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I
SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers
March 16-17, 1986
PPS-86-2
CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY
& BUSINESS
Graduate School of Management
University of Rochester
SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers
March 16-17, 1986
PPS-86-2
1.
2.
3.
Shadow Open Market Committee Members - March 1986
SOMC Policy Statement, March 17, 1986
Position papers prepared for the March 1986 meeting:
Economic Outlook, Jerry L. Jordan, First Interstate Bancorp
Fiscal and Monetary Policy Overkills, William Poole, Brown University
A Positive Trend in the Federal Budget Outlook, Mickey D. Levy, Fidelity Bank
Multiplier Forecasts and the Velocities of Various M's, Robert H. Rasche,
Michigan State University
External Debt and the Banking System, Anna J. Schwartz, National Bureau of
Economic Research, Inc.
Tables submitted by, H. Erich Heinemann, Ladenburg, Thalmann & Co., Inc.
SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. to 7:30 p.m. on Sunday, March 16, 1986.
Members of SOMC:
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.
MR. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann & Company,
Inc., New York, New York.
DR. JERRY L. JORDAN, Senior Vice President and Economist, First Interstate
Bancorp, Los Angeles, California.
DR. MICKEY D. LEVY, Chief Economist, Fidelity Bank, Philadelphia,
Pennsylvania.
PROFESSOR WILLIAM POOLE, Department of Economics, Brown University,
Providence, Rhode Island.
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, On leave from the SOMC; currently Chairman of the
Council of Economic Advisers.
The Committee noted with sadness the death of its friend and former
colleague, Homer Jones, retired senior vice president and director of
research at the Federal Reserve Bank of St. Louis. He was a wise man. We
will miss him.
POLICY STATEMENT
Shadow Open Market Committee
March 17, 1986
At the start of 1986, the economy is poised for accelerated expansion.
It will benefit from the favorable effects of a decline in oil prices. For
the first time in decades, policymakers have the opportunity to achieve a
permanent reduction in inflation. This opportunity should be seized, but we
are fearful that it may be discarded. It should not be. The Federal
Reserve should lower the annual growth rate of the monetary base to 5% to
achieve a lasting reduction in the rate of inflation.
Effects of the Decline in Oil Prices
The substantial fall in crude oil prices in recent weeks reverses the
largest part of the oil price increases of the 1970s and increases the real
wealth of the U.S. and all other oil-importing countries. After adjusting
for general inflation, a current oil price of $14.00 per barrel is
approximately the same as a price of $6.00 in 1973. At this price the cost
of oil imports falls by more than $25 billion per year. At current interest
rates, and assuming that the reduction in oil prices persists, the price
decline is equivalent to an increase of more than $250 billion in the wealth
of U.S. citizens. This is a substantial benefit.
The oil price decline — like the earlier rise — has a one-time effect
on prices, output and demands for assets. Since the U.S. (and other oil
importers) are wealthier, people will spend more on goods and services and
will increase their demand for assets. Some of the increased wealth will be
invested in real capital, thereby raising the prices of capital assets, as
the recent behavior of the stock market attests. Some will be invested in
bonds, lowering real and market interest rates on financial assets, and some
1
will be held as money, lowering the price level. Costs of production will
fall in most industries, and both profits and real incomes of employees will
rise. Production and output will be higher.
All of these desirable changes are one-time changes. Some price and
output changes occur immediately, some only gradually. Once the effects of
the oil price decline pass through the economy, the growth rate of output
and the rate of inflation will return to the path determined by the growth
rates of productivity, labor force, capital stock and money. Interest rates
will return to the levels implied by these underlying fundamentals.
It is important not to exaggerate the benefits of lower oil prices.
The $25 billion reduction in the annual cost of imported oil is not large
compared to annual U.S. GNP of $4,000 billion. Some U.S. industries in the
energy producing sector are hurt by the declining oil prices, and the owners
of firms in these industries have suffered a large capital loss. There are
significant redistributions within the U.S. economy. The net gain from
lower oil prices consists of reduced costs of imports less the cost of
adjusting the mix of output.
The claim that inflation will remain low for years as a result of the
oil price decline, though frequently repeated, is mistaken. The oil price
decline in and of itself will lower the measured rate of inflation for a few
quarters at most. Unless a disinflationary monetary policy is adopted,
inflation will rise to higher levels in 1987 and after.
Monetary Policy
We urge the Federal Reserve to announce — and achieve — a growth rate
of the monetary base of 5% for the four quarters ending in the fourth
quarter of 1986 and modest further reductions in subsequent years. This
2
growth rate would be two-and-a-half percentage points below the average rate
of growth of the monetary base over the past five years.
A reduction of this magnitude might reduce temporarily real GNP growth
in 1986. But in any event, growth would be higher than last year. In
exchange, consumers and producers would benefit from a reduction in the rate
of inflation and an environment conducive to sustained future economic
expansion.
If monetary policy were now consistent with stable prices, it would be
appropriate to maintain an unchanged rate of money growth. The fall in the
price level, resulting from the oil price decline, would produce a few
quarters of falling prices. These price declines would distribute the
benefits of the increase in wealth to owners of assets, suppliers of labor
and producers and consumers of goods and services. Over a longer period, the
economy would return to price stability.
Monetary policy in recent years has been too expansive on average to
restore price stability. Present policy runs the risk of accelerating
inflation next year and a recession a year or two after that. The Federal
Reserve has the opportunity to achieve price stability. It can seize that
opportunity, if it is courageous and bold, by ignoring demands for more
expansive policy and choosing, instead, a policy of disinflation.
Some urge that monetary policy should be more expansive. They argue
that we can have more stimulus because the oil price decline reduces inflation. Many of the people who make this argument also urged faster money
growth and more monetary stimulus in the 1970s, following the rise in oil
prices. Apparently, they have one rule of thumb — whatever happens, raise
money growth.
In the past, we have often criticized the Federal Reserve's use of an
interest rate target and urged the System to substitute the growth rate of
3
the monetary base. We emphasize that the Fed's borrowed reserves target is
an interest-rate target, once removed. Reliance on interest rates causes
the Federal Reserve to misinterpret the effects of its policy. This problem
is severe now.
The oil price decline has relatively large short-term effects on
output, the real rate of interest and the price level. There are no
reliable estimates of the magnitude and timing of these effects, so there is
no reliable way to use interest rates to interpret monetary policy. The
prospect of a major error in monetary policy has been increased. The
interpretation of money growth is affected much less than interest rates by
recent changes in oil prices. Once again, we urge the Federal Reserve to
implement monetary policy by controlling the growth rate of the monetary
base.
Fiscal Policy
The Gramm-Rudman-Hollings legislation is constructive in its principle
of spreading spending cuts over a wide range of programs. However, the cuts
in Federal outlays that are mandated were not arrived at by a process of
sorting out and ranking national priorities. The nation has not yet faced
up to the need to find a permanent mechanism for identifying and eliminating
low-priority and wasteful spending programs. We are concerned that the
budget deficit will be reduced through tax increases that will depress
economic growth rather than spending reductions. Both the amount and composition of Government spending relative to the size of the economy should be
arrived at by an explicit process of political decision.
Fiscal policy is extremely important, but it is not a substitute for
monetary policy. Fiscal policy has major effects on the composition of
4
national output, but little effect on its level. That is what the crowdingout phenomenon is all about.
The combination of budget deficits and tax incentives for investment,
with the relative importance of the two uncertain, has been responsible for
the major crowding-out phenomenon of the 1980s, namely the deficit in the
current account of the balance of payments. The strong dollar was the
mechanism through which the crowding-out occurred. For the last year, the
dollar has been depreciating in anticipation of a lower budget deficit and
reduced incentives for business investment. There is, therefore, no need
for monetary policy to offset the forthcoming change in fiscal policy —
assuming it actually occurs — because the market is already doing so.
Banks qncj Int^rnatipn^l D^t
The Administration and the Federal Reserve have had more than three
years to adjust to the debt problem. They have been slow to adopt policies
that reduce the risk to the economy arising from the decline in the real
value of the assets and net worth of banks and other financial institutions.
Their dilatory response has left the banking system in a weaker position and
less able to absorb the losses that may follow loan defaults.
In 1982, we urged the banking authorities to encourage banks (1) to
reduce or eliminate dividends; (2) to increase their capital; and (3) to
increase their reserves for loan losses. Had these policies been followed,
fewer banks would now be at risk. Many more banks would be able to write
down the book value of their loans to reflect current market values.
In current circumstances, banks should be encouraged to build reserves
at a much faster rate and increase capital. The recent rise in the prices
of shares of major banks presents them with an opportunity to do so on
favorable terms. Regulators should require them to take this step.
5
Banks should also be encouraged to reduce their exposure by selling
more of their international loans on the market at market prices, and to
exchange debt for equity even where this involves a cut in the book value of
the debt exchanged. The tax bill approved by the House of Representatives
discourages banks from building loan loss reserves and increasing capital.
This is counterproductive in view of the current eroded capital structure of
many banks. It would increase the risk of future bank insolvencies.
Secretary Baker's proposal to make lending conditional on economic
reforms lacks an effective means of enforcing the reforms. The plan puts
the U.S. government in a position of taking greater responsibility for loans
and future loan losses without providing incentives for major improvements
in efficiency or for reductions in capital flight.
Exchange Rates
The G-5 agreement last September, and recent efforts by the Treasury to
reduce interest rates, shift part of the responsibility for monetary policy
from the Federal Reserve to the Treasury. The Federal Reserve is left to
implement the policy required by interest rate or exchange rate judgments
made in the Treasury or by the Treasury in agreements with foreign governments.
This policy was adopted to depreciate the external value of the dollar.
It actually increases uncertainty about exchange rates and interest rates.
Governments shift frequently from intervention to non-intervention. Rumors
about the intentions and actions of central banks and governments cause wide
swings in interest rates and exchange rates. Contrary to widely repeated
explanations, there are few lasting benefits of exchange market intervention.
6
Efforts to push the dollar down by monetary policy will lower living
standards by raising U.S. prices above what they otherwise would be. The
rise in prices will lower real wages and other costs for a time. It will
temporarily increase the market for U.S. exports and reduce the trade
deficit. But the stimulus to exports will gradually be lost as prices,
wages and costs of production rise in the U.S. relative to costs and prices
abroad. Where prices and wages adjust most rapidly, as in Japan, the effect
of dollar depreciation on the bilateral balance will be of short duration.
Policy Coordination
Exchange rate changes are the result of differences in tax, spending
and monetary policies, differences in productivity growth and in population
growth. Unless countries adopt compatible policies, ministerial agreements
to stabilize exchange rates are empty promises.
International policy coordination is always difficult, but the current
period is a particularly bad time to attempt to fix, or set targets for,
exchange rates. The fall in oil prices has very different effects on the
U.S., European and Japanese economies. Fluctuating exchange rates help the
world economy to adjust to these differences.
An additional problem arises as a result of the large interest and
servicing costs of current international debt. To pay interest, debtor
countries must earn about $40 billion annually by exporting more than they
import. The rest of the world, but mainly the creditor countries, must run
a combined trade deficit that offsets the trade surplus of the debtor countries.
