Full text of Policy Statement and Position Papers : March 8, 1976
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SHADOW OPEN MARKET COMMITTEE Policy Statement and Position Papers March 8, 1976 1. Shadow Open Market Committee Policy Statement, March 8, 1976 2. SOMC Members – March 8, 1976 3. Position Papers Monetary Policy, Economic Expansion and Inflation – Karl Brunner, University of Rochester Implications of Possible Monetary Growth Targets – A. James Meigs, Claremont Men’s College Briefing for the Shadow Open Market Committee Meeting – Wilson E. Schmidt, Virginia Polytechnic Institute and State University Comments on Past, Current, and Future Fiscal Policy Developments – Robert H. Rasche, Michigan State University Directive Shadow Open Market Committee March 8, 1976 Economic activity continues to expand at a moderate rate, and the rate of inflation continues to fall. Continued moderate growth and further gradual reduction in the rate of inflation are likely prospects for the near-term if an appropriate monetary policy is adopted and remains in effect. Recent Monetary Policy At its meeting today, the Shadow Open Market Committee reviewed recent developments in the economy and in economic policy and their effects on recovery and future inflation. The Committee noted that fiscal stimulus stayed within the range projected. The growth of the money stock -- currency and demand deposits -has remained below the 5,5% rate of growth that the Committee recommended at its previous meetings as an appropriate course during the recession and the early stages of expansion. During 1975, the annual average growth of money on a quarterly basis was 4.4%. Much of this growth was the result of a very high rate of monetary expansion in the second quarter. During the last quarter of 1975 and in early 1976, the growth rate of money was below, often far below, the growth rate we recommended and the minimum growth rate chosen by the Federal Reserve as a target. Continuation of sluggish monetary growth would reduce the growth rate of output, slow the recovery and increase the costs of slowing inflation. A slower than expected recovery would increase the pressure for greater fiscal and monetary expansion and a return to the policies that brought high inflation. Recent monetary growth has been defended on the ground that there has been a change in established relations between money and economic activity and inflation. Directive - SOMC/2 This is not the first time that policy makers have justified inappropriate actions by arguing that established relations are no longer valid. Generally, conjectures of this kind about a new and different era have proved to be vacuous ~ empty justifications of past developments. The risk of error is much too great to justify recent retardation in monetary growth. The growth of money should be brought close to the range that would have been achieved if our recommendation in September 1975 had been followed. Reducing Long-Term Inflation The long-term problem of inflation remains. Even if a rate of inflation of 5% is attained on the average for this year, we will enter 1977 with inflation that is high by historical standards. The rate of inflation must be reduced further in 1977 and beyond. Inflation in 1977 depends on the policies of 1976 and earlier years. Although the rate of monetary expansion during the second half of 1975 makes the recovery slower than it would otherwise have been and raises the costs of reducing inflation, slow monetary growth also lowers inflation. It would be a mistake, we believe, to dissipate the benefit -- lower inflation — by shifting to a highly expansive policy. That would be a return to "stop and go.11 The Committee recommends that the Federal Reserve maintain a 4.5% growth rate of money from March 1976 onward. This growth rate should start from a base of $300-billion in March 1976 or a first-quarter average of $297.5-billion. Such a rate would mean the money stock would rise to $304-billion by the third quarter of 1976 and $311-bi11ion by the first quarter of 1977. A 4.5% rate is below the rate we recommended in March and September 1975 but above the recent rate of monetary expansion. It essentially extends the annual average rate the Federal Reserve produced for 1975. Directive - SOMC/3 The rate of monetary expansion for the near future that we recommend is above the long-term rate consistent with zero inflation. Further reductions will be required as the economy recovers and uses resources more fully. Instability and Control The Federal Reserve, the Deutsche Bundesbank, and the Swiss National Bank announced target rates of expansion for monetary aggregates in 1975. The Swiss and Germans achieved their targets. For 1976 they have announced new single targets, not shifting bands. The Federal Reserve, on the other hand, has not achieved its announced target. Federal Reserve implementation is so erratic that monetary growth strays far from the announced target. The target, furthermore, shifts. Although the Federal Reserve announces a planned range of monetary growth rates over the coming year, each quarter it proposes to follow the growth path starting from the existing level of the monetary aggregates. The base values from which the growth path is calculated thus shift each quarter. In effect, the Federal Reserve confines its operations to a quarterly target, contrary to the intent of House Concurrent Resolution 133. High variability of monetary growth increases instability and uncertainty about the economy. We find no justification for erratic actions. The Federal Reserve should be able to achieve what other central banks achieve — a growth rate of money consistent with the announced target. The Bundesbank and the Swiss National Bank achieved their targets because their operating procedures are appropriate for controlling monetary aggregates. The Federal Reserve fails to achieve its announced target because its operating procedures are inappropriate. These procedures must be changed so that monetary policy can contribute more to stability than to instability in the future. Policy Directive - SOMC/4 We propose two changes in present procedures: (1) The Federal Reserve should seek to establish a direct link between monetary aggregates and the required size of open market operations, and eliminate reliance on the Federal Funds rate as a guide. (2) The Federal Reserve should reform institutional arrangements of its own devising that hamper its control of the aggregates. Examples of such arrangements are the proliferation of deposit categories subject to different interest rate ceilings, and the system of lagged reserve requirements. Karl Brunner H, Eric Heineman Homer Jones Jerry L, Jordan Thomas Mayer A* James Meigs Allan Meltzer Robert Rasche Wilson Schmidt Anna Schwartz William Wolman University of Rochester Morgan, Stanley & Company St. Louis, Missouri Pittsburgh National Bank University of California Claremont College Carnegie-Mellon University Michigan State University Virginia Polytechnic Institute National Bureau Business Week ECONOMIC OUTLOOK (BILLIONS OP DOLLARS—SEASONALLY ADJUSTED ANNUAL RATES) ACTUAL 75:1 JANUARY 28, 1976 FORECAST 75:2 75:3 75:4 76:1 76:2 8 61641.0 9.0 76:3 76:4 ANNUAL 1972 ANNUAL 1973 ANNUAL 1974 ArtNUAL 1975 ANNUAL 1976 GROSS NATL PRODUCT %CH 1433.6 1460.6 1523.5 1573.2 1606.0 12.2 7.7 19.9 -2.1 1681.0 1721.0 9.9 10.1 1171.1 10.1 1306.3 11.5 1406.9 7.7 1499.0 6.5 1662.2 10.9 f^LCONSTANT DOLLAR GNP %CH 1158.6 1168.1 1201.5 1217.4 |1226.9 5.4 11.9 -9.2 3.3 \ 3.2 1238.5 1253.5 1268.2 4.8 5.0 3.8 1171.1 5.7 1233.4 5.3 1210.7 -1.8 1186.4 -2.0 1246.8 5.1 1.2374 1.2504 1.2721 1.2922 1.3090 7.8 7.1 4.3 6.5 5.3 1.3250 1.3410 1.3570 4.9 4.9 0.9999 4.1 1.0590 5.9 1.1625 9.8 1.2630 8.6 1.3330 5.5 1037.5 1062.5 1087.5 9.7 10.0 7.7 733.0 9.7 808.6 10.3 885.8 9.6 963.1 8.7 1051.5 9.2 PRICE DEFLATOR %CH CONSUMPTION EXPENDITURES %CH 1 - 926.4 8.2 950.2 10.7 977.4 12.0 998.6 1018.5 8.2 9.0 DURABLES %CK 118.9 5.6 123.8 17.5 131.8 28.5 136.1 13.7 138.0 5.7 140.0 5.9 147.0 21.6 152.0 14.3 113.2 14.6 123.0 10.5 121.9 -0.8 127.7 4.7 144.2 13.0 NOMHURABLES %CH 394.1 7.4 404.8 11.3 416.4 12.0 424.8 8.3 434.0 3.9 442.0 7.6 451.0 8.4 462.0 10.1 299.4 7.8 334.4 11.7 375.7 12.4 410.0 9.1 447.2 9.1 SERVICES %CH 413.4 9.6 421.6 8.2 429.2 7.4 437.7 8.2 446.5 8.3 455.5 8.3 464.5 8.1 473.5 3.0 322.4 9.9 351.3 8.9 388.2 10.5 425.5 9.6 460.0 8.1 168.7 -58.5 161.5 -16.0 195.1 113.0 203.2 29.7 219.0 22.4 230.5 239.0 15.6 248.5 16.9 188.2 17.7 220.4 17.1 212.2 -3.7 183.4 -13.6 23*.2 27.7 149.3 -4.7 146.1 -8.3 146.8 1.9 152.7 17.1 155.5 7.5 1GJ.0 12.1 165.0 13.1 169.0 10.1 11G.8 12.3 13G.5 16.8 147.9 8.4 148.7 0.6 1G2.4 9.2 PRODUCERS DUR EQUIP %CH 94.4 -2.5 95.0 2.6 95.6 2.6 99.3 16.4 101.0 7.0 104.0 12.4 107.5 14.2 111.0 13.7 74.3 14.7 87.5 17.8 93.5 6.8 96.1 2.8 105.9 10.2 BUSINESS STRUCTURES %CH 54.9 -3.3 51.1 -24.9 51.2 0.3 53.4 18.3 54.5 8.5 56.0 11.5 57.5 11.2 58.C 3.5 42.5 8.1 49.0 15.1 54.4 11.1 52.7 -3.2 56.5 7.3 RESIDENTIAL STRUCTURES %CH 44.2 -32.1 45.C 7.4 50.4 57.4 55.7 49.2 62.0 53.5 65.5 24.6 70.0 30.4 71.5 8.9 62.0 25.1 66.5 7.2 54.6 -17.9 48.8 -10.5 67.2 37.7 INVENTORY CHANGE -24.8 -29.6 -2.1 -0.2 1.5 5.0 4.0 8.0 9.4 17.5 9.3 -14.2 4.6 17.3 24.2 22.1 22.4 16.0 14.0 14.0 13.0 -3.3 7.4 7.7 21.5 14.3 321.3 8.9 324.7 4.3 3*34.1 12.1 343.8 12.1 352.5 10.5 359.0 7.6 365.5 7.4 372.0 7.3 253.2 8.3 '270.0 6.6 301.1 11.5 331.0 9.9 362.2 9.4 119.4 4.1 119.2 -0.7 124.2 17.9 129.7 18.9 134.0 13.9 136.0 6.1 138.0 6.0 140.0 5.9 102.2 6.1 102.0 -0.1 111.7 9.5 123.1 10.3 137.0 11.3 81.4 82.1 84.0 37.4 90.0 91.0 92.0 93.0 73.5 73.4 77.4 84.0 91.5 33.0 37.1 39.3 42.3 44.0 45.0 46.0 47.0 28.6 28.6 34.3 39.2 45.5 201.9 11.9 205.5 7.3 209.9 8.8 214.1 8.2 218^5 8.5 223.0 3.5 227.5 8.3 232.0 8.1 151.0 9.8 168.0 11.2 189.4 12.8 207.9 9.7 225.2 8.4 INVESTMENT EXPENDITURES %CM NONRES FIXED EXPEND %CH NET EXPORTS GOVT PURCHASES %CH FEDERAL %CH MILITARY OTHER STATE & LOCAL %CH NOTE: PERCENTAGE CHANGES AT ANNUAL RATES; PRELIMINARY" DATA FOR 75.4 (BILLIONS OF D O L L A R I ~ S E A I S N A H Z Y ° A D J U S T E D ANNUAL RATES) ACTUAL FORECAST ANNUAL 1972 ANNUAL 1973 ANNUAL 1974 ANNUAL 1975 ANNUAL 1976 144.0 15.2 89.6 16.3 98.6 10.1 93.6 -5.0 107.9 15.3 136.2 26.3 -11.0 -12.0 -6.6 -18.5 -38.5 -11.5 -11.8 144.0 5.8 150.0 17.7 156.0 17.0 96.2 17.3 117.0 21.7 132.1 12.9 119.4 -9.6 148.0 24.0 55.4 -2.2 56.2 5.8 58.5 17.7 60.8 17.0 41.5 10.2 48.3 16.2 52.6 9.1 46.4 -11.9 57.7 24.5 86.6 -2.2 87.8 5.8 91.5 17.7 95.2 17.0 54.6 23.3 68.8 26.0 79.5 15.6 73.0 -8.2 90.3 23.6 1203.6 1223.8 1261.7 1294.8 1320.0 1345.0 1379.0 1409.0 3.0 6.9 9.0 13.0 10.9 8.0 7.8 10.5 942.6 9.7 1054.3 11.9 1154.7 9.5 1246.0 7.9 1363.2 9.4 198.1 11.3 141.2 21.5 151.2 7.1 171.2 13.2 169.2 -1.2 190.1 12.4 1024.0 1081.7 1087.1 1114.4 1137.5 1158.1 1186.2 1210.9 3.2 24.5 2.0 10.4 8.6 8.5 7.5 10.0 801.3 7.9 903.1 12.7 983.5 8.9 1076.8 9.5 1173.2 8.9 751.9 9.7 830.5 10.4 909.5 9.5 987.2 8.5 1079.0 9.3 75:1 75:2 75:3 75:4 76:1 76:2 7(5:3 76:4 83.4 -12.0 101.6 120.2 119.6 92.0 127.0 27.1 129.0 6.4 133.0 13.0 139.0 19.3 -13.7 -6.6 -9.9 -15.8 -13.0 -11.0 PRETAX PROFITS 21 %CH 97.1 -62.3 108.2 54.2 129.5 105.2 142.8 47.9 142.0 -2.2 TAX LIABILITY %CH 37.5 -66.3 41.6 51.4 50.7 120.6 55.7 45.6 AFTER TAX PROFITS* %CH 59.6 -59.5 66.6 55.9 78.8 96.0 87.1 49.3 PRETAX PROFITS* & IVA ll %CH INV VAL ADJ PAGE 2 (IVA) PERSONAL INCOME %CH TAX & NONTAX PAYMENT %CH 179.6 1.6 DISPOSABLE INCOME %CH 142.1 -60.8 174.6 127.9 180.4 14.0 182.5 4.8 186.9 9.9 192.8 13.4 PERSONAL OUTLAYS %CH 950.4 7.9 974.1 1001.3 1023.1 1045.4 1064.8 1090.2 1115.6 10.4 9.7 7.6 11.6 9.0 9.0 9.9 PERSONAL SAVINGS %CH 73.6 -39.6 107.6 356.8 85.8 -59.6 91.3 28.2 92.1 3.5 93.3 5.4 96.0 11.9 95.3 -2.7 49.4 -13.9 72.6 47.1 74.0 2.0 89.6 21.0 94.2 5.1 7.2 9.9 7.9 8.2 8.1 8.1 8.1 7.9 6.2 8.0 7.5 8.3 8.0 EMPLOYMENT %CH 84.146 84.311 85.283 85.410 86.000 86.500 87.200 88.000 -7.2 0.8 4.7 0.6 3.7 2.8 2.3 3.3 81.671 3.2 84.408 3.4 85.971 1.9 84.787 -1.4 86.925 2.5 LABOR FORCE %CH 91.810 92.514 93.084 93.234 93.700 94.200 94.700 95.200 0.1 3.1 0.6 2.0 2.2 2.1 2.5 2.1 86.508 2.8 88.711 2.5 91.073 2.7 92.661 1.7 94.450 1.9 7.6 5.6 4.9 5.6 8.5 8.0 13.769 13.855 14.088 14.254 14.26cfTtf.318 14.375 14.412 -2.1 4.8 6.9 0.4 1.6 1.0 2.5 1.5 14.338 2.4 14.613 1.9 14.083 -3.6 13.991 -0.7 14.343 2.5 SAVING RATE(%) 8.3 UNEMPLOYMENT RATE(%) PRODUCTIVITY* %CH 8.9 8.4 8.4 \ 7.9 8.2 INDUSTRIAL PRODUCTION 1.116 -28.3 1.104 -4.5 1.142 14.6 1.175 12.1 1.205 5.1 1.230 8.6 1.255 8.4 1.151 7.9 1.254 9.0 1.243 -0.9 1.134 -8.7 1.220 7.6 MONEY SUPPLY %CH 282.6 0.6 287.8 7.6 292.9 7.2 294.7 \ 298.Oh% 303.5 2.4 V 4.6 ) 7 6 ' 308.0 6.1 312.5 6.0 245.6 6.4 263.3 7.2 277.7 5.5 289.5 4.3 305.5 5.5 INCOME VELOCITY OF MONEY %CH 5.072 -2.7 5.074 0.2 5.219 11.8 5.339 9.6 5.389 3.8 5.458 3.8 5.507 3.7 4.768 4.3 4.961 4.0 5.066 5.176 2.2 5.440 5.1 NOTE: PRODUCTIVITY 1.190 5.2 5.407 1.3 IS CALCULATED AS CONSTANT DOLLAR GNP PER WORKER; li http://fraser.stlouisfed.org/ P^FTAX PROFITS M I W S Federal Reserve Bank of St. Louis INVENTORY PROFITS N PROFITS FOR 75:4 ARE ESTIMATES 2.1 ECONOMIC OUTLOOK ACTUAL 75:1 PAGE 3 FORECAST ANNUAL ANNUAL ANNUAL ANNUAL ANNUAL 1972 1973 1974 1975 1976 7 5 : 2 7 5 : 3 7 5 : 4 7 6 : 1 7 6 : 2 7 6 : 376:4 INTEREST RATES S&P COMP. AAA BONDS 8.000 7.263 7.557 8.250 8.630 8.150 7 . 3 2 7 . 5 6 7 . 5 8 6 . 5 0 6 . 7 5 7 . 0 0 7.50 5.25 8.02 10.80 7.86 6.94 6 . 