — reforms that would tighten
the Federal Reserve's short-run control over monetary movements. The
principal elements in this program include adoption of contemporaneous reserve
accounting, market-oriented discount rate, and explicit targeting of the
monetary base. But it is important to understand the nature of these
proposals — what they would do, and what they would not do. They would not
eliminate short-run volatility in the money supply. In fact, it is probably not
desirable to do so — even assuming that such were possible (which is doubtful).
What such reforms would accomplish is a sharp reduction in both the actual and
the perceived risk that week-to-week blips in the money supply may be
translated into very systematic — and highly inflationary — accelerations in
monetary expansion.
To repeat, random and temporary fluctuations in money growth are, in the
first instance, inevitable, and, in the second, not a problem so long as they do
not become part of a longer run pattern. The Federal Reserve should take the
initiative to tighten its short-run control over the money supply —not to prevent
week-to-week changes, but to assure that random fluctuations remain just that.
Actions of this sort should help lower the risk premium that is now embedded in
the interest rate structure. At the same time, interest rates — except on very
short-term obligations of, say, no more than a few days' duration — should also
be more stable.
BACKGROUND TO CRISIS
In a very real sense, the fact that these hearings are being held here today
is symptomatic of the turmoil with which participants in the financial markets
are now confronted. Roughly two decades of accelerating inflation and rising
transfer payments have produced deep distortions in the economy.
Governmental policies which (1) reward present rather than future consumption,
(2) favor the non-producer at the expense of the producer, and (3) emphasize the
redistribution and not the expansion of income and wealth lie behind the long-




34

term trends of inflation and lower real growth. To an observer sitting in the
capital markets, it would appear that there is now a national consensus that this
deterioration must end. But it is certainly not surprising that there is little
agreement on the manner in which a change of this sort ought to be effected.
This is very plain in the debate over fiscal policy. I like to use a simple
political model to illustrate the diversity of interests involved in the governmental spending process, and their relationship to monetary policy and the
financial markets. There are, obviously, three major constituencies to be
considered:
*

First, there are beneficiaries of governmental programs, who will seek
to obtain as much as possible. This is a very populous group that
consists of individuals who believe they have a compelling need to
spend income earned by someone else — whether in the form of a
transfer payment, a defense contract, or any other purchase of goods
and services by the Government.

*

Second, there are taxpayers, mainly the broad middle class, who will
seek to pay as little as possible. This second group is in practice
clearly not mutually exclusive from the first, but its self interest is
sharply divergent.

*

Third, and finally, there are savers who must make voluntary decisions
whether, and at what price, to purchase Government securities to
bridge the gap between what the former group wants and what the
latter group is willing to pay.

It is natural that public attention should have focused primarily on the
obvious clash between beneficiaries and taxpayers who are numerous and whose
conflicting desires are translated quickly into votes. The savers' position in the
governmental process may be less evident, but it is no less vital. The impact of
the unlegislated tax on savings which inflation represents comes in a stream of
individually small but cumulatively large negative effects that stretch
indefinitely into the future. In part because most fixed-income investments -which are particularly vulnerable to the inflation tax and which comprise the
bulk of individual wealth in the United States — are held indirectly through
banks, thrift institutions, insurance companies, and pension plans, the nature of
this erosion in value is not well perceived. Nonetheless, savers vote, not so
much at the polls (though they do that, too) as every day in the capital market.




35

Today, after 20 years of irregular increases in the unlegislated inflation tax,
savers are demanding a "risk premium" before they will play in the Treasury's
game. Indeed, the premium is now so high that the rest of the economy is
finding it difficult to live with the resulting rise in real interest rates.
In my judgment, it is against this background that we must examine the
appropriate course for monetary policy. The figures that have been presented
with this testimony (and in particular Figure 1, which traces the course of the
monetary base and bank reserves) make clear that the underlying pattern of
federal Reserve actions has already shifted decisively toward restraint. This
means that the ball has now moved largely to the fiscal policy court, even as
the monetary authorities work to achieve further reductions in the rate of
growth in the money stock. Any other course would quickly and inevitably
exacerbate the tensions now evident in financial markets.
THE MORE THINGS CHANGE . . .
I have been active as a chronicler and analyst of this nation's financial
structure for almost a quarter of a century. It is fair to say, I think, that over
this span there has been a tale no more enduring than that of the distortions
produced by, and the breakdown of, the limits placed by Congress during the
Depression on the payment of interest on bank deposits. With the innovation of
the negotiable certificate of deposit and premium rates on Federal funds
approximately 20 years ago, it was plain that this regulatory structure was
beginning to disintegrate.
At the same time, the continued existence of a tattered regulatory
umbrella encouraged thrift institutions — which are designated in the law as the
principal source of home financing — to maintain portfolios of long-term, fixedrate assets and short-term, much more market sensitive liabilities. The severe
mismatch that resulted of course led to recurring "crises" when deposits flowed
out of savings organizations coincident with cyclical peaks in interest rates,
there is little doubt in my mind that Government's desire in each cycle to "do
something" to alleviate the plight of the housing industry has played an
important role in the progressive acceleration in monetary growth, the
continuing increases in inflation, as well as the successively higher peaks in
interest rates and lower rates of real growth.




36

Figure 1
Monetary Policy Has Tightened

——
___

Adjusted Monetary Base
Adjusted Total Bank Reserves

10%n

0 -

i

i

1960

i'

1963

i

' i
"

' i

1966

i

i

i™

8

1969

1972

I

S

I

1975

T

™ n x r "'

1978

|r -~m^---—-j—

1981

Data are 12-month moving averages centered on the sixth month.
Shaded areas, except for the mini-recession of 1966-1967, represent periods of recession as designated
by the National Bureau of Economic Research.
Sources: Federal Reserve Bank of St. Louis; Econalyst Data Base; Morgan Stanley Research




37

The rationale for controls on interest rates is often cited as a desire to
limit the cost of credit. But to the extent that the controls have encouraged a
distorted structure among thrift institutions and recurring Federal Reserve
attempts to "help" in difficult circumstance, this has not been the result. Thus,
as so often happens in such cases, governmental intervention in the market
process designed to force feed the supply of funds for housing and keep the cost
of mortgage finance down has in practice had the opposite consequence.
Turning to the more immediate concern of these hearings — the money
market mutual funds, cash management accounts, negotiable orders of withdrawal, and the like, which have proliferated in recent years — I can see little
to differentiate recent developments in form or substance from the events of
the early 1960's. Indeed, it seems fair to argue that the repeal in the marketplace (if not in Congress) of deposit interest rate ceilings (on both demand and
time accounts) has finally reached the level of the man in the street. Ordinary
savers — if you will, the members of this country's yeoman stock who do the
nation's work, pays its bills, and save for its future — were ripped off during
years of accelerating inflation, but they are now coming into their own.
Increasingly, a fair return is available to the small saver as well as the big one.
From the vantage point of a monetary technician, the most remarkable
characteristic of this entire saga has been the extraordinary stability of the
financial response mechanism through an era of truly dramatic structural
changes. Figure 2, for example, illustrates the essential stability between
sustained movements in the Federal Reserve System's balance sheet (as
measured by the adjusted monetary base calculated by the Federal Reserve
Bank of St. Louis) and the subsequent sustained level of money demand for
goods and services in the United States. As the President's Council of Economic
Advisers stated in its most recent Annual Report;
"It is often stated that such financial innovations as money market funds
undermine the conduct of monetary policy. Statistical support for this
assertion is dubious. What would have to be demonstrated is that financial
innovation — which is to a large extent the result of policy-imposed
constraints on the financial system in an inflationary environment — has
made it more difficult to aehieve a given monetary target, and that the
link between changes in nominal GNP and changes in the monetary




38

Figure 2
The Trend of Velocity Has Been Stable

Ratio: GNP to Monetary Base
Trend 1960-1981
19

17

15

•

13

11

TTTTTTTTTTTTTrTprTTpnrTpTTTT^

1960

1963

1966

1969

1972

1975

197S

1981

Data are trailing four-quarter moving averages. Monetary base has been lagged two quarters.
Shaded areas, except for the mini-recession of 1966-1967, represent periods of recession as designated
by the National Bureau of Economic Research.
Sources: Econalyst Data Base; Morgan Stanley Research




39

aggregates — that is, changes in velocity — has become less predictable.
The evidence does not seem to support either proposition."
Moreover, so far as money market mutual funds are concerned, there are
some important tehenical considerations to keep in mind. The shares of such
funds are of course not "money" in the generally accepted sense of being in and
of themselves assets that would serve as both a medium of exchange and a store
of value. Rather, if I desire to purchase shares in my money market mutual
fund account, I must surrender title to some quantity of money by sending a
check or a wire transfer drawn on an M-l type balance in order to do so.
Conversely, when I pay for someting with a money market mutual fund "check,"
I actually give the fund an order to sell shares in my account. The fund, in
effect, obtains some M-l for me so that my payment can be made. The point is,
that while my money market fund account ebbs and flows, the quantity of
transaction balances in the banking system is not affected. Thus, while money
market funds may create a significant effect on transaction velocity (the
turnover of deposits in the banking system), there has been far less impact on
income velocity (which is the ratio of GNP to money supply).
What's more, the behavior of both the overall economy and of the price
level continues to follow closely prior changes in the monetary base and the
narrowly defined money supply. Figures 3 and 4 trace these relationships over
the past 20 years. For example, short-run changes in the rate of monetary
expansion — which is shown in Figure 3 on a real basis, adjusted for price
changes — are generally reflected with a lag of about six months in the pace of
real activity. This shows clearly in the figure, including the blip in economic
growth in late 1980 and early 1981 that followed the surge in monetary growth
between May and November 1980. (Because the data in Figure 3 have been
computed as four-quarter moving averages, the current business downturn is not
yet reflected.) Similarly, the rate of change in the price level started to slow in
the spring of 1981, almost exactly two years after parallel slowdown in the
underlying rate of monetary growth in mid-1978 (see Figure 4).
In sharp contrast, Morgan Stanley's measure of the "expanded" money
supply — which includes in addition to M-l, overnight repurchase agreements
and Eurodollars, as well as 50 percent of money mutual funds outstanding — has
shown a sharp acceleration over the past year, owing to the rapid growth of
money market funds. On the assumption that there are systematic associations




