Full text of Policy Statement and Position Papers : September 19, 1977

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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 19, 1977

1. Shadow Open Market Committee Policy Statement, September 19, 1977
2. SOMC Members – September 19, 1977
3. Position Papers

Projections for the Economy – Jerry L. Jordan, Pittsburgh National Bank
Economic Prospects through 1978 – Robert J. Genetski, Harris Bank
Weekly Federal Reserve Report – H. Erich Heinemann, Morgan Stanley & Company
Memo from Homer Jones – Homer Jones, Federal Reserve Bank of St. Louis
The Federal Budget – Rudolph G. Penner, American Enterprise Institute
Financing the Government Deficit – Robert H. Rasche, Michigan State University
Briefing for the Shadow Open market Committee – Wilson E. Schmidt, Virginia Polytechnic
Institute and State University
The Dilemma of Inflationary Policies – Karl Brunner, University of Rochester

Policy Statement
Shadow Open Market Committee
September 19, 1977
The policies that produced sustained recovery, rising employment and lower
inflation have ended. The growth rate of money - currency and demand deposits has returned to the high levels of 1968, 1972 and early 1973. Government spending
is growing again at a faster rate than the economy. The budget deficit is rising.
Prospects for the economy in 1978 and 1979 as a result appear less attractive
than when this Committee met last March. Inflation is expected to increase next year
and the growth of real output is expected to fall. The reasons for slower growth and
higher inflation differ, however. Capacity utilization is high in many industries, and
real growth must slow to the trend rate of capacity growth - three to four percent per
year. Accelerating inflation and an enhanced risk of recession are mainly the result of
the inappropriately expansionary monetary policy that the Federal Reserve pursued
during the past two years, and particularly during the past six months.
Increased money growth in 1977 has restricted the choice of policies for 1978 to
three principal alternatives.

None of the three is attractive, but there are important

differences. At its meeting today the Shadow Open Market Committee discussed these
differences i\\u\ recommended that the Federal Reserve return to a policy of
eliminating inflation gradually, while minimizing the risk of a large recession.
Three Options
The Federal Reserve has three options. (1) It can continue on the path of rapid
money growth that has prevailed in 1977. (2) It can accept the errors of the past
year while immediately restoring the policy of slowing inflation.

(3) Or in some

measure it can correct for the excessive money growth of the past year, and once
again restore a policy of ending inflation.

-2Tlie first option minimizes the risk of recession in 1978, but would result in
increased inflation. By maintaining the recent high rate of money growth, real growth
might temporarily be higher than otherwise, but at the cost of higher inflation later.
As inflation increases, the demands to do something about inflation increase. Controls
on wages and prices would become more likely. But controls, if adopted, would
ultimately prove to be useless against inflation.

Shortages of goods, services, and

materials used in production would be the inevitable result. Sooner or later money
growth would be reduced as part of a new, anti-inflation policy. This option adds to
real growth in 1978 at the cost of higher inflation. This policy would squander the
progress that has been made in restoring stability. The benefits of this option seem
small when compared to the costs.
The second option would be to accept higher inflation as an unavoidable, but
temporary, consequence of excessive money growth. Money growth would be reduced
to an annual rate of 4% starting from present levels. This policy means that the
federal Reserve's summer errors would be translated into a recession. Output growth
under this policy would probably be less than the trend rate.
The third option is to partially correct the summer bulge in the money stock.
This bulge can be partly eliminated without severe consequences for real growth
because the economy has not yet adjusted to the higher level.
At the previous meeting of this Committee, in March 1977, we recommended
that the growth rate of money be held between 4% and 4-1/2% during the year ending
in the first quarter 1978. The growth rate of money for the second and third quarter
has been over twice the rate we recommended. The annual rate of money growth is
far above the 5-1/4% midpoint of the target chosen by the Federal Open Market
Committee, November 1976, and reaffirmed at subsequent meetings.
standards, as well as ours, the growth rate of money has been excessive.

By their

-3-

This Committee has affirmed repeatedly that stable growth, lower inflation,
and recovery from recession can be achieved together if proper policies are chosen.
The Federal Reserve's I c>77 excesses may mean that a recession will once again follow
when it attempts to reduce inflation.
Recommendations
The inordinate growth of money in the last six months stemmed from two
episodes.

In March and April, Federal Reserve credit was increased rapidly to keep

interest rates from rising; consequently the money stock jumped. But this only postponed the rise in interest rates to the end of April.
Again in June and July, Federal Reserve credit growth was accelerated to keep
short-term interest rates from rising and the stock of money rose rapidly. But the rise
of interest rates was only postponed one month.
The Federal Reserve has not been able to prevent a rise of short-term interest
rates this year. It has only been able to obtain slight delays of rate rises. And it has
done this only at the expense of losing control of the amount of Federal Reserve
Credit and the money stock.
The failure of the Federal Reserve to reach its targets is not an accident.
Excessive money growth has been the result of inappropriate procedures for controlling the stock of money. The Federal Reserve has continued to concentrate on
short-term changes in interest rates and has ignored the movements of the monetary
base and other determinants of the stock of money.

The result has been excessive

money growth in periods of expansion, and insufficient money growth in recession.
This Committee has warned repeatedly that current procedures for controlling
money are inadequate. The result of those procedures is that stable high output has
not been achieved; inflation has increased; price and wage controls have become more
likely; and the risk of returning to a stop and go economy is greater.

-4In addition to the change in procedures, the Shadow Open Market Committee
recommends that the summer bulge in money be removed by reducing the current
level of the money stock by $4-billion, the reduction to be accompanied by an
announcement that the step has been undertaken to return the money stock to the
level it would have reached if the most recent error in monetary policy had not
occurred.

Subsequent to the correction, money growth should resume at a constant

annual rate of 4-1/2%.
A stop-go monetary policy is not inevitable. We urge, again, that the Federal
Reserve refrain from trying to control short-term interest rates. It should not take the
Federal Funds rate as its operating target.

Instead, it should adopt procedures to

directly control money. If it does so, the Federal Reserve is fully capable of achieving
its announced targets for money growth.
The return to stability with rising real income cannot be achieved by monetary
policy alone. The growth rate of government spending is high and rising. A rising
share of resources absorbed by government means fewer resources for private investment, slower growth of private output and fewer jobs in the private sector.
We project that the budget deficit for fiscal 1978 and the borrowing by off
budget agencies will require the private sector to absorb about $60-billion in new
government securities. This amount is much larger than appropriate under current
conditions.

We recommend that nothing further be done to increase the budget

deficit and government borrowing in 1978 and that the budget deficit be reduced in
1979. The Congress and Administration should adopt a program to limit the growth
of government spending, so as to achieve and maintain the balanced budget promised
by the Administration for fiscal 1981.

Professor Karl Brunner, Director of the Center for Research in Government Policy and
Business, Graduate School of Management, University of Rochester, Rochester,
New York.
Professor Allan 11. Meltzcr, Graduate School of Industrial Administration, CarnegieMellon University, Pittsburgh, Pennsylvania.
Mr. H. Erich lleinemann, Morgan Stanley & Company, Inc., New York, New York.
Dr. Homer Jones, retired Vice President and Director of Research, Federal Reserve
Bank of St. Louis, St. Louis, Missouri.
Dr. Jerry Jordan, Senior Vice President and Chief Economist, Pittsburgh National
Bank, Pittsburgh, Pennsylvania.
Professor Thomas Mayer, University of California at Davis, California.
Dr. Rudolph Penner, American Enterprise Institute, Washington, D.C.
Professor Robert Rasche, Department of Economics, Michigan State University,
East Lansing, Michigan.
Professor Wilson Schmidt, Department of Economics, Virginia Polytechnic Institute,
Blacksburg, Virginia.
Dr. Anna Schwartz, National Bureau of Economic Research, New York, New York.
Dr. Beryl Sprinkcl, Senior Vice President and Economist, Harris Trust and Savings
Bank, Chicago, Illinois.
Dr. William Wolman, Senion Editor, BUSINESS WEEK, New York, New York.

$ Billions

MONEY STOCK (Ml)

Averages of Daily Figures
Seasonally Adjusted

* Actual quarterly levels
Solid horizontal lines
plotted are target boundaries assuming
previous quarter as base and using
announced Fed growth ranges.
Dotted horizontal lines
plotted are target boundaries assuming
the year-earlier quarter as base and
using the growth ranges of the base
quarter.

Average so far this quarter *
J

I
S

i
L
O N D
1975

-L

L
M

-L J
J A
1976

L
S

-L
D

'L .. .
.

; Last date plotted

1
J

j
M

i
A

i
M

i
J

i
A

1977

i
S

j _ l

t
O

$ Brilions

MONEY STOCK PLUS TIME DEPOSITS (M2)
Averages of Daily Figures
Seasonally Adjusted

* Actual quarterly levels
Solid horizontal lines
plotted are target boundaries assuming
previous quarter as base and using
announced Fed growth ranges.

770

-.•-..
Dotted horizontal lines
plotted are target boundaries assuming
the year-earlier quarter as base and
using the growth ranges of the base
quarter

A
O N
http://fraser.stlouisfed.org/ S
Federal Reserve Bank of St. Louis
1975

Average so far t h i s quarter

J
F

I
M

I
A

I
M

I
J

I
J A
1976

I
S

I
O

' < fc>/cZ .
*

Last

plotted.. ^ 7 ~ '

date

1
I
I
I
D J F M A .

1
M

y / i

1
1
I
1 .I
I 1
J J A S O N D
1977

qzfjg}. / / , I%£ (^**+^

purport U<^bj

PROJECTIONS FOR THE ECONOMY

PREPARED FOR THE
SHADOW OPEN MARKET COMMITTEE MEETING
September 8, 1977

By
JERRY L. JORDAN
Sr. Vice President & Economist
Pittsburgh National Bank
Pittsburgh, PA

PITTSBURGH NATIONAL BANK
SHADOW OPEN MARKET COMMITTEE
OM

Jerry L. Jordan

BJECT

ECONOMIC PROJECTIONS

PHONE NO.

412-355-3101
DATE September

8, 1977

At the March 7, 1977 S.O.M.C. meeting the following assumptions for money growth and velocity were presented:

M±

Q4/76-Q4/77

6.0%

9.0%

4.0%

1.2%

1976 - 1977

6.0%

9.9%

3.6%

-0.02

Based on actual results for the first 8 months, money growth
is expected to be one percentage point greater by year-end,
and also velocity growth is likely to be somewhat greater, as
follows:

M±

Q4/76--Q4/77

6.9%

10,
.0%

5.1%

2.1%

1976 -- 1977

6.5%

10,
.6%

4.2%

0.3%

1
The above figures assume that growth of M
and 9% respectively in Q4/77.
2)

2
and M

slow to 6%

At the March 1977 meeting real output growth was projected to
be 5.9% by year-end, and that projection is maintained.

Prices

were projected to rise only 4.2% by year-end, and that is now
revised to 5.9%.

Corresponding to the more rapid monetary

growth and inflation than earlier projected, nominal income

2
growth is expected to be somewhat over 12%, compared with the
March projection of 10.3%.
For 1978 M

and M

growth are assumed to beI6%/and 9%, respec-

'
\

tively from Q4/77 to Q4/78.

~V
CX,

Projections for the economy are:

GNP

REAL
OUTPUT

PRICE •
DEFLATOR

Q4/77-Q4/78
1977 - 1978

6.0%

\y \c x

Implied velocity growth is

Q4/77-Q4/78
1977 - 1978

3.7%

1.0%

(a) Monetary growth in 1977 has been excessive by almost any
standard, and the slowing assumed above for 1978 is only
that necessary to get back down to the upper limits of
the Fed's announced target ranges.
(b) At the March 1977 meeting, the S.O.M.C. recommended money

growth of 4 to 4.5%, or a level of M
Ql/1978.

(\ "sr^fc

of $326 billion for

Since the level of M 1 for Q3/1977 is expected

to be about $328 billion, a decline in the money stock of
$2 billion would be necessary to hit the S.O.M.C. target.
A decline in the money stock during Q4/77 and Ql/78, following an average growth of 8.7% in Q2 and Q3/77 would

3
produce at least a mini-recession in 1978.
(c)

If the S.O.M.C. were to accept the Fed approach of "bygones
are bygones" and recommend a 4 to 4.5% growth of M

from

Q3/77 foreward, a significant slowing in nominal income
growth and real output could be expected.

(d)

If monetary growth continues into 1978 at rates similar
to the past two quarters, inflation in 1978 could be expected to be in the range of 7 - 8%.

(e)

Since monetary growth over the past two-and

four-quarter

periods (ending Q3/1977) is the most rapid since 1972
there are no good alternatives available for monetary
policy.

The appearance of a trade-off between inflation

and real output growth next year should be put into the
context of a level of prices and real output three to
four years from now.

Policies to maintain output growth

in 1978 at the expense of continuing high inflation would
imply eventual adoption of more restrictive policies and
most likely a recession in 1979 or 1980.
of M

A curtailment

growth in Q4/77 and 1978 to the 4 to 4.5% range

would imply a few quarters of real output growth below
the long-run potential, but would halt the acceleration
of inflation and provide an environment for greater real
growth with less inflation in 1978 and 1980.

On bal-

ance, output and employment would be greater, and price
levels lower, in 1980 if the recent acceleration in mone-

4
tary growth is halted before the "whites-of-the-eyes"
of re-accelerating inflation are in sight.

JLJ

JLJ/ky
Enclosures

MONEY GROWTH RATES
( Change from Previous Year)
%

FROM:

TO:

M
n

MONETARY
BASE

1971/Q1

1972/Q1

6.8

10.9

7.1

6.3

9.7

7.1

6.7

10.4

7.0

8.4

11.2

8.3

1972/Q1

1973/Q1

8.5

10.5

9.0

8.0

10.0

8.8

7.2

9.2

9.0

6.2

8.8

8.1

1973/Q1

1974/Q1

5.9

8.9

8.0

5.6

8.7

8.6

5.3

8.3

8.4

5.1

7.7

9.0

1974/Q1

1975/Q1

3.6

6.6

8.3

4.1

7.3

7.7

4.8

8.3

8.0

4.4

8.3

7.6

1975/Q1

1976/Q1

4.9

9.4

8.1

5.2

9.6

8.8

4.5

9.3

8.4

5.6

10.9

8.6

1976/Q1

1977/Q1

6.0

10.9

8.2

6.0

10.6

7.8

7.1

11.0

8.9

*
*

Projected by Pittsburgh National Bank

TWO-QUARTER COMPOUNDED ANNUAL RATES OF CHANGE

Monetary
Base

Ql/71 - Q3/71

8.1

l
8.6

Q2/71 - Q4/71

6.6

9.6

8.0

Q3/71 - Ql/72

6.2

5.1

10.0

Q4/71 - Q2/72

7.7

7.9

11.4

Ql/72 - Q3/72

7.8

8.3

10.8

Q2/72 - Q4/72

8.9

11.0

Q3/72 - Ql/73

10.2

8.6

10.2

Q4/72 - Q2/73

8.8

7.0

Ql/73 - Q3/73

7.8

5.9

9.0
8.2

Q2/73 - Q4/73

7.5

5.5

8.7

Q3/73 - Ql/74

8.2

5.8

9.7

Q4/73 - Q2/74

9.7

Ql/74 - Q3/74

8.6

5.8
4.8

8.8
7.0

Q2/74 - Q4/74

8.4

4.3

6.6

Q3/74 - Ql/75

8.0

2.5

6.2

Q4/74 - Q2/75

7.0

8.1

Ql/75 - Q3/75

8.1

3.9
7.2

10.4

Q2/75 - Q4/75

8.2

4.9

8.5

Q3/75 - Ql/76

8.2

8.4

Q4/75 - Q2/76

10.6

Ql/76 - Q3/76

9.4
8.6

2.7
5.6
6.4

10.2

Q2/76 - Q4/76

7.8

5.6

11.2

Q3/76 - Ql/77

7.9

5.5

11.7

Q4/76 - Q2/77

7.7

6.5

10.0

* Ql/77 - Q3/77

10.0

8.7

10.3

Projected by Pittsburgh National Bank

11.7

g ^ = HARRIS

mS BANK

IPQI^'*$
Harris Economic Research Office Service
A u g u s t 3,

1977

ECONOMIC PROSPECTS THROUGH 1978
Slower economic growth and some moderation in inflation are forecast for the balance of the year. For 1978, real growth is expected to
rise moderately while the inflation rate renews its upward march.
Monetary Growth and the Outlook
The significance of monetary growth was once again apparent in
economic developments during the first half of the year. Total spending
rose at a ra'pid 13% annual rate following a strong increase in the money
supply in the last half of 1976. M2 (currency plus most bank deposits)
increased at a \2l^% annual rate from June to December of 1976. For the
first half of 1977, M2 growth slowed to a 9% annual rare. This development
is a major factor underlying the forecast of a 9% - 9J$% annual rare rise in
total spending or GNP for the balance of the year. Inflation as measured
by the GNP price deflator is expected to moderate to the 5% - 6% range during
the next six months, following the 6% pace in the first half of the year.
For 1978, the speed of the economic advance will depend critically
on monetary growth rates for the balance of this year—and here lies the
dilemma. Monetary growth at the top end of the Federal Reserve Board's
targets would allow for only a 3% increase in real growth in 1978.
Examined from a different perspective, if the Administration wants to
realize its own forecast for a 5% real growth rate in 1978, then M2 would
have to increase by about 12%. If continued, such an increase would send
inflation into the double digit range by 1979. Given these choices, the
forecast assumes M 2 will grow at a 10% rate through the remainder of this
year and into 1978. This would be one-half percentage point above the
upper end of the Federal Reserved targeted range and would lead to real
growth in the 3%% - 4% range during 1978.
Inflation
Although some moderation in inflation is anticipated during the
balance of the year, it merely offsets the effect of the sharp price increases earlier in the year. The key determinant of inflation is past
monetary growth. For the past two years money supply growth has been
fairly high. M2 growth has averaged 9.7% at an annual rate over the past
two years, and this implies an inflation rate of 6% - 7% for 1978.
Consumer Expenditures
Consumer spending is expected to be fairly weak in the latter half
of 1977 and to provide only a moderate boost to the economy through 1978.
fTHe strong pace of auto sales in the second^quarter is not likely to Jbe
Ijisustained in the months ahead. Also, the^~savTng rateTl^lxh reached 5^% of
"^rspo^ainirT^come^
second quarter, is expected to rise as the year progresses. This will be reflected in the generally moderate advance in consumer spending.