5 6 5.92 6.67 6.12 5.25 5.75 6.50 7.00 4.73 8.15 9.84 6.32 6.13 AUTO SALES 1) 8.3 7.9 9.1 9.1 9.1 9.1 9.9 10.2 10.9 11.5 9.0 8.6 9.6 DOMESTIC 6.6 6.3 7.4 7.8 7.8 7.8 8.4 8.7', 9.3 9.8 7.6 7.0 8.2 I 1.6 1.8 1.4 1.6 1.4 2.361 2.047 1.337 1.173 1.612 PRIME RATE COMftERCIAL PAPER 4 - 6 M T S . IMPORTS HOUSING STARTS 1) 8.610 8.98 1.7 0.995 8.610 1.6 8.670 1.7 8.630 1.3 8.400 1.3 1.3 8.000 1.5 1.5 1.068 1.258 1.372 1.500 1.600 1.650 1.700 IN MILLIONS OP UNITS—SEASONALLY ADJUSTED ANNUAL RATES 8.200 MONETARY POLICY, ECONOMIC EXPANSION AND INFLATION by Kail Biunnci Giaduate School of Management University of Rochester Rochester, NY 14627 Position paper for the Sixth meeting of the Shadow Open Maiket Committee (SOMC) March 8, 1976 I. Introduction The sixth meeting of the Shadow Open Maiket Committee (SOMC) faces policy issues involving important long-run consequences. The economic recovery initiated in the second quarter of 1975 raised real national output in the second half of 1975 by approximately 9% p.a. But the current prospects for the balance of 1976 aie somewhat uncertain at this stage. Monetary growth dropped below the desired giowth path for a lengthy period and possibly weakened somewhat the rate of recoveiy in the next quarters. On the other hand it probably lowers also the inflationaiy pressures built into the system. The appropriate couise of fiscal and monetaiy policy lequires serious examination at this time. The SOMC directed in March 1975 (the fouith meeting) attention to the longer-run consequences of a persistent budget deficit and warned in September 1975 (the fifth meeting) against the dangers inherent in activist financial policies. These problems remain and their effects are reinforced by a widening uncertainty of the rules of the game confronting the private sector. The pattern of policies pursued will crucially determine whether our economy moves eventually towards gradual stagnation of real growth accompanied by comparatively high unemployment rates and peimanent mfiation. Some major trends in our budgetary and general economic policies point in this direction. But fortunately we are not the victims of a deterministic process. The weight of probabilities always leaves a chance and this offers the SOMC an opportunity to raise a small voice and hope. The position paper is organized into five sections. The first section after the introduction examines recent monetary trends and considers the role of various factors shaping monetary evolution. It also describes the relative role of velocity and government expendituies in postwar cyclic patterns and particularly in early recovery phases. The next section discusses monetary policy, with particular attention to the pioblems emanating from the Fed's internal procedures and mode of implementation. Some of the major questions raised and assertions made by Fed officials in recent months are also considered. Section IV evaluates recent monetary trends and submits a proposal foi the direction of monetary policy this year. The last section attends to the piotracted issue posed by financial activism. It outlines reasons for rejecting a policy conception which gradually emerged during the 1960's and still finds strong suppoit among influential groups. n. Monetary Trends It is useful to leview the patterns of monetary evolution obseived in 1975. From February 12, 1975 to February 11, 1976 the money stock grew at 5% and the monetary base (from February 19, 1975 to Februaiy 18, 1976) by 7%. A rising currency ratio and time deposit ratio lowered the monetary multiplier over the 12 months by about 2%. The average growth rate achieved over the year is remarkably close to the proposals formulated by the SOMC in March and September 1975. The SOMC pjoposed at the fourth and fifth meeting a growth rate of 5% to 6% centered on 5.5%. The SOMC proposed however also on both occasions an immediate sharp mciease in the money stock to a specified level in order to compensate the effects of monetary retaidations in previous quarters. The "fiontloading" was almost achieved in the early spring last winter. But its effect was gradually offset to some extent by the subsequent monetary trends. The average growth rate eventually achieved covers wide variations over shorter intervals which reveal a fundamental problem in our policy institutions. The year opened with a declining money stock which continued a receding pattern initiated in November 1974. The Federal Resetve authorities attributed the monetary contraction to a falling credit demand caused by the lecession. The position paper prepaied for the fouith meeting of the SOMC in March 1975 emphasized the crucial role of the Federal Reserve's internal policymaking procedures converting a sagging demand for credit into a monetary deceleration. Monetary contraction or deceleration is not the automatic result of shrinking credit demand. It is produced by a policy proceduie geaied to an interest target policy. The traditional implementation of monetary policy transferred the falling demand for credit into last winter's monetary contraction. A policy procedure genuinely addressed to monetaiy control could have prevented this development which remforced at the time the ongoing recession. TABLE 1 MONEY STOCK BILLIOW 305 AVERAGES OF DAILY FIGURES SEASONALLY ADJUSTED OF DOLLARS C BILLIONS OF DOLLARS 305 1 1 I 1976 - JAN. 14 300 — F £ B - Z\ 28 4 It 1 6 BILLIONS 295.0 294.6 298.5 297.3 297.9 300 /TV 295 295 290 220 285 255 280 2C0 1 1 1 1 1111! 1 15 29 12 20 12 JAW FES MAR 11 1 y 25 / 21 APR WAY LATEST DATA TLOTTED UECK EI^DIt^t 1 1 Mil 4 IB 2 16 JUN JUL 1975 FEHRUARY 1 8 , MM I 1 1 \ 1 111! U> Zl 10 24 0 22 AUG SEP OCT b 18 NOV JLL _LJJ.t 3 U 51 M Z « 11 £2 to X DEC JAN FEB 1976 1976 CURRENT DATA APPEAR I N TtfS BOARD Or COVERNOf^S* H.G RELEASE. V1E MWEY STOCJ< CONSISTS OF DEMAND D£FOS|TS PLUS CURRENCY AND COIN HELD BY Th£ FUTLIC. 4 The contraction was succeeded by a sharp acceleration from the end of January to the middle of March followed by an essentially constant money stock until the end of April. A massive acceleration erupted in May receding rapidly into a low aveiage growth from the end of May 1975 to the end of January 1976. Monetary growth averaged over this period about 2.6% p.a., which is only about half of the Federal Reserve's proclaimed lower boundaiy for the desired growth path. The period of lethargic growth was interrupted by bursts of acceleration and intervals of substantial deceleration. The reader will find additional information describing the patterns of shorter-run acceleration and deceleration in 1975 in the tables 2 and 3. Table 2 describes peaks and trouglis in monetary growth and the growth rate of the monetary base observed last year. The growth rates reported describe changes between successive and non-ovei lapping four week averages. The letardation of April is clearly visible. Monetary growth fell from a peak of 10.3% p.a. in late Maich to slightly less than 1% p.a. by the end of April. The subsequent acceleration m May carried monetary growth to 18.7% p.a. There followed two decelerations separated by one more acceleration. The magnitude of the respective accelerations and decelerations are summarized in table 3. We note that the accelciation in May dominates the other two accelerations observed in 1975. Moreover, the following deceleration of June/July 1975 also dominates the other thiee decelerations listed in table 4. One frequently leads that the monetary authorities possess little, if any control over money stock and monetary growth. The financial press pursues this theme usually offeied by Federal Reserve officials whenever monetary growth drifts substantially away from the anticipated path. This theme is not particularly new. We can observe its regular emergence at opportune moments over many decades. It appears unavoidable that some basic facts of monetary processes must be elaborated and emphasized with patient repetition. The determinants of monetary growth and the relative role of authorities, public and banks were discussed on several occasions in previous position papers. These discussions recognized the specific contribution made by the public's behavior expressed by changes in the currency latio, the time deposit ratio or the bank's behavior revealed by changes in the (adjusted) resetve ratio. It was also shown however that the monetary Table 2: The Magnitude and Timing of Extreme Values in the Growth Rate of Money Stock Mi and Monetary Base in 1975 B % - Change Date % - Change Date 10.3 3/26/75 12.4 3/26/75 .9 4/30/75 -1.6 5/21/75 6/11-18/75 18.5 6/25 and 7/2/75 2.0 8/13/75 -1.9 8/13/75 9.1 9/10/75 10.10 9/10/75 -4.9 10/15/75 1.9 10/22/75 11.2 U/26/75 16.3 12/10/75 -4.3 12/31/75 -10.3 1/21/76 18.7 All changes are computed between successive four week averages. The dates indicate the last week of the forward lying four week period used in the comparison. The date 3/26/75 lefers thus to a comparison between the four week period ending 2/26/75 with the four week period ending 3/26/75. Average lag of extreme growth in base behind extreme growth in Mj: 1.1 week authoiities affect the movements in monetary growth with a substantial margin. The behavior of the authoiities (i.e. Fed and Treasury) is succinctly summarized by changes in the monetary base. Additional information bearing on the association between monetary growth and growth rates of the base can be inferred from last year's observation. The reader is again referred to tables 2 and 3 for this purpose. We note fust that the swings of the two series for Mj and B are closely related both in time and in relative magnitude. The peaks and troughs in monetary giowth lead the giowth rate of the base in the average over 1975 by 1.1 weeks. This lag is well within the interval of four weeks used to average the weekly data. It should be noted here that the last deceleration of the monetary base initiated in December 1975 and carried to January 1976 overstates the relevant deceleiation emanating from the authorities'behavior. The contribution made by the adjusted leseive ratio increased in late January to about 13% or 14% p.a. A portion of this increase should be added to the contribution made by the base. The estimated net result of -19% p.a. is listed in parenthesis below the unadjusted figme for the last observed retaidation. The data presented in the two tables also disclose that countermovements of Mj and B occur only foi a few weeks never exceeding the averaging period used for computations. Acceleiations and decelerations in the monetary base are typically associated with accelerations and decelerations in the base. We can thus safely expect that any pei sis tent acceleration or deceleration of the base will eventually dominate the other deteiminants reflecting the public's or the banks' behavior. The emphasis on the monetary base and the behavior of the monetary authorities does not imply that the public's behavior in the money supply process is iirelevant. This behavior exeited an increasing effect in recent years. Pertinent information elucidating some of the important facts is presented in table 4. The first pait of the table indicates that the cmrency ratio contributed moie persistently and to a iaiger degree to monetary retardation than the time deposit ratio. The range of variation in the contributions to the slioiter-run movements of monetaiy growth obseived in 1975 were essentially similar for both currency ratio k and time deposit ratio t. They both ranged fiom about - 6% p.a. to approximately + 3% p.a. But the currency latio contributed less than half the Table 3: The Comparative Magnitude of Swings in the Money Stock and Monetary Base The decelerations in M^ and the The sequence of accelerations in Mj associated decelerations in B and the associated accelerations in B B B -9.4 19.6 20.1 -16.7 7.1 12.0 •14.0 16.1 18.2 •15.5 number of positive contributions noted for the time deposit ratio and almost one half as many negative contributions below - 3% p.a. We also remark on the lower part of the table that the positive and negative contribution to monetaiy growth emanating from the public's behavior were not evenly distributed ovei the calendai year. All the (20) positive contributions resulting from the time deposit ratio were concentrated among the first 31 weeks of the year. The same front period of the year also contains 7 out of 9 positive contributions made by changes in the cunency ratio. Over the last 21 weeks both contributions were dominantly negative. The movements of short-term interest rates over the year explains to a large extent the variations m the contribution of the time deposit ratio. The behavior of the cunency contribution diverges on the other hand from typical cyclic patterns obsei ved in the past and may reflect a sense of financial uncertainty. A decomposition of the movements exhibited by nominal GNP yields further information on the interaction between monetary growth, changes in velocity and government expenditures. This decomposition is based on the formula GNP = M V + G where V expresses in this case monetary velocity lelative to private expenditure. Table 5 shows the contributions made to changes in GNP between successive six month periods for each postwar recovery phase. The intervals begin with the last six month period showing a decline in GNP or the period with the smallest positive change in nominal GNP. The interval ends with the six month period showing the maximal increase in nominal GNP. The data in table 5 clearly demonstrate the role of velocity over the recovery phase. Changes in velocity contribute with one exception the largest component to the increase in GNP. The exception was the recovery of the early 1970's. But the acceleration of GNP over the recovery phase dominantly reflects without exception the acceleration of velocity. It is particularly noteworthy for our purposes that the velocity increase obseived thus far in the current lecoveiy exceeds all lecovery phases with the exception of the 1950 experience. The acceleration of velocity exceeded in the current experience also all the previous observations with the exception of the early part of 1950. The first six months of 1950 already showed, Table 4: The Relative Fiequency of Negative and Positive Contributions Made by Currency Ratio k and Time Deposit Ratio t to Short-Run Monetaiy Growth Patterns in 1975 The computation period contained 52 weeks. The growth patterns were computed between successive non-overlapping four week averages. The successive computations shift the two four week periods by one week forward in time. Number of contributions made by The currency ratio k The time deposit ratio 9 20 negative: above - 3 % 29 22 at most - 3% 14 10 positive The lange of contributions made by the currency ratio k and the time deposit t ratio in 1975 is for k: - 6% to + 3% fort: -5.5% to+ 3.3% Hie distribution of positive k and t contributions between the fiist 31 weeks and the last 21 weeks Number of positive contributions k the first 31 weeks 7 t 20 the last 21 weeks 2 none 10 Table 5: The Decomposition of the Giowth Rate in Nominal GNP in the Recovery Phase to the Period with Maximal GNP Giowth 1. 2. 3. 4. \\ Periods l'st recovery I/49-IH/49 n/49 - IV/49 ni/49 -1/50 IV/49 - n/50 1/50 - in/50 2'nd recovery HI/53 -1/54 IV/53-11/54 1/54 • IH/54 n/54 - IV/54 ni/54 -1/55 3d lecovery II/60 - IV/60 IH/60 -1/61 IV/60-11/61 1/61 -111/61 11/61-IV/61 4'th recovery HI/69 -1/70 IV/69-11/70 1/70 -111/70 H/70 - IV/70 m/70-I/71 5. 