Given the policies of Germany and Japan, it is mainly the U.S. trade
deficits that will permit the debtor countries to export enough to service
their debts. To oversimplify, the debtor countries run trade surpluses to
7
pay their interest. Even if Germany and Japan were to run zero trade
surpluses, the United States would have to run trade deficits of $40 to $50
billion to permit the transfer to be made. So the U.S. must borrow internationally to finance its trade deficit. Japan runs a trade surplus and
lends to the United States to finance the U.S. deficit.
If this continues, the U.S. will have an ever-increasing international
debt and Japan, Germany and other countries that have frequent trade surpluses will have increasing dollar credits. A world of this kind is not
likely to be a world of stable, fixed exchange rates.
8
ECONOMIC OUTLOOK
Jerry L. JORDAN
First Interstate Bancorp
Growth of Ml in 1985 was a record 11.9%, exceeding the previous peak
rate of 1983. The odds are that money growth will be rapid again in 1986.
Public disclosure of monetary targets by the Federal Reserve started in
early 1975. In the eleven years from Q4/74 to Q4/85, Ml growth has averaged
7.6% while the St. Louis monetary base has grown at a 7.9% rate. The FOMC
target range for Ml growth was never higher than 7.5% during that entire
period. Now, for 1986, the FOMC has set a target range of 3-8%, the widest
range and highest upper limit so far. It seems safe to assume Ml growth
will continue to be about 8% or somewhat more. I choose to assume (but not
advocate) Ml growth in the 8 to 9% range this year. For 1987, one might
assume the Fed will further widen the range to 2 to 9%, then in 1988 go to 1
to 10% and so on.
The point is, the announced target ranges are not taken seriously by the
Fed and should not be taken seriously by anyone else. The Fed suffers no
consequences for failing to remain within the announced ranges, so no effort
is made to try to do so.
Other central banks, such as those in Germany, Japan, and Switzerland,
appear to take their targets seriously and want private decisionmakers to
believe the targets will be adhered to. In those countries, the central
banks* resolve to maintain a non-inflationary environment is influenced by
their success at matching deeds to words. In the United States, central
bank officials have been on a campaign to convince market participants to
"watch what we say, not what we doH. So far, it seems to be succeeding.
9
Outlook for 1986
Table 1 shows alternative projections of economic growth and inflation
for 1986. Most private forecasters have been raising their real GNP projections while lowering their inflation forecasts as a result of falling world
oil prices. It is likely that the next survey of members by NABE and Blue
Chip will result in a higher consensus forecast of real output in 1986.
The idea that lower oil prices will result in lower inflation should be
tempered by the effects of the falling U.S. dollar on forex markets. Prices
of both imported goods and domestically produced competing products are
already showing the effects of the weaker dollar. After the transitory
effects of falling oil prices have been reflected in the price indexes, the
reported rate of inflation will accelerate.
In 1985, real consumer, investment, and government spending growth was
strong even though real GNP did not show it. A surprisingly large decline
in business inventory accumulation and a further large decline in net exports last year account for the discrepancy between last year's strong
domestic final demand and anemic real GNP growth. Since neither further
declines in business inventory accumulation nor further declines in net
exports are anticipated, real GNP growth should be faster. If the falling
dollar results in a steady or smaller trade deficit, real GNP growth will
exceed growth of gross domestic sales.
Income Velocity of Money
The most controversial issue regarding monetary policy during the past
year has involved the behavior of the "velocity" of ML Several charts are
attached to show past relationships between money growth and income/output
growth. For discussion purposes, the issue can be separated into questions
10
about the appropriate numerator and appropriate denominator in the velocity
ratio.
In terms of the "quantity equation" — MV • PT — the issue is which
measure of the money supply to sue, and which measure of economic activity
to put on the right hand side of the identity. Some analysts have argued in
favor of using broader measures of money, such as M2 or M3, while others
favor using a narrow measure that excludes market interest-bearing balances
from Ml. Instead of using domestic output as the measure of economic
activity, it may be appropriate to focus on some measure of domestic demand.
The attached charts show the velocity ratio using final domestic sales as an
alternative to GNP as a measure of economic activity.
Table I
Price?
GNP
Output
Deflator
FOMC:
5-8-1/2
3.0-3.5
3.0 - 4.0
FOMC Wide Range:
5.0 - 8.5
2.75 - 4.25
2.5-4.5
£Ei
Administration:
8.0
4.0
3.8
3.7
Congressional Budget Office:
7.6
3.6
3.9
3.5
NABE Consensus:
—
3.0
Blue Chip Consensus:
—
3.4
3.3
UCLA:
6.8
3.2
3.6
8-9
4-5
4-5
Shadow Committee:
11
4.0
3.2
GROWTH OF M1 & M1 NET OF OTHER CHECKABLES
FB^ra^CHA^IGEO^«RPFO^aMFrImA^NUALRATE
20.0-r
15.0 +
10.0 +
-5.0
-10.0
-15.0 +
\—I—I—I—I—I—I—I—I—I—I—I—I—I—I—I
-20.0
1980
1981
1982
FIRST INTERSTATE ECONOMICS
1983
1984
MAR. 7,1986
1985
GAP BETWEEN DEMAND AND PRODUCTION
CUMJlAnVECHAhX3ESNCE4THQUARTER19e2
REALGKP
v*>
1983
1984
FIRST INTERSTATE ECONOMICS
1985
MAR. 7,1986
MONEY MULTIPLIER-M1 & M1 NET OF OTHER CHECKABLES
ASARATIO TOTHEADJUS7EDM0NETARVBASE
2.70-r
2.00 +
1.90 +
1.80
H
1980
1 1 — I
F
1981
\—I—I—I—I—I—I—I—I—I—I—I—I—I—I—I—I
1982
FIRST INTERSTATE ECONOMICS
1983
1984
MAR. 7,1986
1985
GNP VEL0CITY-M1 & LAGGED M1
p&&mawGEOjmPF^ajfiFm\/wi)PLmTE
20.0 T
15.0 +
10.0 +
Oi
-10.0 +
-15.0
FIRST INTERSTATE ECONOMICS
MAR. 7,1986
GNP & SALES VEL0CITY-M1 & LAGGED M1 NET
PEPCBtfCM^ajmppmamrmmwpLrvtiE
-15.0 -j
1
1980
1
1
j
1
1
1981
1
1
j
1
1
1982
j
1
I
1
1
1983
FIRST INTERSTATE ECONOMICS
1
1
I
1
1
1984
1
1
|
MAR. 7,1986
1
1
1985
1 1
|
GNP & SALES VELOCITY-LAGGED M1 NET
PERCENTCHANGEO\e^PRI0R<XWRIH^ArMJ/lRATC
20.0 - r
1980
|
1981
|
1982
I
1983
FIRST INTERSTATE ECONOMICS
I
1984
I
MAR. 7,1986
1985
GNP & SALES VELOCITY-LAGGED MONETARY BASE
12.0 -r
. 1 0 .0 -J
1
1980
1
1
J
1
1
1981
1
1
|
1
1
1982
1
1
j
1
1
1983
FIRST INTERSTATE ECONOMICS
1
1
|
1
1
1984
1
1
1
|
MAR. 7,1986
1
1985
1 1
I
FISCAL AND MONETARY POLICY OVERKILLS
William POOLE
Brown University
In studying economic policy we sometimes concentrate excessively on
numerical data. Here instead are some verbal data to consider:
...With this measure I sign today, we will cut $20 billion from the
deficit in fiscal year 1969. This marks the largest shift of the
budget toward restraint in the past two decades.... (President Lyndon
Johnson upon signing the Revenue and Expenditure Control Act of 1968 on
28 June 1968.)
...The new fiscal restraint measures are expected to contribute to a
considerable moderation of the rate of advance in aggregate demands....
System open market operations until the next meeting of the Committee
shall be conducted with a view to accommodating the tendency toward
somewhat less firm conditions in the money market that has developed
since the preceding meeting of the Committee.... (Current economic
policy directive issued to the Federal Reserve Bank of New York by the
Federal Open Market Committee on 16 July 1968; Federal Reserve
Bulletin, October 1968, p. 866.)
It is inconceivable that such a [fiscal policy] shift will not
eventually contribute to the emergence of much less buoyant economic
conditions than now prevail. (Quoted from a bank newsletter in an
article by John H. Allen in the New York Times, 30 June 1968.)
...The recently enacted tax surcharge, which is expected to have a
dampening influence on activity, apparently had little impact on
consumer spending in July.... (Survey of Current Biisiness, August
1968, p. 1.)
The economy continues to exhibit remarkable strength.... (Survey of
Current Business March, 1969, p. 1.)
...It is now admitted that the Federal Reserve Board made a blunder
last year after the surcharge was passed by easing monetary policy —
making more money available -- in the fear of an "overkill" of the boom
and inflation.... (New York Times, 15 June 1969, Sec. 2, p. 4.)
The failure of fiscal policy restraint in 1968 to slow the economy is
well known and thoroughly forgotten. By Keynesian standards the fiscal
restraint did exist. Using Federal budget concepts, the total on-budget
and off-budget surplus went from $-25.2 billion in fiscal year 1968 to $3.2
billion in fiscal year 1969, for a total swing toward surplus of $28.4
19
billion. Using National Income and Product Accounts budget concepts, the
Federal surplus went from $-12.3 billion in fiscal year 1968 to $5.2 billion
in fiscal year 1969, for a swing of $17.5 billion toward surplus.
The 1968-69 experience with fiscal restraint may be put in today's
perspective by expressing the deficit reduction in 1985 dollars. In 1985
the GNP deflator was almost exactly three times its 1968 level. In 1985
dollars, then, the swing toward surplus in 1968-69 was about $84 billion
using official budget concepts and about $52 billion using NIPA budget concepts. The difference between the FY 1968 and FY 1969 NIPA Federal surplus
was 2.0% of 1968 GNP.
The maximum fiscal restraint promised for next year will be less than
the restraint applied in 1968. According to recent estimates by the Congressional Budget Office, if the Gramm-Rudman-Hollings targets are met the
deficit will decline from $208 billion in FY 1968 to $144 billion in FY
1987, a reduction of $64 billion or 1.5% of the CBO forecast of GNP for
calendar year 1986. Also, from past experience it is realistic rather than
cynical to expect that reduction of the deficit will be less than promised.
The excessive weight assigned to the budget deficit as a determinant of
economic activity was partly responsible for the monetary policy mistake of
1967 as well as that of 1968. By the middle of 1967 the Federal Reserve was
well aware that the economy was under growing inflationary pressure. But
the Fed was convinced that fiscal restraint was the key to solving the
problem. The effect of monetary restraint, it was thought, would be
relatively small except in the areas of housing finance and construction.
The Fed wanted fiscal restraint in order to avoid battering the thrift industry as had occurred in the 1966 credit crunch. After recognizing the danger
of rising inflation, the Fed permitted money growth to run at an accelerated
20
rate for a year before seeing fiscal restraint put in place. Almost another
year passed before the Fed came to the conclusion that the fiscal restraint
wasn't working.