-2-

Investment Expenditures
Plant and equipment expenditures are forecast to increase in the
13% - 15% range for both the balance of this year and for 1978. Strong
profit gains in 1975 and 1976 combined with approaching capacity limitations in certain industries should provide the main ingredients for sharp
gains in business fixed investment.
Financial Markets
The federal deficit for fiscal 1978 is estimated by the Administration at close to $60 billion compared to approximately $50 billion in
the current fiscal year. Increased federal borrowing combined with greater
economic activity in the private sector and an underlying inflation rate of
6% will serve to boost short-term interest rates. The 4 to 6 month cxmnercial
paper rate (currently 5J$%) is forecast to average 7% in 1978. The general
direction of long-term rates is also likely to be up, but the slower pace of
business activity anticipated in the fall could delay the increase. As a
result, new issue rates on AA industrial bonds are expected to average 8% in
the current quarter before climbing to the 9% area by the end of next year.
Corporate Profits Revised Upward
A major revision in the GNP numbers going back to 1974 now indicates that after-tax profits were much stronger than previously reported.
The revisions which are based on more complete corporate income tax report
indicate that after-tax profits adjusted to exclude inventory profits and
allow for depreciation at replacement cost were up .25% in 1976 from the
previous high in 1972. Moreover/ preliminary estimates of second quarter
profits show an additional 7% gain over the average for 1976. Although
the slower economic growth expected in the third quarter will adversely
affect reported profits, the moderation in inflation will increase the
quality of those profits. For 1978, continued moderate rates of expansion
in the economy should lead to gains in after-tax profits of approximately
10%.
Summary
A slower expansion is anticipated for the last half of 1977,
leading to growing political pressures for faster monetary growth. The
forecast assumes that to some extent these pressures are held in check and
that monetary growth comes in slightly above the upper end of the Federal
Reserve's targeted range while interest rates continue to rise. This
result leads to an uneasy compromise of moderate real growth along with
6% - 7% inflation for 1978.
Robert J. Genetski
Economist

7/29/7

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

FORECAST
ACTUAL
1976:4 1977:1 T97Tf2 1977:3 T9T7:4 197671 197872 f978:3 197b:4

WfS

YEARS
1976
1977"

T978

1755.4 1810.8 1869.0 1910.0 1954.0 2003.0 2052.0 2100.0 2152.01
6.7
10. i
9.5
13.2
10.4
10.2
13.5
9.1
9.7

1528.8 1706.4 1886.0
8.2
11.6
10.5

2076.8
10.1

CONSTANT DOLLAR GNP

1287.4 1311.0 1331.6 1342.7 1355.1 1366.4 1380.7 1391.3 1403.J
7.5
1.2
3.4
3.1
6.4
4.0
3.6
3.1
3.7

1202.1 1274.7 1335.1
-1.3
6.0
4.7

1386.1
3.8

PRICE DEFLATOR

1.3635 1.3813 1.4036 1.4225 1.4420 1.4637 1.4662 1.5094 1.S329
6.4)
5.4
5.3
5.5
6.3
5.b
6.2
6.4
6.6

1.2714 1.3386 1.4124
9.6
5.3
5.5

1.4981
6.1

1139.0 1172.4 1194.0 1217.0 1242.7 1271.7 1301.0 1330.6 1361.fi!
8.7
12.3
9.7
9.5
9.4
9.d
14.0
7.9
7.6

980.4 1093.9 1206.5
10.2
11.6
10.3

1316.2
9.1

GROSS NATL PRODUCT
%Ch
r

_ 5 ^

PAGE 1

4 - 0 * CONSUMPTION
f
%CH

EXPENDITURES

DURABLES
%CH

166.3
18.8

177.0
26.3

179.1
4.8

181.4
5.2

185.5
9.4

190.6
11.9

195.5
10.2

200.0
9.5

205.0
10.4)

132.9
8.9

158.9
19.6

160.6
13.8

197.8
9.4

NONDURABLES
%CH

458.6
13.3

466.6
7.0

475.3
7.7

483.6
7.2

492.3
7.4

501.9
6.0

511.9
8.2

522.1
8.2

532. T(

409.3
8.6

442.8
8.2

479.4
8.3

517.2
7.9

SERVICES
%CH

513.9
13.2

528.8
12.1

539.6
8.4

552.0
9.5

564.9
9.7

579.0
10.4

593.6
10.5

606.5
10.4

10.5J

438.2
12.0

492.3
12.3

546.3
11.0

601.3
10.1

243.4
-16.1

271.8
55.5

293.0
35.0

300.9
11.2

307.0
8.4

315.9
12.1

324.1
10.8

330.3
7.9

338.91
10.81

189.1
-11.9

243.3
28.7

293.2
20.5

327.3
11.6

167.6
0.7

177.0
24.4

163.3
15.0

190.3
16.2

196.7
14.1

203.7
15.0

210.9
14.9

217.9
14.0

225.1)
13. 9

149.1
-1.0

161.9
8.6

166.8
15.4

214.4
14.8

PRODUCERS DUR EQUIP
%Ch

110.6
6.0

119.2
34.9

123.1
13.7

127.5
15.1

131.7
13.6

136.0
13.7

140.5
13.9

145.0
13.4

149.5J
13.0

96.3
0.1

106.1
10.2

125.4
18.2

142.6
13.9

BUSINESS STRUCTURES
%CH

57.0
7.3

57.9
6.5

60.2
16.9

62.8
16.4

65.0
14.8

67.7
17.7

70.4
16.9

72.9
15.0

75.6|
15.7|

52.9
-2.9

55.9
5.7

61.5
10.0

71.7
16.6

RES FIXED EXPEND
%CH

76.7
63.6

61.0
24.4

90.0
52.4

93.5
16.5

95.7
9.7*

97.5
7.7

98.0
2.1

97.0
-4.0

95.0
-8.0

51.4
-6.6

68.0
32.3

90.0
32.3

96.9
7.6

INVENTORY CHANGE

-0.9

13.8

19.7

17.1

14.6

14.7

15.2

15.4

18.8

-11.4

13.3

16.3

16.0

3.0

-8.2

-8.1

-6.1

-6.2

-5.6

-2.6

1.8

2.5

20.3

7.8

-7.1

-1.0

INVESTMENT EXPENDITURES
%CH
NONRES FIXED EXPEND
%CH

NET EXPORTS

8.4J
1
623.91

GOVT PURCHASES
%CH

370.0
7.9

374.9
5.4

390.1
17.2

398.2
6.6

410.5
12.9

421.0
10.6

429.5
6.3

437.3
7.5

449.0
11.1

338.9
12.0

361.4
6.6

393.4
8.9

434.2
10.4

FEDERAL
%CH
MILITARY
%CH
OTHER
%CH

134.2
12.9
88.4
9.6
45.8
19.6

136.3
6.4
89.7
6.0
46.7
8.1

143.3
22.2
94.2
21.6
49.1
22.2

146.7
9.8
96.0
7.9
50.7
13.7

154.0
21.4
100.5
20.1
53.5
24.0

159.0
13.6
104.5
16.9
54.5
7.7

162.0
7.8
106.5
7.9
55.5
7.5

164.3
5.8
106.0
5.8
56.3
5.9

170.51
lb.0|
112.01
15.7
Sb.5
16.6

123.3
11.0
83.9
9.0
39.4
15.5

130.1
5.5
86.6
3.4
43.3
10.0

145.1
11.5
95.1
9.6
50.0
15.3

163.9
13.0
107.8
13.3
56.2
12.4

SThTB & LOCAL
%CH

235.8
5.4

238.5
4.7

246.7
14.5

251.5
8.0

256.5
8.2

262.0
8.9

267.5
8.7

273.0
8.5

^7ti.5
8.3

215.6
12.5

231.2
7.2

248.3
7.4

270.3
8.8

NOTE: PERCENTAGE CHANGES AT ANNUAL RATES;

PRELIMINARY DATA FOR 77:2

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

PAGE 2

1975

YEARS
1977
1976

198.3
14.2

123.5
-2.7

156.8
27.0

168.8
7.6

189.3
12.1

76.2
13.1

79.2
16.6

50.2
-4.2

64.8
29.0

67.2
3.9

75.2
11.9

112.3
13.7

115.8
13.1

119.3
12.7

73.4
-1.6

92.1
25.5

101.6
10.3

114.0
12.3

72.1
14.1

74.0
10.7

75.9
10.7

77.4
8.3

49.1
57.5

63.3
29.0

67.8
7.1

74.8
10.4

1590.0
9.7

1630.0
10.4

1669.0
9.9

1710.0
10.2

1751.0
9.9

1253.4
8.5

1382.7
10.3

1535.1
11.0

1690.0
10.1

225.4
0.9

232.5
13.2

234.6
3.7

242.4
14.0

254.1
20.7

262.4
13.7

169.0
-0.8

196.9
16.5

226.8
15.2

248.4
9.5

1295.2
14.4

1328.1
10.6

1357.5
9.1

1395.4
11.6

1426.6
9.2

1455.9
8.5

1488.6
9.3

1084.4
10.1

1185.8
9.4

1308.3
10.3

1441.6
10.2

1201.0
12.4

1223.6
7.7

1247.1
7.9

1275.8
9.5

1306.1
9.8

1336.7
9.7

1367.3
9.5

1398.7
9.5

1004.2
10.0

1119.9
11.5

1236.9
10.4

1352.2
9.3

56.3
-43.0

51.4
-30.5

71.6
276.5

81.0
63.8

81.7
3.4

89.3
42.6

89.9
2.7

88.6
-5.6

89.9
6.1

80.2
11.9

66.0
-17.7

71.4
8.3

89.4
25.2

4.6

4.1

5.5

6.1

6.0

6.4

6.3

6.1

6.0

7.4

5.6

5.4

6.2

EMPLOYMENT
%Ch

88.133
1.5

88.998
4.0

90.370
6.3

90.800
1.9

91.200
1.8

91.700
2.2

92.300
2.6

92.800
2.2

93.400
2.6

84.768
-1.3

67.488
3.2

90.342
3.3

92.550
2.4

LABOR FORCE
%CH

95.711
1.9

96.067
1.5

97.186
4.7

97.600
1.7

98.100
2.1

98.500
1.6

99.000
2.0

99.400
1.6

99.900
2.0

92.631
1.8

94.790
2.3

97.238
2.6

99.200
2.0

7.900

7.367

7.000

6.967

6.904

6.768

6.640

6.507

8.483

7.708

7.092

6.704

14.607
-0.3

14.731
3.4

14.735
0.1

14.788
1.4

14.858- 14.923
1.8
1.9

14.959
1.0

14.992
0.9

15.031
1.0

14.180
0.1

14.569
2.7

14.778
1.4

14.976
1.3

1.318
2.6

1.335
5.4

1.375
12.4

1.395
6.0

1.428
5.2

1.444
4.6

1.459
4.2

1.475
4.5

1.178
-8.9

1.298
10.1

1.379
6.2

1.452
5.3

FORECAST
1978:1 1978:2

1976:3

1~978:4

180.3
15.0

186.2
13.7

192.0
13.1

69.1
5.6

71.6
15.0

73.9
13.7

102.7
5.6

105.0
9.1

106.7
15.0

67.6
51.1

72.8
34.4

69.8
-15.6

1476.8
13.1

1520.1
12.3

1553.5
9.1

209.5
19.0

224.4
31.6

224.9
0.9

1222.6
10.2

1252.4
10.1

PERSONAL OUTLAYS
%CH

1166.3
14.1

PERSONAL SAVINGS
%CH

1976:4

ACTUAL
197?:1

1977:2

1977:3

1977:4

154.8
-12.2

161.7
19.1

168.6
18.2

170.9
5.6

174.1
7.7

TAX LIABILITY
%CH

63.9
-11.6

64.4
3.2

67.3
19.1

68.2
5.6

AFTER TAX PROFITS
%CH

90.9
-12.6

97.2
30.7

101.3
18.1

59.2
-41.2

61.0
12.7

1432.2
11.5

PRETAX PROFITS*
%CH '

AFT TAX PROF ADjl)
%CH
PERSONAL INCOME
%CH
^^XT'a

TAX & NONTAX PAYMENT

SjV

%H
C

* V ^

DISPOSABLE INCOME
%CIi

SAVING RATB(%)

UNEMPLOYMENT RATE{%)
PRODUCTIVITY*
%CH
INDUSTRIAL PRODUCTION
%Ch
MONEY SUPPLY-(Ml)
%CH
VELOCITY OF Ml
%CH
MONEY SUPPLY-(M2)
%CH
VELOCITY OF M2
%Ch

7.034.

1.410
4.4

311.067 314.400 321.067 327.000 332.500 338.000 343.500 349.000 355.000
6.6
6.8
8.8
4.4
6.6
6^9
6V7
7a
5.643
• 0.1

5.760
8.5

5.821
4.4

5.841
1.4

5.877
2.5

5.926
3.4

5.974
3.3

6.017
2.9

6.062
3.0

732.833 751.033 768.367 787.000 806.000 825.000 844.000 863.50" 884.500
9.6
10.1
9.5
10.1
9.b
9.8
10.0
10.3
13.1
2.395
-5.7

2.411
2.7

2.432
3.6

2.427
-0.9

2.424
-0.4

2.428
0.6

2.431
0.6

2.432
0.1

2.433
0.2 1

1978

289.475 304.192 323.742 346.375
5.1
4.2
6.4
7.0
5.279
3.8

5.609
6.2

5.825
3.8

5.995
2.9

640.958 703.833 778.100 654.250
9.8
10.6
9.8
7.7
2.384
0.5

2.425
1.7

2.424
-0.1

2.431
0.3

NOTE: PROFITS FOR 77:2 ARE ESTIMATES; PRODUCTIVITY TS CALCULATED AS CONSTANT DOLLAR GNP PER WORKER
1) AFTER TAX PROFITS ADJUSTED TO EXCLUDE INVENTORY PROFITS AND ALLOW FOR DEPRECIATION A'n REPLACEMENT COST

iiS-?' fi
6/7^

ECONOMIC OUTLOOK

PAGE 3

,
ACTUAL
,
FORECAST
1976:4 1977:1 1977:2 1977:3 1977:4 1978:1 1978:2 1978:3 1978:4

1975

YEARS
1976
1977

1978

INTEREST RATES.
7.85

7.88

7.92

8.00

8.25

8.50

8.70

8.75

9.00|

8.91

8.25

8.01

8.74

PRIME RATE

6.543

6.250

6.470

6.750

7.000

7.500

7.750

8.000

8.000^

7.863

6.841

6.617

7.813

COMMERCIAL PAPER 4-6 MOS.