5'th recovery in/74 -1/75 IV/74 - II/75 1/75 -111/75 GNP - .6 Peicentages per annum M V -.4 .5 4.3 5.8 2.4 -1.5 3.1 8.1 12.4 15.5 +1.2 -.2 -1.4 -.8 1.8 .7 1.3 2.5 3.3 3.2 .5 3.2 4.2 6.6 7.7 -3.0 -3.6 -1.9 -.6 .1 2.8 6.6 8.1 9.0 1.3 1.5 2.1 2.3 2.4 •2.8 -.1 3.0 4.1 4.1 1.3 1.4 1.5 1.7 2.5 4.2 5.3 4.9 6.1 9.9 3.3 4.5 4.7 4.7 5.6 -.3 .1 1.2 1.0 1.2 1.7 1.6 2.0 7.8 2.4 4.3 4.5 3.3 11.0 17.4 19.6 -1.8 .9 4.8 9.3 10.9 - .2 13.8 •1 0 -.3 2.7 •2.2 1.9 7.1 1.7 1.6 2.2 Remarks: the peiiod indicated with 1/49 -111/49 refers to the change from quarters I and II of 1949 to quaiters III and IV of 1949. The decomposition is based on the formula GNP = MV + G where V is private spending velocity and G measures government expenditures on goods and services. 11 before the outbreak of the Korean war, an increase in V of 8.1% p.a. over the second half year 1949. The anticipations unleashed with the outbreak of the war accelerated velocity further by a large margin I The increase on V moved from 8.1% p.a. to 15.5% p.a. The further increases in velocity beyond the tliird period of a recovery stayed for all the other iccovery phases between 1.1 and 3.5 percentage points. But a substantial further increase in velocity from the second half of 1975 to the first half of 1976 and into the second half of 1976 depends at least partly on the monetary growth path permitted or puisued by the Fedeial Reserve Authorities. It is not very probable at this stage that a retardation of monetary growth from the second half of 1975 to the first half of 1976 and a lowei contribution of M to the growth of GNP would be offset by a sufficiently large further increase in velocity over the first and second half of the current calendar year. The probabilities weighing the course of velocity associated with the different paths of monetary growth strongly suggest a conservative pattern of monetaiy policy along the lines suggested by the SOMC. This issue will be covered however in more detail in sections IV and V of the position paper. The final paragraph of section II examines several statements made by Chairman Burns at the occasion of recent Congressional Hearings. The statement presented on February 3, 1976 discusses the low level of monetary growth observed since June. The Chairman attributes this observation to a change in "regulation issued by the banking agencies last November." This change "enables partnerships and corporations to open savings accounts at commercial banks in amounts up to $150,000." The Federal Reserve Authorities investigated the effect of this regulatory change and Chairman Burns notes that "by January 7 around §2 billion had already been moved into these new accounts. Since the bulk of these funds probably were held previously as demand deposits, this shift in deposits has undoubtedly accounted for a significant pait of the weakness of Mj in late 1975 and early this year." An examination of the short-run decomposition of monetary growth between successive moving four week periods indicates an increase in the negative contribution made by the time deposit ratio during December 1975. It is noteworthy however that this contribution fell even lower (algebraically) in October and over a somewhat longer interval. Moieover, the contribution resulting from changes in the time deposit ratio aveiaged beyond the comparison period ending with the first week 12 of January at around -1.1% p.a., an amount about one fourth of the average contribution in October 1975 before the regulatory change. We also note that the contribution made by the base, or more appropriately for this period, by the sum of the contributions made by base and adjusted reserve ratio, declined from late November to late January. The regulatoiy change piobably raised the time deposit ratio somewhat and retarded monetary growth tliis winter to some extent. But the order of magnitude involved is small compared to the variations in the contnbiition to monetary growth attributable to the Federal Reserve Authorities. The statement quoted thus directs attention away from the crucial determinant, viz. the behavior of the monetary authorities. Chairman Bums also notes the bulge in monetary growth which occurred in May/June 1975. This bulge is attributed to the Treasury's management of funds. Most of the variations in Treasury balances occur with the Treasury's deposits at the Federal Reserve Banks. Changes in Treasury balances thus immediately affect the monetary base. Chairman Burns essentially argues that large amounts of "tax rebate checks and supplemental social security payments" were disbursed by the Treasury. Such disbursements simultaneously raise deposits at commercial banks and the monetaiy base. The concurrent acceleration of the two magnitudes can be cleaily noted in table 1. The essentially similar order of acceleration for both M j and B also shows that the accelerated injection of base money was rapidly diffused over the system and suggests that the amplifying response occuried with comparatively small lag. Chairman Burns' description how the bulge disappeared is particularly interesting in this context. We lead that "the explosion of the monetary aggregates subsided as individuals disposed of their additional funds," This is a most remarkable statement. It asserts that the money stock declines or decelerates whenever individuals spend money. The bulge disappeared of course as soon as the decline in Treasury balances, not offset by a decline in Federal Reserve Credit was terminated. We should thus clearly recognize that the Federal Reserve Authorities permitted the bulge to occur and were similarly responsible for the subsequent retardation in the second half of 1975. But this aspect of our story should be examined in the next section. 13 III. Monetary Policy; Targets and Procedures Congress expressed early in 1975 an explicit interest in monetary policymaking. The result of this interest was codified in House Concurrent Resolution 133 adopted by Congress in February 1975. The importance of this resolution was discussed in the two previous position papers prepared for March and September 1975. The Federal Reserve Authorities were obliged by the resolution to present a target range of monetary growth for a period of 6 to 12 months into the future. They announced in April a target lange of 5% to 1VI% based on March 1975. The range has been widened m February 1976 to AVi% to lxh% per annum. The target lange lemained thus fixed for almost a year and Chairman Burns saw no reason in late summer 1975 to modify this range. But a growth path is not fixed by its growth rate alone. The growth rate determines the slope, but the position of the growth line still depends on the base chosen. The Federal Reserve Authorities initiated the new procedures imposed by Congress with a base equal to the data for March 1975. The resulting target cone is drawn in graph 2 attached at the end of the paper. The broken line describes the actual path of the money stock since January 1975. By June monetary growth pushed the money stock substantially above the target cone. Monetary growth subsided beyond June and the growth path moves across the target cone and drops after December below the range targeted in April 1975. This range was soon changed however. The base was shifted in early summer to the average of the second quartei placed in graph 3 on the line indicating the montli of May. We note that the monetary path drops in October below the target range and falls beyond Novembei even further below the desired growth pattern. The early February data indicate a minimal shortfall of about $3.5 billion m the money stock. Relative to the early February data the money stock would have to grow fiom February to March by at least $6.5 billion in Older to satisfy the policy targets deemed appropriate by Chaiiman Burns late last summer. But the base was again shifted in the fall. It was moved from the second quarter to the third quaiter. The result is depicted in graph 4. One single month lies now within the desired target range. And the last shift in basis to the fourth quartei 1975 barely impioves matters. All points of the path are far below the policy cone. 14 At the last meeting of the SOMC preliminary data including August and the first week ending in September weie just available. My position paper acknowledged at the time that the monetary path moved beyond June quite appropriately according to the Fed's announced target lange. The money stock was pulled back into the planned range Witli six months more information available we note at this stage that the Federal Reseive Authorities allowed the monetary path to drift across and even to diop below the target range. The relative short fall in monetary growth under the four different selections of a basis made by the Fed and the SOMC's proposals advanced in March 1975 and reaffirmed in the meeting of September 1975 is presented in table 6. Table 5* The Minimal Increase of Mj from February 1976 to March 1976 Required to Move the Path into the Taiget Range m Billions of $ Fed Basis March 2'ndQ 3 4.5 SOMC Basis 3'dQ 5 4'fli Q March (= $290) 3. 5 8.7 The reader should be leminded that the SOMC proposed m March 1975 that the Fed immediately raise Mj to $290 billion in Match and proceed thereafter at a giowth rate of about 5.5% p.a. The frontloadmg policy implicit in the SOMC proposal explains the compaiatively laige shoit-fall of Mj compaied to the Fed's policy programs. The SOMC pioposed moieover in September that the money stock be raised by about $2.5 billion within a month in order to move the monetaiy path into the SOMC's taiget range proposed at the March meetings. 15 The persistent and substantial deviation of monetary evolution from the Fedcial Reserve Authorities'progiams requires some attention. The actual performance is particularly noteworthy when we read Chairman Bums' satisfied evaluation at the Hearings of February 3,1976. "Since last spring, growth rates of the major monetary aggregates . . . have generally been within the langes specified by the Fedcial Reserve." Such satisfaction appears most remaikable. Chairman Bums attempts however to justify the low rate of monetary growth observed since June 1975. The statement piepared for the Hearings before the House Committee on Banking, Currency and Housing (February 3, 1976) attributes to a shifting money demand a major role. Chairman Burns explains that "the relatively slow rate of giowth in money balances during recent months has been watched carefully, and at times with consideiable concern, by the Federal Reseive. . . . we have been inclined to view the recent sluggish rate of expansion in Mj as reflecting the influence of various factors that are leducmg the amount of narrowly defined money needed to finance economic expansion." This theme is elaborated on several occasions in the Chairman's statement. We are informed that ccnumeious financial innovations and regulatory changes have facilitated the process of economizing on the sums held in the foim of demand deposits. These developments have included the spread of oveidraft facilities in banks, incieased use by consumers of geneial purpose credit cards, the growth of NOW accounts . . . the emeigence of money market mutual funds, the development of telephonic transfeis of funds from savings to checking accounts and the growing use of savings deposits to pay utility bills, moitgage payments and other obligations." The regulatory changes opening savings accounts at commercial banks to partnerships and corpoiations is added to this list by Bums. Some of these changes indeed laise the opportunity cost of holding money balances for any given level of yields and wealth, and otheis lower transaction costs. In either case money demand may be loweied by these developments. But others, e.g. the NOW account, do not involve "shifts in money demand" but the proper measuiement of monetary aggregates A plausible description offeis of comse no assurance of relevant explanation. But Chairman Bums lefers also to the econometric work undertaken at the Board. He notes 16 that "since the Iliiid quaitcr of 1974 . . . ((he money demand) equation (used at the Boaid) has pcisistently and increasingly oveipicdicted Ihc amount of money demanded by the public to finance liansactions." The shift in money demand is tints infened from obscivations contradicting the Fedeial Reseive's piefetred hypothesis. Such infeiences are of couise widely used and tlicy wcie alieady applied by Ihc Fed dining (he 1930's in order to justify its position. The conflict between traditional beliefs, expressed by the inherited Federal Reseive theory, and obseivations, was mleipicted to leveal in the 1930's the "breakdown of an oidcily world" 01 "that the wotld had changed." Theie is of course an alternative inteipictation, viz. that the theoiy involved is pooily designed and should be rejected. But we do have a pioblcm heic and the Fcdcial Reserve's conjectme based on its econometiic woik descivcs some attention. It was unfoitunately not possible m the shoit time available since the House Committee Ileaimgs to examine the Fed equation and compaic its peiformance with alternative specifications involving a diffeicnt lag stuictiue, long teim interest lates and possibly even equity yields. I conjectuie that alternative specifications of money demand probably yield no suppoit foi the Chairman's contention It would seem highly mappropiiatc lo justify a low rate of monctaiy giowth, which deviates substantially fiom the planned path still found acceptable late last summer, in terms of the lesiduals obtained fiom an essentially uninteicsted hypothesis. If the Fedeial Reseive Authontics Iiad initiated a systematic examination and comparison of available money demand hypotheses and dominantly found the same pattern we could ccitainly assign moie weight to their conjecture. But we obseive no signs of such studies and Chanman Bums oflcis certainly no information in this lespect. The leadei should also be lcmmded that scvciat ycais ago the Fed told us a leveisc tale. When monetruy giowth spin ted in the spung of 1972 the Fed assured us subsequently that money demand had mcieascd. A study picpaied by Michael Ilambiugei and published in the Journal of Money, Ciedit and Banking (May 1973) found no evidence of the contention made at the time The positive coirelation between assertions of shifting money demand and obscivations of "unanticipated" oi "unplanned" monctaiy giowth is peihaps the most lehable regularity in this context 17 Chairman Burns concludes his evaluation of changes in money demand with the following comments* "However, since we could not be cnthely certain of out views, we have taken steps recently to insuie thai the rate of monctaiy expansion does not slow too much or for too long. During the past thiee months 01 so, open market