40

Figure 3
The Synchronous Movement of Money and the Economy

Real GN'P
Real Money Supply (M-l/Personal Consumption Deflator)
7.5% 1

4.8

2.1

-0.8

fa
-3.3

X

-6.0 • TffflTITITITTITjTfTTIT^

1960

1963

1966

1969

1972

1975

1978

frtntn
1
1981

Data are trailing four-quarter moving averages. Money supply has been lagged two quarters.
Shaded areas, except for the mini-recession of 1966-1967, represent periods of recession as designated
by the National Bureau of Economic Research.
Sources: Econalyst Data Base; Morgan Stanley Research




41

Figure 4
Disinflation is on Schedule

Left Scale: Money Supply (M-l) 24 Months Earlier
Right Scale: Prices (Personal Consumption Deflator)
8.5%

6.8

10.5%

-

i
n
© 6.5

5.1

3.4

m 4.5

-

i.:

0

2.5

-

1960

1963

1966

1969

1972

1975

1978

1981

1984

Data are 12-month moving averages centered on the sixth month.
Shaded areas, except for the mini-recession of 1966-1967, represent periods of recession as designated
by the National Bureau of Economic Research.
Sources: Econalyst Data Base: Morgan Stanley Research




42

between money, spending, and prices, one would have expected an acceleration
of this sort to be reflected in the economy (the year-over-year increase in
expanded money was almost 17 percent in January 1982, up from 9.4 percent a
year earlier). The fact that it has not been so reflected could be an indication
that (1) money fund shares lack some of the critical properties of money, or
(2) as is more likely, their creation does not result in a net expansion of the
effective stock of transaction blances. (Data on the expanded money stock are
reported regularly in Morgan Stanley's weekly publication, Money and the
Economy.)
In summary, it seems to me unlikely that the rapid spread of devices to
avoid Federal limitations on the payment of interest on deposits has impaired in
any material way the conduct of monetary policy. Aggregate economic activity
continues to be most closely related to prior changes in traditional measures of
transaction balances. In any event, to the extent that financial innovations of
the sort being focused on in these hearings represent a "problem" — which I
doubt — the way to deal with it is to reduce inflation and eliminate regulations.
New rules, which would have as their primary purpose a reduction in the yield to
investors, would serve no useful end and would be inequitable to some of the
nation's most productive citizens, who too long have been penalized by the
unlegislated inflation tax.
TARGETS FOR MONETARY POLICY
One of the central themes in these hearings, as I understand the questions
raised by the Chairman, concerns the proper definition of the "money supply"
that the Federal Reserve System should be seeking to control in its day-to-day
implementation of policy. This is, of course, one of the oldest questions in
economics, and one which has never been answered satisfactorily. To be sure,
there is fairly general agreement that currency and accounts available for third
party payments inlcude most of the criteria of "money." The Federal Reserve's
official definition of a "transaction account" picks up most of these
characteristics:
"All deposits on which the account holder is permitted to make
withdrawals by negotiable or transferable instruments, payment orders of
withdrawal, and telephone and preauthorized transfers (in excess of three
per month) for the purpose of making payments to third persons or
others."




43

In practice, however, it is obvious that there are many gray areas that
greatly complicate the problem of defining and measuring "money" for the
purposes of monetary control. Just to cite one very simple example — how
would you classify a bank account which is generally inactive but is occasionally
used aggressively (say, once every two or three years) when its holder decides to
make a series of major expenditures? There are no easy answers to questions of
this sort. In the meantime, the Federal Reserve is left with the totally
practical need to decide what it should be controlling, and how. I have already
argued that the monetary base and conventionally defined M-1 have provided
adequate gauges of monetary changes during a period of major structural
upheaval in the financial system. Sustained accelerations or decelerations in
these aggregates have generally provided reliable clues to subsequent
developments in total spending, and, eventually, in inflation. But adequate
performance is not optimal performance. Therefore, it seems to me that
consideration should be given to reforms that could further stabilize the
relationships between Federal Reserve actions in controlling the monetary base,
growth in the money supply, and the overall performance of the economy.
The Monetary Control Act of 1980 was designed, as you know, to simplify
and rationalize bank reserve requirements. To some extent, it succeeded in
doing so. When the Act is fully implemented in 1987, bank reserve requirements
will indeed be less complicated than they were prior to its passage. But to my
way of thinking, reserve requirements will still be too complicated and will still
represent a thinly disguised, unlegislated tax on the banking system. There will
still be three categories of bank reserves (12 percent, 3 percent, and zero,
depending on the type of account and its maturity), and the actual level of
reserves will still be well in excess of the cash balances prudent bankers would
hold in the absence of any regulation. In rough outline, the approach I would
prefer is as follows:
*




Remove all constraints on the payment of interest on deposits,
including the remaining prohibition on the payment of interest on
demand deposits. Action of this sort would represent an essential first
step to eliminating the incentive to develop subterfuges to avoid rate
ceilings and differential reserve requirements. For example, the
automatic transfer service offered by many banks had the effect —
prior to the passage of the Monetary Control Act — of reclassifying
44

what in reality were demand deposits into savings accounts. This
lowered the effective reserve requirement for the bank and allowed
the depositor to earn interest on a checking balance, which at that
time was illegal.
* Impose a single, uniform reserve requirement at an absolutely low
level (say, one or two percent) on all liabilities of all financial
institutions that offer deposit services to the public. The only possible
exemption from this reserve requirement might be capital notes of
perhaps seven years' or more maturity. There would be no need for
banks to try to avoid such a reserve requirement, since prudent
banking demands that some cash be kept on hand at all times.
* Allow the marketplace to determine the yield on all liabilities of
financial institutions. For purposes of social accounting, the public
and the institutions would be asked to distinguish between sight
accounts (from which third-party payments could be made) and time
accounts (from which such payments could not be made). There would
be no incentive for banks to allow their depositors to blur the
distinction between the two types of accounts because both would
carry market rates of interest.
*

Require the Federal Reserve to manage its own balance sheet
explicitly by setting targets for the monetary base. The base is the
only aggregate that the central bank can control directly and in any
event (with or without additional reforms) ought to be the primary
focus of Federal Reserve actions. The present system of multiple
monetary targets has its bureaucratic uses, since emphasis can always
be placed on the aggregate that is closest to the mark, but it does not
provide optimal policy performance.

The advantage which in my judgment would emerge from an approach of
this sort would be a substantial stabilization of the relationship between direct
actions by the monetary authorities and the subsequent response in monetary
growth, in the financial markets, and in the overall economy.
On the
assumption that growth in the monetary base was then maintained along a




45

stable and non-inflationary path (a critical assumption, to be sure), the likelihood of attaining a sustainable acceleration in real economic growth would be
greatly enhanced.
Thank you for the opportunity to present my views here this morning.




46

APPENDIX

Additional material provided to the Shadow Open Market Committee by H.
Erich Heinemann, Morgan Stanley & Co.. Incorporated.




47

Figure 1
The Laggrd Relationship Between Bank Reserves «nd Monclar) Expansion

———

Total Adjusted Bank Reserve* (Lagged 20 Weeks)
Mone> Supp!) ( M l )

24%°

18

«**^

-

1

1

1
1

»

1

/»
• i
i /A

!

t

•e
Z

12

1
•£
|
5

6

»j A

*

f 1F 1

-

<

JT
/ %
* // / \
I

1

£
£
0




-

*

\ »
1•
1«

\

\e\

*

Pi

1
1

/

i . l

i f\

' I ' l l
1 / / »1
»I •
i
.

i l l

»|

•! A 1r
i I ll»/W
» V

1

' »n

i f

l l
u

||

»

4

A
/1

' I ¥\
1

# |

1

l/i
1 ii
1 A/

* /
e-

1/80

M

i

•

1/82

1/81

Data are four-week moving average;.
Sources: EeonJyrt Data Bate; Morgan StaaJey Research

48

A

i l l

II

I

I»
I

Figure*

*

Monetan Base and Short-Term Interest Rates

Left Scale: Adjusted Monetary Base
Right Scale: Interest Rate on Three-Month Treasur) Bills
9.2%^

r 2 7.25%

8.2

I- 15.00

7.2

1-12.75

6.2 H

S-10.50

5.2

h 8.25

C
K

£
6,

>•
h.
i,

>

c

4.2

A. g 00
1979




1982

Data are four-week moving averages
Sources- Econalyt! Data Base; Morgan St«nle> Research

49

Figure S
Bank Reserves and Short-Term Interest Rates

Left Scale: Total Adjusted Bank Reserves
Right Scale: Interest Rate on Three-Month Treasury Bills
8.5%«i

7.0

6

r 17.25%

I-15.00

4

5.5

h 12.75

4.0 A

h 10.50

>

2.5 A

\

I*

r 8.25

\l
I'
If
6.00

1.0
1979




Data are four-week moving averages.
Sources: Econalyit Data Bate; Morgan Stanley ReKarch

50

THE BEHAVIOR OF THE MONETARY AGGREGATES:
THE PREDICTABILITY OF THE PAST AND SOME
PROGNOSTICATIONS FOR THE FUTURE
James M. Johannes and Robert H. Rasche
Michigan State University

I.