4.990

4.810

5.237

5.750

6.000

6.500

7.000

7.250

7.500

6.318

5.345

5.449

7.063

10.167 11.233 11.667 11.113 11.232 11.432 11.500 11.444 11.510

8.675

10.125 11.311

11.471

NEW ISSUE AA INDUS BONDS

AUTO SALES 1)
DOMESTIC

8.467

9.400

9.300

9.400

9-603

9.660

9.613

9.668

7.100

8.633

9.350

9.636

IMPORTS

1.700

1.833

2.367

1.813

1.832

1.829

1.840

1.831

1.842

1.575

1.492

1.961

1.836

1.770

1.758

1.889

1.857

1.831

1.835

1.766

1.669

1.6501

1.162

1.541

1.834

1.730

HOUSING STARTS 1)

1) IN MILLIONS OF UNITS—SEASONALLY ADJUSTED ANNUAL RATES

t.7&
33XC

cZ^tZZ

MORGAN STANLEY&

CO.

Institutional

Incorporated

Weekly

Federal Reserve

Report

Research

September 9, 1977

The chickens of August may be coming home to roost. Following two months during
which the Federal Reserve has been pumping up the total of high-powered money in
the economy at an excessive rate, participants in the financial markets should not
be surprised to see outsized increases in the money supply. We will admit to
having been taken aback a bit by the timing of the $3-billion jump in M-l that was
announced late yesterday afternoon. Our estimates had suggested demand deposits
in the banking system (which account for almost all of the volatility in the
money supply) would rise about $1-bi11 ion before seasonal adjustment in the week
of August 31, in contrast to the central bank's initial estimate of a $3.1-billion
increase. But the fact that growth in the money supply has once again spurted
ahead is a natural consequence of the monetary policy that the Federal Reserve has
actually implemented since late June. For the past 10 weeks, the four-week to^
four-week annual rate of increase in the monetary base has averaged 11.6%. This
is not only far above a level that would be consistent with the money managers'
announced objective of gradually restoring general price stability, but also has
had the effect of actually injecting reserves into the banking system faster than
banks have been able to make efficient use of them.
As we commented in our Weekly Federal Reserve Report dated August 19, "the Federal
Reserve System has not yet succeeded in bring ing monetary expansion under control."
The fact is, time is growing short for the
central bank to take effective action to
restore monetary stability. If the rate of
growth in the money supply is not reduced
CONTENTS
quickly, the fabric of improved inflationary
expectations -- so painfully woven over the
The Chickens Come Home
past four years -- will begin to disinteto Roost
1
grate. Such a development would of course
The New IMF Annual Report
3
pose a serious threat to financial markets,
but, in addition, it would also foreshadow
4
Money Market Developments
new and dangerous instabilities in the real
economy as well.
Targets for the Monetary
Base
Speaking to the graduating class at Jackson4
ville University last month, Arthur F. Burns,
Factors Affecting the Money
chairman of the Federal Reserve Board,
Multiplier (A Chart
rightly observed that "in a period of ris5-7
Display)
ing demands for funds, a determined effort
by the System to keep interest rates down
8
Figures of the Week
could quickly turn the Federal Reserve into
something akin to the engine of inflation
J Statistical Appendix
that it was during the early Korean War

This memorandum is for general information and is not to be relied upon in connection with the purchase or sale of any securities. No representation is made that
the information contained herein is accurate or complete. Morgan Stanley & Co. Incorporated, its directors, advisory directors, officers, affiliates, and accounts with respect
to which the foregoing have investment discretion, may have long or short positions in and may from time to time purchase or sell securities of companies referred to
in this memorandum. Morgan Stanley & Co. Incorporated or one of its affiliates may from time to time perform investment banking services for, or solicit investment
banking business from, companies referred to in this memorandum.

http://fraser.stlouisfed.org/
Stanley &
Federal Reserve Bank of St. Co. Incorporated
Louis

1251 Avenue of the Americas, New York, N.Y. 10020

(212)977-4000

-2period...Actually, the consequences now would almost certainly be far worse than
they were a quarter-century ago because the public has become far more sensitive
to inflation. Long-term interest rates, in particular, tend to respond quickly
nowadays to changing inflationary expectations. Once the financial community
perceived that the Federal Reserve was pumping massive reserves into commercial
banks with a view to creating monetary ease, fears of a new wave of inflation would

Federal Reserve Data
(Weekly Averages of Daily Figures; in Mill ions of Dollars)

Latest Week

Change From
Prev. Week

Rates of Change Over
3 Months 6 Months 1 Year

$330,400

$+3,000

+ 9.3%

+ 9.2%

+ 7.0%

Money Supply Plus Comm'l
Bank Time Deposits Other
Than Large CDs (M-2)* (1)

791,200

+4,000

+10.5

+10.0

+10.8

Monetary Base* (2)

126,500

300

+10.4

+ 9.5

+ 8.4

Adjusted Federal Reserve
Credit* (2)

106,900

600

+12.0

+10.9

+ 8.7

35,500

260

+11.2

+ 7.6

+ 4.7

637

755

[Money Supply (M-l)* (1)

Total Member Bank
Reserves* (2)
Member Bank Borrowing (2)

Wednesday Figures
Short-Term Business
Credit* (1)

192,720

114

+ 7.6

+ 8.9

+ 7.9

60,843

+30.8

+31.2

+17.5

119,795

Total Commercial Paper
Outstanding* (1)

281

+ 6.1

+ 4.6

+ 6.5

+ 4.0

+ 1.3

+ 4.2

- 4.8

- 5.3

+ 2.4

Business Loans:
All Large Banks* (1)
New York City Banks* (2)

34,063

Chicago Banks* (2)

11,117

*Seasonally Adjusted

NA = Not Applicable

Rates of change are compound annual rates except for total reserves. Short-term
business credit includes commercial and industrial loans at large banks plus loans
sold to affiliates less bankers' acceptances plus loans at large banks to finance
companies and nonbank financial institutions plus nonbank commercial paper. Loan
reclassifications and mergers at New York City banks increased the reported total
of commercial and industrial loans at these banks by $684-million at year-end 1976.
(1) August 31

(2) September 7

MORGAN STANLEY*

CO.

Incorporated

quickly spread...Heightened inflationary expectations would soon overwhelm markets
in today's inflation-conscious environment by actually causing long-term interest
rates...to rise. The policy of seeking lower interest rates by flooding banks with
reserves would thus be frustrated. And I need hardly add that adverse effects on
production, employment, and the dollar's purchasing power would follow."
Dr. Burns averred that "the Federal Reserve System, I assure you, will not be deterred by the drumbeat of dubious propositions concerning money and interest rates.
We are determined to continue on a path of further gradual unwinding of the inflationary tendencies that have become so deeply embedded in our economic life." For
ourselves, we find Dr. Burns' stirring rhetoric to be ironic, for if the central
bank had not been seeking to peg short-term interest rates at an inappropriately low
level during the summer months, then clearly expansion of the monetary base would
not have accelerated to an average of more than 11%.
The importance of steady, even-handed, longer-range policies to deal with the symptoms of stagflation that appear to be troubling the world economy was stressed by
the International Monetary Fund in its 1977 annual report, which was published this
weekend:
"Economic policies in the industrial countries, and in most other
countries as well, are now placing a primary emphasis on mediumterm objectives. The central aim is to combat inflation and, where
necessary, strengthen the external position during the next few
years, in the firm belief that such an approach will yield the
best results for economic growth and employment in the longer run.
"Implementation of policies with an emphasis on medium-term objectives—involving a gradual approach to reduction of inflation,
absorption of the unemployed, and adjustment of the external position—is likely to prove difficult. It will require skill, patience,
and courage on the part of the authorities, together with a substantial measure of continuity. However, despite the problems that
might attend the gradual or moderate approach that has been generally
adopted, it would not appear that any better or more promising approach is available
"From this and other behavior in the recent period, it would appear
that (the industrial) countries have adopted a rather patient and
even-handed approach to the short-term conduct of fiscal and monetary policies, in contrast to the frequent changes of policy undertaken in the late 1960s and early 1970s. More than in the past, the
current approach involves the steering of a general course toward
medium-term growth objectives judged to be compatible with objectives for employment and prices and with the strength of the balance
of payments. It is this apparently greater tendency to gear shortterm demand management to a set of interrelated objectives over the
medium term that distinguishes current practice from that of the
earlier period, when the primary emphasis was on short-term growth
targets that frequently proved to be overly ambitious. "

in this memorandum. Morgan Stanley & Co. Incorporated or one of its affiliates may from time to time perform investment banking services for, or solicit investment
banking business
http://fraser.stlouisfed.org/ from, companies referred to in this memorandum.

Federal Reserve Bank of St. Louis

-4In this context, it would be disappointing indeed if the Federal Reserve System were
to fail to follow its own policy prescription.
MONEY MARKET DEVELOPMENTS
Federal Reserve member banks responded in predictable fashion to the too-long-delayed
increase in the discount rate to 5 3/4% that the Reserve Board finally implemented
in the last week of August. Borrowing at the discount window dropped by $755-million on a daily average to a total of $637-million. This more than offset a contraseasonal jump in Federal Reserve "float" (central bank credit automatically extended
on cash items in process of collection), and allowed the money managers overall to
reduce both the monetary base and Federal Reserve credit during the week. Even so,
the monetary base is continuing to expand at a rate well above that implied by the
money managers' official targets. The monetary base averaged $126.5-bil1 ion a day
during the four weeks ended on September 7, up at a 9.2% seasonally adjusted, compound annual rate from the average of $125.65-billion during the four weeks ended
on August 10. (These data, of course, refer to the monetary base as recently revised by the Federal Reserve Bank of St. Louis. See our Weekly Federal Reserve
Reports dated August 12 and August 19 for an extensive discussion of this revision.)
Demand for short-term credit from the business sector has been moderate in recent
weeks, continuing a trend that first began to be apparent around midyear. The
Morgan Stanley proxy for total short-term business credit outstanding—which declined slightly during the week ended August 31 (see the table on page 2)--averaged
$192.96-bil1 ion during the four weeks ended on that date, up at a compound annual
rate of 7.8% from the average of $191.8-billion outstanding during the four weeks
ended on August 3. This was well under the rate of gain in short-term borrowing by
business that was typical in the first part of the year. The Treasury has recently
announced its first net borrowing of new money in the short-term bill market (threeand six-month maturities) in quite some time. This announcement came somewhat earlier than many analysts had assumed, but as an offset to this demand—which is moderate in any event—foreign buyers of Treasuries have been aggressive recently.
According to the Federal Reserve Bank of New York, marketable Treasury securities
held in custody by the central bank for official foreign holders rose by almost
$1.5-bil1 ion during the week ended September 7 to a total of $62.2-billion. This
gain—in large part reflecting the regular monthly transfer of funds to the main oil
exporting nations—brought the total increase in these holdings from the comparable
date a year earlier to $12.7 billion.
TARGETS FOR MONETARY POLICY
We have argued many times in these letters that the Federal Reserve's standard operating procedure of trying to manage the monetary aggregates by manipulating shortterm interest rates is fraught with operational and economic problems. In effect,
the central bank attempts to peg the price for a commodity (namely, short-credit)
in a market where demand is yery unstable. In order for the market to clear, the
authorities are compelled to use their powers to produce substantial variations in
the supply of funds. The problem is that apart from the ministerial function of
offsetting daily swings in the availability of bank reserves caused by such factors
as changes in Treasury balances at the Federal Reserve banks, changes in Federal
Reserve "float", and changes in the public's demand for currency, the authorities
have continuously to probe the market to determine through ad hoc experimentation
what the demand for funds actually is.

MORGAN STANLEY& CO.
Incorporated

•5-

Figure 1
The Money Multiplier

—
-—

Ratio: M-l to Monetary Base
Least-Squares Trend

2.96 >

2.80

2.72

2.64

2.56
10/24/73

Sources:

7/31/74

5/7/75

2/11/76

11/17/76

*
8/24/77

Chase Econometric Associates Data Base; Morgan Stanley Research

Figure 2
The Reserve Ratio

———

Ratio: Total Effective Bank Reserves to Total Bank Deposits
Least-Squares Trend

.0563 -

.0555 -

.0547

.0539

.0531

"*lj

Y x

10/24/73

Sources:

7/31/74

5/7/75

2/11/76

11/17/76

8/24/77

Chase Econometric Associates Data Base; Morgan Stanley Research

Federal Reserve Bank of St. Louis

-6Errors in central bank judgment about the underlying equilibrium rate in the money
markets—of the sort, we would submit, that has developed this summer—have helped
to produce much of the instability in central bank policy in recent years. As we
have stated many times in the past, we would prefer that the Federal Reserve seek
explicitly to manage the monetary base, which in the long run accounts for most of
the change in the money supply. There remains, then, the problem of identifying an
appropriate target rate for the expansion of the monetary base. Plainly, as Figure
1 shows, the ratio of the money supply to the monetary base is not one, but rather
shifts in response to changes in the public's portfolio decisions concerning the
form in which money assets are held. The key relationships that determine these
changes in money multiplier are shown in Figures 2, 3, and 4. Each of these ratios
bears an inverse relationship to the money multiplier—a higher ratio means a lower
multiplier. (We have discussed the reasons for these associations repeatedly in our
regular monthly analyses of the relationship between Federal Reserve action and
monetary growth, most recently on August 19.)
In effect, this method of analysis seeks to separate the money stock into two components: that portion which is determined by central bank policy (namely, the monetary base) and that portion which is determined by actions of the public, the banking system and the Treasury (namely, the money multiplier). Obviously, the policy
maker must have some notion of the interaction of these external factors in making
a decision about the target band within which growth in the monetary base should be
contained. Vie have done considerable analysis—both short- and long-run—of the
behavior of the factors that determine the money multiplier. We have concluded that,
despite the substantial short-run volatility in the reserve ratio (which on a weekto-week basis is an approximate measure of the efficiency with which banks are using
reserves supplied by the central bank), there are basic trends which are evident that
can be useful for policy purposes.
For instance, from 1956 through mid-1977, the average quarter-to-quarter rate of
change in M-l was 4.18%, while the average rate of change in the monetary base was
5.23%. This difference of 1.05 percentage points was accounted for by a mean positive contribution of 98 basis points from the reserve ratio (largely reflecting the
secular increase in time deposits relative to demand deposits, since time deposits
have a lower reserve requirement than demand); a negative contribution of 46 basis
points from the increase of currency relative to demand deposits; a negative contribution of 143 basis points from the rise of time deposits relative to demand deposits (rising time deposits absorb reserves otherwise available to support demand deposits, the principal component of M-l); and a negative contribution of 14 basis
points from the Treasury deposit ratio.
The postwar history has been that the monetary base has grown on average at about
25% faster than the narrowly defined money supply. This, it would seem to us, should
be an outer constraint on the permissible rate of expansion of the base. In other
words, if the desired rate of growth of the money supply is 5.5%, then the monetary
base should in general not expand faster than 6.875%. This should be the maximum,
for there is evidence (as the charts show) that the rate of increase in both the
currency ratio and the time deposit ratio has been slowing down in recent months,
which, in turn, has led to a slower rate of decline in the money multiplier.
If the implications of this analysis are correct, then there is no question that
the monetary authorities have been following a high-risk course this summer. The

MORGAN STANLEY & CO.
Incorporated

-7-

Figure 3
The Currency Ratio

_
.38

.36

.34

Ratio: Currency to Demand Deposits
Least-Squares Trend

.32

.30

**-*£>'
*

28
"~

Sources:

•
10/24/73

7/31/74

5/7/75

2/11/76

11/17/76

8/24/77

Chase Econometric Associates Data Base; Morgan Stanley Research
Figure 4
The Time Deposit Ratio

Ratio: Total Time Deposits to Demand Deposits, All Banks
Least-Squares Trend
2.2

y
/•
-1**

2.1

•

2.0

1.9

1.8

y *

y* f
y *

1 7 "
10/24/73

Sources:

7/31/74

•

' '•

5/7/75

T - ' "

2/11/76

'••*-'-'-'"

•
'

11/17/76

•""

8/24/77

Chase Econometric Associates Data Base; Morgan Stanley Research

This memorandum is for general information and is not to be relied upon in connection with the purchase or sale of any securities. No representation is made that
the information contained herein is accurate or complete. Morgan Stanley & Co. Incorporated, its directors, advisory directors, officers, affiliates, and accounts with respect
to which the foregoing have investment discretion, may have long or short positions in and may from time to time purchase or sell securities of companies referred to
in this memorandum. Morgan Stanley & Co. Incorporated or one of its affiliates may from time to time perform investment banking services for, or solicit investment
for FRASER
banking business from, companies referred to in this memorandum.