During this two-year period in the late 1960s the monetary policy
pendulum was pulled far to the go side. The pendulum swung toward stop in
1969-70, toward go in 1972-73, toward stop in 1973-74, toward go in 1977-78,
toward a shaky stop in 1979-82, and toward an uneven go in 1983-85. Our sad
experience has been that once this pendulum starts swinging it is very
difficult and expensive to stop it.
Fiscal policy is extremely important, but it is not a substitute for
monetary policy. Fiscal policy has major effects on the composition of
national output, but little effect on its level. That is what the crowdingout phenomenon is all about.
The combination of budget deficits and tax incentives, with the relative importance of the two uncertain, has been responsible for the major
crowding-out phenomenon of the 1980s -- the current account deficit in the
balance of payments. The strong dollar was the mechanism through which the
crowding out occurred. The stimulus to aggregate demand from the budget
deficit and investment incentives was offset by the "drag" of the trade
deficit. (This Keynesian terminology is unfortunate in its implication that
the trade drag could have been offset to yield stronger growth of real
output. Attempting to eliminate the trade drag would have displaced the
crowding-out to a different sector.)
The dollar has been depreciating for a year now in anticipation of a
lower budget deficit and reduced incentives for business investment. There
is, therefore, no need for monetary policy to anticipate the forthcoming
change in fiscal policy - assuming that it actually occurs - because the
market is already doing so. Indeed, a Keynesian might even argue that the
21
stimulus already in the works from a weaker dollar now requires fiscal
restraint to avoid excessive aggregate demand from a declining current
account deficit.
Our experience with fiscal overkill in 1968 should put us on warning
that inverting the last two digits of the year of fiscal restraint is
unlikely to change the aggregate effect of the restraint. Also from experience, we know that we ought not to use the word "inconceivable" in this
context, but "unlikely" ought be be enough for any policymaker. Fed
officials might find it useful to read the FOMC Memorandum of Discussion for
1967-69 to gain deeper insight into the situation they face today.
A Random Walk Down Velocity Lane
First economists, and later financial analysts and writers, came to
accept the random walk hypothesis of stock price behavior. Most economists
have now come to accept the random walk characterization of the income
velocity of money, but the financial community has hardly even heard of the
idea.
Velocity is a random walk, or at least close enough to being so that we
can explore important conceptual and policy issues within the pure random
walk framework. This idea seems, initially, so foreign to established
monetary doctrines that we need to break some bad thought habits before we
can fully come to grips with the implications of random walk velocity.
L The material in this section relies heavily on William S. Haraf,
"The Recent Behavior of Velocity: Implications for Alternative Monetary
Rules", presented at The Cato Institute Fourth Annual Monetary Conference,
Washington, January 16, 1986. This paper reports statistical evidence
supporting the random walk hypothesis for velocity, and a bibliography of
other work with similar evidence.
22
The income velocity of money is the ratio of the flow of some measure
of nominal national income or aggregate demand to the stock of some monetary
measure. The basic finding of numerous studies is that velocity, no matter
what income and monetary measures are used, is approximately a random walk.
I will concentrate my discussion on the familiar Ml velocity defined as the
ratio of nominal GNP to Ml; a similar analysis applies to velocity concepts
employing alternative measures of income and/or money.
What we mean by random walk velocity is this. Let V^ « Y+fls/L, where Y
is nominal GNP, M is Ml and t indicates the quarter or year. We may then
write,
Vvt-i
-D
+ e
t
The mean, or average, change of velocity each period is D, which is called
the MdriftM of the process. Beyond the drift is the random change et*
Velocity is said to follow a random walk if the random change e t in any
given period is statistically independent of the random changes in all other
periods. That is, e t cannot be predicted from knowledge of prior changes in
velocity.
It is best to begin the analysis by noting that the random walk character of velocity is a statistical feature of the velocity time series. In
and of itself this feature says nothing about causation or monetary theory.
But any theory of velocity must have implications that are consistent with
the observed behavior of velocity, or the theory must be rejected. It is
essential to understand that the random walk character of velocity does not
imply that velocity is "uncaused" or that money and income have no connection to each other.
An analogy with random walk stock price behavior may make this point
clear. Stock price changes are unpredictable, except for a small drift,
from the past history of stock prices. But for a particular stock the price
23
changes are caused, at least in part, by changes in the profitability of the
firm and the value of its assets. If an oil firm operating in the desert is
lucky enough (these days) to strike water instead of oil the value of the
firm will rise. Such an event is unpredictable from the past history of the
firm's stock price. Changes in the stock price are caused but yet statistically random because information about the causal events arrives randomly
over time.
Implications of random walk velocity. The causes of most individual
velocity changes, as with most individual stock price changes, are not
understood. But several conclusions can nevertheless be drawn from the
known random walk character of velocity changes.
The data indicate that once velocity has changed there is no reason to
believe from that fact alone that velocity will change in the opposite
direction in the future. Nor is there any reason to believe that velocity
will continue to change in the same direction in the future. In a random
walk the changes in velocity provide no predictive power with respect to
future changes.
These arguments may seem puzzling. Surely, it is argued, velocity
changes will display negative serial correlation following a major burst of
money growth. Nominal income growth will react to a burst of money growth
with a lag. The initial effect of a burst of money will be to reduce
velocity. In time, however, GNP will respond to money growth and velocity
will return to normal. That is, the initial decline in velocity will be
followed by an increase in velocity as the monetary impulse works its way
through the economy.
This argument is correct, but incomplete. For convenience, call the
above sequence of events a type I sequence. Now consider a type II
24
sequence. Suppose there is a disturbance to aggregate demand that increases
nominal GNP without there being an abnormal increase in money growth. In
this case velocity rises. Suppose also that the disturbance to aggregate
demand is persistent, so that velocity rises several periods in a row. In a
type II sequence, then, an increase in velocity is followed by additional
increases in subsequent periods.
The data indicate that sequence I and sequence II disturbances are
about equally frequent. Thus, when an increase in velocity is observed, the
increase per se provides no predictive information as to whether velocity is
likely to increase further or to decline. With additional information it
may be possible to determine whether a particular velocity disturbance
arises from sequence I or sequence II, but a conclusion cannot be drawn from
the velocity change itself.
These observations have an important bearing on present monetary policy
debates. Unless there has been a change in the random walk process for
velocity — an issue to be taken up shortly — there is no reason to believe
that the decline of velocity in 1985 will be offset by an increase in 1986
or some subsequent year. Nor is there reason to believe that the decline
will be extended into 1986 and subsequent years. In the absence of evidence
that sequence I or sequence II is involved, or that the random walk process
itself has changed, the best guess is that velocity will change each period
according to the historical drift, D.
Has the velocity process changed! There is in fact clear evidence that
the drift in the random walk velocity process has declined in recent years.
Given the change in Fed policy in October 1979, it is convenient to date the
beginning of the new lower velocity drift at the first quarter of 1980, but
the exact date doesn't matter much for this analysis. If velocity had
continued to rise at the drift rate of about three percent per year prevail
25
ing up to 1980, then by the end of 1985 velocity would have been about 20%
above its level at the end of 1979- Again speaking roughly — for that is
all that is necessary — if we take account of the variance of the random
changes e t between late 1979 and late 1985 velocity would have risen by 15
to 25% if we use a range of one standard deviation around 20%, or 10 to 30%
if we use a range of two standard deviations. Over this period velocity
increases in these ranges would have been consistent with the old drift
process, but the actual change of about zero was not.
The change in the velocity process is evident from a casual glance at a
velocity chart. Unfortunately, many have concluded from this experience
that velocity now means nothing. To discuss this contention it is necessary
to go beyond the statistical properties of velocity to discuss monetary
theory.
Causes of velocity changes. Some observers discuss velocity as though
the decline in the velocity drift after 1979 is conclusive evidence that
money and GNP are no longer reliably linked at all. One way to
formalize this view is to think of the random walk in velocity as reflecting
unconnected random walks in GNP and money. Let lower case letters be the
natural logarithms of velocity, GNP, and money. Then,
Log Vt - v t « y t - mr
If money and GNP are unconnected and each follow their own separate and
independent random walks with their own drifts, then we have,
Avt+ • d y - dm+ u.t - w^r
where u and w are, respectively, the random terms in the GNP and money
random walks.
One of the first things to note here is that if the money and GNP
random walks are indeed unconnected, then there is no reason not to have less
26
money growth rather than more. But those who argue that velocity has broken
down always seem to be arguing for more money growth. In their hearts,
apparently, they believe that money does matter for something.
There is ample evidence that money and GNP are intimately connected,
and that they do not follow independent random walks. The relation of
excessive money creation to hyperinflation is well known. But more can be
said within the random walk setting being explored here.
In studying timing relations between money and nominal GNP some
analysts have examined velocity defined as Vt • Y^/M^ where s may be either
larger or smaller than t. In logarithmic terms, we have v^ « y^ - mg. If
the GNP and money random walks were independent the variance of velocity
changes would not depend on whether s equalled t or were larger or smaller.
In fact, with quarterly data the smallest variance occurs for s * t-2. Put
another way, the highest correlation between money and GNP occurs for GNP
against money two quarters earlier. The correlation becomes smaller and
smaller for s = t-3, t-4, t-5, and so forth, and for s « t-1, t, t+1, t+2,
and so forth.
This same relationship holds for money and GNP data for 1980-85. However, because there are relatively few observations in so short a period it
is not possible to push this test very far. Indeed, the limited number of
observations raises even more difficult issues than this one.
If the only data available to test the money-GNP relation were for the
1980-85 period then no economist would want to assert very much. If the two
variables were relabeled X and Z and given to a graduate econometrics class
for analysis I would hope that no student would be willing to make a very
strong statement about the appropriate model to fit to the two series. Put
another way, the only way to say anything sensible about the relation between money and GNP over the past six years is to rely heavily on established
27
historical regularities. Anyone so convinced that monetary relationships
have completely broken down as to be unwilling to reason on the basis of
past regularities is unreachable through the ordinary methods of economic
analysis.
If we do not discard the past, what can, or should we say? If we
retain the basic random walk model of velocity we have enough evidence to
say that the drift has declined. One reasonable approach would be to say
that the velocity process changed in late 1979 and that the best estimate of
the velocity drift is now about zero. Under this view, for example, a
target of about 8% nominal GNP growth implies that monetary policy should
aim for about 8% money growth.
Some would argue that although zero velocity drift might be the best
guess the uncertainty over the drift justifies a Hflexiblew approach toward
setting and achieving the money growth target. That, unfortunately, will
not do. The evidence continues to support the view that the effect of money
on GNP occurs with a lag. We have no choice other than to develop some
policy conviction over the appropriate rate of money growth.
Last year Ml growth ran at about 12%. This rate is well above the rate
that can be justified by any reasonable statistical estimate of Ml velocity
drift, no matter how open one's mind may be to the interpretation of the
evidence. I call it "monetary overkilF.