A RETROSPECTIVE ANALYSIS OF 1981

Judging by the hand wringing and gnashing of teeth on the part of Federal
Reserve officials in the course of recent speeches, 1981 represents a year of
historically unprecedented difficulties for monetary management. A representative sampling of the anguish can be culled from the recent sayings of
President Solomon of the Federal Reserve Bank of New York: 1)
The ongoing process of financial innovation seems to have produced
a sharp and largely unexpected divergence this year in the performance of the narrow money measures (such as M-1B) and the
broader measures (such as M-2 and M-3). In the eleven months
through November, Ml-B, adjusted for the effects of the
introduction of nationwide NOW accounts at the beginning of the
year, rose at a 2.8 percent annual rate. The comparable rates for
the broader measures M-2 and M-3, however, were 10.1 percent and
11.3 percent, respectively. . . . Perhaps just as important, we did
not anticipate, and almost certainly could not have anticipated, the
extent of these divergencies. In terms of the midpoints of our 1981
targets for M-1B and the broader measures, the divergencies allowed
for were far smaller than the divergencies that have actually
materialized. . . . Thus the very large gap between M-2 and M-1B in
1981 represents an extremely unusual, if not actually unique
situation that has complicated the task of setting policy as the year
has proceeded.
The basic message of this report to the Shadow Open Market Committee is that
we find no substantive basis for these contentions.
There was nothing
particularly unusual about the differential behavior of the various monetary
aggregates during 1981 (adjusted for the regulatory change allowing for nationwide NOW accounts; the behavior was certainly not unique; and while the
behavior obviously was unexpected by the Federal Reserve System, there is no
reason why it should have been unexpected. The current bewilderment within




51

the Federal Reserve System about the events of 1981 is yet another
demonstration of the old proverbs that "you can lead a horse to water, but you
can't make him drink" or even more appropriately "you can't teach an old dog
new tricks."
In spite of all the talk about the behavior of the different monetary
aggregates in 1981, there has been pitiful little analysis of what actually
happened. This problem is easily analyzed within the Brunner-Meltzer nonlinear money multiplier framework, and thus the empirical question raised by
President Solomon in the quotations above can be addressed using our money
multiplier component forecasting models.
First consider the money multipliers for two monetary aggregates
(indexed by i) with respect to any of the various reserve or monetary base
aggregates (indexed by j). We can express this relationship as:
InM. = lnm.. + InR.
1

1J

i = 1,1.
J = 1,J.

J

(1)

The relative behavior of two monetary aggregates, L and i„, is completely
determined by the behavior of the two money multipliers, since, given an R.,
InM. -InM. = lnm. . - l n m . ..

(2)

In addition, the multipliers for the various monetary aggregates can be written
as the ratio of a numerator which depends only on the monetary aggregate
(i.e is indexed only by i) and a denominator that depends only on the reserve
aggregate selected (i.e. indexed only by j). Thus we can write
lnm., = InNum. - InDen.

(3)

and regardless of the reserve aggregate we can rewrite (2) as:
InM. -InM. = InNum. -InNum. .
J
l
l
l
l
2
l
2

(4)

In the case of Ml and M2, the numerators of the respective multipliers are
[1 + k(l+tc) ] and [1 + k(l+tc) + t ] using the notation of our previous reports
to this committee. The convenient part of this analysis is that the result, (4), is
invarient to our choice of reserve aggregate on which to base the multiplier.




52

Our predictions of the relative behavior of Ml and M2 and Ml to M3,
based on our multiplier component forecasts over a one month horizon for the
12 months of 1981 are presented in table 1. The forecasts for January through
June are those that are prepared on an export basis for the September, 1981
Shadow committee meeting, and reflect the data available as of August, 1981.
The forecasts for July through December are new and reflect the data that is
available as of January 1982. It is important to note that these forecasts of the
component ratios include intervention terms to allow for the extension of NOW
accounts nationwide in January, 1981. These intervention terms are those
described in our last report to this committee and reflect a simple log linear
adjustment for the months of January through April, 1981.2) The models used
to generate the forecasts are estimated over sample periods ending in
December, 1979. 3) It should also be noted that no adjustments have been made
to the models or forecasts for the introduction of All Savers Certificates in
October, 1981.
The forecast errors in table 1 fail to indicate that anything unique, or
indeed even highly unusual, is going on with respect to the relative behavior of
the various monetary aggregates in 1981, after allowance is made for the
extension of NOW accounts nationwide. The average (one month ahead)
forecast error for the M-3, M-1B differential is essentially zero. There is a
small positive error on average for the M-2, M-1B differential, but it is this
differential that would be most sensitive to the NOW account shift, and the
largest positive errors are in the first four months of the year. Since our NOW
account adjustment was not designed to be exact, but rather to replicate on
average, with a very simple functional form, the type of shift that the Board of
Governors found from its sampling information, we feel that it is safe to
interpret the data in table 1 as suggesting that the impact of financial
innovation, as contrasted with the impact of changes in the regulatory
environment, on the differential behavior of the various monetary aggregates
was highly predictable during 1981.
It is one thing to claim that the behavior of the various monetary
aggregates during 1981 is explainable with perfect hindsight as in table 1. It is
quite another thing to claim that they should have been foreseen. In this case,
we feel that there is substantial evidence for even this stronger claim. Last
March we presented a set of forecasts to the Shadow Open Market Committee




53

TABLE 1
Differential Behavior of Various Monetary Aggregates: 1981

ln(M3)-ln(M1B )

ln(M2)-ln(M1B)
Actual

Predicted

Difference

Actual

Predicted

Difference

Jan.

1.38677

1.38145

.00532

1.55625

1.54930

.00695

Feb.

1.41667

1.40869

.00808

1.58827

1.58384

-.00443

March

1.41810

1.41722

.00088

1.58493

1.58939

-.00446

Apr.

1.39223

1.38090

.01133

1.55384

1.56341

-.00957

May

1.41611

1.41599

.00012

1.58298

1.57651

.00647

June

1.41521

1.41009

.00512

1.58346

1.57556

.007.90

July

1.40540

1.40406

.00134

1.57661

1.58201

-.00540

Aug.

1.41391

1.41470

-.00079

1.58802

1.58994

-.00192

Sept.

1.41721

1.41235

.00486

1.59387

1.58621

.00766

Oct.

1.42018

1.41369

.00649

1.59528

1.59594

-.00066

Nov.

1.42000

1.41847

.00153

1.59434

1.59139

.00294

Dec.

1.40701

1.41603

-.00902

1.58052

1.58864

-.00812

Mean error

.00294

-.00022

Standa rd deviation of errors

.00498

.00612




54

meeting that indicated our predictions of the behavior of the M-1B, M-2 and M3 adjusted unborrowed reserves multipliers for the remainder of 1981, based on
information available at the end of February, 1981. This included the data on
the monetary aggregates for January, 1981, and the initial results of the Board
of Governors survey data on shifts into NOW accounts from non-demand deposit
sources as reported in Chairman Voleker's testimony of February 25, 1981.
These forecasts are a matter of public record. 4) Using those forecasts, which
incorporate only the NOW account shifts that occurred in January, 1981, and
assume no subsequent shifts into NOW's from non-demand deposit sources, we
find an average forecast error of 2.4 percent for the fourth quarter of 1981 in
the ratio of M-1B to M-2, and an average forecast error of 2.3 percent for the
fourth quarter of 1981 in the ratio of M-1B to M-3. Such errors are very small
when it is realized that the average forecasting horizon is 10 months! Furthermore, the 2+ percent error is divided into an underestimate of fourth quarter M1B of approximately 1.6 percent and an overestimate of fourth quarter M-2 and
M-3 of .8 and .7 percent, respectively. This is just the type of forecasting
errors that are to be expected given our incomplete information on the extent
of the NOW account shifts. Given that by all estimates the NOW account shift
was completed by the end of April, 1981, there is no reason why anyone should
remain bewildered about the differential behavior of the monetary aggregates
after the middle of 1981.
II.

PROGNOSTICATIONS FOR 1982

At present, we are somewhat handicapped in making forecasts for 1982.
The Board of Governors has just released (February 5, 1982) revisions to the
monetary aggregates. Many of the revisions (changes in seasonal adjustment
techniques, new call report benchmarks, renaming M 1 0 as M j do not cause us
any difficulty. The consolidation adjustment for vault cash of thrift institutions
in M-1 and the ne tings of CIPC of thrifts against transactions deposits also
should not cause us severe problems, since they have negligible impact on
growth rates of M-1. Unfortunately, the compositional changes involving the
allocation of retail RP's and money market mutual,funds between M-2 and M-3
have a substantial impact on our t- and t„ component ratios. At the present
(March 1, 1982) historical data for the revised series are not available. Thus we
have not been able to reestimate our models with the new data, nor can we
forecast with the existing models and the revised data.