Digitized

-8recent increases in the monetary base may well be translated into very large rises
in the money supply.
The interest rates regularly monitored by the Federal Reserve were as follows:
Rate
Federal Funds
90-Day Treasury Bills
90- to 119-Day Commercial Paper
90-Day CDs (Secondary Market)
90-Day Eurodollars
20-Year Governments

Daily Avennge Week Ended
August 31
September 7
6.02%
5.56
5.88
5.98
6.30
7.53

5.97%
5.57
5.88
5.97
6.26
7.51

Change in
Basis Points
- 5
+ 1
--

- 1
- 4
- 2

H. Erich Heinemann
(212) 977-4410
September 9, 1977

MORGAN STANLEY& CO.
Incorporated

-l-

STATISTICAL APPENDIX - CAPITAL MARKET ACTIVITY 1976-1977
Table 1
Bond Market Volume 1971-1977*
Publicly Offered Nonconvertible Debt
($ Millions)
1976

1977

$ 3,680
3,759
3,684

$ 2,670
2,323
3,267

$ 2,964
1,371
2,652

6,899

11,123

8,260

6,987

1,635
996
1,524

2,149
2,288
1,917

2,866
3,844
4,150

2,713
2,425
3,610

2,263
1,496
2,890

4,987

4,155

6,354

10,860

8,748

6,649

1,684
1,438
2,158

1,905
1,495
1,313

1,200
986
656

2,065
2,018
1,025

3,112
1,287
1,569

1,681
1,746
2,264

3,053
1,825

Total 3rd Quarter

5,280

4,713

2,842

5,108

5,968

5,691

October
November
December

2,307
1,895
1,502

2,015
1,952
1,532

1,800
1,936
2,138

3,565
3,066
2,701

2,345
2,292
2,537

2,857
2,423
2,687

Total 4th Quarter

5,704

5,499

5,874

9,332

7,174

7,967

$24,792

$21,821

$16,391

$27,693

$35,125

$30,666

1971

1972

$ 2,017
2,116
3,925

$ 2,849
1,855
1,918

$ 1,231
611
1,678

$ 2,532
2,060
2,307

Total 1st Quarter

8,058

6,622

3,520

April
May
June

1,822
2,004
1,924

1,901
1,616
1,470

Total 2nd Quarter

5,750

July
August
September

January
February
March

Total

1973

1974

1975

*Excludes Federal, state, and local issues as well as tax-exempt pollution contral financing;
includes a limited number of underwritten offers by Federal agencies
Source:

Morgan Stanley & Co. Incorporated

banking business
http://fraser.stlouisfed.org/from, companies referred to in this memorandum.

Federal Reserve Bank of St. Louis

-nTable 2

Public Bond Sal

1976
January
February
March
Total 1st Quarter

$ 100
335

Transport.
Utility
$
77 $ 548
193
320
107
595

$ 1,265

$ 3,070

$ 435

15.3%

37.2%

5.3%

$ 1,400
16.9%
$

315

$ 3,018
34.5%

210 $ 400
380
367
400

$ 1,060
18.6%

20.5%

250

$ 1,915
24.0%

Total 1976
Percent
1977
January
February
March

$ 7,393
$ 24.1%
800
265
475

$ 4,820
$ 15.7%
300
433
125

$1,540

June
Total 2nd Quarter

750
561

380

125

$1,270

$ 300

22.3%

5.3%

862 $ 150
220
150
885

$ 1,967

$ 8,294
27.0%

178 $ 1,272

$ 2,175
7.1%

$ 1,660

$ 1,085

12.3%

23.8%
$

260

$ 1,060

33.5%

37.4%
$ 5,628
30.4%

5
$

15.9%
$

185
150
8.2%

$ 2,253
12.2%

580 $ 275
150
135

11.1%
$

3,267
250

3.0%
$

$ 8,260
100.0%

150

$ 2,713
2,425

63
1

3,610

210

$ 8,748

2.4%

14.5%

136 $ 525
84
160

100.0%

200

$ 5,691
100.0%
$ 2,857
2,423
2,687

104

$ 7,967
100.0%

185 $ 680
84
655
252

380
$

2,264

22.9%

$ 1,681
1,746

3.5%

100
100

620

389 $ 1,305
6.8%

521
6.5%

$ 1,715
21.5%
$

$ 1,465
4.8%
$
379

$ 5,755
18.8%
$
610

567

$ 1,117

2.5%

764

100.0%

$30,666

420

8.1%
$

60
100

1,371
2,652

160

$ 6,987

2.3%

16.0%

11.7%

560
250

682

256

$ 1,492

3.9%

98
40

$ 2,964
$

118

370

735 $ 780

$ 2,670
2,323

1.3%

15.5%

$ 2,226

682

825 $ 50
200
280
635
755

150
100

525

169

$ 450
5.6%

Total

100

150

24.7%

800

Percent

$ 175

$ 217
530

2.0%

$ 310
580

858

915

$ 1,18,0

Percent

93
62
22_

16.3%

22.0%

Percent
July
August

Total Year to Date

Misc.

17.7%

142

Total 1st Quarter

April
May

11.3%

$ 1,295

Percent

22.7%

377 $ 1,463
4.6%

$ 990

745 $ 235
500
810
670

775 $ 450
715
497
540

$1,987

$ 1,167

December
Total 4th Quarter

12.5%

470

Percent
October
November

$ 1,093

September
Total 3rd Quarter

428

1,650

Percent
July
August

350

June
Total 2nd Quarter

600

768

Telephone

-To-Date 1977

IndusBanks
For &
& Fin.
Provinc. t r i a l s
$ 590 $ 455 $ 850
900
300
410
1,320
510
400

Percent
April
May

;; 1975-1976 and Yea
By Type of Issuer
($ M i l l i o n s )

22.4%

860 $

400

21.9%

2.5%

$ 3,655

$ 1,952

$ 1,362

$ 3,344

19.7%

10.5%

7.4%

18.1%

331
208
11.4%

100

—

$ 2,263
1,496

2,890
$ 6,649

1.5%
$

100

100.0%

$ 3,053
1 ,825

395

100.0%

340
18.6%

100.0%

320

518,514

1.7%

100.0%

MORGAN STANLEY& CO.
Incorporated

-IT 1Tab!e 3
Publ ic Bond Sal es; 1975-1976 and Year -To-•Date 1977
By Rating of Issuer
($ Mill ions)
Moody's Rating
Aaa

1976
January
February
March

Baa

Unrated
or lower

Total

$ 1,037
994
797

578
352
890

175
60
455

30
202

$ 2,670
2,323
3,267

$ 2,690

$ 2,828

$ 1,820

690

232

$ 8,260

32.6%

Total 1st Quarter

850
715
1,125

34.2%

22.0%

2.8%

100.0%

Percent
April
May
June

$ 1,225
615
1,640

Total 2nd Quarter

$ 3,480

$ 1,820

Percent

39.8%

July
August
September

Total 3rd Quarter

$ 1,197

October
November
December

Total 4th Quarter

$ 1,956

544
1,075
337

894
370
820

95
195

48
479
82

$ 2,713
2,425
3,610

$ 2,084

755

609

$ 8,748

7.0%

100.0%

20.8%

21.0%

Percent

463
192
542

451
766
603

233
436
1,125

8.4%

23.8%
387
390
447

475
325
150

123
403

$ 1,681
1,746
2,254

$ 1,794

$ 1,224

950

526

$ 5,691

31.5%

21,5%

871
761
585

8.6%

16.7%

9.2%

100.0%

Percent
1977
January
February
March

140
180
355

192
57
245

$ 2,857
2,423
1,687

$ 2,217

$ 2,625

675

494

$ 7,967

27.8%

32.9%

8.5%

6.2%

100.0%

$ 9,323

$ 8,659

$ 7,753

$ 3,070

30.4%

Total 1976

24.5%

Percent

$ 1,110
350
1,165

28.2%

25.3%

10.0%

$ 1,709
713
1,181

Total 1st Quarter
Percent

$ 3,603

51.6%

655
173
83

911

$ 1,687

475
300

9J1
$

24.1%

13.0%

$30,666

6.1%

100.0%

125
50
250

135
_226

$ 2,964
1,371
2,652

425

361

$ 6,987

5.2%

100.0%

6.1%

April
May
June

$ 1,175
505
1,250

546
210
730

278
230
__255

140
280
182

124
271
473

$ 2,263
1,496
2,890

Total 2nd Quarter

$ 2,930

$ 1,486

763

602

868

$ 6,649

Percent

44.1%

22.3%

13.0%

100.0%

July
August

$ 1,550
250

424
494

$ 3,053
1,825

Percent

13.6%

20.4%

28.5%

27.1%

100.0%

$ 8,333

$ 3,397

$ 3,370

$ 2,147

$18,514

45.0%

18.4%

18.3%

11.5%

100.0%

Total Year to Date
Percent
Source:

629
371

11.5%
$

400
520

9.1%

50
190
10.4%

$ 1,267
6.8%

Morgan Stanley & Co. Incorporated

This memorandum is for general information and is not to be relied upon in connection with the purchase or sale of any securities. No representation is made that
the information contained herein is accurate or complete. Morgan Stanley & Co. Incorporated, its directors, advisory directors, officers, affiliates, and accounts with respect
to which the foregoing have investment discretion, may have long or short positions in and may from time to time purchase or sell securities of companies referred to
in this memorandum. Morgan Stanley & Co. Incorporated or one of its affiliates may from time to time perform investment banking services for, or solicit investment
for FRASER
banking business from, companies referred to in this memorandum.

Digitized

IVTable 4
Public Bond Sales; 1975 -1976 and Year-To-Date 1977
Maturity
By 1
($ M illions)
Over Ten Years

Total

978
750
1,005

$ 1,692
1,573
2,262

$ 2,670
2,323
3,267

$ 2,733

$ 5,527

$ 8,260

33.1%

66.9%

100.0%

Five To Ten Years
1976
January
February
March
Total 1st Quarter

Percent
April
May
June

998
718
1,029

$ 1,715
1,707
2,581

$ 2,713
2,425

Total 2nd Quarter

$ 2,745

$ 6,003

$ 8,748

31.4%

68.6%

100.0%

Percent

J, 6JO

July
August
September

670
530
970

$ 1,011
1,216
1,294

$ 1,681
1,746
2,264

Total 3rd Quarter

$ 2,170

$ 3,521

$ 5,691

38.0%

62.0%

100.0%

Percent
October
November
December

650
653
905

$ 2,207
1,770
1,782

$ 2,857
2,423
2,687

Total 4th Quarter

$ 2,208

$ 5,759

$ 7,976

27.8%

72.2%

100.0%

$ 9,856

$20,810

$30,666

32.1%

67.9%

100.0%

625
478
225

$ 2,339
893
2^427

$ 2,964
1,371
2,652

$ 1,328

$ 5,659

$ 6,987

19.0%

81.0%

100.0%

Percent
Total 1376
Percent
1977
January
February
March
Total 1st Quarter

Percent
April
May
June

575
360
890

$ 1,688
1,136
2,000

$ 2,263
1,496
2,890

Total 2nd Quarter

$ 1,825

$ 4,824

$ 6,649

27.4%

72.6%

100.0%

925
150

$ 2,128
1,675

$ 3,053
1,825

8.3%

91.7%

100.0%

$ 4,228

$14,286

$18,514

22.8%

77.2%

100.0%

Percent
July
August
Percent
Total Year to Date
Percent

Source: Morgan Stanley & Co. Incorporated

MORGAN STANLEY& CO.
Incorporated
-V-

Table 5
cly Offered Convertiblt? Debt
Publi.
1975 -1976 and Year-To-Date 1977
($ Millions)
Trans. &
Utility

Banks &
& Fin.

Industrials

—

$ 120
90
120

—

$ 120
90
120

$ 330

Percent

—

100.0%

—

100.0%

Apri 1
May
June

32
15
426^

—

Total 2nd Quarter

—

$ 473

Percent

—

100.0%

1976
January
February
March
Total 1st Quarter

July
August
September

$ "" 4
3

Total 3rd Quarter

Tejjephone

32
15
426

$ 473

100.0%

—

Total 4thQuarter

—

Percent

—

91.5%

44.4%
7

$ 819

$ _J75

Percent

0.8%

89.0%

Total 1st Quarter

—

April
May
June

—

8.1%

—

55.6%

100.0%

$_?_21_

2.1%

100.0%

_
_

—

- * •

—
$

Total 2ndQuarter

15
21

—

Total 1976

15
1

4
78

—

8.5%

October
November
December

—
$

Percent

Total

56
$

Percent

July
August

Percent

—

100.0%

—

Total Year to Date

—

$ 335

—

Percent

87.1%

52.8%
21
258

---

$ 106

47.2%

100.0%
$

-—

21
258

100.0%

50
12.9%

$ 335
100.0%

Source: Morgan Stanley & Co. Incorporated

This memorandum is for general information and is not to be relied upon in connection with the purchase or sale of any securities. No representation is made that
the information contained herein is accurate or complete. Morgan Stanley & Co. Incorporated, its directors, advisory directors, officers, affiliates, and accounts with respect
to which the foregoing have investment discretion, may have long or short positions in and may from time to time purchase or sell securities of companies referred to
forin this memorandum. Morgan Stanley & Co. Incorporated or one of its affiliates may from time to time perform investment banking services for, or solicit investment
FRASER
banking business from, companies referred to in this memorandum.

Digitized

-VI'

Table 6
Underwritten Public Common Stock Sales, 1975.-1976 and Year-To-Date 1977
By Type of Issuer and Issue

($ Millions)
Banks &
& Fin.
1976
January
February
March
Total 1st Quarter

$
$
$

144

Total 2nd Quarter

4
3
7

Percent
$

Total 3rd Quarter

Total 4th Quarter

170

181

490

—

39.9%

—

$
36
5
41

3.1%

Total 2nd Quarter

Percent

220

Percent
$

8.4%

$
147
147

257
182
537

100.0%

18
19
20

—

$1,227

4.6%

—

100.0%

18
22
26

—

$1,425

100.0%

682

_
_

$7,831

8.7%

100.0%

74
868
192

432

$1,134

2.3%

18.6%

—

$ "" 2

$1,324
100.0%

$1,993

—

89
9

15
1.2%

100.0%

JL2
8.0%
i

—

61.0%

0.1%

14.2%

$ 354
258

17.8%

$ 555

370
907
716

—

38
46

582
388
45

289
389
646

428
381
418

7
_

$ 160

22.9%

4.8%

0.1%

644
713
1,162

10
9
77

—

$2,397

7.2%

228
59

192

—

56.9%

976

93
27
312

10.2%

—

0.1%

73,7%

11.1%

16.0%

0.5%

50.4%

Source: Morgan Stanley & Co. Incorporated

$3,951

—

9.3%

659

402

$2,519

—

88
48

78.8%

105

366

40.7%

$ "" 6

$1,118

21.7%

11.0%

295
41
242

—

402

0.08%

3.7%

114
3
103

13
15
21_

—

4.6%

354
357
407

26.9%

282
70
50

47.1%

40
9
6

$2,103

100.0%

157

578

—

29.5%
$

115
303
72

$2,665.