More, however, can be said. It has been known for a long time that
velocity depends on the cost of holding money. Lower velocity drift after
1979 is fully consistent with lower interest rates. The decline in money
growth after 1979 reduced inflation and interest rates with a lag. Once
that process was fully under way velocity growth declined. Experience since
1979 is qualitatively consistent with established monetary regularities.
28
However, it is important to admit that the quantitative magnitudes were
uncertain ex-ante and are not fully understood ex-post.
It is possible to argue that high money growth in 1985 was justified
by, and helped to produce, lower interest rates. That position can be fit
into the random walk model without difficulty. If velocity is a function of
interest rates, and interest rates fluctuate randomly, as they do to a first
approximation, then velocity changes will be random. Permitting velocity
changes to occur through changes in the money stock rather than through
unwanted changes in GNP is obviously desirable if it can be done reliably.
Advocates of expansionist monetary policy may be quite comfortable with
this argument until they examine its opposite side. Should interest rates
start to rise, money growth will have to fall to offset the expected
increase in velocity. Money growth on this view should fluctuate so as to
augment rather than dampen short-run fluctuations in interest rates. However desirable this policy might seem on the way down, few will support it on
the way up. A policy that cannot be operated symmetrically will produce an
asymmetrical outcome - in this case, a bias toward inflation.
My reading of recent events is that the signs of monetary overkill are
all around us. Not only has money growth itself been high, but also the
extraordinary increase in bond and stock market values is consistent with a
situation of excessive money supply. Because inflationary expectations are
subdued the excessive money growth is bidding up the prices of financial
assets, including foreign currencies, instead of the prices of goods. Goods
prices will come next, although not necessarily immediately.
I will not conclude by saying that it is inevitable that the present
monetary policy will cause a significant increase of inflation. I will say
that it is damn likely to do so.
29
Ml VELOCITY, QUARTERLY
GNP(t)/Ml(t-2)
a —
7
-
I
6 -
5
Std. Dev. Quarterly Changes Percent Annual Rate
V(0) »(-l) V(-2) V(-3)
1950.H6.4
4.9
4.9
5.1
5.6
1950.1-79.4
4.4
4.6
4.8
5.1
1960.1-79.4
4.6
4.6
4.4
5.0
1950.H9.4
5.5
5.6
6.4
6.8
1960.H9.4
3.6
3.8
3.2
3.8
1970.1-79.4
3.7
4.0
4.1
4.1
1980.1-85.4
6.2
5.7
5.7
6.8
GNP
5.0
5.1
4.1
6.4
3.6
4.1
4.8
HI
3.4
2.8
2.6
2.2
2.5
2.0
4.4
-
4 -
3
-
C, —| i n ii n n n i n n n i | i n i i n m i I I i n i r i { i n i n n n u M i n i r j i n m m i i 111 n n i j 11 \\ 11111 n n 11 H I111 n 111111111 n 11 n 1111111111 i n 11 11111 111111
1950
1955
1960
1965
1970
Prepared 16 March 1986
1975
1980
1985
A POSITIVE TREND IN THE FEDERAL BUDGET OUTLOOK
Mickey D. LEVY
Fidelity Bank
According to new official current services estimates, the federal
budget deficit will know recede through FY1991, reversing earlier projections of continually rising spending, persistent huge deficits, and a disturbing rise in the federal debt-to-GNP ratio. The Administration's current
services budget projects deficits to decline to $104 billion in FY1991,
approximately one-half of FY1986 levels. Using different assumptions, the
CBO's baseline projection issued in February 1986 estimates a similar
deficit path. Both projections expect most of the budget savings to occur
through reduced spending. As recently as August 1985, CBO's baseline forecast projected the deficit to rise to $285 billion by FY 1990. What has
changed so dramatically in the current services projections since early
1985? Will the budget imbalance shrink according to these forecasts, or
should we remain skeptical? In addition, the Administration, in its FY1987
Budget^ constrained by the deficit targets of the Balanced Budget amendment
of 1985 (Gramm-Rudman-Hollings, or GRH) proposes aggressive spending cuts
and relies on sustained strong economic performance and declining interest
rates to achieve sharply lower deficits and balanced budget in FY1991 (see
Table 1). Does the Administration's proposed budget provide a realistic
path for achieving the GRH deficit targets?
A turnaround in the current services budget outlook has been generated
by sharp interest rate declines, the budget cuts in the First Concurrent
Resolution on the Fiscal Year 1986 budget, and the GRH sequestering in
FY1986. Certainly, the first steps toward reducing spending, lowering the
deficit, and stabilizing the federal debt-to-GNP ratio have been taken.
31
However, substantial uncertainty surrounds the current services projections.
While the Administration and CBO forecast very similar current services
deficit paths, the CBO assumes budget authority for defense to remain constant in real dollars, but the Administration assumes a 3% annual rise.
Therefore, the Administration's current services non-defense outlays are
significantly lower than the CBO's baseline projections. This dispute
creates a confusing and shaky base for reaching a budget compromise. Also,
the longer-run economic assumptions, especially the Administration's sharply
lower interest rates and sustained strong economic growth, presume everything will go right, and add an extra degree of uncertainty to the long-term
budget projections.
Achieving the ambitious GRH deficit targets set by law seems improbable. Based on the same budget authority for defense, the CBO estimates $14
billion higher defense outlays than the Administration in FY1987, and that
gap widens in later years. To the extent that the Administration has underestimated defense outlays based on its proposed budget authority for
defense, its FY1987 budget proposals to cut non-defense programs and increase some revenues are not sufficient to meet the GRH deficit targets. And
the Congressional budget committees already have rejected the Administration's proposals in principle. The fall-back GRH automatic sequestering
process could become unglued by the sheer magnitude of the cuts needed to
reach the targets and the fact that over half of total federal spending is
excluded from the sequestering process. Yet GRH is law, and given the
widespread recognition of the need to cut deficits, current legislative
efforts should focus on that goal.
32
Cyirrgnj §grviy$$ FprgyastS
On the surface, the similarity of receding deficits in the Administration's
current services budget and the CBO's baseline forecast may provide comfort
that the struggle with high deficits has been won. To the contrary, the
forecasts are based on two different sets of assumptions that generate
different paths of revenues and spending and, perhaps most importantly,
strikingly different paths of defense and non-defense spending. Consequently, these projections actually heighten uncertainty about the budget
outcome, and are a major source of skepticism about the lower deficit projections.
Both the Administration's current services projection assumed 3% annual
real growth in budget authority for defense and the CBO's assumed no change
in real defense budget authority involve lower defense spending paths compared to February 1985 projections (the CBO baseline in February 1985 included 5% annual growth in real defense authority). The Administration's
current services defense spending projection is similar to the CBO August
1985 baseline and the First Concurrent Resolution on the FY1986 budget (S.
Con. Res. 32). The CBO assumes that the intent of that concurrent resolution has been superceded by GRH. The dispute between zero and 3% annual
growth in budget authority generates mounting differences in current services defense outlays.
Also, the Administration's budget projections are based on more optimistic economic assumptions than the CBO uses: the Administration assumes
stronger real GNP growth, particularly its 4% annual growth in 1987 and
1988; inflation that drops from 4.2% in 1987 to 2.1% in 1991 (the CBO's
long-run GNP deflator rises by 4.1% annually); and sharply lower interest
rates. It also projects nominal GNP growth to exceed the CBO's up until
1988, and grow slower thereafter (see Table 2).
33
Table 1
DEFICIT FORECASTS
(in billions of dollars)
1986
1987
Fiscal Year
1988
1989
(2) CBO Baseline
206.6
208.3
181.8
181.3
150.0
164.9
138.9
143.6
120.1
(3) Administration's FY 1987
Budget
202.8
143.6
93.6
67.5
35.8
-1.3<"
(4) CBO Estimate of Administration's Proposal
204.7
159.7
132.3
91.4
66.6
40.1
Projection
(1) Administration Current
Services
Notes:
1990
1991
126.3
103.9
104.3
(1)
(2)
(3)
(4)
Assumes 3% annual growth in real defense outlays
Assumes 0% annual growth in real defense outlays after FY 1986 sequestration
Incorporates FY 1987 Budget proposals, and meets Gramm-Rudman targets
Based on CBO's economic assumptions and technical re-estimates of the
Administration's budget proposal
(5) Surplus of $1.3 billion
Consequently, the Administration's current services forecast involves
considerably faster defense spending growth than the CBO baseline forecast,
but a significantly lower path of net interest outlays, and modestly lower
total outlays (see Table 3). These differences between the two forecasts
are not large in FY1987-FY1988, but they mount - by FY1991, the Administration's defense outlays are $35.4 billion higher than in the CBO's baseline
projection, while its net interest outlays are $31.7 billion less. An
additional concern is the Administration's method of projecting defense
outlays from its budget authority requests. The CBO asserts that based on
historical relationships, the Administration's defense outlays are too low
relative to its projected path for budget authority.
34
Table 2
ECONOMIC PROJECTIONS AND ASSUMPTIONS
Calemdar Years
Actual
1985
1986
1987
1988
1989
1990
1991
Real GNP (% Chg.)
Administration
CBO
2.3
2.3
3.4
3.2
4.0
3.1
4.0
3.3
3.9
3.5
3.6
3.5
3.5
3.2
Nominal GNP (% Chg.)
Administration
CBO
5.8
5.8
7.0
6.9
8.3
7.3
7.9
7.6
7.3
7.8
6.5
7.8
5.7
7.5
GNP deflator (% Chg.)
Administration
CBO
3.3
3.3
3.5
3.6
4.2
4.1
3.7
4.1
3.3
4.1
2.8
4.1
2.1
4.1
CPI (% Chg.)
Administration
CBO
3.5
3.5
3.5
3.4
4.1
4.2
3.7
4.4
3.3
4.4
2.8
4.3
2.1
4.3
Interest Rate, 91-day T-Bill (%)
Administration
CBO
7.5
7.5
7.3
6.8
6.5
6.7
5.6
6.4
4.8
6.1
4.3
5.8
4.0
5.4
Interest Rate, 10-year T-Note (%)
Administration
10.6
CBO
10.6
8.9
9.0
8.5
8.9
7.3
8.2
5.5
7.5
4.8
6.6
4.5
6.1
Sources: Executive Office of the President, Budget of the United States Government,
Fiscal Year 1987, and CBO, The Economic and Budget Outlook: Fiscal Years
1987-1991.
This major disagreement on the current services or baseline path of
outlays is a point of argument about the basis for evaluating policy alternatives. With a disputed starting point for measuring spending cuts, the
basis for achieving a desirable budget outcome is very weak. In fact, the
Senate Budget Committee's recent rejection of the Administration's FY1987
budget reflected the heated dispute over the current services spending paths
as well as a rejection of the Administration's budget proposals.