55

We have chosen to use the old (1981) data and construct M-1 forecasts for
1982 based on a December, 1981 origin. While our forecasts for t and t„
obviously will be in error compared with the new data, the errors should be
essentially offsetting since only the sum of t.. and t is involved in forecasting
the various M-1 multipliers. Our M-1 multiplier forecasts should not be
affected systematically by the recent revisions. Our current forecasts on the
M-1 adjusted unborrowed reserves multiplier ares




1981
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dee.

10.2693
10.1550
10.0738
9.9806
9.9497
9.9497
9.9757

56

1982
9.6489
9.7931
9.8717
9.9980
9.7494
9.9360
9.8506
9.8320
9.8041
9.7761
9.7434
9.7434 >
9.7409

-2.2%

FOOTNOTES

1)

Anthony M. Solomon, "Financial Innovation and Monetary Policy," SixtySeventh Annual Report of the Federal Reserve Bank of New York, 1981,
pp. 4-5. (Emphasis added.)

2)

The NOW account adjustment is that described in the "Shadow Open
Market Committee Policy Statement and Position Papers, September 1314, 1981," Center for Research in Government Policy and Business,
Graduate School of Management, University of Rochester, PPS-81-8, p.
42-46.

3)

For what follows it is interesting to note parenthetically that the models
are nearly identical to models estimated through 1978. See ibid., p. 40.

4)

Shadow Open Market Committee Policy Statement and Position Papers,
op^ cit., pp. 61-64.




57




SOURCES OF FINANCING FOR THE GOVERNMENT DEFICIT
Robert H. Rasche
Michigan State University

This analysis updates materials that I supplied to the Shadow meeting on a
regular basis several years ago. The analysis is derived from the combination of
the Treasury identity for the government financing requirement, including both
the unified budget deficit and the deficit of off-budget agencies, and the
Federal Reserve identity for the sources and uses of member bank reserves. In
table 1 the three major categories of financing for the government deficit are
identified: 1) borrowing from private capital markets, 2) increases in the net
source base by the Federal Reserve (monetization of the deficit if you like) and
3) borrowings from Foreign Official Institutions. The latter represents that
portion of the government deficit that is financed by Foreign Official
Institutions and does not have to be sold on the private capital markets. All
other of the detailed sources of financing of the government deficit have been
lumped into the fourth category, "other" in table 1. Most of the detailed items
in this category are either Federal Reserve or Treasury "float" accounts that
may be a substantial source of financing in the short run, but are not available
in any large amount as a permanent source of financing. I have the detailed
data available on a monthly and quarterly basis, but none of it is seasonally
adjusted, and the strong seasonal components in the series tend to obliterate the
longer run movements of the series. Therefore, the information in table 1 has
been aggregated to an annual basis.
The first striking feature of table 1 is the dramatic decline since 1977-78
in the percentage of the deficit that has been financed by foreign official
institutions. Unfortunately, the component data of this series are not available
1)

A full explanation of the derivation of the numbers in table 1 appears in
my earlier article "Financing the Government Defict," Policy Studies
Journal, Autumn 1980.




59

TABLE 1
Sources of Financing of U.S. Government Deficit
(Billions of Dollars)

A.

CT>
O

Calendar Years

Total Financing Required
(1) Borrowing on Private Capital Market
(2) Change in Net Source Base
(3) Borrowings from Foreign Official
Institutions
(4) Other

B.

Fiscal Years

Total
(1)
(2)
(3)

Financing Required
Borrowing on Private Capital Market
Change in Net Source Base
Borrowings from Foreign Official
Institutions

(4)

Other




76

77

78

79

80

81 (11 mo.)

62.1

61.4

52.8

41.4

83.3

74.5

49.6

19.4

22.3

51.6

64.5

6.4

11.4

14.3

9.3

65.1
9.0

7.0

29.4

29.0

22.6

2.8

5.0

-1.0

1.3

-12.8

3.1

6.5

2.4

-

2.6

77

78

79

80

81

53.7

59.0

39.7

23.5

24.3

35.2

5.3

12.3

13.6

20.3

23.3

1.2

73.2
68.6
10.4
-4.5

78.9
68.7
5.6
4.6

4.7

-.9

-10.3

-1.3

on a geographic basis, but some insight into what is happening can be obtained
from table 3.14, "Selected U.S. Liabilities to Foreign Official Institutions" in
the Federal Reserve Bulletin. These data include more items than U.S.
Government Securities, but among the various types of liabilities included, the
major changes in volume outstanding since the end of 1978 has been in the
Treasury Security subset.
In the geographic area distribution, Official
Institutions in Western Europe have reduced their holdings from 93.1 billion at
the end of 1978 to 63.0 billion at the end of November, 1981. The decrease in
1981 alone was 18.6 billion; probably in large part the losses suffered by
Europeans in the attempt to defend their currencies against a rising dollar in
the absence of Federal Reserve intervention in foreign exchange markets.
The other large, and offsetting movement has been the increase in U.S.
dollar liabilities to Asian Official Institutions from 70.8 billion at the end of
1979 to 91.3 at the end of November, 1981. Presumably this represents significant accumulations by OPEC members.
What financing is likely to be provided by foreign official sources in the
coming months? Given recent trends in the spot price of oil and the outbreak of
price cutting within OPEC, it seems unlikely that "petro dollars" will continue
to accumulate at rapid rates in the near future. Indeed if we are to take
seriously the recent reports of the balance of payments situations in a number
of OPEC countries, it is conceivable that a "runoff" of petro dollars could occur
in the near future if the price of oil continues to decline. Also, given the
current price of the U.S. dollar in terms of Western European currencies, it does
not seem likely that European central banks would intervene to buy large
quantities of dollars, even if the dollar were to start declining. Therefore, my
conclusion is that it is unlikely that these institutions, around the world, will be
a major factor in the financing of the U.S. deficit. I think 1982 in this respect,
will more closely resemble 1979-81 than 1977-78.
That brings us to the Federal Reserve. If we assume a maximum of 3-5
percent growth in the net source based over 1982, allowing for the Fed to be
somewhere near or above its ]VL targets and some upward drift in the M —
gives something in the range of 4.5 to 7.5 billion of financing to be provided by
the Federal Reserve. Thus it is likely that the bulk of the 1982 deficit will have
to be financed in the private market as it was in 1980-81.

Prepared for Shadow Open Market Committee, March, 1981.




61




ECONOMIC PROSPECTS THROUGH 1983
and
BUSINESS OUTLOOK-MONTHLY UPDATE
Robert J. Genetski
Harris Trust and Savings Bank

Background paper prepared for the March 14-15, 1982 meeting of the Shadow
Open Market Committee and distributed earlier by Harris Trust and Savings
Bank.







Harris
Econo

HARRIS

Q

Chicago Illinois

February 26, 1982
BUSINESS OUTLOOK-MONTHLY UPDATE
The decline in business activity appears to be moderating and soon will
give way to the beginning of an economic recovery. Signs of recovery could
appear anytime from now to July. However, the recent conduct of monetary
policy poses a significant threat to attaining economic prosperity with low
inflation. Although signs of an economic recovery are likely to appear soon,
there is a growing probability that any such recovery will be characterized by
a surge in spending that ushers in higher inflation and another roller coaster
pattern of business activity.
The Recession Continues
Business activity dropped sharply in January as bad weather aggravated an
already serious decline. Tentative data for early February indicate that some
of the extreme weakness of the previous month is being offset. In early February,
initial claims for unemployment insurance dipped to 520,000 per week on average,
(down from the 550,000 range of the previous two months). Autos also staged
a modest comeback, with sales of domestic cars in the first 20 days of February
averaging 6.5 million units at an annual rate, up from 6.0 million units in
January.
In spite of these coincident indicators, leading indicators such as sensitive
commodity prices, housing starts and stock prices continue to point to a weak
economy in the period immediately ahead. At this point the decline in business
activity appears to have moderated, but evidence on the precise timing of the
recovery is not conclusive.
The Surge in Money Continues
The Fed does not appear to have made any headway in solving its monetary
problems. In the four months since October the Ml measure of money (currency
plus checkable deposits) has grown at a double digit pace. As shown in the
following table, the main factor in the recent spurt in the money supply was
aggressive purchases of securities by the Fed. Between October and February
the Fed purchased $4 billion of securities. During the entire year ending in
October, 1981 when policy was highly restrictive, the Fed added only $1.4
billion to its holdings of securities.