policies have therefore been somewliat more accommodative in the provision of leseives to the banking system." The time profile of the monetary base shows however the following pattern* The base increased fiom about $119 billion to about $120.5 billion duiing November, moved between $120 billion and $121 billion duiing December, declined to $119.5 billion by the middle of January and surged to $120 billion by February 10. We can find no evidence of a more expansionary policy between the end of November and the middle of January. The monetary base actually declined over this interval and only increased after the middle of January. The obseivable lecord yields thus little suppoit for the Chairman's contention. The Chairman may have been misled on this point by the traditional misconception cultivated among Federal Reseive officials. This misconception follows from the indicative interpietation assigned to the movement of short-teim rates, and most particulaily to movements of the Federal Funds late. This interest rate drifted from the beginning of November until the end of January downwards by about 50 basis points, the commercial paper rate by about 80 and the Treasury bill rate by about 70 basis points. This drift was probably aitiibuted to the Fed's "more accommodative policy." Actually the Fed's "accommodative policy" geared in a traditional procedme to a short-run control over the Federal fluids rate tends to conveit changing market pressmes on shoit-term rates into acceleiatioas oi decelerations of the monetary base The falling market pressures between eaily November and the middle of January were accommodatingly translated into a letardation of the monetary base leflected by a deceleration of the money stock. Chahman Bums also expresses substantial uncertainty about the measuiement of the money stock. Such uncei tain tics do affect our judgment bearing on the desired target path of measmed Mj, oi on the interpietation of the obseived taigct path relative to the planned lange. The Chaiiman conjectmes in particular that bioader aggiegates may be moie appiopriate foi monetaiy analysis and policy making in the future. This 18 may indeed be the case and the SOMC should share the Chahman's concern. But I find it difficult to sympathize with the Chah man's position. The Boaid of Governors of the Federal System has vast lesources at its disposal foi useful lesearch bearing on non-contrived policy problems. There also exist Federal Resetve Banks with reasonably competent research staffs. I see no evidence that the Boaid encourages these staffs to examine an important issue foi policymaking. The clues available to an outsider seem to reflect moie discouragement than cncouiagement m this lespect. The Committee assembled by the Board to examine issues associated with the proper measurement of the money stock may have finished its work. No lepoit is available so far and we cannot judge the quality and the lelevance of the work performed. Once the leport is published the SOMC will have more information to judge the substantive relevance of the measuiement problem. Repeated lefeiences to a measuiement pioblem may be valuable as a political smokescieen They could be a memento of a substantive and possibly impoitant pioblem. But that would be shown by the Boaid's investment of lesouices in a substantial and prolonged examination of measuiement pioblems and the behavioi patterns associated with the diverse monetary aggicgates quoted by Chairman Bums. The variety of aiguments used by Federal Reseive officials to remove attention fiom a paiticulai monetaiy aggiegate spans a consideiable range. We find in Chan man Burns* statement piesented to the House Committee on Banking, Currency and Housing on July 24, 1975 the following passage " . . . the narrowly defined money supply, Mj, can actually be a misleading guide to the degree of monetary ease or lestiiction. For example, in peiiods of declining economic activity both the transaction demand for cash and the private demand foi credit will tend to weaken and thus slow the giowth late of Mj." It is also noted that during economic downswings lower market rates tend to raise the time deposit latio and to retard Mj still fuither. Seveial points should be noted in this context. Falling money and credit demand affect monetary growth essentially via the mteiest mechanism This interest mechanism operates on the time deposit latio and the monetaiy base. The effect on the base is a consequence of the Federal Reserve's interest target policy and would disappear with pioper monetary 19 control. Moieovci, the channel opciating via the tune deposit has been confined for moie than 50 yeais to moderate propoitions compaicd to the joint influence of monetaiy base and the behavior of the cunency tatio. Lastly, even rcpicsenting a highly endogeneous monetary giowtli, still induced accelciations and deceleration of Mj, impose vaiiations in monetary impulses fencing an accommodation of output in the shoiter-iun and pricelevels over the longei-run Such consequences cannot be cxcicised by the simple asciiption of "endogeneity." IV. What Happened and What Should Be Done So what happened leally since Congiess passed HC133 and lequcstcd that the Federal Rescivc Authorities attend moie effectively to co.Uiol monetaiy giowth? Oui monetary authorities lesponded to some extent with the announcement of a planned range of giowtli lates. The stability of this langc was made somewhat luclcvant with the obseived instability of the base used foi computation Foui diffcient base values have been used within one yeai. Tins means that contnuy to the idea expressed by Congiess with IIC133 the Federal P^eseive Autlioiities effectively confine then operation to a quaiteily progtam. This involves a substantial erosion of the longer-iun monetaiy control and stability of monetaiy giowtli addiesscd by HC133 We also noted that the actual path perfoimed pooily lelative to the targeted ian*je. This pciformance was unavoidably accompanied by numeious explanations 01 justifications adducing appiopnatc shifts in money demand, measuiement pioblcms or the inclevance of Mj We cannot leject the possible ldcvance of this contention, but we should rescivc a substantial modicum of doubt about these conjcctuics We should invite the Fedeial Rescivc to foster an extensive lcsearch piogram at the Board (and even some Fedeial Reseive Banks) attending to these questions. We should be icady and willing to be convinced — provided such matenal is piesented in a competitive piofcssional context. But it seems prudent to suspend these doubts and inteipiet the data to show some letaulation of monetaiy giowth conflicting with the planned objective of the Fed and also conflicting of course with the SOMCs pioposals made last Maicli and last Scptcmbei. 20 How do we explain this retardation relative to the planned objective? The basic reason still lies in the internal procediues used to implement policy. This aspect has been discussed many times in numerous contexts since we described the problem for the first time in our joint report on Federal Reserve Policy-Making to the House Committee on Banking, Currency and Housing in 1963/64. The problem results from an execution of policy couched in terms of a short-run target for the Federal funds rate. The account manager adjusts his daily (or houily) operations accoiding to the lelation of the market rate with the targeted band. Whenever the maiket rate tends to drift below the target band open market piuchases are letarded (01 sales increased), and a tendency to drift above the target band induces increased open market purchases. The target band is of course adjusted to changing market conditions. Such adjustments frequently lag behind evolving events however and produce under the circumstances acceleiations (or deceleiations) in the rate at which base money is injected into the system. Moieover the Federal Reserve staff usually prepared profiles of Fedeial funds rates associated with desired or planned paths of the money stock. This procedure was not so much used in recent years as an instrument to implement an explicit interest target policy. It was presented as a device to translate the monetary goals of the FOMC into operational standards for the account manager. The experience since 1970 suggests however that this implementation procedure endangers an adequate control of monetary growth. The attention directed towaids monetary aggregates emerging in the early 1970's never involved a major change in internal proceduies. It was simply integiated with the aid of translation procedures developed by the staff. The problems typically associated with the inherited arrangement thus continued in a possibly muted form. This issue remains particularly important as influential groups inside and outside the Federal Reserve System attempt to move the Federal Reserve to an explicit policy of controlling levels of selected interest rates. There aie some indications wliich suggest that the Fed may shift the weight of attention somewhat further towards interest rates. The recent experience raises again a fundamental issue bearing on the quality of monetary control. Chairman Bums emphasized in his statemend presented on July 24,1975 to the House Committee on Banking, Currency and Housing (he basic "imprecision" 21 of monetary control. Such imperfection certainly exists and will continue to plague us. There remains however the question about the nature of this imperfection and the causes shaping the degree of achievable contiol. The Qiairman properly refers to variations in the public's behavior expressed by cunency and time deposit ratio, the changes in the excess reserve ratio and shifts of deposits between member and non-member banks' deposits. All these aspects contribute to lower the degree of control below perfection. But Chairman Burns* list of problems affecting the degiee of control over monetary growth is incomplete. Institution arrangements in various countries obstruct the achievable degree of monetary control. We should note foi the USA in this context the specification of reserve requirements, the prohibition of interest rates on demand deposits, and most particularly the FOMC's internal procedures governing the making and implementation of policy. It is for this reason that I include below proposals 2 and 3 originally advanced in my position paper prepared for the Septembei meeting of the SOMC. Pioposal 1 tentatively suggests to the SOMC a course of monetary policy to be followed foi the balance of the current calendar year. 1. It is proposed that a portion of the accumulated short-fall of Mj be removed. The money stock should be raised to about $299 or at most $300 for March 1975. This would imply relative to early data for February 1976 an increase of Mj from February to March by about $3 to $4 billion. The average increase of the monetary base required for this purpose is approximately $1.2 to $1.6 billion. Beyond March the Federal Reserve Authorities should hold monetary growth (determinedly) to a path of 5% per annum for at least six months and probably to the end of this year. This proposal combines again a measure of "frontloading" with an avowedly conseivative course followed subsequently. The fiontloading is designed to offset the probably retarding effect of a low monetary growth held over 7 months, and the modest growth rate for the balance of the year should help to retard inflation gradually further. 2. The shifting targets and the wide range admitted by the FOMC directs our attention to the policy making proceduies. The SOMC should emphasize in my judgment the importance of suitable modifications in the Fed's internal procedure. The FOMC should be made responsible for the development of a useful targeting of monetary giowth. 22 This involves in paiticular the development of more leliable and more appiopriately defined measures of the money stock. The Fed has recently enlarged the number of money stock measures to eight. One wonders of course whether this is an attempt at obfuscation to assure a sufficient supply of numbers. The larger the range of possible numbers available for selection, the greater the probability that the Fed will find a number, ex post facto, which fits its political purpose. This reservation associated with the manner in which the numbers appeared should not distract us however from the fact tlaat a serious examination of the measuiement problem is quite urgent. Some elements of current measurements seem barely appropriate and poorly designed to yield the analytically desired measuie. The SOMC should certainly await with great interest the findings of the special committee instituted by the Board of Governors to review the measurement problem. In view of the variety of measures listed by the Chairman of the Board and the sense of uncertainty recently conveyed in this matter by an article in the Wall Stieet Journal, the SOMC should explicitly state that the Fed be advised to assess systematically the relative usefulness of the various measuies for purposes of monetary control and monetary policy. I would also contend that we are not lost in a fog of diffuse uncertainty in this matter. We do possess some information. No evidence has been submitted thus far to the profession that any of the more inclusive measures beyond M2 offer useful information for purposes of monetary control. The best measures still seem to center around M j and M2, and I expect this situation to peisist. This does not mean that I expect the present measures of Mj or M2 to be really adequate for our purposes. I suspect on the contrary definite modifications of these measures once the Fed seriously proceeds to untangle the measurement problem. The targeting of monetary growth forms the basis for the FOMC's determination of the required giowth of the monetary base. This involves additional staff work under the FOMC's responsibility. Hie required growth path of the base should then form the centerpiece of the directive to the account manager. The responsibility for monetary policy is divided in this manner in a specific way between account manager and FOMC. The account manager is responsible for the growth path of the monetary base over a specified interval of time. The discharge of this responsibility can be regularly assessed 23 by the FOMC. The latter, on the other hand, is made lesponsible for the choice of monetaiy growth target and its translation into a taigeting range foi the monetaiy base. The FOMC would also be responsible for the proper development of facilities and piocedures necessary for its assigned task* It appears to me that this division of responsibilities would improve the Fed's policy making procedures. 