35
Table 3
COMPARISON OF ADMINISTRATION'^ CURRENT SERVICES AND THE
CBO'S BASELINE BUDGET ESTIMATES
(in billions of dollars)
Calendar Years
1986
Base
1987
1988
1989
1990
1991
Outlays
Administration
CBO
Difference
982
986
-4
1026
1025
1
1077
1086
-9
1128
1135
-7
1179
1188
-9
1224
1248
-24
Defense Outlays
Administration
CBO
Difference
266
269
-3
285
284
1
304
296
8
329
311
18
354
327
27
379
344
35
149
145
4
149
154
-5
143
158
-15
135
159
-24
129
160
-31
592
596
-4
625
635
-10
657
666
-9
690
702
-12
716
744
-28
182
181
1
150
164
-14
139
144
-5
126
120
6
104
104
0
Net Interest Outlays
Administration
142
CBO
139
Difference
3
Other Nondefense Outlays
Administration
575
CBO
578
Difference
-3
Deficit
Administration
206
CBO
208
Difference
-2
Sources:
Executive Office of the President, Budget of the United States Government,
Fiscal Year 1987, and CBO, The Economic and Budget Outlook: Fiscal Years
1987-1991.
Note*
a/
Includes social security benefits, low income support benefits, other nondefense programs, and undistributed offsetting receipts.
36
Nevertheless, FY1986 and FY1987 deficits may be lower than the current
services projections. The FY 1986 deficit is projected to remain near $200
billion, not substantially lower than the $212.3 billion deficit in FY1985.
Recent interest rate declines will reduce net interest costs of servicing
the nation's $1.8 trillion outstanding debt. Approximately $10.6 billion
will be saved from the reduced appropriation's passed in the First Concurrent Resolution on the FY1986 budget, and over $11 billion will be
sequestered under GRH. These positive factors will be offset by a legislated jump in farm price support outlays and a shortfall in tax revenues due
to lower-than-expected nominal GNP growth. Reflecting these factors, the
CBO baseline projection estimates that spending outlays rise 4.2% and 4.0%
in FY1986 and FY1987, significantly slower than the projected 6.5% and 7.4%
growth in nominal GNP. This would allow the ratio of federal spending-toGNP recede from 24.0% in FY1985 to 22.8% in FY1986 and 22.4% in FY1987.
From FY1985 to FY 1987, the ratio of tax revenues-to-GNP would rise modestly
from 18.6% to 18.7%, so the deficit-to-GNP ratio would decline from 5.4% to
approximately 4.8%.
The full impact of the sharp oil price declines, which occurred after
these publications were released, were not incorporated into the projections. Besides stimulating economic growth, the sharp drop in oil prices
will temporarily reduce inflation. It is probable that the Consumer Price
Index (CPI-W) will rise by less than 3% from the third quarter 1985 to the
third quarter 1986, eliminating the automatic COLA for social security and
several transfer payment programs effective January 1987. If this occurs,
budget savings would exceed over $4 billion in FY 1987 and over $7 billion in
FY 1988, unless Congress votes to reinstate the COLA. However, that vote may
be very difficult in the current deficit-cutting environment.
37
The longer-run current services projections allow little room for
error. If something goes wrong, staying within the GRH law may require
additional deficit-cutting legislation. For example, if defense outlays
rise along the Administration's current services path, but net interest and
other non-defense outlays follow the course projected by the CBO, spending
and deficits would remain well above CBO or Administration forecasts, corrective legislation would be required. Accordingly, room for skepticism
remains.
The economic projections underlying the budget forecasts also may be
sources of disappointment in efforts to reduce deficits. The Administration's economic growth forecast is above average. Also, neither forecast
assumes enactment of tax reform. The House tax package (H.R. 3838, the Tax
Reform Act of 1985) would reduce economic growth and depress tax revenues
relative to spending, thwarting efforts to reduce the budget imbalance.'
Also, the Administration's long-run interest rate assumptions — 91-day
Treasury Bill rates drop to 4% and 10-year Treasury notes to 4.5% — seem
wildly optimistic, even in the context of recent rate declines. Everything
has gone right in financial markets lately; a prudent approach to budget
forecasting should not assume perpetual good fortune. In particular, recent
monetary policy has been inconsistent with declining inflation in the longrun; without permanently lower inflation, the Administration's long-run
lower interest rates associated with strong economic growth are seemingly
inconsistent.
1. Interestingly, the Administration and CBO project sustained healthy
economic expansion while assuming full implementation of GRH that would
eliminate cyclically-adjusted deficits. The Administration also assumes
gradually slower money supply growth.
38
Legislative Proposals to Cut the Deficit
Frustration and impatience with the ability of the existing Congressional budget process to deal with the deficit problem led to passage of the
GRH Balanced Budget Amendment. An alternative set of procedures with the
same deficit target could go into effect if the Supreme Court upholds the
District Court view that GRH is unconstitutional. Yet full implementation
of GRH may be a long-shot. The deficit reduction targets seem very severe.
In FY 1985, the primary deficit (the $212.3 billion deficit minus $129.4 net
interest outlays) was $82.9 billion. To meet the GRH deficit targets in
FY 1987, the primary deficit must be eliminated; to meet the GRH targets in
every following fiscal year and achieve a balanced budget in FY1991 will
require that the budget, excluding net interest costs, must be in surplus by
approximately $115 billion. This task will be all-the-more difficult since
over one-half of all outlays are excluded from the GRH sequestering process,
including social security and numerous low income programs. Special rules
apply to several other programs. Achieving the deficit targets through the
automatic GRH sequestering process would dramatically shift the composition
of outlays in a questionable manner. And the automatic across-the-board
cuts would be neither fair nor painless. Another concern is that if the
Administration's budget proposal fails to achieve the ambitious GRH deficit
targets, an ill-conceived tax increase may become part of a political
compromise.
The Administration's FY1987 Budget proposes a budget that based on
assumed sustained, strong economic growth and declining interest rates
achieves the GRH deficit targets. The Administration requests $38.2 billion
cut from current services deficits in FY1987, with $31.9 billion in spending
cuts and $6.3 billion in higher revenues from various fees, excise taxes, and
39
minor tax code changes. It proposes cuts of $2.7 billion from defense, $0.7
billion from low income support benefits, and $24.9 billion from non-defense
outlays other than social security and low income support programs. Proposed cuts in this latter cluster of programs rises to $68.1 billion in
FY1991. The Administration proposes no cuts in social security benefits.
As a consequence of these proposals, defense outlays would rise from 27.1%
of total outlays in FY1986 to 32.6% in FY1991, and social security benefits
(excluding Medicare) would rise from 20.1% to 23.3%. In contrast, proposed
outlays for non-defense outlays other than social security and income
support programs would recede from 37.7% of total proposed spending to 34.4
percent, and net interest costs would fall from 14.6% to 10.3%.
Although the proposed cuts involve structural reform of many nondefense programs, Congress will not approve these cuts, in part because most
of the proposed spending cuts are from non-defense programs. Included in the
Administration's agenda are cuts in Medicare and Medicaid, housing assistance, higher education, agriculture, and other politically sensitive programs. Also, the Administration's requested defense cuts are from a disputed current services base, and the CBO's assessment that the Administration's proposed defense outlays are high with respect to its proposed budget
authority carries substantial weight in Congress. Congress has not developed an agreed-upon set of proposals to stay within the deficit targets of
the GRH law, nor has there arisen any movement to repeal GRH. Thus, the
budget outcome of GRH remains highly uncertain.
The economic impact of achieving the GRH targets would depend on how
the deficits were reduced. Spending cuts in general would have a positive
long-run impact on investment and economic growth. In the short-run, cuts
in non-defense outlays would have a negligible impact on the rate of
economic growth but would change the composition of economic activity —
40
toward investment and away from consumption. Reductions in some federal
programs may be replaced by private sector substitution of activities, or by
state or local provision of the goods and services. In contrast, cuts in
defense outlays and the lower federal provision of defense programs would
lower government purchases. This would reduce the level of economic activity
in the short-run if the cuts in government defense purchases were not offset
by an increase in private sector jobs and economic activity.
The timing of the economic impact of GRH may also be affected by
changes in Federal Reserve policy. Several FOMC members have suggested that
the Fed would alter monetary policy if it perceives that GRH would adversely
affect the economy. In light of the lack of knowledge about the magnitude,
timing or even direction of the short-run economic impact shifts in government spending, it would be a mistake for the Fed to manage the economy
through explicit attempts to alter the "policy mix".
The economic impact of a tax increase — which could become part of a
political compromise to achieve the deficit targets — also would depend on
how taxes are raised. In general, a consumption-oriented tax would be less
damaging to the economy than higher marginal rates on personal income or
higher taxes on capital.
In contrast to the positive impact of sharply lower federal spending, a
tax policy change similar to H.R. 3838 would be very damaging to short- and
long-run investment and economic growth. While the tax proposal was designed as revenue neutral, it would not be economically neutral. The bill
proposes $138.9 billion increase in corporate taxes from 1986 to 1990.
Approximately $97.8 billion, or 70% of the total estimated rise in corporate
tax burdens would accrue from eliminating the Investment Tax Credit.
Individual taxes would be raised as additional $22.5 billion by dropping the
41
ITC. Investment incentives would be severely reduced, even with lower
proposed corporate and individual marginal tax rates. Businesses that are
less capital intensive or have lower debt burdens would benefit from the tax
package; many businesses in service-producing industries such as wholesale
and retail trade would have lower taxes. In contrast, capital intensive
firms would bear the brunt of the proposed tax changes, and the international competitiveness of the traditional manufacturing industries would
suffer an untimely setback. If enacted, H.R. 3838 would slow economic
growth and thereby push the deficit further away from the GRH targets. The
ultimate irony of GRH would arise if enactment of a tax policy change
generated sufficient weakness in the economy to temporarily suspend implementation of the GRH sequestering process (under law, this would occur if
real GNP growth for any two consecutive quarters is less than one percent,
or if either the CBO or OMB forecasts negative growth within six quarters).
Creating a fiscal environment conducive to long-run economic growth
requires that the deficit be reduced substantially, and this should be
accomplished through spending cuts, as the Administration proposes. But to
be successful and fair, all programs, including social security, should be
subject to spending reductions. Efforts to cut spending and deficits should
take priority over tax reform, particularly the types of tax policy changes
being discussed currently. And any tax revenue increase considered as part
of a large deficit-cutting compromise should be consumption-oriented, and
should not create disincentives to invest or involve measures that would
weaken international competitiveness.
42
MULTIPLIER FORECASTS AND THE VELOCITIES OF VARIOUS M'S
Robert H. Rasche
Michigan State University
The past year can only be characterized as great vintage for our
Adjusted Monetary Base - Ml multiplier forecasting models. This is illustrated in Table 1, where the one month ahead ex-ante forecasts for the
period March, 1985 through December, 1985 are presented and compared with
the "actual dataM on the same series prior to the annual revisions that have
just been announced. The sample presented here is chosen to squeeze between
the 1985 and 1986 revisions of the monetary aggregates.
The third column of the table presents the month by month percentage
forecast errors in the multiplier. The mean error over the ten months is
.10 percent and the root-mean squared error is .23 percent. Since these
numbers speak for themselves, I have decided not to dwell on them. Rather I
will try to use the results of our forecasting model to address, at least
indirectly, another issue that has received a lot of attention recently,
namely is the behavior of Ml velocity beyond explanation, particularly
compared with the velocities of broader monetary aggregates?