65

-2-

MONETARY AGGREGATES
(Annual Rates of Change)
October 1980October 1981

October 1981February 1982 E

Ml

4.2%

10.8%

St. Louis Monetary Base

4.7%

9.0%

Fed Holdings of Securities and Acceptances

1.1%

9.3%

^Estimate for Ml is an average of the two weeks ending February 10; estimates
for the Monetary Base and Holdings of Securities are for the three weeks
ending February 17.
Source: Federal Reserve Board; Harris Bank
Inflation—Another Cycle?
After several years of gradually lower monetary growth the inflation
cycle appears to be broken. Sensitive commodity prices have dropped 40%
over the past two years, producer price increases have averaged 4%-5% at an
annual rate since last spring, and consumer prices and wages during the past
four months slowed to the 5% and 7% vicinity, respectively. However, this
relief may not last. The sharp boost in the monetary base in recent months
has lifted the 2-year average growth of Ml (our key indicator of future inflation)
from the 5%-6% range to 7%. While this change should not affect the inflation
numbers in the immediate future, it does suggest that by year-end inflation
may be moving back toward the 8% vicinity.
Interest Rates - More Erratic Moves Ahead
The recent drop in short-term rates reflects the continued instability
inherent in recent swings in the money supply. A forthcoming Harris Economics
paper on interest rates will show that the volatility of month-to-month moves
in the money supply during the past two years has added as much as 4 to 6
percentage points to the real rate for short-term commercial paper. The
impact of monetary volatility and the resultant funding risk has been so strong
as to overwhelm the impact of liquidity and cyclical factors in determining
interest rates. Recognizing the role of monetary volatility in determining
interest rates suggests that there is a wide band of interest rate possibilities
associated with the same average yearly increase in the money supply.
After allowing for inflationary expectations of 896-9%, 4-month commercial
paper rates of 13%-14% incorporate a real premium of approximately 5 percentage
points. If, as we expect, the inflationary premium drops to 7% by year-end,
while monetary volatility remains high, commercial paper rates of 12% and a
prime of 14% could be expected by December. However, if the Fed were to
stabilize monetary growth, interest rates could be as much as 3-4 percentage
points lower, while even greater monetary volatility would imply a prime rate
in the 17%-18% vicinity. A year-«nd prime rate range of 10%-18% is obviously
too wide a range to be helpful for planning purposes. However, this is indicative
of the extreme risk that most businesses face and will continue to face as long
as the degree of monetary volatility remains uncertain.




66

-3-

Summary
Although the near-term economic forecast dated February 11, 1982 has
not changed, more recent monetary developments imply substantial volatility,
the probability of a more vigorous rebound in the second half of 1982, and
higher inflation rates for 1983. These indications are still preliminary and
could be altered if the Fed quickly returns monetary growth to its targeted
range.

Robert J. Genetski
Vice President and Economist




67

CUHKFNT FCONOMIC STATISTICS
JUNF
1981

JULY
1981

AUGUST
1981

SFPTFMBFR
1981

OCTOBFR
1981

HONFTARY BASF (BILLIONS OF %)
i CHANGF*

167.?
5„?

167.7
3.6

168. 5
5.9

168.5
0.0

168.1
-?.8

169.?
8. 1

M-1 (BILLIONS OF $)
f ''HANGF®

1?8.1
-?.?

1?9. 1
?.8

'111. 1
1.9

131.?
0.3

13?.9
1.8

?70„3
0.6

?71.3
0. 1

?7?. 1
0.3

?7?.6
0.?

?70.6
0.7

?73.7
1.1

?75.9
0.8

15?.9
0.1

153.9
0.7

88.303
0.?

?3.?30
-?.7

HOVFMBFR
1981

DFCFMBFR
1981

JANUARY
198?

FFBRUARY
198?

170.7
11.?

171.9
8.8

173.0 F
8.0

136.1
10. 1

110.9
13. 1

118.6
?1.1

117.9 F
-1.9

?73.9
0.5

?75.3
0.5

?76. 1
0. 3

?77.1
0.1

NA
NA

?78.9
1.1

?80. 1
0.1

?81„5
0.5

?8?.6
0.1

?83.1
0.3

NA
NA

153.6
-0.?

151.6
-1.3

119. 1
-1.6

116.1
-1.8

113.1
-?.0

139. 1
-3.0

NA
NA

89.696
1.6

87.350
-?.6

86.?78
-1.?

77.801
-9.8

79.956
?.8

79.761
-0.?

78.513
-1.5

NA
NA

?1.??6
1.3

?1.700
?.0

?3.0?6
-6.8

?0.996
-8.8

?3.813
13.1

??.518
-5.1

??.??7
-1.3

NA
HA

1.010

0.916

0.899

0.851

0.860

0.899

0.891

NA

?,16?„6
0.8

?,171.7
0.5

?,19?.0
0.7

?,190.9
0.0

?.191.7
0.?

NA
NA

86.660
-?.3

87.???
0.6

87.060
-0.?

86.119
-1.1

NA
NA

HONFY AND PRICFS

WPI-FINISHFD
t CHANGF

GOODS

C P I - A L L URBAN
i CHANGF
PRODUCTION

(1967=100)

(1967=100)

AND ORDFRS

I N D U S T R I A L PRODUCTION
I CHANGF

(1967=100)

DURABLF. GOODS NFW ORDFRS
( B I L L I O N S OF $ )
f CHANGF

oo

NONDFFFNSF C A P I T A L GOODS
NFW ORDFRS ( B I L L I O N S OF $ )
I CHANGF
HOUSING

STARTS"

INCOMF.SALFS

AND

1.016

FMPLOYMFWT

PFRSONAL I t t C O H F
% CHANGF

(BILLIONS

OF

l-SAAR)

RFTAIL SALFS (BILLIONS OF $)
% CHANGF
AUTO SALFS-TOTAL"
DOMFSTIC"
IMPORTS"
FHPLOYMFNT (HILLIOMS OF PFRSONS)
f CHANGF
UNFHPLOYMFNT RATF
LFADING INDICATORS (1967=100)
f CHANGF

?,381.3
?,381.3
0.7

?,119.?
1.5

?,113.1
1.0

87.385
?.?

87.356
0.0

88.593
1.1

7.5
5.?
?.?

8.?
5.9
?.3

10.1
8.?
?.?

8.8
6.7
?.1

7.?
5.?
?.l

7.7
5.1
?.3

7.?
5.0
?.l

8.?
5.7
?.5

100.130
-Q.6

100.861
0.1

100.810
0.0

100.?58
-0.6

100.313
0.1

100. 17?
-0.?

99.613
-0.6

99.581
0.0

7.1»
131. 1
-0.9

7.?S
1H.3
0.1

ALL DATA ARF SFASONALLY ADJUSTFD
J CHANGF UtVFS MONTH-TO-NONTH PFRCFNT CHANGFS
• PFRCFNT CHANGFS ARF MONTH-TO-MONTH CHANGFS AT AN ANNUAL RATF
BB
MILLtONS OF UNITS AT A SFASONALLY ADJ ANNUAL RATF
F HARRIS BANK FSTIHATF



7.3f
113.3
-0.7

88.699
0. 1

7.61
131.1
-1.7

8.0J
1?8.8
-1.8

8.3J
1?8.6
-0.?

8.8>
1?9.1
0.6

8.9*
?.1p
NA
HA

8.5J

NA

1?6.1 F
-?.3

NA
NA

SDi RK

S

Harris
Econoi

Chicago Illinois

February 12, 1982
ECONOMIC PROSPECTS THROUGH 1983
A volatile monetary policy is leading to erratic and conflicting signals
throughout the economy. These signals are likely to continue through the first
half of 1982 before giving way to clear signs of recovery in business activity.
At the present time prospects for 1983 are for a moderate recovery. This
forecast is based on the assumption that the small change in government tax
and spending policies will have a moderately positive impact on productivity,
while monetary policy limits the expansion in spending. As more information
becomes available on policy changes and the magnitude of the economy's response
to supply-side economics, a more definitive view of 1983 will be possible.
Conflicting Economic Signals
The increase in money creation between October and December began to
pave the way for a typical cyclical recovery. Lower interest rates, a boost in
housing activity and an increase in the leading indicators in December were
clear signals that a cyclical recovery was nearing. However, when a 13%
annual rate increase in money in December was followed by a 24% annual rate
rise in January, the magnitude of these numbers increased uncertainty, lifted
interest rates and dimished the likelihood of a sustainable recovery.
The lack of a clear direction in the economy is likely to continue in the
months ahead. Once the Fed has reattained its money targets, the process of
recovery can start anew. At the present time the recovery is expected to
begin in earnest by this summer.
Interest Rate Problems
Interest rates moved sharply higher in December and January. While
many observers attribute the move to concern over future federal deficits, the
higher rates developed as it became apparent that the Fed was rapidly increasing
the growth in money. A recent study by the Economic Research Office shows
that month-to-month volatility in the money supply can add a significant risk
premium to interest rates (over and above inflation). The reduction in this risk
premium during the fourth quarter, which followed six months of more stable
money growth, as well as recent increases in this premium are consistent with
the results of our study.
Unfortunately, our volatility measure suggests that the recent erratic
moves in money will add to the risk premium and keep interest rates higher
than previously expected during the first half of this year. Continued extreme
volatility in money in the months ahead will drive rates even higher than our
present forecast sugests, while more stable month-to-month moves in money
will cause interest rates to fall short of our forecast. The outlook for interest
rates presented in the following tables assumes that month-to-month volatility
in money continues to be as erratic as it has been in the past two years.