5.9%

742

26.2%

28.1%

428

Percent

659

5.5%

April
May
June

Total Year to Date

336
884
1,445

213
366
163

659

707

3.8%

Percent

145
272
290

9
37

—

12.8%

Percent

July
August

56.8%

Percent

Total 1st Quarter

—

7.8%

October
November
December

1977
January
February
March

Total

Misc,

$1,513

Percent

Secondary
Offers
$

296
443
774

851

18
78
96

Trans.

31.9%

0.3%

July
August
September

Utility

—

5.4%

April
May
June

Telephone

31
368
452

36
108

Percent

Total 1976

Industrials

100.0%
15

$3,929

0.4%

100.0%

MORGAN STANLEY & CO.
Incorporated
-V1V

Table 7
Public Preferred Stock Sales; 1975-1976 and Year-To-Date 1977
By Type of Issuer
($ Millions)
Utility
1976
January
February
March

Total 1st Qularter

Percent

Total 2nd Qilarter

Percent

529

Total 3rd Qilarter

Percent

10(c)
135
239

Total 4th Qijarter

Percent

384

Total 1st Quarter

April
May
June

Total 2nd Qularter

Percent

Includes
Includes
Includes
Includes
Includes
Includes
Includes
Includes
Includes
Includes
Includes

100.0%

31
264
289
584

110

—

18.8%

100.0%

50
5(f)

280

18.3%

90
114
140

13.4%

410

100.0%

—

140
190
240

570

100(g)
150

26.3%

13.3%

495

$230

21.6%

5.7%

$2,293

5.7%

100.0%

—

53
200

228

38.6%

65
163

262

100.0%

131

407

253

707

$ "~75
187(1)

22
50

85
190
135

95
42
270

47.9%
(a)
(b)
(c)
(d)
(e)
f)
(g)
(h)
(i)

21(b)
19(d)
50

95
117
467

679

10
10
1.5%

100.0%
$

49.8%
$

100(d)

16(e!)

615

41.7%

1.1%

508

100.0%

$
100(k) $

66.7%
$

65
218
225

2(m)
25(n)

5.3%

33.3%

Total Year to Date

729

44.9%

July
August

50
25(e)

59.9%

Percent

139
165
425

—

2.7%

15.4%

344

67.0%

1977
January
February
March

Total

Ins. &
Banks

85
90
105

$1,537

Percent

180

60.4%

Total 1976

20
100(a)
60

68.3%

October
November
December

Telephone

24.7%

65.8%

July
August
September

Notes:

119
45
365

72.6%

April
May
June

Trans. &
Industrials

138
150

100.0%

137

$1,475

9.3%

100.0%

$100-mil1ion of convertibl e preferred stock
$21-million of convertible preferred stock
$2-mi11ion of convertible preferred stock
$19-million of convertible preferred stock
$25-mil1ion of convertible preferred stock
$5-million of convertible preferred stock
$100-million of convertibl e preferred stock
$62-million of convertible preferred stock
$2-million of convertible preferred stock
$25-million of convertible preferred stock
$100-mi11ion of convertibl e preferred stock

Source: Morgan Stanley & Co. Incorporated

Federal Reserve Bank of St. Louis

-viii-

Table 8
Private Placements by Type of Issuer
($ Milllions)
Transportation

Utility

Misc.

Total

$ 63

$ 57
26
15

$ 1,646
818
1,014

$ 27

$ 63

$ 98

$ 3,478

66.3%

0.8%

1.8%

2.8%

100.0%

45
248

$ 961
703
657

$ 28
21
89

$147
64
34

$392
40
112

293

$2,321

$138

$245

$544

$ 4,093

7.1%

56.7%

3.4%

6.0%

13.3%

100.0%

70
150

$ 889
722

$203

$ 37
87

$111

$ 75

$ 1,482
969

$ 958

$1,197

$6,239

$368

$432

$753

$ 75

$10,022

9.5%

11.9%

62.3%

3.6%

4.4%

7.5%

0.8%

100.0%

Bank

Industrial

Telephone

363
160
161

$1,174
476
657

$ 1
9

684

$2,307

19.7%

Foreign

1977
January
February
March

$ 51
147
101

Total 1st Quarter

$ 299

Percent

8.6%

April
May
June

$ 43
210
299

Total 2nd Quarter

$ 552

Percent

13.5%

July
August
Total Year to Date
Percent

97
10

Source: Morgan Stanley & Co. Incorporated

—

1,616
1,286
1,191

S e p t e m b e r 9, 1977

Memo f r o m H o m e r J o n e s
With r e s p e c t to the forthcoming m e e t i n g S e p t e m b e r 19,
I f e a r it will of n e c e s s i t y be a quickie as the p a s t o n e s .

But p o s s i b l y

a groundwork could be laid for making s o m e p r o g r e s s subsequent to
the m e e t i n g .

P o s s i b l y t h e r e could be a v e r y s m a l l s u b c o m m i t t e e which

could examine some of the fundamental p r o b l e m s .

The s u b c o m m i t t e e

might not need to m e e t physically but could m a k e p r o g r e s s by post and
telephone.
This is an opportune time for the Shadow C o m m i t t e e to look
at how m o n e t a r y policy gets i m p l e m e n t e d - - n o w that we have gotten so
far off the t r a c k in the l a s t six m o n t h s .

We might examine:
1.

Does v e s t i g i a l (and still dominant? ) c o n c e r n with

i n t e r e s t r a t e s ( p r i m a r i l y s h o r t - t e r m , in both s e n s e s )
account for our getting off the track?
2.

Should we fear a s y s t e m of u t t e r l y free i n t e r e s t r a t e s ?

Would it be p r a c t i c a l or d e s i r a b l e to have f r e e d o m

of m o v e m e n t of i n t e r e s t r a t e s while a s s u r i n g that the
m o v e m e n t s not be " d i s o r d e r l y " yet avoiding getting led
a s t r a y as we r e c e n t l y have?
4.

Do we get led a s t r a y by not c o r r e c t i n g deviations f r o m

plan and blithely wiping the slate clean and s t a r t i n g off
f r o m a new base e v e r y q u a r t e r ?

- 2 -

Is t h e r e any s e n s e or is t h e r e g r e a t h a r m f r o m

operating on the "band" principle r a t h e r than s t r a i g h t forward t a r g e t s ?
6.

Does m o n e t a r y policy and the execution thereof

become confused by a multiplicity of " a g g r e g a t e " t a r g e t s ?
7.

Could we profit f r o m a simple paper examining v a r i o u s

p o s s i b l e " a g g r e g a t e " t a r g e t s , possibly concluding that
while c e r t a i n ones s e e m p r e f e r a b l e to o t h e r s the m o s t
i m p o r t a n t thing is to follow one and not a multitude in
s o m e unspecified and i n d e t e r m i n a t e way.
The m o s t i m m e d i a t e p r o b l e m will be to what extent the e r r o r s of the
p a s t six months should be offset in the next t h r e e or six or twelve months
and to what extent we m u s t let bygones be bygones.

Offsetting those e r r o r s

in t h r e e months would r e q u i r e a decline in M , in six months would
r e q u i r e e s s e n t i a l l y no i n c r e a s e , while in a y e a r would p e r m i t slight
growth over the y e a r .

MEMORANDUM
TO:
FROM:

Members of the Shadow Open Market Committee

DATE:

September 14, 1977

Rudy Penner
SUBJECT:

Enclosed is a report on the Federal Budget for the September 19th meeting.

AMERICAN ENTERPRISE INSTITUTE
FOR PUBLIC POLICY RESEARCH

THE FEDERAL BUDGET

A Report Prepared for the Shadow-Open Market Committee

Rudolph G. Penner
American Enterprise Institute

Background
Table 1 shows the evolution of the 1977 and 1978 Budgets from the
,f

lame-duck,f recommendations submitted by President Ford in January 1977

through the official July 1977 estimates of the Carter Administration.

Table 1
Budget Recommendations, Ford and Carter, Final Years
1977 and 1976
(billions of dollars)

1976
actual

Ford
(Jan.)

1977
Carter
(Feb.)

Carter
(July)*

Ford
(Jan.)

1978
Carter
(Feb.)

Carter
(July)*

Outlays

$365.7

$411.2

$417.4

$406.4

$440.0

$459.4

$462.9

Receipts

299.2

354.0

349.4

358.3

393.0

401.6

401.4

$ 66.5

$ 57.2

$ 68.0

$ 48.1

$47.0

$ 57.7

$ 61.5

Deficit

In the July estimates, refunds under the earned income credit which had earlier been defined

as an outlay were redefined to be reductions in receipts.
receipts and outlays by $0.9 billion.

This has the effect of lowering 1978

Through the first six months of 1977, changes in the economic assumptions,
technical estimating changes, and Congressional actions, all influenced the
budget totals, but the most important changes were the result of shifts in
Presidential policy.

The most significant Presidential initiatives were

as follows:
The Ford recommendations provided a major net permanent tax cut of
$14.6 billion for 1978 compared to the levels implied by constant tax law.
Outlays were cut $5.4 billion from current policy levels.
Prior to taking office, President Carter announced his own "stimulus
package11 as a substitute for the Ford tax cuts.

The package consisted of

minor permanent tax cuts, a major temporary tax rebate worth $11.4 billion,
and increases in spending on accelerated public works, public service employment, countercyclical revenue sharing and training programs. This package
was worth $15.7 billion in 1977 and $15.9 billion in 1978.
In February, President Carter submitted a more complete set of
revisions to the Ford Budget.

The net result was an increase in Ford's

recommended 1977 deficit from $57.2 to $68.0 billion while the 1978 deficit
was increased from $47.0 to $57.7 billion.

The increase in the deficits was

less than the value of the stimulus package primarily because of the rejection
of the Ford tax cut. Carter also assumed that his package would lead to a
somewhat more ebullient economy, and made other minor program changes and
changes in the estimates.
In April, the re-acceleration of the economic recovery and developing
Congressional hostility to the rebate proposal led to its withdrawal by President
Carter.
As shown in the table, the withdrawal of the rebate combined with the net
impact of the policy initiatives and re-estimates significantly reduced the

July estimate of the 1977 deficit compared to that shown in the February
Budget Revisions.

However, those portions of the stimulus package that

were retained have a major spending impact in 1978, and as a result the
deficit increases by $13.4 billion in that year. Because the Carter estimates
presume a continuing strong recovery, which would reduce the deficit significantly given constant policies, the increase in the unified deficit between
1977 and 1978 represents a strong discretionary shift toward an expansionary
fiscal policy between the two years.
This shift appears somewhat less significant if national income
accounting (N1A) definitions are used to compute Federal expenditures and
revenues.

The NIA Budgets consistent with Carter's July estimates are pro-

vided in Table 2.

Table 2
President Carter's July Budget Estimates on a National
Income Accounting Basis, Fiscal 1977 and 1978
(billions of dollars)
1977

1978

Expenditures

417.2

469.3

Revenues

365.4

415.3

51.8

54.0

Deficit

5
It should be emphasized that although the $2.2 billion increase in the
NIA Budget deficit seems small, it still represents a significant shift toward
expansion in discretionary policy.
discretionary

One can get a highly imperfect measure of

shifts using revenues and expenditures calculated as if the

economy were at full employment.

Official full employment estimates have

not been provided by the new Administration, but my own crude estimates suggest
that the full employment deficit rises by more than $15 billion between 1977
and 1978 on an NIA basis.
All of the above is based on the Administration's July estimate of the
Budget.

No forecast of Budget totals is completely reliable.

The following

section explores some of the most important estimation problems in order to
develop somewhat more precise forecasts of the Budget's likely impact over the
next few quarters.
Estimating Problems
While monitarists, fiscalists, and rational expectations theorists can
engage in lively debates regarding the impact of the budget on the economy,
there is no denying that the economy has a major impact on budget totals. On
the outlay side, changes in the unemployment rate have a major impact on unemployment benefits; changes in interest rates alter the cost of the national
debt; and changes in the rate of inflation have a major impact on outlays on
indexed programs such as social security, food stamps, school lunches, etc.
The sensitivity of unified budget outlays to hypothetical changes in
various economic variables is provided in Table 3 for the 1977 Budget.

Table 3
Sensitivity of FY 1977 Budget Outlays to
Economic Assumptions
(billions of dollars)

Inflation (effect on indexed program only)
One percentage point increase in CPI level by:
First quarter, CY 1976
Third quarter, CY 1976
First quarter, CY 1977

Addition to
Outlays
$1.1
0.4
0.2

Interest Rates
One percentage point increase* by:
January 1, 1976
July 1, 1976
October 1, 1976
January 1, 1977
July 1, 1977

$2.3
1.8
1.3
0.8
0.1

Unemployment Rate (unemployment assistance only)
One percentage point increase for fiscal year

$2.5

The increase is assumed to be for short-term rates with a somewhat

smaller increase in long-term rates.

7
The revenue side is even more sensitive to economic changes. A one
percentage point change in the forecast of money GNP in fiscal 1977 would
affect revenue estimates by more than $4 billion with the exact amount highly
dependent on how the change affected personal income (for personal income taxes),
corporate profits (for corporate taxes), and wages and salaries (for payroll
taxes).
For the purposes of the analysis in this paper the Administration's July
economic forecast will be accepted.

This is shown in Appendix Table A.

Even if the economic forecast underlying budget estimates is precisely
correct, there is plenty of room for error.

For example, corporations have

considerable discretion regarding the timing of their tax payments out of
given corporate profits; one is never sure what proportion of the eligible
population will claim benefits in entitlement programs; and in recent times,
OMB has been bedeviled by overestimates of spending for non-entitlement programs—the so-called "shortfall" problem.
In February, the Carter Administration estimated 1977 unified outlays
at $416.5 billion.

Definitional changes, involving the earned income credit,

and the withdrawal of the rebate lowered this figure to about $413 billion.
However, the July update estimates outlays at only $406.4 billion.

This reduc-

tion of more than $6 billion is primarily due to the shortfall problem.
The very latest offical estimate lowers 1977 outlays further to $404 billion,
and it is quite possible that actual outlays will be two or three billion
lower than this figure.
There is no simple explanation for this phenomenon and the following
attempt at a description of the problem must be regarded as being highly oversimplified.

OMB has had a tendency to overestimate spending for a very long

time, but the problem did not attract much public attention until the shortfall

became especially large during fiscal 1976 and the transition quarter.
While a large number of random events conspired against OMB in 1976 and made
the problem especially serious, there are a number of continuing political
and administrative factors which create a very strong bias toward overestimation.
Whenever Congress undertakes a new policy direction at the behest of an
Administration there is a strong tendency on the part of the Executive Branch
to claim that it will be implemented posthaste.

This is especially true

when the policy is aimed at some perceived national "emergency" as in energy
or in fighting unemployment.

For example, it was claimed that the accelerated

public works program would be implemented with far greater alacrity than was
assumed by most experts, but the official claims had to be duly reflected in
the Budget.
Even when there are no political pressures of this type, the bureaucracy
has a difficult time adjusting to policy shifts. The spending of money requires
a great deal of work.

Proposals have to be studied; contracts have to be

negotiated and signed; etc.

There is a pervasive human tendency to believe

that more work can be accomplished within a certain time period than is practically possible.

Typically, insufficient allowances are provided for vaca-

tions, illnesses, and the myriad of other things that can go wrong.
As experience builds with a new program direction the outlay forecasts
should become more precise, and there is some evidence that this is now
occuring in the defense sector.

That sector had to live with severe budget

stringency in the post Viet Nam era and it was slow to adjust to large
increases in procurement allowed in the 1976 and 1977 budgets. While significant defense shortfalls will occur in the 1977 budget, it appears likely
that the gap will be closed somewhat in 1978. However, in that year the

9
the bureaucracy will still be struggling with the implementation of the
relatively new stimulus programs, and a significant shortfall is likely
relative to program size, particularly in the public works component of the
package.
As a result of such factors, it has already been noted that 1977 unified
outlays are likely to be around $401 or $402 billion. Outlays in 1978 could
be seven or eight billion lower than the $462.9 estimated in July even_ifjtlie
Administrationfs economic forecast and policy stance remains constant.
However, because both 1977 and 1978 outlays will fall short of the
July estimates the increase in the deficit between the two years will be
only slightly lower than was discussed earlier.
Short-Run Fiscal Policy Implications
In order for there to be no shortfall from the July estimates in the
NIA budget for 1977, expenditures would have to soar at an annual rate
exceeding forty percent in the last quarter of the fiscal year, that is, the
third calendar quarter of 1977. This is clearly unreasonable and no one
expects it. While quarter-by-quarter estimates of the shortfall are treacherous, to say the least, I guess that, despite the shortfall, there will be a
major surge in spending during the third and fourth quarter of this calendar
year as the stimulus programs get rolling—albeit behind schedule. Again,
the tentative nature of any estimate must be emphasized, but it is not unreasonable to expect annual rates of growth of NIA spending between 15 and 20
percent during the last half of this calendar year with a deceleration to the
seven to ten percent level in the first three quarters of calendar 1978.
It would, however, be unwise to conclude that the expansionary impact of
the surge in spending over the last half of this year will be as great as is
suggested by these estimates, if the acceleration occurs, it will, in large

10
part, be due to extraordinary rates of growth in the grants component of the
NIA budget.