The Relationship Between Multiplier Forecasts and Velocity Forecasts
In the past deliberations of this Committee we have focused on the
behavior of the monetary base and Ml. In that context, we have recognized
that forecasts of the Ml-monetary base multiplier give an independent check
on the relative behavior of the velocity of the monetary base (usually denoted V0) and the velocity of Ml (denoted VI). This arises since:
1) In B + In V0 - In Y
and
43
2) In Ml + In VI - In Y
so by subtraction and a bit of rearranging we get:
3) In ml - In Ml - In B - In VO - In VI
where ml is the Ml-monetary base multiplier. Thus forecasts of the (log of)
the multiplier give a forecast of the behavior of VI relative to VO.
Our procedure of constructing forecasts for the multiplier from its
component ratios gives additional information which we typically have not
considered, but which may be of interest in the present situation. We can
define the velocity of the M2 (V2) and M3 (V3) broad monetary aggregates by:
4) In M2 + In V2 - In Y
and
5) In M3 + In V3 = In Y
By subtracting equation 1 from equations 4 and 5 we obtain:
6) In m2 - In M2 - In B « In VO - In V2
7) In m3 = In M3 - In B - In VO - In V3,
where m2 and m3 are the adjusted monetary base multipliers for M2 and M3,
respectively. Finally, subtract equation 3 from equation 6 and 7 respectively, to obtain:
8) In m2 - In ml « In VI - In V2
9) In m3 - In ml - In VI - In V3
The conclusion of all this is that the percentage difference between the
monetary base multipliers for the broader aggregates and the monetary base
multiplier for Ml provides a measure of the relative behavior of the
velocities of these aggregates.
It is important to remember that the base multipliers for all of the
monetary aggregates, expressed in terms of their common component ratios,
differ only in the numerator. They all have the same denominator. Thus in
forecasting the components of the Ml multiplier, we are also implicitly
44
forecasting the relative behavior of the velocities of Ml, M2 and M3. This
relative behavior is measured by:
10) In VI - In V2 « ln[l + k(l+tc) + tj) - ln[l + k(l+tc)]
and:
11) In VI - In V3 = ln[l + k(l+tc) + t } + t^ - ln[l + k(l+tc)]
The forecast errors of equations 10 and 11 are tabulated in Tables 2 and 3
for the second half of 1985, These are presented on a not seasonally
adjusted basis, in part because the numbers were conveniently available in
that form, in part because the forecasting models for the components are
specified in not seasonally adjusted form. The forecasts are presented for
one month ahead, two months ahead, three months ahead, and on a three month
moving average basis. The motivation for the three month horizon is to
provide a common frame of reference with other models that are constructed
on quarterly average data. It could be argued that it is no great accomplishment to be able to forecast the relative behavior of the various velocities on a one month horizon if the forecasting errors get very large on a
three month horizon.
One possible interpretation of the results presented in Table 1 is that
by luck we have been able to do a good job of forecasting the behavior of Ml
relative to the monetary base, through offsetting forecast errors of the
component ratios. A skeptic might conclude that since Ml velocity is
behaving in such an atypical manner, all that the forecasts in Table 1 do is
prove the uselessness of the base as a monetary indicator and/or target.
The results in Table 2 and 3 suggest that such a conclusion is inappropriate. In both cases, the mean error in the forecast of the velocity of
either M2 and M3 on a one month ahead basis for the second half of 1985 is
about .4 percent. More importantly, this bias does not become larger as the
45
forecasting horizon increases up to three months. Indeed, the forecast
error for the velocity of Ml relative to the velocity of the broader aggregates on a three month moving average basis is no larger than on a one month
forecast horizon. The percentage root-mean-squared error on a three month
moving average basis is about .4 percent; slightly smaller than the same
statistic for the one month ahead forecasts. It seems appropriate to conclude from this that if we can explain what is happening to the velocity of
one of the monetary aggregates (from the monetary base to M3) during this
period, then we can understand what is going on with all of the aggregates.
Forecasts of the Mi-Adjusted Monetary Base Multiplier for 1986
Our present forecast for the Ml-Adjusted Monetary Base Multiplier on a
seasonally adjusted basis is presented in Table 4. This forecast is based
on the available data through January, and covers the period for February
through July. The data employed include the recently released annual
revision of the monetary aggregates and the newly announced seasonal factors
for both the monetary aggregates and the adjusted monetary base.
The annual revision of the monetary aggregates seems to have produced
very little change in the data on a not seasonally adjusted basis. We do
not yet have the full set of historical data, but the revisions to not
seasonally adjusted Ml for the first half of 1985 are .1 billion dollars.
More substantial revisions were introduced in the second half of 1985, but
we are quite comfortable with splicing the revised data for 1985 to the
unrevised data through the end of 1984 for purposes of this forecasting
exercise. The seasonal factor changes are more substantial, especially for
the adjusted monetary base.
For reference we have included the currently available "actual" value
for the multiplier for January, 1986 compared with the forecast that we made
46
using the unrevised data available early in January, but seasonally adjusted
with the newly published seasonal factors. This forecast was virtually
without error. With the exception of the forecast value for February, the
prediction is that the multiplier will remain basically stable on a seasonally adjusted basis through the middle of the second quarter, and then start
drifting upward again. February seems rather peculiar, in that the forecast
suggests a sharp drop from the January value, and then a rapid jump back to
the January level by April. We have looked at the not seasonally adjusted
component forecasts and compared them with data from past years. There
doesn't seem to be anything in these numbers to account for the February
pattern. We are presently inclined to believe that there may be something
peculiar with the new February seasonal factor for the adjusted monetary
base, but we have not yet confirmed this suspicion (recall that the switch
from lagged to contemporaneous reserve requirements occurred in February,
1984).
47
TABLE 1
SEASONALLY ADJUSTED Ml-ADJUSTED MONETARY BASE
MULTIPLIER FORECASTS
1985 (ONE MONTH AHEAD)
FORECAST FOR:
FORECAST
INITIAL
ACTUAL
PERCENT
ERROR
March
2.581 1
2.5766
-.17
Apr1 I
May
June
2.5891
2.5931
2.5877
2.5908
2.5946
2.5971
.06
.06
.36
July
August:
September
2.6171
2.6305
2.6465
2.6150
2.6423
2.6417
-.08
.45
.18
October
November
December
2.6427
2.6454
2.6559
2.6426
2.6532
2.6518
.00
.30
-. 15
.10
.23
Mean error
Root-Mean-Squared Error
48
TABLE 2
PERCENTAGE FORECAST ERRORS FOR Ln VI - Ln V2 (NSA)
Forecast
Base
Aug.
July
August
September
-.55
Sept.
.53
-1. 16
Forecast for:
NOV.
Oct.
Dec.
-.73
-.05
-.17
.1 1
.01
Octooer
November
December
-.13
Jan.
3Mo. Ave.
-.25
-.46
-.08
-.36
-1.05
-.86
-.31
-.50
-.31
-.56
FORECAST ERROR STATISTICS
1 month
ahead
mean error (7.)
RMSE (7.)
-.39
.56
2 months
ahead
3 months
ahead
-.17
.50
3 month
moving ave.
.34
.39
.58
.45
TABLE 3
PERCENTAGE FORECAST ERRORS FOR Ln VI -• Ln V3 (NSA)
Forecast
Base
July
August
September
Aug.
Sept.
-.60
.20
-.63
Forecast for:
Oct.
Nov.
Dec.
-.48
.37
.07
. 10
-.25
October
November
December
-.34
Jan.
3Mo. Ave.
-.29
-.05
-.29
-.69
-.78
-.21
-1.33
-.66
-.46
-.82
FORECAST ERROR STATISTICS
mean error(7.)
RMSE (7.)
1 month
ahead
2 months
ahead
-.36
.43
-.22
.51
49
3 months
ahead
.60
.79
3 month
moving ave.
-.36
.46
TABLE 4
CURRENT FORECASTS FOR SEASONALLY ADJUSTED
Ml-ADJUSTED MONETARY BASE MULTIPLIER
1986
January
February
March
2.6608 (actual)
2.6355
2.6504
Apri 1
May
June
2.6614
2.6588
2.6694
July
2.6765
50
2.6609 (predicted on
December, 1985 base)
EXTERNAL DEBT AND THE BANKING SYSTEM
Anna J. SCHWARTZ
National Bureau of Economic Research, Inc.
I first report on the recurrence of Mexico's debt repayment problems
and the renewal of fears for the safety of U.S. creditor banks. I then
suggest that resort to the short-term palliatives that have been relied on
to solve the Mexican difficulties do not address the fundamental roadblocks
to debt repayment. Only appropriate redirection of the Mexican economy will
provide a lasting solution, but such a recommendation, even if it is now on
the drawing board of players in the game of rescuing Mexico in order to
safeguard U.S. banks, will not easily be accomplished. I conclude by asking
what regulatory or legislative measures could be taken to uncouple the U.S.
bank solvency aspect from the debt repayment problem.
Mexico's External Debt Problems
Three and a half years after Mexico announced in August 1982 that it
could not pay the interest on its then $82 billion external debt — an
interval during which what were regarded as corrective actions were taken -its ability to pay the interest on its debt that has since grown to $97
billion is again in question.
Mexico's current financial difficulties are reflected in its external
balance of trade in billions of U.S. dollars, shown since 1981:
Exports
Imports
Trade balance
1981
1982
1983
1984
1985
19.9
24.0
-4.1
21.2
14.4
6.8
22.3
8.5
13.8
24.1
11.3
12.8
21.8
14.0
7.8
51
Conventional wisdom related Mexico's problem in 1982 to world recession, disinflation, and high real interest rates. The prescription to solve
the problem hinged on recovery in the industrialized countries to ensure
growth in demand for Mexico's exports, a reduction in interest rates payable
on its loans, improvement in its balance of trade, and continued lending by
international agencies and creditor banks, pending the country's return to
economic health. In the interim, Mexico would have the means to pay contractual interest instead of defaulting and endangering the solvency of the
creditor banks.
The improvement in Mexico's trade balance in 1983 was hailed as proof
of the success of the prescription. Skeptics noted that the improvement was
unsustainable, since it was mainly attributable to a decline in imports
rather than an increase in exports. The cut in imports not only reduced the
country's standard of living, but by limiting inventories of raw materials
and spare parts also curtailed the output of firms producing for export.
Imports have since increased, but the 14% growth in exports between 1982 and
1984 was reversed in 1985. The trade balance in 1985 was only slightly
improved over the 1982 position.
In 1982 the U.S. shouldered the responsibility for fashioning a financial rescue plan for Mexico. It arranged for a program of adjustment for the
Mexican economy, the purchase of $1 billion of Mexican oil, rescheduling of
debt, and lending by the IMF, the World Bank, industrialized country governments, and creditor banks. In 1983 small amounts of sovereign debt due
within the year were rescheduled. In September about $50 billion of
Mexico's outstanding public debt maturing over the following six years was
rescheduled, stretching out the debt repayment period, reducing both the
interest spread and loan fees charged by the banks.