3. Lastly, the Federal Reserve authorities should be uiged to review the existing arrangements and examine their usefulness for purposes of monetary control. I suspect that numerous institutions, including the present manner of computing required reserves, ceiling rates, etc., lower the controllability of the money stock. The FOMC should immediately initiate a study systematically reviewing the institutional changes under the Board's power which can be expected to impiove monetary control. V. The Protracted Issue The last section of my position paper prepared for the meeting in September 1975 discussed basic and persistent issues with the "Keynesian establishment." Two major alternative strands dominated professional thinking over many years. One view advocates an activist exploitation jf fiscal and monetary instiuments in order to guide effectively and in some detail the global couise of our economy. The other view cautions against such activism and attributes a good part of the problems encountered in past yeais to the longer-run consequences of such activist policies. It argues therefore for a set of stable rules designed to confine economic fluctuations and changes in the price-level to a tolerable margin The alternative views are again Ieflected in the proposals for macro-policies debated since last summer. One group, centered aiound the Brookings Institution, argues the necessity for a highly expansionist fiscal and monetary policy. A large nominal expansion is desired in order to lower the unemployment to an "acceptable" oi its natuial longer-run level. Moreovei, the large gap between potential and actual output (or the actual and the natural late of unemployment) can be expected to moderate inflation even in contexts of a laige nominal expansion. The SOMC on the other hand approached the problem over the past three years in a substantially different 24 manner. It argues and still argues that a moderate and stable monetary giowth and a substantially lower deficit should be the goal of our policies. The differences between the proposals are immediately visible and easily recognizable. It seems useful however to explore the background of these differences. Two fundamental conditions shape the conflicting views. These conditions pertain to the degree of reliable information about economic dynamics and the inteipretation of the government sector's behavior. These basic differences deserve a fuller discussion at another occasion. This holds in particular for the second aspect bearing on government. We note here only that the activist thesis is essentially based on a public interest hypothesis of "government behavior." It is assumed that legislators and bureauciacies will generally be guided in their actions by an obvious public interest. This contrasts sharply with an entrepreneurial hypothesis of the behavior of bureaucracies, legislative bodies and even courts of law. This thesis states that legislators and members of bureaucracies compete in a maiket with programs and proposals designed to optimize their long-run private interest. The alternative hypothesis about the behavioi of political institutions crucially determine the approach to stabilization policy. Adherents of a public inteiest hypothesis are usually inclined towards an activist conception of policy, whereas advocates of the alternative view maintain the importance of stable rules confining an essentially unstable political piocess yielding "stabilization policies" as an essentially haphazard side-product of the competitive political game. The information problem and the inherent uncertainties confronting us aie the second major conditions affecting the differences in policy conception. This aspect may be elaborated in terms of the standard analysis used by the profession and couched in teims of the IS-LM diagiam presented in figure I. The vertical axis measuies the F - line - line 25 rate of interest and the horizontal describes national product. The vertical F-line represents full employment output and the horizontal i - line describes the inherited level of interest rates prevailing in the economy. The LM-line describes the locus of (i, y) values equilibrating money demand with money supply, whereas the IS line summarizes the locus of (i, y) combinations equilibrating the output market. It seems to be argued that we know the position of full employment F and oui cuiient position A We also "know," it appears, that inflation rates fall at any position to the left of F. It follows that the best policy combination relies on fiscal policy to move IS to the right and apply monetary policy to hold interest rates constant until the IS line inteisects the F at the point E. This policy implies of course a monetary expansion of some oidei, but the lesulting level of monetary growth is baiely assigned much further significance in this argument. We should have little doubt that all this could be done, possibly and maybe. But the probabilities of a useful outcome are murky and the probabilities of a lepetition of the increasing cycles of inflation and unemployment too large. The crucial condition of the argument depends on the implicit assumption that we Imow at any time with a sufficient measure of reliability the position of the IS line and its motion over the nearer future (say up to one or two years). Should we possess such knowledge we indeed could deteimine in some detail and reliably the time profile of policy. We would know when to open the faucets and how to regulate the lunoffs and when to start closing some faucets. The IS line moves however with a momentum determined by the system's internal dynamics and this profile is not known with sufficient reliability. It is quite probable that we open the faucets too much and too long. We simply do not know in sufficient detail and with the reliability requiied the dynamic patterns involved. By the tune the expansionist stance is modified the IS line may have a momentum carrying it substantially beyond the desired position. Moreover, the subsequent reversal in policy introduces a new range of instabilities into the system. These un certain ties are real and noncontnved in my judgment. Any particular econometric model will give us of course a definite answer to these questions. But the time piofile and orders of magnitudes of these answers differ quite substantially between model. Moreover, we possess little evidence supporting the cognitive claims of any particular econometric model. It appears thus wiser to admit 26 our lack of detailed information and pursue a stable longer-range couise designed to lowei gradually both the inflation rate and the rate of unemployment. And most importantly, this course (hopefully) adopted by the SOMC will pievent the ticnd towards evci incieasing cycles of rates of inflation and unemployment experiences since 1965. Two additional considerations reinfoice the geneial aigument outlined above. The last section of the position paper prepared for the September meeting questions the validity of the standard measures of the "potential gap" in national output. It is generally acknowledged that external (or real) shocks substantially raised the inflation rate in 1974/75 for a time. But it would appear that these shocks also affect measiues of potential output. One should wonder therefore whethei the usual measiues do not exaggerate the actual "gap" in our resouice utilization. The lelevant occunence of real shock effects on the level of potential output would disrupt over some period the operation of "Qkun's law." It also implies that the unemployment rate would not be a good pioxy of the "gap" appropiiately guiding the magnitude of nominal expansion. The non-vanishing probability of a smaller gap leinforces the uncertainty discussed above. They are supplemented with an additional question concerning the precise position of the veitical full output line Lastly, the uncertainties encumerated in detail by Chairman Bums, beaiing on falling (or lowered) money demand and measurement errors in monetary aggregates offei additional reasons to move conservatively and avoid large variations in the course laid out for monetary policy. These reasons, grounded in our unfortunate uncertainty, determine the proposal submitted to the SOMC and formulated m the previous section. One last aspect of the protracteq^s noteworthy at this time. It was suggested during the debate on the appropriate course of "stabilization policies" last summei that a monetary growth confined to 5% or 6% p.a. would probably abort or at least seriously endangei the recovery. It was argued that a laige monetary expansion, piobably exceeding 10% p.a. would be necessary in oider to support a viable upswing for 1975/76. We should note in retrospect that the unfolding events eventually suppoited the SOMC's position in this respect and suiely lefuted the expansionist statements made last summer. ft" § 8 M 0 N ' ' ' <s 3 # Men'S College Bauer Center, Claremont, California 91711 Telephone (714) 626-8511 Applied Financial Economics Center Memo to the Shadow Open Market Committee, for Meeting of March 8, 1976 From: A. James Meigs Re: Implications of Possible Monetary Growth Targets The attached tables summarize the results of simulations run on a monetary forecasting model at the Applied Financial Economics Center. The main objective of this project was to indicate some of the relative costs and benefits of various monetary policies that might be pursued by the Federal Reserve during the period from fourth quarter 1975 through the fourth quarter 1977. At the September 12, 1975 meeting of the Shadow Open Market Committee, we recommended that the Federal Reserve should maintain the growth rate of M, (demand deposits and currency) at a steady 5.5% annual rate. If this policy had been followed, the average level of M, in the first quarter of 1976 would have been $304.1 billion. Because the third-quarter to fourth-quarter rate was only 2.3%, the money stock would have to grow at an 11.7% annual rate from the fourth quarter of last year to the first quarter of this year to reach the $304.1 billion level. All of the simulations reported in this memo indicate that real GNP will be lower in the first half of this year than it would have been with a higher monetary growth rate in the fourth quarter of last year. Table 1 assumes that the monetary growth rates of 1975 will be repeated in 1976 and 1977. Table 2 assumes that money growth will fall to a 2% annual rate in the first quarter of this year and stay at that rate through 1976 and 1977. Table 3 assumes that money growth will be maintained at a steady 4.5% annual rate through 1976 and 1977. This is the new lower target rate reported by Dr. Burns in his most recent report to the Congress. Table 4 assumes that money growth will be maintained at a steady 5% annual rate through 1976 and 1977. Ciaremont Men's College Memo to the Shadow Open Market Committee for Meeting of March 8, 1976 - A. J. Meigs Implications of Possible Monetary Growth Targets Table 5 assumes that money growth will be maintained at a steady 7% annual rate through 1976 and 1977. All of the simulations assume that real Federal purchases of goods and services will be held roughly constant, in order to focus the analysis on the effects of monetary policies. There was no attempt to adjust fiscal policy to counteract effects of the various monetary policies simulated, although some of these effects probably would induce changes in fiscal policy. The equations in the models were fit over the period from second-quarter 1953 through second quarter 1971 (to avoid distortions introduced by price-wage controls after mid-1971.) Conclusions: 1. If M-. growth does not accelerate from the fourth-quarter '75 rate of 2.3%, or if it declines further, the rate of growth of real GNP would be sharply reduced within this year. This is illustrated in Table 2, which assumes a 2% M-j growth rate for all of '76 and '77. In this model, a 2% M-j growth rate would mean no growth in real GNP from first-quarter '76 through second-quarter '77, unless the monetary deceleration were offset by other forces in the economy. The 2% M-| growth rate would have the benefit of putting substantial downward pressure on the inflation rate, bringing the GNP deflator to a lower level by the end of 1977 than would any of the other monetary policies simulated. 2. It is, of course, highly unlikely that the Federal Reserve would maintain such a low growth rate for M, for more than a brief time, expecially if symptoms of recession were to appear. Table 1 illustrates a policy of repeating the 1975 pattern of monetary growth rates, with a quarter of low growth followed by two quarters of much greater growth and a final quarter of low growth. From fourth quarter to fourth quarter the assumed compound annual rate of growth is 4.4%. Claremont Men's College Memo to the Shadow Open Market Committee for Meeting of March 8, 1976 - A. J. Meigs Implications of Possible Monetary Growth Targets 3. This policy apparently would avert the recession, implied by a steady 2% monetary growth rate, although it would produce wide swings in quarterly growth rates of both nominal GNP and real GNP. It also would continue to push the inflation rate down, to a level of around 4% per year during 1977. 3. The anti-inflationary benefits of the 1975 pattern of monetary growth rates could be produced also by a steady 4.5% annual rate of M-, growth with less variation in quarterly changes in GNP. The fourth-quarter-'77 levels are almost identical under both sets of money-growth assumptions. 4. The higher M^ growth rates simulated--5% and 7%--do increase the growth rates of real GNP. However, they also raise the inflation rate. The 7% M-. growth indicates substantially higher interest rates in 1977 than would result from the lower monetary growth rates. This is partly because money-supply growth rates influence inflation expectations directly in this model. The 7% money-growth rate would be interpreted by lenders and borrowers as a sign that inflation would be rising again in 1978, even though the inflation rate had risen very little in '77. 