69

-2-

Federal Deficits and Supply-Side Economics
Of all recent statements concerning future federal deficits, the most
perceptive came from President Reagan when he indicated that no one really
has any idea of the true magnitude of those deficits. Most forecasts of receipts
fail to capture the feedback effects from lower taxes. It is reasonable to
assume that lower tax rates will mean increases in taxable relative to nontaxable
activities. There is no reliable estimate of how large an increase in revenues
can be expected from this shift, so most forecasts assume no feedback at all.
In an upcoming report on the federal budget we will show that tax receipts in
the fourth quarter of 1981 were higher than might have been expected. If the
fourth quarter figures are reflecting the feedback effects of supply-side tax
cuts instead of a possible random erratic movement, then they suggest that
future government revenues could be substantially higher than conventional
forecasts have assumed.
Strong Profit Gain Seen for 1983
Since 1979, a weak economy and high interest rates have taken their toll
on corporate profits. After-tax profits (adjusted to exclude inventory profits
and to allow for depreciation at replacement cost) are expected to show yearover-year declines of almost 10% in the first half of 1982. For 1982 as a
whole, this measure of profits is forecast to be the same as it was in 1979.
For 1983, the combination of an economic recovery, lower interest rates, and
corporate tax breaks is expected to produce an increase in after-tax adjusted
profits of close to 20%.
Summary
The sharp rise in money in January has increased uncertainty and added a
further premium to interest rates. If monetary growth remains rapid in the
months ahead, then the odds for a sustained and lasting recovery will decline.
Further volatile money growth threatens to keep interest rates extremely high,
thereby threatening the Administration's future objectives. At present, the
forecast assumes that the Fed will quickly reduce the money supply and put
the recovery back on schedule.

Robert J. Genetski
Vice President and Economist




70

2/11/82
(BILLIONS

ECONOMIC OUTLOOK
OF DOLL4RS--SEASONALLY ADJUSTED ANNUAL

1CTU8L

RATES)

YEARS

FORECAST

1982

1981

2626. 1 2922.2
8.8
11.3

3132.6
7.2

1411 9
9 6

1574.7
2.8

1480.7
-0.2

1509.5
2.0

1505.9
-0.2

1558 7
1 5

2.2163
5.5

2.2452
5.3

1.7738
9.0

1.9360 2.0799
7.4
9. 1

2188.7
8.5

2234.1
8.6

2278.6
8.2

1672.7
10.7

1858.1
11.1

274.4
14.3

283.0
13.1

292.4
14.0

302.7
14.9

211.9
-0.2

232.0
9.5

246.7
6.3

^88 1
16 b

819.2
8.9

834.5
7.7

848.5
6.9

862.2
6.6

874.2
5.7

675.7
12.2

743.4
10.0

794. 1
6.8

854 9
7 7

990.6
11.1

1013.8
9.7

1035.4
8.8

1057.2
8.7

1079.5
8.7

1101.7
8.5

785.2
12.8

882.7
12.4

978.1
10.8

1068 5
9 2

440.S
7.1

458.5
17.1

475.0
15.2

495.2
18;!

510.6
13.0

525.7
12.4

540.S
12.0

395.1
-4.9

450.6
14.0

451 .9
0.1

518 1
14 6

333.1
0.6

331.9
-1.4

335.7
4.7

340 5
5 8

347 2
8 1

353.9
7.9

360 2
7 3

366 9
7 7

295.9
5.8

327. 1
10.5

335.3
2.5

157 1
6 5

201.2
-10.5

201.8
1.3

202. 1
0.6

206. 1
8.2

210 5
8 8

215 9
10 7

220.8
9. 4

225 0
7 8

229 3
7 9

187. 1
2.0

202.0
8.0

205. 1
1.5

222 8
8 6

131.4
10.2

131.3
-0.4

129.8
-4.5

129.6
-0.6

130 0
1 2

131 3
4 1

133.1
5.6

135 2
6 5

137 6
7 3

108.8
13.0

125.0
14.9

130.2
4.1

114 1
1 2

93.4
-25.4

89.3
-16.4

93.6
20.7

104.4
54.8

117
58

1
3

132 5
63 9

144. 1
39.9

155
35

[j

3

167 7
35 6

105.3
-11.2

105.3
0.1

101. 1
-4.0

149 9
48 3

17.6

10.9

15.3

18.4

17 4

15 5

12.6

10

1

6 2

-5.9

18.2

15.5

1 1 1

16.0

17.6

19.5

19.0

14 5

11 7

8.. 4

4 0

-H 0

23.3

23.8

17.7

5 0

G0¥T PURCHASES
ICH

615.7
19.5

624.7
6.0

637.5
8.5

648.1
6.8

665.7
11.3

677.9
7.5

689.6
7.1

701.9
7.3

720.1
10.8

534.7
12.9

589.6
10.3

644.0
9.2

b97 4
8 1

FEDERAL
fCM
MILITANT

246.7
41.0
165.8

249.2
4.1
175.7

256.0
11.4
182.7

260.3
6.9
187.0

272.2
19.6
197.1

278.6
9.7
203.5

284.4
8.6
210.4

291.4
10.2
217.<^

104.6
19.7
tV9. 1

198.9
18.5
131.7

228.6
14.9
153.1

259.4
13.5
185.b

2H9 8
1 1 7
215 1

81.0

73.5

73-3

73.1

75.1

75.1

74.0

T>. ^

75.7

67.2

75.2

71.8

J69.0
7.4

375.5
7.2

381.5
6.5

387.8
6.8

393.5
6.0

399.3
6.0

405.2
6.0

410.5
'j.i

415.J
4.3

115.8
9.8

361.1
7.5

384.6
6.5

1981:4

1982:1

1982:2

1982:3

1982:4

1983:1

1983:2

1983:3

1983:4

2984.9
2.7

3019.7
4.7

3084.5
8.9

3172.7
11.9

3253.6
10.6

3329.1
9.6

3397.3
8.4

3465.7
8.3

3535.5
8.3

CONSTANT DOLLAN GUP
SCH

1495.6
-5.2

14S7.6
-2.1

1493.8
1.7

1513.6
5.4

1528.7
4.1

1542.7
3.7

1553.5
2.8

1563.7
2.6

M I C E DErLATOt
ICH

1.995S 2 . 0 2 9 9
8.4
7.0

2.0649
7.1

2.0962
6.2

2.1284
6.3

2.1580
5.7

2.1868
5.4

1909.5
5.6

19*4.1
7.4

19S6.7
9.1

2047.1
12.7

2098.4
10.4

2144.3
9.0

DUIiPl.es
»CH

226.4
-15.6

229.2
5.1

237.5
15.3

254.6
32.1

265.4
18.1

itOWUgABLES
8CM

760.9
5.2

771.0
5.4

784.3
7.1

801.9
9.3

3ENVICE3
SCI4

922.2
12.0

943.9
9.7

964.9
9.2

44J.6
-15.7

433.3
-9.0

332.6
-3.0

MOSS M I L
SCH

PIODUCT

COiSUMfTIOif
ICH

lifESTMEUT
ICH

EXPENDITURES

EHPEIDITUIES

HOMES H X E D

EIKND

acts
r i O D U C E l S DUR EQUIP

act!
BUSIIESS
SCH

STIUCTUIES

RES F I X E D EXPEND
SCH
INVENTONT

CHAiGE

EXPORTS

OTHEI

STATE 4 LOCAL
ICH

MOTE:

PEWCEMTAUE CHArtoES AT AliHUAL




NATES

t980

1981

2.2016
5.9

2 0 1 9 . 1 221 1 4
8.7
9 5

74

8

407.6
6.0

ECONOMIC OUTLOOK
(BILLIONS OF DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES)

2/1 1/82

ACTUAL

YEARS

FORECAST

1981:1 1982:1

1982:2 1982:3 1982:1 1983:1

1983:2 1983:3 1983:1

1980

1981

1982

1983

207.3
-38.8

200. 3
-12.9

201.1
2.3

209.0
15.8

212.9
7.7

217.7
9.1

219.3
3.0

220.7
2.1

222. 3
3.0

215.5
-3.8

231.9
-5.5

205.9
-11.2

220.0
6.8

176.0
-31.6

168.5
-16.0

169.7
2.8

180.5
28.2

188. 1
17.8

191.8
15.0

198.7
8.5

202.1
7.6

206.5
8.3

182.7
-7.2

191.3
1.7

176.7
-7.6

200.6
13.5

TAX LIABILITY
XCH

66.9
-16.3

61.2
-15.0

61.2
-0.3

67.8
-0. 2

67.7
-0.9

32.1
-6.0

77.3
-6.2

65.2
-15.6

67.8
3.9

AFTER TAX PROFITS
XCH

110.5
-31.7

136. 1
-11.9

137.3
3.5

112.8
17.2

116.6
10.9

150. 1
10.0

151 .5
3.6

152.8
3.6

151.6
1.8

163.2
-2.7

151.7
-5.2

110.7
-9.0

152.3
8.2

109. 1
-25.8

101.3
-16.6

105.5
1.6

111.1
38.2

121.7
28.3

127. 1
19.0

130.9
12.2

131.6
11.8

138.8
13.2

100.3
-8.1

111.0
13.6

111.5
-2.2

132.8
19.2

2181.1
7.2

2513.7
1.8

2561.9
7.9

2623.1
9.9

2677.8
8.6

2796.3
8.5

2852.6
8.3

2910.0
8.3

2160.3
11.1

2103.6
11.3

259L1
7.9

2821.7
8.9

109.9
10.5

388.8
-19.1

391.1
5.9

117.2
11.1

389.9
-23.7

399.8
10.5

338.5
12.1

388.2
11.7

PRETAX PROFITS*
XCH
PRETAX PROFITS ADJ
XCH

AFT TAX
XCH

PERSONAL
XCH

-a

PROF

1 )

ADJ

1)