Virtually, the entire stimulus package is financed by grants and

is implemented at the state and local level. Although the accelerated public
works and public service jobs components of the package have been designed
to reduce the extent to which the funds can be used to undertake projects that
would have been undertaken in any case at the state and local level, considerable "substitution" is sure to occur anyway.

Thus, to some degree, these

programs simply reduce state and local deficits or raise surpluses at the expense
of the Federal deficit.

This is even more true of the counter cyclical revenue

sharing component of the package.

As a result, the surge in grants is unlikely

to have the same expansionary impact as would a similar surge in the purchases
or transfer component of the NIA budget.
Long-Run Fiscal Policy Issues
President Carter has promised to balance the Budget in fiscal 1981. Barring
an economic slowdown which would cause the abandonment of this promise, he
will have to adopt a fairly stringent 1979 Budget if his 1981 goal is to have
any hope of realization.

0MB has revealed that for planning purposes it is

using a 1979 outlay figure of about $500 billion.

Such planning figures seldom

endure until the final Budget is presented, but if this one should happen to
hold, the implied real increase in spending over the July estimates for 1978 is
less than one percent.

A 1978 shortfall of seven to eight billion would raise

the implied rate of real growth in 1979 spending to over two percent, but still
implies great stringency between the two years.
Over the longer run, the nature of the Administration's tax reform package
will be of significant importance to the long-run budget outlook and to the
allocation of resources.

In this regard, the proposed net revenue loss assoc-

iated with tax reform may be as important as the compositional changes in the
tax structure.
Since the Korean War, the ratio of total Government receipts to GNP has

11
been held remarkably constant.

There is no clear trend in the ratio and its

average since 1953 has been 18.6 percent, exactly the level achieved in
fiscal 1976. To maintain relative stability in the ratio, numerous discretionary tax cuts have been necessary to offset the effect of inflation and real
growth pushing income taxpayers into higher and higher tax brackets.
Because of the current high inflation rate, constant tax law implies a
very rapidly increasing tax burden, because taxpayers are pushed into higher
brackets at a much faster rate than they were in the past.
In 1978 the expected ratio of receipts to GNP is 19.6 percent or only
slightly above the historical average of 18.6 percent.

Given the Administration's

economic projections it will rise to almost 22 percent by fiscal 1981 if tax
laws remain unchanged.

Returning the 1981 ratio to the 19.6 percent prevailing

in 1978 would require a massive tax cut of over $60 billion in 1981 dollars.
There is a clear conflict between the historical tendency for the Congress to
keep the ratio of receipts to GNP relatively constant and the Administration's
desire to obtain the revenues necessary to facilitate budget balancing in 1981.
The announced goal of the Administration is to hold outlays to 21 percent
of the GNP in 1981 compared to the 22.6 implied by the July estimates for 1978.

P/
A balanced budget obviously implies that receipts will have to equal 21 percent <2Zof GNP and they have not reached this level since the Korean War—although they
came close during the Viet Nam War. Whether or not the Congress will accept the
implied increase in the tax burden will be one of the more interesting fiscal
policy questions of the next three years. All of this, of course, accepts the
relatively optimistic economic projections of the Administration.

This is not

the place for a detailed critique of those projections, but any slowdown in
the recovery could cause the dream of a balanced budget to be postponed for
many years.

Appendix Table A
President C a r t e r ' s July 1976 Economic Forecasts and
Long-Run Projections
(Calendar Years: d o l l a r s in b i l l i o n s )
Actual

-JJl^
5ross n a t i o n a l p r o d u c t
Current d o l l a r s :
Amount
1,692
Percent change
11.6
Constant (1972) dollars:
Amount
• • 1,265
Percent change
+
6.1
Incomes (current dollars)
Personal income
•
1,375
Wages and salaries
890
Corporate profits
•
148
Prices (percent change)
GNP deflator:
Year over year
5#1
Fourth quarter over fourth quarter
4#5
CPI:
Year over year
«• 5.7
December over December
„«•
4#y
Unemployment rates (percent)
Total:
Yearly average
*
7.7
Fourth quarter
7^9
Insured 1/
..••••
6.4
Federal pay raise, October (percent)
4 ^Q
Interest rate, 91-day Treasury bills (percent) 2/...
5 (
J

Forpraqf—LxLliS^E.^-.

-n
Projection

1977

1978

1979

1980

1981

1982

1,08 3
11.3

2,106
11.9

2,345
11.3

2 ,592
10.6

2 ,836
19.4

3 ,081
3.6

1,330
5.1

1,399
5.3

1,468
5.0

1 ,545
5.2

1 ,621
4.9

1 ,690
4.3

1,526
991
173

1,693
1,10 5
199

1,894
1,231
223

2 ,097
1 ,366
246

2 ,29 4
1 ,495
268

2 ,493
1 ,624
291

5.9
6.5

6.3
6.1

6.1
5.9

5.1
4.6

4.3
4.2

4.2
4.2

6.5
6.9

6.0
• 6.1

5.9
5.7

5.0
4.5

4.3
4.3

4.3
4.2

7.0
6.6
5.1
6.5
4.9

6.3
6.1
4.2
6.5
5.0

5.7
5.5
3.7
6.5
5.0

5.2
5.0
3.2
6.0
5.0

4.8
4.6
3.0
5.5
5.0

4.5
4.4
2.8
5.0
5.0

1/ Insured unemployment as a percentage of covered employment; includes unemployed
workers receiving extended benefits.
2/ Average rate of new issues within period. The forecast assumes continuation of
current market rates.

FINANCING THE GOVERNMENT DEFICIT
By
Robert H. Rasche
Michigan State University

The following comments are divided into essentially two parts. In
Section I, an explicit financing relationship for the U.S. government is
derived, which relates the deficit or surplus (unified budget) plus the
deficit or surplus of off budget agencies to changes in the net source
base and other factors.

I have included a discussion of what items are

involved in these other factors, and identified the items which must be
forecast in order to make a projection of the impact of a projected
deficit or surplus in the private capital markets under different assumptions about monetary policy.

I welcome any comment on the appropriate-

ness of the categories which I have devised, and/or the techniques which
I propose to forecast some of the components.

In addition, I would

appreciate any helpful suggestions on forecasting the component of the
relationship related to foreign transactions.
In Section II I have made some comments on things which"I see as
significant factors in recent financing, and make some rough guesses as
to what the coming fiscal year may bring.

I»

Components of the Financing Identity
and Some Forecasting Proposals

At various meetings in the past, I have tried a number of semisystematic presentations of the relationship between the government deficit
or surplus and various components of the financing problem.

I have finally

made the effort to trace down a systematic relationship between changes in
the net source base and the deficit or surplus.
from two basic identities:

The relationship is derived

the first the so called means of financing

identity data for which are available in various Treasury publications,
and the second the balance sheet of the Federal Reserve S>sten which is
presented in the Consolidated Statement of Condition in the Federal Reserve
Bulletin.

Several other minor definitions also enter into the computations.

The details of the development are presented in the Appendix to this paper.
The data for fiscal years 1974-1976, and quarterly thereafter, are presented
in Table 1.

It should be noted that all data are derived from changes in

end-of-quarter stock figures and are seasonally unadjusted, hence they
are not compatable with the average of daily figures, seasonally adjusted
data which are usually cited.
It seems to me that the goal of this type of investigation is to
be able to attempt to project the amount of financing through private credit
markets which will be associated with a projected deficit and proppsed
(or projected) growth paths of the base. As can be seen from Table 1,
in reality this does not amount to a straightforward subtraction of the
change in the base from the projected deficit, as the issue is typically
presented in the textbook discussion of the subject.

There are a large

number of other components in the relationship, some of which have been
and can be quite important in at least short run financing developments.
I shall fi

t try to identify what is in the various groupings which I

have developed and then discuss how they have affected recent financing
and speculate on some future developments.
The first category is an approximation to the volume of funds raised
by the Treasury in credit markets from private sources.

It is the total

amount of Treasury and Agency debt issued outside of the Treasury less the
change in debt holdings by the Federal Reserve and Foreign official
institutions.

The latter is not quite accurate, as it excludes changes

in holdings of agency debt by such institutions, since I have been unable
to find any published source in which this information is tabulated separately.
It is also possible that since this is an attempt to measure on a net basis,
changes in acceptances held by the Federal Reserve System (which now
appear in category VII) should be subtracted from this grouping.
The second, third and fourth categories are self explanatory.

The

fifth, which involves foreign transactions probably needs some explanation,
particularly with respect to the treatment of "swaps.11 When the Fed
engages in "swap" operations, the two accounts which are involved are
the other assets of the Federal Reserve System (denominated in foreign
currencies) and foreign deposits at the Federal Reserve.

For example,

when the Fed obtains foreign currencies in a "swap" operation, it increases
both other assets and foreign deposits.

Thus, category V is unaffected

by foreign currency swap operations.
See Federal Reserve Bank of New York, Glossary:
Reserve Statements, p. 18.

Weekly Federal

Categories VI and VII are also fairly clear.

Category VIII

warrents some explanation, since a number of the items are not familiar,
and the definitions are not easily available.

First, other cash and

monetary assets of the Treasury includes Treasury Cash and the Gold Balance
as sub items.

Thus, VII essentially includes net cash and monetary assets

of the Treasury which involves basically time deposits, some cash items
in process of collection, and some miscellaneous transit items.

The other

two categories which are difficult to identify are Miscellaneous Treasury
Liabilities and Miscellaneous Treasury Assets. Much of what is included
2
in these entries is of the nature of float.

However, there are two

important exceptions which arise out of the pecularities of the book
valuation of Treasury securities.
The book valuation of all government securities is at par, not
at issue price. Hence, the discrepancy between the book value of the
debt issue (changes in which are indicated under I above), and the actual
revenue raised from a debt sale has to be accounted for somehow.
is handled in the miscellaneous asset and liability accounts.

This

If debt

is sold at a discount (as for example with a Treasury Bill auction, then
the outstanding value of the debt is increased by the par value of the
bills on the books of the Treasury, and the discount is entered as a
miscellaneous asset account entitled "deferred interest (discount) on
marketable United States Treasury securities.'1

On the other hand, if

2
See the Combined Statement of Receipts, Expenditures and Balances
of the United States Government.

a note or bond is issued at a premium, then the par value of the issue
is added to the value of the outstanding debt, and a miscellaneous liability
item entitled "deferred interest (premium) on public debt subscriptions,
United States Treasury11 is increased by the amount of the premium.

have been unable to determine if these miscellaneous accounts are left
unchanged until the time that the debt issue is retired, or if some
schedule is used to allocate the discount or premium into interest paid
over the life of the security.

Judging from the accounting practices

of the Federal Reserve, which also carries its government securities at
par value, I suspect that the premium or discount is gradually phased out
over the life of the security.

In any case, the changes in these categories,

particularly the asset item have been substantial at times in the recent
past, and their character is such that their behavior should not be the
random kind of behavior that can be expected from the float type items
which comprise the remainder of the entry.
The final category is that of deposit funds. Deposit funds are
defined as:
combined receipt and outlay accounts established to account
for receipts that are either (a) held in suspence temporarily
and later refunded or paid into some other fund of the
government upon administrative or legal determination as
to the proper disposition thereof, or (b) held by the government
as a banker or agent for others and paid out at the direction
of the depositor. Such funds are not available for paying
salaries, expenses, grants, or other outlays of the government.
3
See Federal Reserve Bank of New York, Glossary: Weekly Federal
Reserve Statements, p. 13, "Other Liabilities and Accrued Dividends."
4
Combined Statement of Receipts, Expenditures and Balances of the
United States Government, 1976, p. 3.

6
I have made a preliminary attempt to reconcile the identity which
I have derived with the published information in the Flow of Funds data.
I am rather pessimistic that the Flow of Funds source will ever prove
useful in tracking down the identity.

Some of the items just cannot be

identified in the Flow of Funds data; some of the published categories
combine items from different categories which I have defined (though
this is probably surmountable with the use of unpublished data), and
most troublesome of all, in places where the categories would seem to
match up, the numbers frequently are completely dissimilar (even when
looking at the seasonally unadjusted flows in the Flow of Funds accounts).
I intend to pursue this investigation somewhat further, but it may prove
that to obtain any sort of time series on the various elements of the financing
process, the original sources will have to be painstakingly pulled together.
What about forecasting of the impact of the projected deficits on
domestic credit markets?

One category, the net source base, is close to

the monetary base concept which is of major concern to this committee.
We can project our desired growth of this aggregate, or we can project our
best guess estimate of what actually will occur, given the existing management techniques for monetary policy.

A second category which seems to

warrent some consideration from the perspective of economic theory is the
foreign transaction category, V.

I think that this grouping comes pretty

close to the concept which is referred to as the balance of payments in
the literature on the monetary theory of the balance of payments, though
not being an expert in that area, I may be mistaken.

In any case I would

like some discussion of how forecasts of this component could be developed.

The remaining items of the identity have large random behavior
about which there is very little that economic theory can tell us. It
seems to me that these are things for which a pure time series approach
to forecasting, such as that of Box-Jenkins is not only highly useful,
but also highly appropriate,

II*

Some Issues in Recent Government Financing

With the exception of the transition quarter, a common characteristic
of the last several years has been the fact that the government has bad to
go to the private capital markets for considerably less than the total
financing which it has required.

In part this is due to the rapid growth

of the monetary base with which we are all familiar.

An additional factor

which has made an important contribution is the item which I have entitled
changes in Foreign Transaction Balances,

In particular, over the last

four quarters tabulated in Table 1, over six billion dollars of the deficit
has been financed by increases in this item.

For the most part this reflects

increases in Foreign Official holdings of U.S, Government securities.

the two prior fiscal years, foreign official holdings of U,S. Government
securities increased by four billion dollars.

Thus, the recent rate of

increase reflects a doubling of the rate of acquisition.

I suspect that

these may reflect changes in holding by the Germans and Japanese for the
most part, but I have to confess that I have not tracked things down, and
I shall defer to other expertise in this area.

The one thing which seems

clear is that there is considerable management of the float going on,
and if anything it has increased substantially in recent months.

What impact on the private capital markets can be expected in the
coming fiscal year?

The present official projections of the fiscal 1978

budget deficit are in the neighborhood of 60 billion dollars.

In addition,

something has to be added for off budget agencies. The major contributors
to the off budget deficit are the postal service and the Federal Financing
Bank.

In the recent past, the deficit in this category has been reduced

somewhat because of unexpectedly favorable experience on the part of the
postal service.

Judging from recent pronouncements, and the political

opposition to cost cutting innovations such as the abolition of Saturday
delivery and the consolidation of rural postal facilities, the recent
experience cannot be extrapolated into the future.

Therefore, it is likely

that something of the order of 10 billion should be added for required
off budget financing.

If we scale down the official budget deficit

estimates somewhat to account for the positive serial correlation of the
0MB forecasting errors in the recent past (the so called budget underruns),
then it seems appropriate to conclude that something approaching, but
probably not exceeding 70 billion dollars of financing will be required
over the next fiscal year.
The net source base amounted to about 120.6 billion dollars
(seasonally unadjusted) at the end of June, 1977.

If we assume a growth

rate of the order of six percent per annum for the next fifteen months
(on the assumption that this is a likely outcome, not a desirable outcome),
about seven billion would be financed by increases in the base (given growth
in the money stock over the last two months, this might be regarded as

too high for a likely outcome, although care should be taken to distinguish
growth in the monetary base in the last few weeks because of increases in
borrowing which does not count in the net source base).