52
This year the earthquakes visited on Mexico in the fall of 1985 and the
decline in world crude oil prices since then are cited as the reasons for
supplementing financial aid to the country and for another round of renegotiating the terms of its multiyear rescheduling agreement. Failure to
respond to Mexico's plight (and that of other LDC oil exporters) on this
view would again raise the specter of insolvency for the creditor banks.
At this juncture no formal rescue plan for Mexico has as yet evolved.
What is new in the current discussion as compared with earlier optimistic
forecasts for the resolution of the debt repayment problem is the focus on
misguided economic policies in Mexico (and other LDC countries) in contributing to difficulties in servicing debt. An issue that is not raised is
whether outstanding debts were invested in income-earning assets that can
provide means of repayment. A large part of the borrowed funds apparently
was applied to consumption use. Moreover, it has been estimated that 50% of
the net amount borrowed by Mexico is accounted for by capital flight. That
part of the net amount borrowed was not therefore squandered but presumably
might be repatriated if conditions in Mexico changed to provide a favorable
investment climate.
The plan announced by Secretary Baker in October 1985 at the IMF-World
Bank annual meeting in Seoul linked continued financial aid to the troubled
debtors to their adoption of macroeconomic and microeconomic policies to
promote growth, reduce inflation, and adjust their balance of payments. The
aid package seems inadequate to induce reform of the debtors' misguided
domestic economic policies. In any event, the strength of their commitment
to change is doubtful. But even if that were not the case, for the Mexican
economy the needed reform is a tall order. Consider the policy changes that
would be required there.
53
The Mexican Government dominates the economy as owner of hundreds of
enterprises — oil, electrical, communications, railroads, banks, hotels,
steel mills, motion picture companies. Subsidies to state-owned mismanaged
companies are said to account for 50% of the Mexican Government budget
deficit, which was 10% of GNP in 1985. Divestment initiatives if they were
seriously pursued are hindered by the Government's role in fixing prices for
many inputs the companies buy as well as output prices. Why would investors
who are denied control over outlays and revenues seek to acquire state-owned
enterprises?
The Government manages the exchange rate system. Foreign exchange can
be bought at a lower rate for preferential imports and exports and a free
rate for other imports. Even at the free rate, import licenses are required
for about one-third of all items. For other items, high tariffs act as
barriers. Although Mexico has begun discussions with GATT about joining
later this year, there is reason for skepticism that that outcome is
assured. Membership will require lowering tariffs and eliminating license
requirements. Moreover, domestic investors are wary of the credibility of
the Government's professions to liberalize trade. Such professions were
also made in the mid-1970s and came to nothing. In addition, unifying
exchange rates at real levels that are not overvalued will be essential.
Long-standing Mexican rules that bar foreign majority ownership of
operations in Mexico inhibit foreign ventures. A history of expropriation
also chills the climate for foreigners. Some change, however, may be in
prospect. After an initial rejection IBM was recently given permission to
build a plant retaining 100% ownership to manufacture personal computers.
Conditions the Government imposed nevertheless might deter others: an
increase in the amount that IBM originally intended to invest, some market-
54
ing restrictions, and obligating IBM to teach microchip design technology to
Mexican companies.
Political opposition to a change in direction from interventionist and
wealth distribution policies to emphasis on market mechanisms that increase
productivity and output should not be minimized. Even if reform were undertaken, only in the long term would greater and improved allocation of
resources result. How soon export earnings over and above what the existing
system provides could be counted on is an unknown. And who can say whether
change will proceed without backsliding. Mexican debt repayment difficulties are likely to persist far longer than is currently envisaged.
What does this assessment portend for U.S. bank that are the largest
lenders to Mexico? It is desirable to search for ways that would lift the
cloud under which they operate from the international debt repayment
problem.
Succor for the Banks
The external debts of the Latin American countries will not be repaid
at face value. In the case of troubled domestic loans, banks arrange to
take some of their loan repayment in the form of equity shares in the
borrowing companies, to reduce interest rates, and to take partial writeoffs that reduce reported profits.
The first best solution for the banks would have been, on the revelation of the problem loans, for them to pay no dividends in order to build up
reserves against losses that would eventually have to be charged against the
profits. In addition, they should have increased their additions to
reserves for bad debts. The rules permit them to deduct from corporate
income tax liabilities additions to loss reserves equal to a proportion of
loans outstanding. Had the banks been farsighted, they would have increased
55
the additions to bad debt reserves even above the amounts eligible under IRS
rules as a tax deduction. Changes also could have been made in IRS rules to
increase the proportion of loans outstanding that could be added to bad debt
reserves. Ultimately, this might not have turned out to be a bailout at
taxpayers' expense. As the debtors resumed payment, bank income would have
become taxable. In any case, the proportion has varied since 1967, so
raising it would not have been out of line with past limits. Had this been
the course the banks and regulators followed, losses from imprudent foreign
lending could have been written off over a period of years from bank profits. Instead they have preferred to preserve book values and have not
advocated market value accounting.
The stock market is not fooled by the banks' phony balance sheets, and
the rates banks pay for CD's also reflect the market's evaluation of the
true condition of the banks.
If market value accounting had been in place, the number of bank
failures recorded in 1985 — more than 100 — and the number of problem
banks — over 1100 — would have been greater. The threat of even more
insolvencies if the true condition of the banks were revealed has deterred
facing up to the general problem and instead focused attention on each
specific insolvency that had to be dealt with.
What is the second-best solution in today's circumstances? Encouraging
writedowns risks impairment of capital when capital requirements exist. One
possibility would be to authorize the FDIC to purchase capital issues of
banks with non-performing loans on the understanding that the investment
would be retired out of some fraction of the net earnings of the banks after
payment of interest or dividends on the capital issues. The investment
would permit the banks to write down loans to market values. Without a
shift from book value to market value accounting, the proposal the Fed has
56
issued for public comment on "adjusted capital-asset ratios" contributes
nothing to remove the threat posed by bad debts to the banks* viability.
It will be objected that an infusion of bank capital by the FDIC is
equivalent to nationalization. My response is that extraordinary action is
justified given the alternative of a wave of bank failures under market
value accounting. In any event, the provision of capital to the banks does
not preclude the continuation of operations under private control of bank
managers.
Currently a move is afoot to reregulate the banks. Strains in the U.S.
banking system manifested themselves when disinflation followed the surge of
high and variable inflation rates. That surge produced a rise in nominal
interest rates that forced a relaxation of Reg Q ceilings and their near
abandonment as well as of other regulations that restricted bank activities.
U.S. bank regulators now seem to associate with deregulation the loans that
were extended when inflation was expected to continue and subsequently
proved to be troubled, including loans for agriculture, energy, real estate,
and LDC countries.
In present circumstances, with their liabilities underwritten by federal insurance, banks are rewarded for aggressive lending policies to obtain
high returns. But imposing new regulations will serve only to encourage
innovators to discover unregulated forms of risk bearing. What is needed is
a redesign of the existing deposit insurance system so that banks will be
confronted with a tradeoff of risk against reduced coverage and increased
insurance fees.
To deal with the problem loans extended in the past, my recommendation
is regulatory and legislative changes, including a program to provide banks
with additions to capital, that would result in the buildup of loss reserves
57
and write down of loans to market values. To deal with the role of risk in
present and future bank portfolios, reform of the deposit insurance system
is urgent.
58
TABLES SUBMITTED BY
H. Erich HEINEMANN
Ladenburg, Thalmann & Company, Inc.
EASY MONEV
Bank Reserves are Growing at a Record Rate
F
0
U
R
Q
U
ft
R
fP
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h
c
K
ft
N
G
E
1965 1967 1969 1971 1973 19'
Note." Vertical lines indicate periods of recession.
Sources: Wharton Econometrics; Heinenann Economic Research
THE DEMAND FOR CREDIT HAS SOARED
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ON
0
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1970
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1974
1976
1978
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1982
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Note: Adjusted for changes in Treasury cash and equity redenption by non
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Table 1 - Fart 2
federal Reserve Action and Monetary Growth
(11)
Date
Adjusted
Reserve
Ratio
(3/10)
Jun 1983
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1984
Feb
Mar
Apr
Hay
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1985
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
(
'ict
Nov
Dec
Jan 1986
Feb P
0.0255
0.0253
0.0252
0.0252
0.0248
0.0247
0.0244
0.0249
0.0251
0.0249
0.0246
0.0247
0.0249
0.0249
0.0250
0.0246
0.0246
0.0246
0.0247
0.0247
0.0249
0.0249
0.0249
0.0249
0.0254
0.0253
0.0255
0.0255
0.0256
0.0258
0.0259
0.0257
0.0258
(12)
(13)
(14)
(IS)
(16)
(17)
(18)
Savings
& Snail
Jut?
Deposit
Ratio
Large
Iue
Deposit
Ratio
Nondeposit
Liabil.