INCOME

TAX & NONTAX
XCH
DISPOSABLE
XCH

PAYMENT

INCOME

PERSONAL OUTLAYS
XCH
PERSONAL SAVINGS
XCH

398.0
-1.8

399.8
1.8

EMPLOYMENT
XCH

100.0
-2.1

99.9
-0.6

LABOR FORCE
XCH

109.2
1.8

109.5
1.3

0.980
-7.1

INDUSTRIAL
XCH

1 .163
-16.5

0.975
-2.0
1 .138
-6.8

110.1
-18.8

103.3
1.3

130.6
98.0

126.8
-11.1

129.5
8.8

129.2
-0.9

165.9
171.9

167.3
3.1

101.1
17.6

106.6
5.2

120.9
13.1

118.0
22.1

5.8

5.6

5.5

5.1

6.7

6.7

5.6

5.3

5.5

6. 1

100.0
0.1

100.5
2.0

101.2
2.8

102.0
3.2

102.7
2.8

103.3
2.1

103.7
1.6

97.3
0.3

100.1
3.2

100.1
0.0

102.9
2.5

109.8
1.1

110.1
1.1

110.5
1.5

111.0
1.8

111.5
1.8

112.0
1.8

112.5
1.8

101.8
1.8

108.7
3.7

110.0
1.2

111.8
1.6

8.7

8.1

7.9

7.8

7.8

7.2

7.6

8.7

7.9

0.975
0.1

0.982
2.6

0.986
1.9

0.991
1.9

0.991
1.1

0.998
1.1

1 .001
1.5

0.988
-0.3

0.996
0.8

0.980
-1.6

0.996
1.7

1.111 1.171
0.8
8.7

1.192
5.8

1.510
5.1

1.523
3.3

1.533
2.9

1.516
3.2

1.170
-3.6

1.509
2.6

1.160
-3.2

1.528
1.6

5. 1

•>NOTE: PROFITS FOR 81:1 ARE ESTIMATES.
1) PROFITS ARE ADJUSTED TO EXCLUDE INVENTORY



398.2
2.6

8.9

8.1

PRODUCTIVITY-NONFARM
XCH
PRODUCTION

106.1
12.7

1720.3 1908.8 2075.0 2273.1
10.6
11.0
8.7
9.6

5.5

RATE(X)

2739.8
9.6

67.9
1 .7

1962.3 1997.9 2011.9 2103.7 2156.6 2203.9 2219.9 2296.8 2312.9
5.7
7.5
9.1
12.7
10.1
9.1
8.6
8.6
8.3

6.0

UNEMPLOYMENT

67.6
8.0

1821.7 2015.5 2195.9 2121.1
11.0
10.6
9.0
10.3

116.0
-23.7

RATK(J)

66. 3
1 . 1

2086.1 2113.9 2152.0 2231.3 2283.1 2333.1 2379.1 2162.7 2510.2
9.0
5.1
7.1
16.2
9.1
9.1
8.1
11.8
7.9

121.1
81.6

SAVING

66. 1
13.0

I. 1

PROFITS AND ALLOW FOR DEPRECIATION AT REPLACEMENT COST.

2/1 1/82

ECONOMIC OUTLOOK

ACTUAL

YEARS

FORECAST

1981:1 1982:1

1982:2 1982:3 1982:1 1983:1

1983:2 1983:3 1983:1

1980

1981

1982

1983

INTEREST RATES
NEW ISSUE AA INDUS BONDS

15,. 7

15.. 9

1 1 .. 8

1 1 ,. 5

13 . 6

13,. 0

12.8

1 1. 6

11.3

12.3

15.1

11.7

1 2 .. 2

NEW ISSUE AA UTIL BONDS

16.. 9

1 7 .. 0

1 5 .. 9

1 5 ,. 5

1 1.,6

1 1 .. 0

13.8

1 2 ,. 6

12.3

13.3

16.2

15.7

1 3 .. 2

PRIME RATE

1 7 .. 0

1 6 ., 0

1 5 .. 5

1 3 .. 8

1 3 .. 1

1 2 .. 3

1 1.6

1 1, 1

11.2

15.3

18.9

11.6

1 1 ..6

COMMERCIAL PAPER 1 MOS 1)

13. 0

1 3 . ,7

1 3 .. 2

1 1 ,5
.

1 0 ., 8

1 0 ,. 3

9.9

9 .. 7

9.5

12.6

15.2

12.3

9 ., 8

3 MONTH T-BILLS

1 i.8
.

1 3 .. 0

1 2 .. 2

1 0 . ,6

9. 9

9. 5

9. 1

8 .. 9

8.7

11.1

11.0

11.1

9 ., 0

PRIMARY 90 DAY COS

1 3 .. 1

1 1 .. 6

1 3 . .5

1 1 ., 8

1 1 .. 1

1 0 .. 6

10.2

1 0 .. 0

9.8

12.9

15.7

12.8

1 0 .. 1

172.3
7.1

171.3
1.7

176.6
5.1

181.7
5.9

181.1
6.1

187.1
6.0

189.8
5.9

156.6

166.9

175.6

185.8

8.1

6.5

5.2

5.8

17.112 17.985 18.311
0.7
3.1
1.8

19.016
3.9

MONEY AND VELOCITY
MONETARY
$CH
VELOCITY
$CH
"<1
CA3

BASE-(MB)
OF MB*

169.3
2.6

179.1
5.8

17.927 17.950 18.219 18.111 18.667 18.851 18.969 19.071 19.173
-1.8
0.5
6.1
1.5
5.6
1.0
2.5
2.2
2.1
136.7
5.9

116.1
8.9

151.9
5.3

157.8
5.3

163.7
5.3

169.1
5.0

175.2
5.0

181.0
5.0

186.9
5.0

102.1

129.5

151.9

178.1

6.2

6.7

5.9

5.1

6.937
-6.3

7.015
1.6

7.063
2.8

7.112
2.8

7.200
5.0

7.272
1.1

7.326
3.0

7.383
3.1

7.110
3.1

6.729
1.7

1806.9
9.8

1850.5
10.0

1885.6
7.8

1921.3
7.8

1960.0
8.3

1998.1
8.0

2036.9
8.0

2076.5
8.0

2116.8
8.0

VELOCITY OP M2®
ICH

1.723
-8.7

1.711
-2.9

1.707
-0.9

1.715
1.8

1.726
2.6

1.733
1.7

1.733
0.1

1.731
0.3

1.736
0.3

NA
NA

NA
NA

1.711
NA

1.731
1.1

CPI-ALL URBAN
%CH

2.813
7.8

2.861
7.1

2.909
6.1

2.953
6.2

2.998
6.2

3.039
b.6

3.079
5.1

3.120
5.1

3.160
5.2

2.170
13.5

2.721
10.3

2.931
7.6

3.100
5.7

AUTO SALES 2)

7.375

7.900

8.600

9.100

10.000

10.100

10.600

10.700

10.800

8.977

8.602

8.975

10.625

DOMESTIC

5.181

5.600

6.100

6.800

7.200

7.600

7.700

7.800

7.900

6.596

6.271

6.125

7.750

IMPORTS

2.221

2.300

2.500

2.600

2.800

2.800

2.900

2.900

2.900

2.105

2.331

2.550

2.875

0.903

0.861

1.032

1.120

1.311

1.523

1.616

1.750

1.800

1.303

1.109

1.089.

1.672

MONEY S U P P L Y - ( M 1
%Cti
VELOCITY
ICH

) "

OF M1»

MONEY SUPPLY-(M2)«><»
ICH

HOUSING STARTS 2)

6.988
3.9

7.098
1.6

7.355
3.6

NA 1716.1 1901.3 2057.1
NA
NA
9.0
8.0

•NOTE:
VELOCITY IS MEASURED AS GNP DIVIDED BY MONEY SERIES LAGGED TWO QUARTERS
"NOTE:
DUE TO REVISIONS, Ml DATA ARE TEMPORARILY INCONSISTENT, AND H2 DATA ARE NOT YET AVAILABLE PRIOR TO OCTOBER
1) PRIOR TO NOVEMBER 1979, COMMERCIAL PAPER 1-6 MOS
2) IN MILLIONS OF UN ITS-SEASONALLY ADJUSTED ANNUAL RATES



1980




ECONOMIC PROJECTIONS
Burton Zwick
Prudential Insurance Company of America*

Since the election of President Reagan in November 1980, the inflation
rate has declined from the 10-11 percent area to about 8 percent in response to
monetary restraint and slack in the economy. Despite many forecasts that
inflation will continue to decline to the 6-7 percent area over the next 12 to 18
months, government bond rates remain near 14 percent, compared with a 12
percent rate in November 1980 and single digit rates as recently as October
1979. Following a decline in late 1981, short-term rates have recently risen
above November 1980 levels, suggesting that double digit rates will persist
throughout 1982.
Whether the rise in nominal rates reflects a rise in real rates or expectations that inflation will reaccelerate, economists both outside and inside the
Administration perceive the rise in rates as a "no confidence" vote on Reagannomics from the financial markets. Unless confidence is restored, a major
Reagan Administration objective — to promote capital formation and
productivity growth — cannot be achieved.
A number of financial economists have pointed to changes in the financial
structure and the determination of investors to earn after tax real returns to
explain the rise in rates. While these factors undoubtably account for some of
the increase in rates, I believe that most of the rise can be explained by two of
the more traditional determinants of income and interest rates, namely,
monetary policy and fiscal policy.
In October 1979, in response to a second dollar crisis within a year, the
Federal Reserve reaffirmed its determination to control inflation by controlling
money and announced a change in operating procedures, namely that policy
The projections presented here reflect my own personal views and should
not be interpreted as the official view of the Prudential. I appreciate the
comments of Michael J. Hamburger.