If we assume

that changes in foreign transaction balance increase at somewhere
between the four billion annual rate of 75-r76, and the eight billion
rate of recent months, and further assume that the net impact of the
remaining components is of the order of one billion dollars one way or
the other, then the total borrowings which will be required in the private
capital markets can be projected at somewhere around 55 to 60 oillion
dollars.

APPENDIX

DERIVATION OF THE U.S. GOVERNMENT
FINANCING IDENTITY

The basic identity and data for the financing requirement are
found in the Monthly Treasury Statement of Receipts and Expenditures,
and in the Federal Reserve Bulletin.

The first relationship is found

in a table entitled "Means of Financing.ff

This equation indicates that

the
Unified Budget Deficit(+) or Surplus ( )
plus

Transactions not applied to the current year's deficit
or surplus

equals

Changes in U.S. Government and Agency Securities held
by the Public (net of securities held as investments
by government accounts)

plus

Change in accrued interest payable on public debt
securities

plus

Changes in deposit funds

plus

Changes in miscellaneous liability accounts of the Treasury

Other helpful, though not necessarily complete or accurate tables
can be found in the monthly Treasury Bulletin. Additional sources of
information of a fiscal year basis are the Annual Report of the Secretary
of the Treasury and the Combined Statement of Receipts, Expenditures and
Balances of the United States Government. The latter is the most
comprehensive, informative, and probably the most accurate.

less

Changes in U.S. Treasury Operating Cash (including
balances held at Federal Reserve Banks + Tax and Loan
account balances 4 demand balances held at other
depositories)

less

Changes in total holdings of SDRfs net of changes in
SDR certificates issued to Federal Reserve Banks

less

Changes in gold tranche drawing rights

less

Changes in other cash and monetary assets

less

Changes in miscellaneous asset accounts of the Treasury

The second identity is the balance sheet of the Federal Reserve
System found in the Consolidated Condition Statement.

This identity can

be solved for the Treasury Balances with the Federal Reserve System and
substituted into the Means of Financing identity.

Two additional identities

are useful:
(1) Gold Stock

Gold Certificates held by Federal Reserve
Banks + Balance of Gold

(2) Treasury Cash

Federal Reserve Notes held in the Treasury

+ Treasury currency held in the Treasury.
Finally the definition of Transactions not applied to current year's
deficit or surplus is required.

This is perhaps the most elusive component

of the whole problem; as far as I can discover, the only place where the
data are regularly published is in the Monthly Treasury Statement.

This

aggregate consists of:

Deficit(+) or Surplus(-) of Off Budget Agencies (including
the Federal Financing Bank in recent years)
plus

Seigniorage

plus

Increment on gold

12
plus

Net gain/loss from U.S. currency valuation adjustment

plus

Net gain/loss from IMF loan valuation adjustment (starting
fiscal 77)

plus

Change in interest receipts on government accounts to
accrual.

Manipulation of these identities gives the nine categories listed
in Table 1, where the components of each category are as follows:

II.

III.

IV.

Borrowing from Private Capital Markets
la. (+) Borrowing From the Public
lb. ( ) Changes in Federal Reserve Holdings of U.S. Government
Securities
Ic. ( ) Changes in Federal Reserve Holdings of Agency Lssues
Id. ( ) Changes in U.S. Government Securities Held by
Foreign Official Institutions (from Table 3.13,
Federal Reserve Bulletin. Foreign official holdings
of agency issues are not published separately)
Change in Net Source Base
Ila. (+) Change in Member Bank Deposits at Federal Reserve
Banks
lib, (+) Change in Currency in Circulation
lie. ( ) Change in Member Bank Borrowings From the Federal
Reserve
Change in Federal Reserve Float
Ilia. (+) Change in Deferred Availability Cash Items
Illb. ( ) Change in Cash Items in Process of Collection
Change in U.S. Treasury Cash Balances
IVa. (+) Change in Tax and Loan Account Balances
IVb. (+) Change in Balances at Other Depositories (demand)
Change in Foreign Transaction Balances
Va. (+) Change in Foreign Deposits at the Federal Reserve
System
Vb. (-) Change in Other Federal Reserve Assets Denominated
in Foreign Currencies (swaps)
Vc. (+) Change in U.S. Government Securities Held by Foreign
Official Institutions
Vd. ( ) Change in the U.S. Gold Stock
Ve. ( ) Change in SDR Holdings
Vf. (-) Change in Gold Tranche Drawing Rights
Vg. (-) Change in Loans to I.M.F. (fiscal 1977 only)

Change in Interest Accruals
Via. (+) Change in Accrued Interest Payable on U.S. Government
Securities
VIb. ( ) Conversion of Interest Receipts on Government
Accounts to Accrual
Change in Excess of Miscellaneous F.R. Liabilities Over Misc. Assets
Vila. (+) Change in Other Deposits at Federal Reserve Banks
Vllb. (+) Change in Other Liabilities of Federal Reserve
VIIc. (+') Change in Federal Reserve Capital Accounts
Vlld. ( ) Change in Other Federal Reserve Loans
Vile. ( ) Change in Acceptances Held by Federal Reserve Banks
Vllf. ( ) Change in Bank Premises and Operating Equipment
Vllg. ( ) Change in Other Federal Reserve Assets (excluding
those denominated in foreign currencies (swap?))
in Miscellaneous Treasury Accounts
(+) Change in Treasury Cash
(+) Change in Balance of Gold
(+) Change in Misc. Treasury Liability Accounts
(-) Change in Other Cash and Monetary Assets of the Treasury
(-) Change in Misc. Treasury Asset Accounts
( ) Seigniorage
( ) Increment on Gold
( ) Net Gain of Loss From U.S. Currency Valuation Adjustment
( ) Net Gain or Loss From IMF Loan Valuation Adjustment
(-) Change in Treasury Currency Outstanding
Change in Deposit Funds
IXa. (+) Change in Allocations of SDR?s
IXb. (4-) Change in Other Deposit Fund Balances

September 16, 1977
Briefing for the Shadow Open Market Committee
September 19, 1977
by Wilson E. Schmidt*

There has been a great deal of excitement over our international
transactions in the last six months.
There has been fear that our excess of imports over exports
could not last, that it has caused or would cause a depreciation of
the dollar which leads to inflation, that it causes unemployment, and
that it stimulates protectionist pressure in the United States.
There has been continued pressure on the part of the U.S. Government
to stimulate the two other supposed locomotives of the world economy,
Germany and Japan.

And there has been concern about the repayment

of our credits to foreigners and our ability to repay our debts.
Actually, very little of importance happened that is worth
noting, with one exception.
The exception is that the International Monetary Fund in April
backed off its notion of norms or zones for exchange rates for the
purpose of guiding countries1 exchange rate intervention over fouryear periods with its implicit danger of fixing rates.

Instead the

new rules continue to call for intervention to prevent disorderly
markets, though, as Dr. Burns has indicated, no two men can agree
on what such conditions are (a view expressed in my September 1975
SOMC paper), so this is hardly a meaningful guideline but few would
interpret it to be the equivalent of target zones.

The new rules also

call upon the members to avoid manipulating exchange rates to prevent

*Professor of Economics, Virginia Polytechnic Institute and State University

2
effective balance of payments adjustment or to gain an unfair advantage.
Again it is hard to know what this means and the Fund has said "difficult
judgments will have to be made." In any event, zoning is gone.
The amount of intervention chiefly by the G-10 countries in the
six months ending in July hit a record high of $7 billion per month
against an average of about $4 billion since the float began. But
the data do not reveal how much of this was sustained, unidirectional
intervention, as against mere diddling with the rates. U.S. intervention
fell from $3.2 billion in the six months ending January 1977 to $1.5
billion through August 1977, though these are crude estimates. Much more
persuasive and heartening is the rise in the proportion of world trade by
countries whose currencies are not maintained within relatively narrow
margins in terms of any currency, group of currencies, or composite of
currencies.

On the basis of 1975 world imports, the proportion has risen

from 43% at the end of 1975 to 52% at the end of 1976 and now to about 55%.
(This figure understates the amount of trade subject to floating; all imports by countries that fix on something from countries that fix on
nothing, so that the imports are subject in fact to floating, are excluded
from the numerator, e.g., imports by Germany, Belgium, and the Netherlands
from the U.S.).
Most attention has been given to our excess of imports over exports
of $15 billion during the first half of the year. The Secretary of the
Treasury reportedly has projected this to reach $25 billion or maybe a
bit more for the year. Little attention has been given the inflows
of capital and other transactions that must offset it under the
floating exchange rate system.
During the first half of the year, the growth in foreign official
assets in the U.S. was $11.4 billion, covering three-quarters of the

-3-

trade balance. About $9.7 billion was placed in U.S. Government
securities, equal to almost half of the increase in Federal debt
outstanding, thereby easing the Treasury's need to finance the budget
deficit from the private sector or the Fed.

It is difficult to tell

how much of this constitutes direct intervention in the foreign exchange
markets.

Not an insubstantial part of the growth in foreign official

assets must be attributed to interest income on those assets - if
one assumes a 6% yield, $3 billion over the first half of the year,
leaving $8.4 billion to be explained otherwise during the first half
of the year.

In 1976, the OPEC countries accounted for somewhat more

than half of the increase in our liquid foreign official liabilities.
This held true for the first quarter of 1977 also. But in the second
quarter, their share fell to under 15% and the portion attributable
to industrial countries rose to over three-quarters. While there
are no data, this sharp shift probably reflects the efforts of the UK
Italy,

and

France to increase their gross international reserves

by intervention in the foreign exchange market, buying dollars and
thus preventing a depreciation of the dollar.
The trade figures have exhilarated some people, especially some
in the Department of Commerce which has programs to stimulate exports
that are under attack.
basic deficit.

The Department is now even talking about a

One high Commerce official is quoted as stating that

it will take us a decade to get back into equilibrium, as if equality
of exports and imports implies equilibrium.

It is hard to justify

costly export promotion schemes when we finance a large part of our
imports with loans at zero real rates of interest, that is after
allowing for the effect of U.S. inflation on the nominal returns in
dollars to foreigners.

-4On the other hand, the trade balance has depressed others. One
distinguished economist worries that we will not be able to repay our
external debts. But since our interest payments to foreigners slightly
more than offset our interest income from foreigners, it is hard to
see that the United States is anywhere near the parlous condition of
the weakest LDCs

when the average LDC has a ratio of debt service to

exports of 16%.
Others believe that the trade deficit has depressed the dollar
which in turn causes inflation.

Without accepting the proposition

that depreciation of the dollar leads to inflation, we need only note
that the average value of the dollar in terms of 46 main trading
countries fell by six tenths of one per cent from the beginning of the
year through the end of July. What seems to have caught the public's
eye is the substantial appreciation of the mark and the yen, but
of course those two currencies are not the whole story.
Still others are concerned with the growth of protectionist
sentiment at home because of the trade balance.
has been pressing for protection.
to little for labor

as a whole.

Labor in particular

But such efforts are likely to lead
Though the estimates are dated, the

amount of labor contained in a million dollars of our exports is
just about the same as the amount of labor contained in a million
dollars of U.S. production that competes with imports. The imposition
of import restrictions might help labor in the protected industry
but the consequent reduction in imports will lead to an appreciation
of the dollar which will deter our exports by a similar amount,
hurting labor in the export industries.

-5-

Finally, there are those who complain that the trade imbalance
destroys jobs and slows the growth of GNP.
fear is well founded.

It is doubtful that this

The evidence suggests that changes in money

are more important and more lasting by far than changes in the federal budget (and thus, by inference, more important than changes in
the trade balance) in determining the level of aggregate demand.
Since our international transactions cannot affect the stock of
money and the monetary base because we are floating, the relationship
between our trade balance and the state of employment is very weak
and short-lived.
In another unimportant development, the Administration continues
to push its locomotive theory, pressing the surplus countries, such
as Germany and Japan to expand domestic demand.

A 1% increase in the

combined GNP of Germany and Japan would cause the rest of the world's
12
output to rise by only y^r

of 1% with fixed exchange rates.

With

floating, the impact will be even smaller.
The next Administration push will be to obtain congressional
support for the Witteween facility, a fund of approximately $10
billion to be loaned in almost equal shares to the International
Monetary Fund by the industrial and the OPEC countries. The issue
here is adjustment versus financing of deficits. The loans under
the new facility to countries in balance of payments difficulty will
be of longer maturity (up to seven years) than the normal Fund loans
(up to five years).

By and large, the world has sought to meet the

challenge of the OPEC surpluses by borrowing to cover them rather than
simply letting the oil producers hold and invest the currencies they
have gained.
achieve.

The longer adjustment is delayed, the harder it is to

The new facility on this test appears to be a continued step

in the wrong direction.

The Dilemma of Inflationary Policies
Karl Brunner
University of Rochester and Hoover Institution

Position paper prepared for the 9th meeting of the
Shadow Open Market Committee

September 19, 1977

The Re-Emergence of an Old Problem
Inflation dominated over recent years official attitude and

pronouncements of the Federal Reserve Authorities.

This attitude

was expressed by the Federal Reserve's management of new procedures
developed under House Concurrent Resolution 133.

The Resolution

addresses the Federal Reserve Authorities to pursue a policy of
monetary control conducive to longer-range stability of the price-level
For two and a half years the Federal Reserve announced in quarterly
Hearings before Senate or House a target range guiding monetary growth.
The average money stock observed in the quarter preceding the Hearings
was usually introduced as the basis of the targeted'monetary growth.
Monetary policy was thus formulated in terms of a target range containing the acceptable paths of the money stock.
Changes in the target range apparently reflect under tne circumstances modifications in the course of policy.

They seem to signal

the general trend in monetary affairs to be expected over the near
future.

The information collected in Table 1 presents the official

signals conveyed to the public since the middle of 1975.

The target

range guiding growth paths for >L and M~ drifted generally lower.

The

upper boundary for M, was lowered from 7.5% to 6.5% and from 10.5%
to 9.5% for M . The lower boundary of the range for >L was lowered
from 5.0% to 4.5% and from 8.5% to 7% for M • At one single occurrence
tin November 1976; the Federal Reserve raised the upper boundary on
>L.

They simultaneously lowered, however, the upper boundary placed

on M . • The official actions can also be described by the changes in
.

the mean growth between the upper and lower boundary.

The mean path

for M1 was lowered over the past two years from 6.25% to 5.5% and from
9.5% to 8.25% for }/L .
The trend summarized in Table 1 apparently nudges the inherited
rate of inflation to lower levels. We seem to be assured a
persistent decline in the magnitude of inflation over
the period 1977-79.

The Shadow Open Market Committee noted this

pattern in previous sessions.

It also approved the generally modest

rate of monetary growth maintained in the average over a 12 month
period.

It expressed, however, some concern about the violatile

behavior of monetary growth observed within one year.

It also warned

that the Federal Reserve's internal procedures were ill suited to
execute an effective monetary control.

The traditional mode of

implementing policy would remain, in the Shadow Committee's view, ..an'
uncertain and unreliable instrument for the purposes defined by House
Concurrent Resolution 133.

The Committee emphasized, moreover, the

potential drift built into monetary growth as a result of the peculiar
targeting techniques evolved by.the Federal Reserve Authorities.
Table I:

The Target Range on Growth
Rates for M, and H

12-MONTH GROWTH RANGE TARGETS: Ml
Congressional
Hearing
Date
5/77
2/77
11/76
7/76
5/76
2/76
11/76
7/75
5/75

Base
Quarter
Of the
Forecast
Ql 77
Q4 76
Q3 76
Q2 76
Ql 76
Q4 75
Q3 75
Q2 75
3/75

Targeted Ml
Growth Range
For Next 12 Months
Range
Average
4.5
4. 5
4.5
4.5
4.5
4.5
5.0
5.0
5.0

to'6. 5%
to 6. 5%
to 6.5%
to 7.0%
to 7.0%
to 7.5%
to 7. 5%
to 7.5%
to 7.5%

5.50%
5.50%
5.50%
5.75%
5.75%
6.00%
6.25%
6.25%
6.25%

12-MONTH GROWTH RANGE TARGETS:, M2,
Congressional
Hearing
Date
5/77
2/77
11/76
7/76
5/76
2/76
11/75
7/75
5/75

Base
Quarter
Of the
Forecast
Ql 77
Q4 76
Q3 76
Q2 76
Ql 76
Q4 75
Q3 75
Q2.76
3/75

Targeted M2
Growth-Rang*
For Next 12 Months
Range
Average
7.0
7.0
7.5
7. 5
7.5
7.5
7.5
8. 5
8.5

to
to
to
to
to
to
to
to
to

9.5%
10.0%
10.0%
9. 5%
10.0%
10.0%
10.5%
10.5%
10.5%

8.25%
8.50%
8.75%
8. 50%
8.75%
8.75%
9.00%
9.50%
9.50%

The potential dangers posed by the Federal Reserve's institutional
inheritance emerged this year with a sharper focus.