5. The growth rates for real GNP in all of the simulations are disappointingly low. I don't know why that is so. It may be that the equations underestimate the growth of income velocity, because they were fit over the period mid-'53 to mid-171 and so do not reflect more recent experience. Nevertheless, they do indicate velocity growth of more than 3% per year, which is not low by past standards. The large rise in velocity from second-quarter '75 to fourthquarter "75 occurred over too brief a period to be taken as evidence of a new, higher trend-rate of velocity growth that can be relied on to persist. The slow growth in real GNP may also reflect the slowness of adjustment in the price level. Claremont Men's College Memo to the Shadow Open Market Committee for Meeting of March 8, 1976 - A. J. Meigs 4. Implications of Possible Monetary Growth Targets During 1975, the inflation rate fell to the trend-rate indicated by the deceleration in money growth after mid-'73. Part of the *73-'74 rise in the price level, furthermore, was a one-time upward step produced by the removal of price controls, the devaluation of the dollar, and the increase in energy prices. Reductions in the inflation rate may be slower from here on. 6. Behavior of both velocity and prices may be more favorable to the prospects for growth in real GNP than these simulations indicate. And the recent deceleration in growth of Mp (demand deposits plus time deposits other than large CDs plus currency) may partially compensate for a slowing in growth of M-,. However, I do not think we should view a substantial deceleration in the growth of M, as something that can be safely ignored. From first-quarter '71 to secondquarter '74, M, grew at a 6.9% annual rate. The deceleration to a 2.4% annual rate of M, growth from second-quarter '74 to first-quarter '75 certainly contributed to the severity of the recession, if it was not the primary cause. The very high 8.9% and 7.1%-monetary growth rates of the second and third quarters of '75 surely contributed to the recovery from the recession directly and through inducing a rise in velocity in the fourth quarter. A 7% M1 growth rate clearly is too high to be consistent with continuing reduction in the inflation rate. But I believe that too low a rate of monetary expansion in 1976--2% per year for instance-would raise a serious risk of recession. IMPLICATIONS OF MONETARY GROWTH TARGETS Table 1 Actual 1975 Money Growth Rates 1975 1 Mi (bil $) 283.0 AMi ( arm. rate) % GNP (bil $) -0.3 1434 AGNP ( ann. rate) % Real GNP (bil 72$) AReal GNP ( ann. rate) % GNP Deflator (1972=100) -2.1 1159 -9.2 XI 289.1 8.9 1461 7.7 1168 3.3 i976 III 296.1 7.1 1528 19.9 1201 12.0 IV 295.8 2.3 1572 12.0 1216 4.9 123.7 125.0 127.2 129.3 j 295.6 -o.3 1591 4.9 1216 0.1 n 302.0 8.9 1620 7.8 1224 2.6 1977 I Z I I V 307.2 308.9 7.1 2.3 1658 1690 9.7 7.9 1238 4.6 1247 3.0 i 308.7 -0.3 1713 5.6 1249 0.6 ii 315.4 8.9 1747 8.3 1259 3.3 in 320.8 7.1 iv 322.7 2.3 1790 1825 10.0 8.2 1274 1283 4.9 130.8 132.3 133.8 135.3 136.6 138.0 139.4 140.8 7.8 4.3 7.1 6.8 4.8 4.6 4.7 4.4 4.0 4.0 4-6 mo. Comm. Paper Rate ( ) % 6.56 5.92 6.67 6.12 4.87 4.73 4.87 5.21 5.34 5.28 5.44 5.67 AAA Long-term Corporate Bond Yield ( ) % 8.71 8.87 8.91 8.81 8.38 8.48 8.62 8.54 8.33 8.55 8.76 8.65 ADeflator ( ann. rate) % 4.2 2.8 4.1 IMPLICATIONS OF MONETARY GROWTH TARGETS Table 2 Actual 2% Mi Growth Assumption 1975 1976 1977 I 283.0 Mi (bil $) AMi ( ann. rate) % II 289,1 III 296.1 IV 295.8 I 297.3 II 298.7 in 300.2 IV 301.7 I 303.2 II 304.7 III 306.2 IV 307.8 -0.3 8.9 7.1 2.3 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 1434 GNP (bil $) AGNP ( ann. rate) % Real GNP (bil 72$) -2.1 1159 1461 7.7 1168 1528 19.9 1201 1572 1594 12.0 1216 1614 5.7 1219 1634 5.1 1218 1651 4.8 1218 1670 4.6 1691 4.7 1218 1713 5.0 1218 1737 5.4 1219 5.7 1222 1225 AReal GNP ( ann. rate) % -9.2 3.3 12.0 4.9 0-9 -0.1 -0.2 -0.1 0.1 0.4 0.8 1.1 GNP Deflatfl^ (1972=100) 123.7 125.0 127.2 129.3 130.9 132.3 133.6 134.8 135.9 137.0 138.0 138.9 ( ann. rate) % 7.8 4.3 7.1 6.8 4.9 4.4 4.1 3.7 3.3 3.1 2.9 2.8 4-6 mo. Comm. Paper Rate ( ) 6.56 % 5.92 6.67 6.12 8.71 8.87 8.91 8.81 AAA Long-term Corporate Bond Yield ( ) % 4 -88 8-47 4 -78 8.23 4 -63 8.03 4 -50 7.90 4 -31 7.77 4 -lx 7.65 3 -91 7.52 3 -71 7.37 IMPLICATIONS OF MONETARY GROWTH TARGETS Table 3 Actual Mi (bil $) ( ann. r a t e ) % GNP ( b i l $) AGNP ( a n n . r a t e ) % Real GNP ( b i l 72$) 283.0 -0.3 1434 -2.1 1159 £> 1975 ^ *0 II III IV 289.1 296.1 295.8 8.9 1461 7.7 7.1 1528 19.9 1168 1201 2.3 1572 12.0 x/2% Mi Growth Assumption 4 1976 II 299.1 302.4 4.5 *16OO 7.2 1216\ % 1223 4.5 1629 7.5 1977 III 305.7 4.5 1659 7.7 II III IV IV 309.1 312.5 316.0 319.5 323.0 4.5 1690 7.7 4.5 1722 7.8 4#5 1755 7.9 1230 1238 1247 1255 1264 4-5 4#5 1790 1824 8.0 8.0 1273 1281 AReal GNP ( ann. r a t e ) % -9.2 3.3 12,0 4.9 2.4 2.3 2.6 2.8 2.8 2.8 2.8 2.6 G P DeflatfiM (1972=100) N 123,7 125.0 127.2 129.3 130.9 132.4 133.9 135.3 136.7 138.1 139.5 140.9 ADeflatiSStf ( ann. r a t e ) % 7.8 4.1 4.1 4.3 7.1 6.8 5.0 4.7 4.6 4.4 4.2 4.1 4-6 mo. Comm. Paper Rate ( ) 6.56 % 5.92 6.67 6.12 4.90 4.95 5.06 5.23 5.37 5.48 5.58 5.63 8.71 8.87 8.91 8.81 8.63 8.55 8.51 8.55 8.59 8.62 8.66 8.65 AAA Long-term Corporate Bond Yield ( ) % IMPLICATIONS OF MONETARY GROWTH TARGETS Table 4 Actual 5% Mi Growth Assumption 1975 I 283.0 Mi (bil $) AMi ( ann. rate) % -0.3 1434 GNP (bil $) AGNP ( ann. rate) % -2.1 II III IV 289.1 296.1 295.8 8.9 1461 7.7 7.1 I 299.4 2.3 1572 1600 19.9 12.0 II III 303.1 306.8 5.0 7.4 1528 1977 5.0 1631 7.9 5.0 1664 8.2 IV I II III IV 310.6 314.4 318.3 322.2 326.1 5.0 1697 8.3 5.0 1731 8.3 5.0 1766 8.4 5.0 5.0 1802 1839 8.4 8.4 1168 1201 1216 1224 1232 1241 1251 1262 1271 -9.2 3.3 12.0 4.9 2.7 2.6 3.0 3.3 3.3 3.2 3.1 2.9 (1972=100) 123.7 125.0 127.2 129.3 130.9 132.4 133.9 135.4 135.3 136.8 138.2 139.7 ADeflatiJBtf ( ann. r a t e ) % 7.8 Real GNP (bil 72$) AReal GNP ( ann. rate) % GNP D e f l a t e * 1159 1976 1281 1290 4.3 7.1 6.8 5.1 4.8 4.7 4.5 4.4 4.3 4-6 mo. Comm. Paper Rate ( ) 6.56 % 5.92 6.67 6.12 4.90 4.98 5.13 5.35 5.54 5.71 5.86 5.95 8.71 8.87 8.91 8.81 8 8*79 8.84 AAA Long-term Corporate Bond Yield ( ) % -65 8 -60 4.3 4.3 8.87 IMPLICATIONS OF MONETARY GROWTH TARGETS Table 5 Actual 7% Mi Growth Assumption 1975 1976 1977 I ( ann. rate) % II III IV I III IV 283.0 Mi (bil $) 289.1 296.1 295.8 300.9 306.0 311.2 316.5 321.9 327.4 333.0 338.7 -0.3 8.9 7.1 2.3 7.0 7.0 7.0 7.0 7.0 7.0 7.0 7.0 1434 GNP (bil $) AGNP ( ann. rate) % -2.1 7.7 1528 19.9 1572 12.0 1605 8.7 1644 10.0 in 1686 10.7 iv 1731 11.0 I 1777 11.0 II 1823 10.9 1870 10.7 1916 10.3 1168 1201 1216 1228 1242 1258 1276 1293 1310 1326 -9.2 3.3 12.0 4.9 3.9 4.7 5.4 5.7 5.6 5.3 4.9 4.2 (1972=100) 123.7 125.0 127.2 129.3 131.0 132.6 134.3 135.9 137.6 139.4 141.2 143.0 ( ann. r a t e ) % 7.8 4.3 7.1 6-8 5.2 5.1 5.1 5.1 5.1 5.2 5.3 5.4 4-6 mo. Comm. Paper Rate ( ) 6.56 % 5.92 6.67 6.12 4.92 5.13 5.48 5.96 6.42 6.86 7.25 7.55 8.71 8.87 8.91 8.81 8.78 8.87 8.99 9.20 9.40 9.60 9.79 9.94 Real GNP (bil 72$) AReal GNP ( ann. rate) % G P Deflates N AAA Long-term Corporate Bond Yield ( ) % 1159 1461 II 1340 3/1/70 BRIEFING FOR THE SHADOW OPEN MARKET COMMITTEE MEETING March 8, 1976 by Wilson E. Schmidt* The reform of the international monetary system is now virtually complete• Upon the approval of parliaments* floating will be legalized in the Articles of Agreement of the International Monetary Fund. The United States Government is on the verge of wiping out the concepts and the measurement of the balance of payments surplus and deficit, a move strongly recommended by this committee. The balance of payments will no longer be a problem. This is not to say that the reform is wrapped up. One problem for example is the possible threat that a powerful interest group, the multinational corporations, may press, through no fault of its own, for return to some form of the old international financial system or increased central bank intervention. The formal part of the reform was achieved in two meetings, one at Rambouillet, France where six countries participated and the other in Kingston, Jamaica attended by the Interim Coinmittee of the Board of Governors of the International Monetary Fund. The product of the meeting was a proposed Article IV which, without mentioning floating, legalizes it. Since President Ford was attacked by flies in Rambouillet and the hotel in Kingston was named The Pegasus, this article will surely be called the Horse-Fly Consensus. The key paragraph in the Article says "Under an international monetary system of the kind prevailing on January 1, 1976, exchange arrangements ir«ay ^Professor and Head, Economics Department, Viroinia Polytechnic Institute and State University; Deputy Assistant Secretary, U. S. Treasury, 1970-72. include • . . other exchange arrangements of a member's choice/1 The proposed article does permit the introduction of a widespread system of "stable but adjustable par values.11 But this requires an 85% vote, which gives the United States a veto because we will have about 20% of the votes. In settling on the new article, some important agreements were apparently reached, particularly between the French and the Americans. That the two agreed may itself be important because it may bring some peace to future meetings in international forums, which seems to be what other nations had in mind when they pressed the pair to settle their differences. Billed by the press as a compromise of the French and American positions* it appears to be more a French surrender. There appears to have been agreement at Rambouillet on the economics of stable exchange rates: If countries stabliiize the underlying economic conditions, stable exchange rate? will be the derivative. To this end, more consultations among countries are to be arranged, presumably leading to more coordination of policies. This makes good sense in terms of economics. But there is increasing evidence that we live in a world of the political business cycle. In its narrowest form, this says that politicians in power will increase government spending as their reelection date approaches and reduce it thereafter. If correct, consultation and coordination will fail to produce stable rates unless elections are set around the same date at least among the major powers. The idea of increased consultation may seem superfluous given the frequent consultation amoung central banks that has prevailed for years. But what is new is that the increased consultation will be among ministries of finance. Since information is ammunition in bureaucratic battles, the U, S. Treasury Department will presumably find its position strengthened. Though some may object that this introduces a greater political element into intervention policy, it seems likely, for the present, to portend less U. S. intervention in foreign exchange markets and perhaps that of other central banks as well. There also was agreement at Rambouillet that central bank intervention shall only be to avoid disorderly market conditions or erratic fluctuations in exchange rates. Each country will be its own judge whether such conditions prevail. Central banks are not supposed to resist fundamental factors, This has been U. S* policy — whatever it means. Unfortunately, these elusive terms remain undefined. But it is a relief to know that Rambouillet did not include a consensus on target or zone rates for exchange rates as originally planned in June Ib74. The recent experience with tho Italian lira shows how miserably intervention can fail. And it is important that the Fed and Treasury are apparently agreed that interest rate differentials among countries are considered fundamental factors so that intervention to offset exchange rate movements induced by them is presumably precluded. All this raises doubts about the view, as expressed in some press stories, that Rambouillet would lead to more central bank intervention. Unfortunately, the legalization of floating cost us something which of course is not surprising since it is the result of carefully balanced international agreement. Twenty-five million ounces of gold in the International Monetary Fund will be sold over a period of four years by the Fund with the profits transferred to the less developed countries. Our share of that gold, had it been returned to the members in proportion to their quotas (as will be the case for another 25 million ounces) so we could sell it at home or abroad would be 5,4 million ounces which at present prices would be worth about $700 million. The sale of gold is part of the U. S. effort to get gold out of the system. Under the agreement the Fund cannot buy gold without an 85% vote. And the Fund won't knowingly sell gold to central banks. Central banks agreed not to peg the price of gold. Whether central banks will buy gold in the private market remains to be seen. The world may also have paid a price in terms of future inflation. The agreement will expand the quotas of the members in the IMF by about $11.7 billion* a sum equal to more than 5% of present reserves. While this impact awaits ratification* the Fund has announced its willingness to increase its lending by AS% on the seme criteria it has used in the past until the increase in quo .as is idtified* While there is no mechanical relationship between quotas, lending policies, and reserves, it is obvious which direction the world price level moves as a result of this. The agreement calls for the continued study of a substitution account. Whether it is for gold or for dollars or both is not yet clear. If it is a device by which central banks can exchange their gold for SDRs at the Tund* it is essential that the Fund be ordered to sell the gold so that it may be used for private purposes rather than be locked up in the Fund's vaults. If it is a device by which central banks can exchange their dollars for SDRs at the Fund, then American agreement to the scheme would be unpatriotic; after all, we gain seigniorage by virtue of printing the money the world uses. Until recently, it has been quite clear that the business community of the United States was quite content with the floating rate system now beinq ratified* For example, in a recent poll, the National Association of Business Economists found that 83£ of its responding membership preferred floating to fixing. But in December a group of accountants, the Financial Accounting Standards Board, decided upon a rule which could induce multinational corporations to oppose floating. It decided that exchange rate gains and losses, whether realized or not, should be reported in currentprofits or losses. (Heretofore, there was no hard and fast rule.) Specifically* virtually all liabilities of a foreign affiliate of a parent American corporation should be reported at the current exchange rate for the dollar when the parent consolidates its