75

operations would henceforth be directed at controlling money rather than
interest rates. Despite the change in policy, the money supply experienced
unprecedented fluctuations in 1980 and sizable fluctuations in 1981 as well.
These fluctuations took money substantially below its target in the spring of
1980 and substantially above its target in late 1980 and again in the first few
weeks of 1982. (See the lower panel of table 1.)
Since interest rates also fluctuated by large amounts in 1980 and 1981,
some analysts have argued that the fluctuations in money growth reflect other
factors — such as credit controls in 1980 and the introduction of NOW accounts
in 1981 — rather than Federal Reserve attempts to control rates. However,
amidst the general interest rate volatility of the 1980-81 period, there have
been several intervals of up to 16 weeks when the Federal funds rate traded
within a narrow range (see table 2). During each of these intervals, money
growth accelerated or decelerated sharply and moved outside or near the
extreme end of the target range. The Federal Reserve was then forced to
adjust the funds rate by large amounts in an attempt to restablish control over
the money supply. This pattern of volatile money supply growth — insofar as it
contributed to unprecedented swings in long rates as well as short rates —
probably raised real rates at the long end of the yield curve by introducing a
"volatility" component to the risk of holding long-term fixed income securities.
Volatile money growth probably raised nominal rates further by undermining
confidence in the Federal Reserve's ability to control money and inflation over
the longer term. Stated somewhat differently, during the year of 1981 when
money growth declined by several percentage points from its average in the
1977-80 period, the pattern of monetary deceleration was so erratic that
investors saw little reason to expect lower money growth to persist.
Probably an even more important cause of high rates are the federal
budget deficits projected not only for the recessionary period running through
1982 but for the recovery period of 1983 and 1984 as well. The Reagan Administration's 1983 budget message calls for budget deficits of $92 billion in 1983
and $83 billion in 1984. If the continued monetary restraint assumed in the
Reagan Administration's projections leads to slower growth in 1983 and 1984,
the 1983-84 deficits could easily rise to the $100-$150 billion range. Deficits of
$100-$150 billion in 1983-84 would be equivalent to about 3 percent to 4 1/2
percent of GNP.




76

TABLE 1

Bill.
$190

ANNUAL TARGETS! MONETARY BASE AND M i
ANNUAL GROWTH

1979
•

I

1980

i 9 8 l Tarq«t for adjusted MIB




TABLE 2

FEDERAL FUNDS RATE

22

/&

16 Weahs
18.19-1933

20

20

18 h

18

16

-3
00

14

12
9 Weeks
12 0 4 - 12 9 8

10

ST. out o? 13 Wteta
8.68-9.68

8

g I

i

i

j

i

1979



a

» i »

a i

1980

i

i

8

I__J

i

i

i

I

I

» i

1981

i

i

i

i

1

i

i

» i

§

1—I—s

1982

1—s—i

Though U.S. government financing (including the off-budget financing
through the Federal Financing Bank) reached about 4 percent of GNP during the
1975 recession, such financing was a much smaller percentage during most of
the 1970's. As shown in table 3, U.S. government financing was 0.6 percent and
1.5 percent of GNP in 1973 and 1979, cyclical peak years preceding the 1974-75
and 1980 recessions. With total funds raised by the non-financial sector running
between 15 percent and 16 percent of GNP in these cyclical peak years, funds
equal to about 14.5 percent of GNP were available for non-financial sector
borrowers other than the U.S. government.
The two right columns of table 3 show a prospective flow of funds distribution in 1983-84, on the assumption that total funds raised remain closely
related to GNP and run 16.5 percent of GNP in 1983-84, slightly higher than in
1973 and 1979. The first column for 1983-84 assumes annual budget deficits of
$100 billion (plus $25 billion of off-budget financings) for total U.S. government
financing equal to 3.5 percent of GNP; the far right column assumes deficits of
$150 billion (plus $25 billion of off-budget financings) for a total equal to 4.9
percent of GNP. With 16.5 percent of funds available for all non-financial
sectors, U.S. government borrowings equal to 3 1/2 percent to 5 percent of GNP
leave 11 1/2 percent to 13 percent for non-U.S. government sectors, down from
about 14.5 percent in the earlier peak years. Such a reduction in funds
available — particularly down to 11 1/2 percent — implies increased pressure on
the Federal Reserve to purchase securities, in which case the deficits promote
inflation and higher nominal rates. Since the Federal Reserve is unlikely to buy
more than $10 or $15 billion of the $100-$150 billion of treasury issues, the
large federal deficit will crowd out some private borrowings and contribute to
higher real rates. In the proposed figures, I have assumed that state and local
government, foreign, and non-financial corporations will hold on to the bulk of
their earlier shares, in which case most of the crowding out will occur in home
mortgage and consumer credit financing. A large part of the deficits will be
financed through higher household saving, but presumably at higher real rates.
Whatever the reasons for high bond rates, I believe that the state of the
bond market — and realization that monetary expansion will further destabilize
the markets — almost precludes a sustained move toward monetary expansion in
1982 by the Federal Reserve. I am assuming that the recent bulge in the money
supply will be offset over the year, and the Federal Reserve will keep Ml




79

TABLE 3

FUNDS RAISED IN CREDIT MARKETS BY NON-FINANCIAL SECTOR
AS PERCENT OF GNP

1973
Total Funds
U.S. Government*
Other
State & Local Govt.
Households
Mortgages
Consumer Credit
Other
Non-financial Business
Foreign

1979

1983-4

1983-4

15.3

16.0

16.5

16.5

0.6

1.5

14.7

14.5

12.9

11.5

1.0
5.9

0.8
71
.

0.8
5.8

0.8
4.8

3.5
1.8
0.6

4.7
1.9
0.4

3.7
1.7
0.4

3.3
1.1
0.4

7.3
0.5

5.8
0.9

5.7
0.7

5.3
0.7

3.5**

A

*Direct Federal Borrowings, including off-budget financing of Federal
Financing Bank.
**Federal Government Budget D e f i c i t of $100 b i l l i o n per year, plus $25
b i l l i o n off-budget financing.
***Federal Government Budget D e f i c i t of $150 b i l l i o n per year, plus $25
b i l l i o n off-budget financing.




80

Q-k-k*

growth near or only slightly above the upper end of the target range of 2 1/2
percent to 5 1/2 percent. I am also assuming limited fiscal policy initiatives
until after the election, leaving prospective budget deficits for 1983 and 1984 at
$100 billion or higher.
The current recession should end within the next few months. However,
continued monetary restraint is likely to produce much slower output growth
during the recovery than in earlier post World War II recoveries. Ml growth of
5.5 percent — and monetary base (MB) growth of 6.5 percent — are consistent
with 1982 nominal income growth of about 9.7 percent. Assuming inflation of
about 6.7 percent, output will grow about 2.8 percent over the four quarters of
1982 (see table 4).
Though rates may remain high in the next few weeks as the Federal
Reserve moves aggressively to bring the money supply under control, I believe
that declining inflation and a slow recovery will promote a modest easing in
rates over the year. By year end, government bond yields should be around 12
percent to 12 1/2 percent, down 150 to 200 basis points from current levels, but
still quite high by historical standards. Short-term rates should be in the 10
percent to 12 percent area. The failure of rates to decline further will keep
interest sensitive sectors, such as the housing and automobile sectors,
extremely weak by historical standards. Reflecting low utilization rates as well
as high interest rates, capital spending will also recover slowly despite the
recent tax incentives to promote business investment.
One risk to this forecast is that current financial pressure — or concern
about fiscal and monetary policies over the longer term — will cause rates to
remain at current levels or, as suggested by some Wall Street economists, move
to new highs before the end of 1982. In this event, I believe that the recovery
will be even slower and the economy could reenter recession by early 1983. I
reject this as a most probably forecast even though I have continuously
underestimated the level of rates for the past year and a half. A second risk is
that the Federal Reserve will move sharply toward expansion, either because of
unacceptably high unemployment or large deficits. As mentioned above, I
believe this is unlikely because the financial markets will simply not permit
monetary reacceleration.
As at the time of the Shadow Open Market Meeting last September, the
Committee emphasized that the Reagan Administration faced a severe
credibility problem because of its failure to come to grips with the imbalance in




81

TABLE 4

ECONOMIC PROJECTIONS

(Percent Changes)
Projections for 1982 as of March 1982 Meeting

GNP
Q4/81Q4-82

Output

Deflator

Ml

Velocity
of Ml

M_
B

Velocity
of MB

9.7

2.8

6.7

5.5

4.0

65
.

3.0

6.0

2.8

Projections for 1982 as of September 1981 Meeting
Q4/81Q4/82

9.0

1.9

7.0

5.0

3.8

(Annual growth in velocity of Ml was 3.7% for 1971-81, 3.6% for 1971-76,
and 3.7% for 1976-81. For velocity of monetary base, annual growth was 2.4%
for 1971-81, 1.9% for 1971-76 and 2.9% for 1976-81.)




82

its fiscal policy program. While its support of non-inflationary monetary policy,
particularly with unemployment rising in an election year, is impressive,
historical evidence strongly suggests that the Federal Reserve will not be able
to maintain a restrictive policy in the face of deficits as large as those
projected for 1983 and beyond. Recent Reagan Administration criticism of the
Federal Reserve, though directed at the erratic pattern of money growth and
the recent monetary expansion, only serves to raise further questions about the
one institution of government that — for the year of 1981 taken as a whole —
promoted a return to lower inflation rates.




83


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102