Ratio
Foreign
Deposit
Ratio
Treasury
Deposit
Ratio
Money
Multiplier
(2/4)
(5/4)
(6/4)
(7/4)
(8/4)
(9/4)
(2+4/1)
0.3887
0.3873
0.3864
0.3897
0.3916
0.3937
0.3959
0.3963
0.3963
0.3967
0.3982
0.3973
0.3978
0.4008
0.4020
0.4024
0.4067
0.4041
0.4022
0.4010
0.3984
0.3978
0.3965
0.3^44
0.3907
0.3888
0.3863
0.3830
0.3838
0.3821
0.3791
0.3826
0.3829
1.8725
1.8659
1.8613
1.8715
1.8807
1.8957
1.9066
1.9080
1.9113
1.9155
1.9288
1.9249
1.9221
1.9335
1.9324
1.9312
1.9575
1.9590
1.9683
1.9814
1.9732
1.9739
1.967*
1.950'}
1.9420
1.9351
1.9093
1.8908
1.8903
1.8819
1.8689
1.8874
1.8815
0.6207
0.6081
0.6087
0.6117
0.6036
0.6092
0.6107
0.6085
0.6098
0.6137
0.6220
0.6375
0.6429
0.6584
0.6576
0.6620
0.6813
0.6747
0.6700
0.6611
0.6539
0.6614
0.6669
0.6508
0.6352
0.6209
0.6202
0.6221
0.6241
0.6226
0.6202
0.6450
0.6515
0.4750
0.4623
0.4617
0.4608
0.4516
0.4675
0.4755
0.4668
0.4720
0.4768
0.4736
0.4766
0.4496
0.4466
0.4531
0.4455
0.4414
0.4487
0.4392
0.4299
0.4355
0.4407
0.4195
0.4210
0.4087
0.3996
0.4027
0.3985
0.3936
0.3956
0.3931
0.3915
0.3930
0.0289
0.0294
0.0281
0.0280
0.0276
0.0286
0.0285
0.0284
0.0288
0.0273
0.0267
0.0281
0.0273
0.0277
0.0266
0.0267
0.0267
0.0279
0.0269
0.0274
0.0268
0.0239
0.0235
0.0244
0.0238
0.0235
0.0227
0.0233
0.0230
0.0230
0.0231
0.0240
0.0224
0.0363
0.0596
0.0443
0.0485
0.0b62
0.0200
0.0288
0.0520
0.0588
0.0459
0.0432
0.0330
0.0320
0.0305
0.0268
0.0449
0.0287
0.0264
0.0317
0.0467
0.0392
0.0316
0.0377
0.0505
0.0352
0.0543
0.0310
0.0384
0.0123
0.0176
0.0322
0.0536
0.0549
2.8254
2.8372
2.8447
2.8293
2.8316
2.8264
2.3207
2.8077
2.7996
2.8030
2.8024
2.8031
2.7998
2.7857
2.7801
2.7853
2.7668
2.7753
2.7800
2.7832
2.7910
2.7927
2.79%
2.8083
2.8193
2.8290
2.8409
2.8556
2.8538
2.8576
2.8673
2.8491
2.8456
Currency
Ratio
Source: Federal Reserve Board; Heineiann Econoiic Research
63
Table 1 - Part 3
Feder al Reserve Action and Honetary Growth
This is accounted 1for by changes in the:
Date
Jun 1983
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1984
Feb
Har
Apr
Hay
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1985
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1986
Feb P
Federal
Reserve
Actions
Monetary (Monetary
Growth
Base
(M-l) Growth)
10.3
12.3
9.1
4.5
8.5
5.2
4.2
7.6
6.6
7.3
4.1
7.7
11.3
-1.1
-1.4
-2.5
6.8
5.7
5.5
3.4
2.5
0.5
11.6
-7.0
-0.4
1.1
4.4
0.8
3.1
7.4
7.5
6.8
13.7
10.3
5.7
4.4
7.3
12.9
9.7
14.9
11.1
5.9
7.4
5.1
4.3
15.3
18.5
11.4
18.7
14.1
11.1
13.0
-6.6
12.1
10.8
5.3
12.5
13.2
Adjusted
Reserve
Ratio
11.7
5.1
7.1
4.0
1.2
8.1
8.6
8.2
4.5
6.4
bution
of the
Honey
Multiplier
6.9
12.9
7.2
6.1
10.7
-2.3
-2.6
-6.1
-3.8
1.6
-0.3
0.3
-1.6
-6.2
-2.5
2.4
-7.8
Savings
& Saall
Tiie
Deposit
Ratio
Large
Tiie
Deposit
Ratio
NonDeposit
Liability
Ratio
1.0
2.4
1.5
-0.4
-0.1
0.4
0.3
0.8
.0
-5.5
-2.8
-3.7
-3.7
-0.6
-0.7
-0.5
-1.0
-0.7
-0.1
-0.2
-0.3
-1.1
-0.2
Currency
Ratio
-4.6
-2.6
.0
2.2
4.0
-0.7
-3.0
1.4
-0.7
-2.5
-0.9
-4.7
-1.9
-0.5
-6.3
.0
-0.6
3.7
.0
-0.7
0.1
0.1
-1.5
-0.1
-0.6
-0.8
4.0
2.2
1.5
3.8
0.8
3.1
4.2
5.4
4.5
5.8
6.8
-0.1
-1.1
-0.8
-1.3
-1.5
-1.0
-1.6
2.2
-1.3
1.8
4.5
4.2
3,2
1.9
4.5
0.9
2.1
3.7
6.6
3.3
4.6
5.8
0.2
-1.9
.0
.0
-0.7
-4.6
0.4
-2.1
0.1
3.1
5.3
1.2
5.8
8.7
9.2
7.4
-8.1
-1.6
-1.0
-5.9
-0.4
1984
5.88
1985
12.25
1984
7.36
1985
8.78
1984
-1.48
1985
3.46
1984
-0.20
1985
-1.03
1984
-0.83
1985
3.36
Source: Fedeiral Reserve Board: He inetann Econo•ic Researclh
0.2
0.2
64
0.5
.0
0.4
1.1
0.6
0.5
1.8
1.3
.0
0.6
0.9
Foreign
Deposit
Ratio
Treasury
Deposit
Ratio
-0.1
-0.1
-1.6
0.5
0.6
0.9
.0
0.1
0.5
-0.4
-0.1
-1.1
-0.5
-0.1
3.2
-0.6
-1.5
-0.4
0.3
.0
.0
.0
0.1
.0
-0.2
-0.1
1.9
0.2
0.1
0.6
-0.1
-0.3
-0.7
-0.9
-0.4
-1.0
-0.3
-0.3
.0
0.1
.0
.0
0.1
-0.4
-0.3
-1.1
0.5
0.2
0.1
.0
0.1
.0
.0
0.4
0.3
0.6
0.5
-0.5
-0.1
0.6
0.6
1.3
0.1
.0
.0
0.2
.0
1.1
1.0
1.0
.0
-0.1
-0.1
-0.1
-0.1
0.3
0.3
0.1
0.2
-0.1
-0.5
-0.3
-0.4
-0.3
0.8
0.6
-0.2
.0
.0
0.1
.0
.0
.0
.0
1.0
-0.3
-1.0
0.8
0.2
0.6
0.1
0.1
0.2
-1.1
1.0
0.1
-0.3
-0.9
0.5
0.5
-0.4
-0.8
1.0
-1.3
1.6
-0.5
1.8
0.2
0.1
-0.1
0.4
-1.7
-0.4
-0.1
0.1
-0.4
-1.0
-1.5
-0.1
1984
-0.34
1985
0.57
1984
-0.31
1985
0.28
1984
0.21
1985
0.25
1984
0.01
1985
0.02
1984
-0.02
1985
0.01
Table 1 - Part 3
Federal Reserve Action and Monetary Growth
THREE-MONTH HOVING AVERAGES
This is accounted for by changes in the:
Date
Jun 1983
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1984
Feb
Mar
Apr
Hay
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1985
Feb
Mar
Apr
Hay
Jun
Jul
Aug
Sep
Oct
NOV
Dec
Jan 1986
Feb P
Federal
Reserve
Actions
Honetary (Honetary
Growth
Base
(M-l) Growth)
11.37
13.17
10.54
8.62
7.35
6.06
5.96
5.67
6.13
7.14
5.99
6.36
7.69
5.94
4.89
3.26
1.43
3.96
5.43
10.37
11.31
10.18
9.42
9.54
13.73
15.06
16.20
14.73
12.68
10.61
10.34
8.97
6.75
9.83
9.20
8.06
8.01
8.21
8.83
7.24
9.36
10.28
9.92
6.82
5.82
8.21
8.43
8.33
5.37
4.07
4.41
5.94
8.29
9.30
8.15
6.85
6.83
9.46
10.34
10.94
9.01
8.72
8.00
3.50
9.56
8.46
Contribution
of the
Honey
Hultiplier
2.03
3.97
2.48
0.62
-0.86
-2.76
-1.28
-3.68
-4.15
-2.78
-0.83
0.54
-0.52
-2.48
-3.44
-2.11
-2.64
-0.46
-0.51
2.58
2.51
2.03
2.57
2.71
4.26
4.72
5.25
5.72
3.96
2.61
1.34
-0.59
-1.70
Adjusted
Reserve
Ratio
Currency
Ratio
1.25
2.83
1.65
-0.54
-2.28
-4.02
-3.41
-2.69
-1.45
-0.45
-1.26
-0.79
-0.84
-1.41
-2.51
-2.40
-2.93
-0.89
0.37
3.13
3.24
2.47
2.51
2.24
4.11
4.53
4.82
4.59
2.96
2.46
2.29
0.84
-0.34
1.03
0.52
0.17
0.88
1.49
1.59
2.73
-0.27
-1.39
-1.69
1.19
1.82
0.25
-1.09
-1.07
1.03
1.05
1.22
-0.39
-0.33
-0.91
-0.55
-0.61
-0.21
-1.75
-1.63
-2.11
-0.54
-1.11
-0.91
-1.28
-0.10
0.08
Source: Federal Reserve Board; Heineiann Economic Research
65
Savings
& Stall
Tiie
Deposit
Ratio
-0.37
0.16
0.13
0.02
-0.30
-0.74
-0.75
-0.61
-0.34
-0.19
-0.53
-0.38
-0.23
-0.09
-0.15
-0.19
-0.46
-0.52
-0.73
-0.50
-0.29
-0.11
0.30
0.49
0.70
0.72
0.96
1.18
1.04
0.62
0.50
0.07
0.01
Large
Tiie
Deposit
Ratio
0.54
0.65
0.24
0.20
0.07
-0.04
-0.01
-0.11
-0.01
-0.06
-0.34
-0.62
-0.66
-0.75
-0.42
-0.39
-0.45
-0.33
-0.14
0.42
0.44
0.19
-0.12
0.09
0.59
1.02
0.68
0.29
-0.07
-0.06
0.04
-0.48
-0.66
NonDeposit
Liability
Ratio
-0.41
0.27
0.51
0.32
0.21
-0.16
-0.36
-0.34
-0.10
-0.02
-0.12
-0.07
0.65
0.62
0.55
0.08
0.10
0.08
0.13
0.24
0.27
-0.03
0.22
0.31
0.68
0.44
0.40
0.23
0.14
0.16
0.13
0.05
0.06
Foreign
Deposit
Ratio
.00
-0.03
-0.01
0.02
0.04
-0.01
-0.01
-0.02
.00
0.03
0.04
0.02
0.01
-0.02
0.03
0.01
0.02
-0.03
.00
-0.02
0.02
0.06
0.08
0.05
.00
.00
0.04
0.01
0.01
-0.01
.00
-0.02
0.01
Treasury
Deposit
Ratio
.00
-0.43
-0.22
-0.27
-0.09
0.63
0.53
0.35
-0.85
-0.39
0.20
0.55
0.31
0.26
0.13
-0.25
0.03
0.01
0.26
-0.37
-0.26
0.01
0.19
-0.25
-0.07
-0.37
0.47
-0.04
0.99
0.33
0.16
-0.95
-0.86
Federal Reserve Action and Monetary Growth
(He«o)
Reserve
Growth
Three-ionth
Moving Average
Reserve
Growth Rate
Honth to Month
Jun 1983
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1984
Feb
Har
Apr
Hay
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1965
Feb
Har
Apr
Hay
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 1986
Feb P
9.92
9.56
7.82
2.93
-1.02
-2.24
-5.96
10.69
20.28
19.94
5.27
1.32
7.44
10.63
8.07
0.66
-1.47
1.53
10.17
15.63
17.60
13.96
10.70
8.53
15.77
17.18
17.28
11.73
9.58
11.57
14.23
16.57
13.17
23.09
-0.61
0.97
8.42
-12.45
-2.70
-2.74
37.53
26.06
-3.77
-6.47
14.19
14.58
3.12
6.51
-7.64
-3.27
15.51
18.27
13.10
21.44
7.33
3.33
14.92
29.06
7.56
15.23
12.39
1.11
21.19
20.38
8.14
10.99
1984
9.55
1985
13.92
Source: Federal Reserve Board; Heineaann Ecofioaic Research
66
@FedFRASER