return. Likewise, all assets should be reported at current retes of exchange except fixed assets (for which the historic rate will be used) and inventories (Tor vJiich a historic rale or current rate will he used), mis tppj^s to insure that when ti.e dollar depreciates on the foreign exch-ngj ruirket the multinationals as a group will show losses that are unrealised beeouse liabilities subject to the depreciated dollar rate will exceed assets subject to the some conversion rate. The problem this creates is obvious. If one assumes that the officials of multinationals are risk-averse, they will become discontented with fluctuations in the exchange rate. That is, while they might like the paper profits that an exchange rate appreciation brings, they will dislike even more the paper losses acconpanying depreciation. As a consequence they may press for more stability (fixing) cf rates. There is growing evidence of this (Business Week, January 26, 1976). Of course fixinq would not be in their long run interest; it was the fixing of exchange rates which led to the U. S. government controls on private foreign investment in the 1960*5. Fortunately* this need not be a problem unless the multinationals want to make it a problem* There is considerable evidence that changes in accounting techniques, such as a switch from U F O to FIFO, which do not change underlying economic facts have little or no impact on stock prices. [A summary of the literature appears in Thomas R Dyckman, tt« a1>,EfPicicnt Capita1 Harkets and Accpuntino, (Englewood Cliffs: Prentice Ha11 * 1975). Apparently the market figures out what is real and what is unreal. If the multinationals come to understand this, 1hey won't press for more exchange rate stability which in the end will load to their control by the Federal Government• Comments on Past, Current, and Future Fiscal Policy Developments Robert H. Rasche Michigan State University February 26, 1976 In the various summaries which I have prepared for past meetings of this Committee, I have attempted on several occasions to summarize what has happened with respect to fiscal policy and the implications of these developments for monetary policy* I must admit that I have not yet settled on a presentation with which I am totally satisfied, and so I have tried yet another format. Tablel, with information on 1971-1975.3, represents an initial step towards a hopefully comprehensive summary statement. The first five columns on Table 1 present information from the National Income and Products Accounts budget for the Federal Sector. These figures are on a seasonally adjusted basis, but, at the risk of confusing everyone, I have stated them at quarterly rates to make them comparable with the flow figures on the right hand side of the table. The story here is very much a continuation of the post-Vietnam period. In terms of its demand on the productive resources of the economy, the Federal Government has shown virtually no growth over the past five years. This can be seen from the con- stant (58) dollar figures on government purchases of goods and services in column 2. Second, transfer payments continue to grow at an extremely rapid rate. Prior to mid 1974 this was primarily because of inflation; in the past year it has been a combination of continuing inflation and high levels of unemployment. Finally, 0/ fi u >1* 2 aJ Of 3 In i fto 0 v M 1 ho O o ^ •* - DO r O V r4 % ri 0 £i •? ? I - 1 xr to «« o ^ <cr to I o rh t 4 S q p o V T o DO oo t 3 DO q o o T *' i ^ H * Vn V sr >o \n ^i 1 f o o o r-* ft no v 22 x in *i Sr V O 03 o T Q o i •O Oo o rt- o * § ^ 73 S A 1 3 na ^ ri 1 — i? N 3 cr i OO i V rt- ^D ^-i l ^ t DO ^ •O C$ N tf~ if f* «•-* — cr" i bo CM OO £>6 i rJ — o to 5 * s cO <3r o 3 ri O S 8 V> ?! rf a 55 1 £ T i 52 fH «i I I ^ Co tn o S ft- ^ po ^ 2 v9 T 5 £ i r*~ o In \ r — <r r- or r r T O 7 cr f ,3 So 3 T cr^0 ^ T*~ C» 5o ^ O «n r** o ^ i^ ^a >*S> ^ ^"i1 ^9 ^"* o o '" •' • 7 T V o 3 iS • 5 to crj -3- B CO O cr w 'i vi i j1 O o ^ Vi IS to 73. TABLE 1.—Assumed Values for Effective Reserve Requirement Ratios. Years Reserve Requirements 1891-1923 .08 1924-1933 .09 1934-1935 .10 1936 .15 1937 .20 1938-1940 .175 1941 .20 1942 .175 1943-1947 .15 1948 .175 1949-1950 .14 1951-1952 .16 1953 .15 1954-1957 .14 1958-1970 .13 Sources: col 1-5: National Income and Product Accounts, Survey of Current Business, Tables col 6-8: Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p A32 col 9: Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p A32: US Budget Surplus or Deficit Plus Other Means of Financing, Net (Net Outlays of Off Budget Federal Agencies, Plus Accrued Interest Payable, Plus Seigniorage. col 10-11: Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p A32:Selected Balances (End of Quarter Beginning of Quarter) col 12: Federal Fiscal Operations: Summary, Federal Reserve Bulletin, p A32 Selected Balances - Other Depositories (End of Quarter-Beginning of Quarter) + Other Cash and Monetary Assets col 13: Consolidated Condition Statement of all Federal Reserve Banks, Federal Reserve Bulletin, p A10, Total U.S. Gov't. Securities (End of Quarter-Beginning of Quarter) col 14: (Col. 10 + Col. 11 + Col. 12 - Col. 9 - Col. 13) —O_ as is well known, the pattern of Federal receipts has changed drastically over the past year. In previous years receipts had grown quite rapidly because of the high income elasticity of the tax laws; in 1975, the recession plus the adjustments to the tax laws in late Spring (subsequently extended in December, 19 75) have caused a sharp V pattern in receipts for the year. The result has been record deficits. The center part of the table indicates the unified budget account information and the recorded financing requirements. Much of the difference between the financing column and the unified budget deficit column is the result of off-budget agencies and accrued interest liabilities. I have not yet attempted to reconcile the financing column with the National Income Accounts Deficit/Surplus column. The reconciliation items fall into three general classes: 1) difference of definition; to the extent that there are definitional differences between the two, adjustments will be necessary to the financing column and the borrowing from the public column. 2) Timing differences; the National Income Accounts Budget is primarily on an accrual basis, while the financing column, with the exception of the interest accruals is on a cash basis. Again adjustments to the financing and bor- rowing from the public columns will be necessary with government accounts payable treated as short-term loans from the public and government accounts receivable treated as short-term borrowing from the public. Finally 3) there will remain one reconciliation item because asset transactions are not included in national income accounting. It should also be noted that the figures in the center and to the right of the table are not seasonally adjusted. -3In the absence of these reconciliations/ the financing requirements of fiscal policy, as measured by National Income Accounts concepts is not accurately represented by the column headed financing. This column, however, can be allocated to changes in cash accounts, borrowing from the Federal Reserve System, and borrowing from the non Federal Reserve Public. 2 This allocation is indicated in the five right columns of Table 1. The figures in these columns indicate that since the beginning of 1971, the Federal Government has required approximately 115 billion of financing. During this period of time, it has run up its cash balances by approximately 15.6 billion, thus requiring it to issue slightly more than 130 billion dolllars of debt. Twenty-five billion, or slightly less than one-fifth of this has been picked by the Fed. In the first three quarters of 1975 the financing requires amounted 54.5 billion dollars. In addition, the Treasury in- creased its cash balances during this period by 5.3 billion dollars, so that total borrowing amounted to 59.8 billion dollars. You may recall that one year ago we estimated that borrowing for the period from the beginning of 197 5 through the end of fiscal 1976 would probably be in excess of 100 billion, and quite likely as large as 125 billion. At this point, it would appear that the available data are roughly consistent with those estimates. Of the 59.8 billion through the first three quarters, 6.5 billion was absorbed by the Federal Reserve. This indicates a considerable change in the Fed's behavior in monetizing the deficit relative to the period 1971-74. In those four years, approximately 20 percent of the total borrowing was absorbed into the Federal Reserve portfolio; in the last three -4quarters for which the data is available only 9 percent of the total borrowing was absorbed into the Federal Reserve portfolio. Budget Projections Two years ago projections about the future state of the Federal government budget were rather hard to come by. there are Currently numerous products to choose among; the problem is to evaluate the product which is being pushed. As in the past, rather than attempt to generate a competing product of my own, I shall attempt to evaluate some of these alternatives; in particular those presented by the administration (O.M.B.) and the Congressional Budget Office (C.B.O.). All soothsaying regarding the Federal Budget is critically dependent on the path of economic activity. Two (not equally valid) alternatives are currently in vogue. The first, which I shall call budget forecasting is distinguished by the use of an implicit or explicit model which recognizes a simultaneous relationship between the outcome for economic activity and the outcome for Federal receipts and outlays. In this case the paths of economic activity and the budget outlays and receipts are mutually consistent forecasts, given " h assumptions regarding te the variables under policy control and other 'exogenous1 variables. The second, which I shall call budget projection is distinguished by the development of assumptions about the path of economic activity independent of fiscal policy parameters, and then uses the constructed path of economic activity to derive projections about the path of budget measures. There is no presumption that the path of economic activity would actually be realized if the fiscal policy parameters were set consistent with the budget projections. TABLE 2.—Economic Assumptions—O.M.B. Budget Projections. 1975 A. 1976 1977 1978 1979 1980 1981 1498 1686 1896 2123 2353 2606 n.a. 794 832 879 936 997 1061 n.a. January 1975 1. 2. Percent Change in CPI 11.3 7.8 6.6 5.2 4.1 4.0 n.a. 4. Unemployment Rate GNP—58$ 3. B. GNP—Current $ 8.1 7.9 7.5 6.9 6.2 5.5 n.a. January 1976 1. GNP—Current $ 1499 1684 1890 2124 2376 2636 2877 2. GNP—72$ 1187 1260 1332 1411 1503 1600 1679 (GNP—58$) (805) (854) (903) (957) (1019) (1085) (1139) Percent Change in CPI 9.1 6.3 6.0 5.9 5.0 4.2 4.0 4. Unemployment Rate 8.5 7.7 6.9 6.4 5.8 5.2 4.9 5. Treasury Bill Rate 5.8 5.5 5.5 5.5 5.5 5.0 5.0 6. Corp. Profits 118 156 181 201 223 247 271 7. Personal Income 1246 1386 1538 1727 1930 2138 2331 3. Source The Budget of the United States Government, Jan. 1975 2 The Budget of the United States Government/ Jan. 1976, pp. 25-26. Data for 1975-77 are forecasts of economic developments, consistent with assumed path of fiscal and monetary developments, Data for 1978-81 are mechanical projections which are not functionally related to derived value offiscal policy measures. -5The O.M.B. economic assumptions are presented in Table 2. The second part of the table indicates those presented with the current budget document, and the corresponding projections from last year are indicated in the first part of the table. The current estimates are true forecasts for the period through 1977; thereafter they are projections in the senseof the above definitions, Note that in terms on nominal GNP there has been essentially no change in the O.M.B.forecasts through 1978. On the other hand, real output has been revised upward for this period; correspondingly the inflation rate has been revised downward. After 1978 the O.M.B. projections have become more pessimistic on the decline in the inflation rate than they choose to be a year ago. The un- employment rate is projected to fall slightly faster than was assumed a year ago, but still is assumed to remain above five percent through 1979. The C.B.O. economic assumptions are presented in Table 3. Two paths for economic activity are given; both are projections in the sense of the above definitions; both are used to attempt to evaluate the cost of the current services budget and the revenues which would be raised under the present tax laws. Path A is constructed so that it averages out to approximately six percent real growth over the period through 1981; Path B is constructed to average out at approximately five percent real growth over the same period. In real terms, Path A and the O.M.B. projections get to approximately the same place at the end of the period; the difference is that O.M.B. has faster real growth in the initial years which slows down considerably in the last few years of the projection period. In real terms, the Path A projection is not much different from that prepared for TABLE 3.—Economic Assumptions—C.B.O, Budget Projections. 1975 1976 1977 1978 1979 1980 1981 1460 1642 1852 2092 2323 2558 n.a. 2) GNP—58$ 793 835 892 960 1023 1085 n.a. 3) Percentage Change in C.P.I. 8.7 7.0 5.8 5.2 4.4 4.0 n.a. 4) Unemployment Rate 8.4 7.6 6.7 6.0 5.5 4.9 n.a. 1472 1675 119 163 1241 1390 1476 1695 1933 2205 2485 2780 3075 2) GNP—58$ 796 856 916 980 1036 1085 1126 3) Percentage Change in C.P.I. 9.2 7.2 7.1 7.0 6.8 6.6 6.6 4) Unemployment Rate 8.5 7.4 6.4 5.4 4.8 4.5 4.5 5) Treasury Bill Rate 5.9 6.1 6.3 6.5 6.8 7.1 7.5 6) Corp. Profits 122 170 215 245 271 297 323 1242 1407 1608 1800 2014 2250 2490 1476 1675 1845 2050 2270 2500 2755 2) GNP—58$ 796 847 880 922 968 1015 1065 3) Percentage Change in C.P.I. 9.2 7.2 6.9 5.9 5.6 4.8 5.0 4) Unemployment Rate 8.5 7.7 7.5 7.1 6.7 6.3 5.9 5.9 6.1 6.3 6.5 6.8 7.1 7.5 122 163 188 205 226 250 275 1242 1390 1530 1700 1860 2045 2248 A) April 1975—Fast Alternative 1) GNP—Current $ B) 2nd Concurrent Resolution (12/12/75) 1) GNP—Current $ 2) Corp. Profits 3) Personal Income C) Budget Projections 1/26/76 Path A 1) GNP—Current $ 7) Personal Income D) Budget Projections 1/26/76 Path B 1) GNP—Current $ 5) Treasury Bill Rate 6) Corp. Profits 7) Personal Income Source 1 1976 Budget: Alternatives and Analysed, Prepared for Congressional Budget Committees, April 6, 1975 2 1976 Congressional Budget Scorekeeping, Congressional Budget Office, Dec, 1975 p. 3 Five Year Budget Projections Fiscal Years 1977-81, Congressional Budget Office, Jan. 26, 1976, pp 4, 31, 45. Neither path is functionally related to the derived value of fiscal policy variables. Path A is a projection at 6% average real growth; Path B is a projection at 5% average real growth. -6the Congressional Budget Committees last April; it shows somewhat faster growth in the earlier years, but comes out at the same place by 1980. The interesting discrepancies among these projections concern the inflation rate represented here by the annual rate of change in the C.P.I. Path A of the C.B.O. shows virtually no decline in the inflation rate over the entire projection period (inflation declines from 7.2 percent in 1976 to 6.6 percent in 1981). Even under the slower real growth assumptions of Path B, the inflation rate declines slowly relative to the projections prepared for the Congressional Budget Committees a year ago. The administration seems equally pessimistic about declining inflation through 1978, but then projects rapid declines through 1981. In every current projection, the unemployment rate is assumed to hang in the 5.5+ percent range at least through 1978. In summary, it seems appropriate to conclude that the budget projectors are counting on a world of high and persistent inflation and high and persistent unemployment in spite of real growth rates which are assumed to be high by historical standards. Defining the economic assumptions allows derivation of the fluctuations in government receipts and outlays which are essentially caused by the functioning of 'automatic stabilizers1. In addition, it is necessary to define assumptions with respect to discretionary action on expenditures and tax laws. Congressional Budget Office projections are all constructed on the basis of the Current Services Budget. On the outlay side, this means that current programs are maintained in real terms; any erosion of purchasing power is assumed to be made up through increases in appropriations. (Maybe this should be viewed as cost-plus as -7constrasted with fixed-price budgeting). On the tax side, it assumes maintenance of the existing tax laws. In the present case, this means the assumption that the modifications to the tax laws which were enacted on a temporary basis last December are assumed to be extended before July 1, 1976 for the remainder of the projection period. No one is trying to sell the current services budget as a forecast of the path of the government budget. Rather it is presented as a what if standard against which changes resulting from Congressional action can be compared. Unfortunately, the system of presentation does not seem to allow for the separation of the direct effects of congressional actions from the effects through induced changes in economic activity. A second unfortunate side effect is that there appears to be the tendency in public discussion to lose sight of the fact that these are not current services budget forecasts, and to act as thought the projections of outlays and receipts are highly probably outcomes for the future which can be used to justify changes in the levels of programs or provisions of the tax laws. This kind of discussion is analagous to that of the 'fiscal dividend1 of the end of the Vietnam war which was popular during the late 1960's. As Table 1 clearly indicates, the 'fiscal dividend' never materialized because the economic envi raiment turned out to be different than the assumptions of the 'fiscal dividend' projections. The O.M.B. combined forecast-projections take a considerably different tack. On the outlay side, the assumption is that pro- grams will remain fixed in current dollar terms, except where specific recommendations are made for changes in program levels (mainly in defense), or where there are cost of living provisions in program benefits or Federal pay scales, or where there will -8be increased costs because of cost of goods purchased from the 4 private economy. It would appear that these assumptions are closely approximated by the statement that Federal purchases of goods and services are assumed to be constant in real terms, while transfers, with the exception of Social Security, are assumed to be steadily declining in real terms. Past congress- ional behavior suggests that the latter assumption is wishful thinking on the part of the administration. On the receipts side of the budget, the administration's projections include a specific tax revision program to be effective on July 1, 1976. The provisions included in the assumptions involve: 1) an increase in the personal exemption from 750 to 1000 dollars 2) the substitution of a flat standard deduction (2500 on joint returns; 1800 on single returns) for the long standing percentage deduction and the low income allowance introduced in 1975 3) reduction in the personal income tax rates. The budget is vague on the details of the rate changes, but an example is indicated in Table 4. 4) reduction of the corporate income tax rate from 48 to 46 percent 5) a tax credit of from 1.5 to 3.8 percent on interest income from residential mortgages effective 1/1/77. 6) temprorary high write-off's of real investment in high unemployment areas (1/2 of useful life on structures; 5 year maximum on equipment) Tax Liabilities for Famiiy with 2 Dependent^ Filing Joint with Itemized Decuctions of 16 Percent of Adjusted Gross Income (If standard deduction exceeds itemized deduction, family uses standard deduction.) 1976 Adjusted Gross Income 1972-74 law $ $ o 5,000 7,000 10,000 15,000 20,000 25,000 30,000 40,000 50,000 Note: 5,000 7,000 : : 98 402 886 1,732 2,710 3,820 5,084 8,114 11,690 1975 : law : $ 0 186 709 1,612 2,590 3,700 4,964 7,994 11,570 Revenue Ad^ustmert Act Extended * Revenue Adjustment Act $ 0 $ 0 268 797 1,552 2,520 3,6*0 4,904 7,934 11,510 1977 Presida Propcs al t $ o 135 651 1,642 2,620 3,730 4,994 8,024 11,600 : Pres:dent's : Proposal : 89 555 1 ,446 2,405 3,507 4,781 7,799 xl,345 Effects oi the earned income credit are excluded. If this family were fully eligible for the earned income credit, i.e., all 'vGI is earned income, then the table rows would be: $ 98 402 -300 86 -150 218 -300 0 8J Where a negative number is indicated, a rebate would be paid. These r e u s e s are the budget as outlays rather than reductions m receipts. Estimates r>ased on a hypothetical extension or the tax cats provided lor the first 6 months of 1976 by tne Revenue Adjustment Act of 1975. 0 60 49o ?25 3 , 2, 280 -,370 4, 648 664 7, 180 f/s e A c Q 0 60 IL -97) increase in the combined employer/employee social security tax rate to 12.3 percent from the present 11.7 percent effective 1/1/77 8) increase in the unemployment insurance tax rate to 0.65 percent from the present 0.5 percent and the base to 6000 dollars of wages per annum from the present 4200 dollars of wages per annum effective 1/1/77 Provisions 7) and 8) are projected to generate an additional 5.4 billion dollars of revenue during fiscal 1977. The forecast - projections of outlays and receipts for fiscal years 1976 through 1981 are indicated in Table 5. Section C, with proposed changes indicates the projections under the assumption that the above tax program is enacted. Section B f current programs is not analagous to the Current Services projections of C.B.O. since it assumes that the tax provisions which were extended last December will be allowed to lapse in July, and the tax law will revert back to the provisions in effect before May, 1975. It seems highly probable considering that 1976 is an election year, that some sort of tax revisions will be enacted which either extend the current temporary provisions, or very similar will be enacted. something Thus section B of Table 5 which shows a decline in the deficit to less than 20 billion dollars in fiscal 1977 is completely unrealistic. The C.B.O. current services projections are given in Table 6. Path A, which is constructed for six percent real growth is probably not worth considering, at least in the later years, because it does not seem that that rate of real growth is sustain- able over that period of time (certainly not with the Federal budget kept at current service levels), and I am unprepared to TABLE 5.—O.M.B. Budget Projections (Fiscal Years). 1975 A. 1976 T.Q. 1977 1 1978 1979 1980 393.1 4.254 451.9 476.7 January 1975 1. Outlays 313.4 349.4 2. Receipts 278.8 297.5 362.5 405.8 452.3 501.7 -34.7 -51.9 -30.6 -19.6 .4 25.0 3. Deficit B. 1981 January 1976 (Current Programs) 1. Outlays 324.6 373.7 98.2 391.9 420.4 441.8 465.0 489.2 2. Receipts 281.0 297.3 87.3 374.1 430.1 491.7 551.1 623.9 -43.6 -76.4 -10.9 -17.8 9.7 49.9 86.1 134.7 3. Deficit C. January 1976 (With Proposed Changes) 1. Outlays 324.6 373.5 98.0 394.2 429.5 455.7 482.5 509.9 2. Receipts 281.0 297.5 81.9 351.3 406.7 465.3 523.1 585.4 -43.6 -76.0 -16.1 -43.0 -22.8 9.6 40.6 75.5 3. Deficit TABLE 6.—C.B.O. Budget Projections (Fiscal Years). 1975 A. 1976 T.Q. 1977 1978 1979 1980 1981 Path A 1. Outlays 324.6 374.9 101.7 419.9 448 480 518 560 2. Receipts 281.0 300.8 86.0 383.3 445 509 577 652 -43.6 -74.1 -15.7 -36.6 -3 29 58 92 3. Deficit B. Path B 1. Outlays 324.6 374.9 101.7 424.9 464 495 530 563 2. Receipts 281.0 300.8 86.0 360.0 401 448 497 550 -43.6 -74.1 -15.7 -64.9 -63 -47 -33 -13 3. Deficit Source: Congressional Budget Office, Five Year Budget Projections9 p. 9. -10accept the presumption that we will be plagued by inflation continually in excess of six percent per year through 1981. This leaves us with a comparison of the C.B.O. path B and the O.M.B. projections with proposed changes. projections through fiscal 1978. I shall concentrate on the The O.M.B. has faster real growth, a faster decline in unemployment, and an initially lower inflation rate (though by 1978 both projections are assuming 5.9 percent inflation). The slower inflation, the lower unemployment, and the assumption about the declining real value of government transfers are jointly responsible for the lower dollar value of outlays in fiscal 1977 and 1978 in the O.M.B. projections. Of the three, I am inclined to belive the first two, and discount the latter. Thus if I had to make an estimate of the dollar value of current services through fiscal 1978, I would place it between the two estimates. On the other hand, I think that we have to allow for increases in government activity beyond the current services levels over this period of time, particularly in such areas as health insurance legislation, which would further increase the level of outlays. If we compare the receipts projections, they are strikingly similar for fiscal 1978, but the O.M.B. projections are lower in fiscal 1977 and the transition quarter. This cannot really be attributed to differences in economic assumptions, since in spite of the differences in the projections of the two agencies for inflation and real income growth, their projections for the paths of personal income and corporate profits are almost identical (see Table 2 and Table 3 ) . It is these latter two which are crucial for determining the yield of the Federal Tax laws. difference in revenue projections is something of a mystery. This -lilt could be written off to the proposed tax law changes in the President's budget, but since those proposals include major increases in the revenue expected to be generated by the social security and unemployment insurance taxes (5.4 billion), it seems hard to account for the difference of almost 9 billion dollars in the revenue projections in fiscal 1977. Both of these revenue projections are conditional on inflation rates not declining signficantly, or even increasing from present epxerience. As we have learned from the experience of the early 1970's, tax revenue projections are extremely elastic with respect to the assumed inflation rate. If we look forward to a continuing decline in the inflation rate, then both revenue projections should probably be revised downward, and more than proportionally to any downward revision in the outlay side of the budget. My conclusion from all of this is that the financing problem, even on a current services basis, will be substantial through the end of fiscal 1978. the C.B.O. path Projections such as that of O.M.B. and A which suggest a return to near budget balance by around fiscal 1979 and the development of 'budget margins' thereafter seem highly suspect. My projection would be that we can expect that somewhere in the order of 100 to 125 billion will have to be financed in the 2 1/4 years starting July 1, 1976. How soon therafter a 'budget margin' might develop is really impossible to forecast at the present time. The actual size of the budget as measured by total outlays is probably best estimated somewhere between the O.M.B. projections and the C.B.O. path B, at least through fiscal 1978. Footnotes Most, if not all, of the information required to do the reconciliation of the financing column and the borrowing from the public column is available in Table 3.12 of the National Income and Product Accounts. 2 There probably exists a minor problem with this allocation. I have taken the figures on borrowing from the Federal Reserve from the Consolidated Condition Statement which appears in the Federal Reserve Bulletin. It is my suspicion that this statement values the Fed's portfolio of governments at par, rather than at transactions prices. Since the borrowing from the public column is obtained as a residual, any errors in evaluation of changes in the Fed's portfolio will contaminate this column also. To illustrate a particularly simple case, assume that the economic assumptions are derived from a mechanical forecasting rule which projects real growth and inflation at constant rates. A current services budget projection (constant outlays in real terms) would indicate nominal outlays growing at the inflation rate, and receipts growing at a rate faster than nominal income. Thus receipts would be growing faster than outlays and the deficit (surplus) would decline (rise) over time. On the other hand, there is no presumption that the constant services budget is exactly what is required to produce the constant real growth and constant inflation rate. see The Budget of the United States Government, January, 1976, p. 27 For example see the proposals recently offered by Rep. Brock Adams, Chairman of the House Budget Committee, for fiscal 1977 expenditures totalling 410.3 billion, compared with the administrations 394.2 billion. (reported in Wall Street Journal, February 19, 1976)