We also possess

at this stage a sufficient segment of observation in order to assess
the basic trend in our monetary affairs.

Table II summarizes the

relevant information bearing on our problem.

The crucial aspect

deserving our attention is the remarkable acceleration in K. and M
maintained since the second half of 1974.

The growth rate of M

more than doubled and the growth rate of M
over the past three years.

increased by almost 70%

Monetary growth rates computed between

corresponding months in successive years, between average values of
successive two-quarter periods or between shifting two-quarter
intervals reveal the same basic pattern.

We observe over two and

a half years a positive drift persistently raising monetary growth.

Table II: Accelerations and Decelerations in M- and M 0
—

Period
QI:72
QII:73
QII:74
QI:75
QI:76

to QII:73
to QII:74
to qi:75
to QI:76
to QI1:77

—

" •

•-'

%
Growth

8.0
5.7
3.1
4.8
6.5

Period
QI:72
QII:73
QII:74
QI:75
QI:76

to QII:73
to QII:74
to QI:75
to QI:76
to QII:77

•••/.

%
Growth
10.1

8.7
6.3
y.4
10.7

An inspection ot the data so far available for the current
calendar year confirms this pattern.

Monetary growth in the second

quarter exceeded substantially the upper target boundary even without
the pressures to finance a tax rebate.

There also exist indications

of continued excessive monetary growth during, the third quarter.

Moreover, the week ending with August 17, 1977, shows a money stock
7.1% above the value in the corresponding week in 1976-

We also

note that monetary growth over successively shorter intervals ail
ending with the central week in August exhibit an accelerating pattern.
An increasing growth exceeding the upper target boundary dominates
the observations accruing since Our last meeting in March 1977.
The data in Table III effectively summarize the problem in a
similar vein the growth rate of M

exceeded in recent months the

upper target: boundary for the respective magnitude.
Table I I I :

Annual Growth R a t e o f Mj_ Over
D i f f e r e n t P e r i o d s In 1977

COMPOUNDED ANNUAL RATES OF CHANGE, AVERAGE OF FOUR WEEKS ENDING:
8/18/76

TO THE AVERAGE
OF FOUR WEEKS
ENDINGt
1/19/77
2/16/77
5/16/77
4/20/77
5/18/77
6/15/77
7/20/77
8/17/77

II.

6.5
5.0
4.9
6.1
6.5
6.0
6.8
7.1

11/17/76

3.7
3.8
6.0
6.5
5.8
7.0
7.3

1/19/77

2/16/77

3/16/77

4/20/77

5/18/77

0.4
5.4
6.4
5.4
7.1
7.4

9.6
9.5
7.5
9.0
9.2

11.9
8.5
10.1
10-1

5.2
8.7
9.0

8.4
8.9

6/15/77

12.5

The Fragile State of Anti-Inflationary Policies
In 1963/64 Allan Meltzer and I concluded in a study on Federal

Reserve Policy-Making prepared for the House Committee on Banking and
Currency that the negative association between actual monetary management and professed policies reflected the central problem of Federal
Reserve policy-making.

This negative association was produced in

past decades by a systematic misinterpretation of monetary actions and
the prevailing monetary state.

The underlying conception about the

monetary process governing the Reserve institution's approach for over
fifty years unavoidly determined the misinterpretations of events observed
during the 1930's, the 195UTs, and into the 1960's.
This systematic misinterpretation seems barely the appropriate
explanation of the current developments described in the previous section.
The discrepancy between announced policy and actual monetary growth is
probably attributable to the operation of internal implementation procedures well adjusted to the old conception prevailing until the middle
1960's centered on tree reserves and money market conditions.

The dis-

position to tailure built into the traditional implementation is occasionally activated by an institutional inheritance stressing interest
rate policies and emphasizing orderly money markets.

This inheritance

is re-enforced by regular Congressional pressure insisting that the
Federal Reserve apply its resources to maintain interest rates at a
low- level.

Lastly,- we also note that ,the targeting technique actually

practiced by the Federal Keserve Authorities offers supplementary
opportunities for the built-in disposition of failure.
Our recent experience thus reveals that the execution of effective
monetary control designed to lower the rate of inflation requires
attention to institutional implementation beyond broad announcements.
It also involves a continuous political struggle with the inflationists
to Congress and the Administration.

It is unfortunate in this context

that the advocates of inflationary policies rarely acknowledge this
implication of their proposals.

The inflationary consequences are

usually hidden beyond a package of worthy intentions directed towards
lower interest rates, lower unemployment, or larger government

expenditures.

And once inflation emerges as a result of such

endeavors, aggravated by even higher interest rates and barely
lowered unemployment, there always will exist opportunities
(and $ incentives) to direct public attention away from the
relevant causes ot the new inflationary burst.

The

interaction between media and political process tends to spin a web
ot deceit and ignorance covering the nature of the ongoing intlation.
It follows that a persistent pattern of anti-inflationary policies
may have a comparatively low political survival value.

It certainly

requires substantial courage and determination by the policy-makers
involved in monetary affairs.

III.

The Dilemma of Monetary Policy
what*are the implications of recent monetary trends?

We suppose

for this purpose that monetary growth (M-) proceeds into 1978 at an
annual rate of about 7%.

At this rate the underlying "permanent"

inflation rate will measure around 6% p.a.
will be higher, however.

The actual rate of inflation

The acceleration of monetary growth will raise

longer-run inflationary anticipations.

I expect that this revision

of inflationary anticipations would add (temporarily) one to one and
a half percentage points to the permanent inflation rate.

The actuai

intlation rate observed in 1978 would thus contain a temporary acceleration component.

This component raises the rate of inflation observed

next year under the circumstances to about 7% - 7.5%.
the growth rate ot nominal GIMP for 1978 under the

My estimate of

same circumstances'is around 10.5% p.a.

The growth rate in real

GNP would therefore subside in the context of the recent monetary
growth path to about 3% - 3.5%.
This estimated trend forms the basis for two alternative scenarios
of monetary policy.

The first scenario involves a reversal of" the

pattern emerging in the recent past.

It would lead the Federal Reserve

back to a determined anti-inflationary course.

Suppose that this is

expressed by a monetary growth of about 4.5% for 1978, i.e., a monetary growth along the lower boundary of the last announced target
range.

The growth in nominal GNP along this monetary path would be

(at the most) about 8.0% and will probably be 7% - 7.5%.

But the

permanent inflation rate in 1978 remains in the range between 5% and
6% as a result of the past monetary acceleration.

Moreover, revisions

of inflationary anticipations may still be more affected by the
recent acceleration and the persistent uncertainties imposed by the
Carter Administration.

The actual rate of inflation would probably

stay above 6% under .the circumstances.
subsides

It follows that real growth

to a figure below 2%. A substantial retardation in economic

activity with probably even a minor decline for about one quarter
seems unavoidable in the context of this scenario.

The reversal in

policy to an anti-inflationary stance should thus be expected to

produce a mini-recession and a corresponding increase in the rate of
unemployment.
The second scenario describes a very different policy.

It assumes

an essentially accommodating behavior on the part of the Federal Reserve

Authorities.

Such behavior would be designed to appease Congressional

pressures directed at interest rates and unemployment.

It would also

appease the inflationist groups within the Carter Administration;

accommodating policy could barely settle along a monetary growth path
of 7% discussed above.

Even along this path real growth subsides and

the unemployment rate remains above 6%.

Th second scenario thus fore-

sees an acceleration in monetary growth beyond /% to, say, 8.5%.

The

permanent inflation rate increases to 7% - 7.i>% and the actual rate
bulges along an accommodating monetary path temporarily to a range
around 8% - 8.5%.

The rate of real growth would thus be confined to

a range ot about 4% - 4.5%.

An accommodating policy may thus be

expected to raise somewhat the level of real growth.

But inflation

would definitely accelerate with corresponding increases over the
whole range of interest rates.
Accommodation could, of course, continue beyond 1978.

The effect

on real growth rapidly declines, however, and the spillover of nominal
expansion raising inflation probably increases.

Inflation

approaches on this course in 1979 a threshold of double digit
figures.

With Presidential elections less than two years away, the

probability of "forceful financial leadership1' increases again.

some stage accommodation will end and new etforts will be made to cope
with the recent burst of inflation.

The ensuing reversal in monetary

policy unleashes a substantial retardation of economic activity.

This

retardation would probably lower output over several quarters and also
raise at least one year the rate of unemployment.

The tacit abandonment of anti-inflationary policies by Congress,
the Carter Administration, and the Federal Reserve Authorities created
an unfortunate but unavoidable dilemma for monetary policy.

Our

relevant choice is between a reversal in policy now or a reversal at
a later stage,

A reversal now brings forth a mini-recession in 1978

at an inflation rate of 6% - 6.5% and lower inflation rates beyond
1978.

The delay of the reversal means that we eventually reap a

larger recession in activity at a substantially higher rate of inflation
requiring a much longer time period to tame inflation.
The ongoing debate about the proper, course of financial policies
offers an alternative formulation of the relevant options.

It is

frequently argued that the social costs associated with an antiinflationary policy are too large.

A wiser course involving a comparatively

negligible social cost, it is suggested, accepts the prevalent inflation
and accommodates monetary policy correspondingly.

The social cost of

an anti-inflationary monetary policy is well established.
ment of the first scenario fully acknowledges this fact.

The assessThe issue

between the two options does not center on this acknowledgement but
on the proper recognition of the social costs associated with a course
of permanent and accommodating inflation.

The advocates of permanent

inflation argue that the social cost of this second option is quite
negligible, essentially associated with the lower level of real money
balances resulting from higher anticipated inflation.

The argument

advanced implicitly assumes that an accommodating policy of permanent

inflation can be reasonably- expected to follow a stable path.
assumption seems essentially naive and seriously faulty.

This

It fails

to. appreciate the political context of financial policy-making.

This

context produces two sets of events which raise the social cost
associated with a policy of permanent inflation to substantial levels.
The first set of conditions refers to the increasing likelihood
of an erratic and unstable inflation.

An accommodating policy of

persistent inflation introduces pervasive incentives into the social
system to explore opportunities for accelerating wage and price
setting as a means of competitive wealth transfers in the expectation
that the emerging price-wage policies will be validated (in the average)
by an accommodating policy.

Such explorations in price-wage policies

tend to exploit the political process to generate an appropriate
accommodating stance in financial policies.

It follows under the

circumstances that a permanent policy of accommodating inflation will
experience repeated waves of increased inflation.

We also observe, more-

over, that every major acceleration in price movements introduces new
political opportunities and raises political rewards for the supply
of "leadership in the fight against inflation".

This pattern has been

observed in many countries all over the world oh repeated occasions.
The resulting shifts in financial policies unleash the unavoidable
retardation of economic activity expressed by a decline in output and
rising unemployment.

A policy of permanent inflation very likely

produces, therefore, sequences of substantially accelerated price movements intermittently interrupted by declines in output and higher

unemployment.

An accommodating inflation policy may thus easily

produce two or three recessions, combined with continued inflation,
over a ten-year span.

The current value of the costs determined by

the future series of recessions forms a first component in the
relevant social cost of permanent inflation.
The first set of conditions still yields another cost component
in our tabulation.

The increasing uncertainty bearing on the course

of financial policies over the next two or three years aftects the
price-wage contracting on labor and output markets in a manner probably
raising the natural level of unemployment.

The current value of the

future stream of social costs associated with a higher natural level
of unemployment forms the second strand in the total social cost to
be considered.
The second set of conditions fostered by a policy of accommodating
permanent inflation determines two more cost components.

The exper-

iences of many countries indicate the rising probability of pricewage controls, or controls over interest rates, as inflation accelerates.
Such controls occur in a variety of shifting forms.

They usually affect

the quality and volume of output and longer-range investment programs.
They lower incentives to produce and dampen the willingness to expand
productive facilities.

The magnitude of these effects depends on the

particular controls and their mode of administration.

Controls and

political institutions replacing market mechanisms also raise the level
of uncertainty bearing on the crucial rules of the game confronting
agents in the private sector.

Obscure rules with shifting interpretations

and frequent changes in rules affecting a broad range of a firm's
activities emerge from the operation of political institutions1
"controlling" wages, prices, and interest rates.

The combined effect

operating via incentives and uncertainty lowers the level of normal
output for given levels ot inputs, raises the natural level of unemployment, and lowers the real rate of growth associated with any level of
output.

The current value of future reductions in normal output and

of lowered growth in real output form the third and fourth component
of the total social cost associated with an accommodating policy
of permanent inflation.

The social cost of persistent inflation

involves thus substantially more than some "negligible esoteric
consideration" based on economizing responses in the use of money
induced by higher anticipated rates of inflation.

At least one of

the four components of the total cost resulting from an inflationary
policy is of the same nature as the social cost of an anti-inflationary
policy.

It expresses the welfare loss associated with temporarily

lower output.

A crucial difference between a determined anti-

inflationary policy and its inflationist alternative should be noted
in this context.

A single, once and for all and temporary loss occurs

in the case of anti-inflationary policy.

The alternative unleashes

a series of repeated losses due to the inherent instability of inflationist policies.

The comparative advantage of an anti-inflationary

program increases with the inclusion of the three additional cost
components associated with inflationist policies.

A determined effort

to remove inflation over the next four years wilj. certainly involve

some costs to our society.

J5ut 1 submit as my considered judgment

that the social cost of an inflationist course in our financial
policies substantially exceeds the cost of an anti-inflationary monetary policy.

IV.

The Recommendation
Three times within the past ten years, the Federal Reserve Authorities

abandoned opportunities to curb inflation.

The mini-recession of 1966/67

rapidly retarded the price movements set in train in 1965.

A stable

course of moderate policies in 1967/68 .would have brought the U.S.
economy back to a stable price level.

This opportunity was lost in a

pronounced shift towards an expansionary policy in early 1967.

This

policy resulted to a major extent from intentions to moderate the
incipient increase in interest rates.

Thus emerged the inflationary

burst observed in 1968/69.
The shallow recession of 1970 broke the momentum of price movements.
This opportunity was not exploited by the Federal Reserve Authorities.
A continuous acceleration of monetary growth from early 1970 to the
middle of 1971 contributed to maintain the inherited rate of inflation.
An anti-inflationary course was initiated by the Federal Reserve
Authorities with President Nixonfs "New Economic Policies" and again
abandoned in the spring of 1972.

The consequences became visible

several months before the Opec-Eclat in the tall of 1973.
And now looms a fourth opportunity lost.
increasingly towards the wrong track.

Monetary growth drifted

We inherited thus a situation

which precludes an easy and comfortable solution.

All our options

involve more.or less unpleasant consequences.

The Shadow Committee

should certainly urge that the Federal Reserve Authorities return to
a moderate growth path along the lines suggested in our previous
recommendations.

These recommendations were determined by our

objective to restore over several years a.stable price level.

The

return to our original growth path may be executed in two distinct
modes.

In one case the Federal Reserve Authorities follows a growth

path of 4.5% until the end of 1978 based on the observed average for the
third quarter of 197 7.

In the other case the Federal Reserve Author-

ities moves the money stock until the first quarter 1978 back to the
growth path implicit in the Shadow Committee's proposal made in March
1977 and proceeds subsequently along this growth path.

I submit

at this stage without further discussion-the first mode to the Shadow
Committee's attention.

The Committee's attention should also be

directed, once more (remember Cato's Ceterum censco...), in view of
recent developments, to the proper. Implementation of. an effective
monetary control.
The social cost of the recommendation is immediately visible.
But the public should recognize the larger cost of a permanent drift
into inflation.

The cost of the"Latin-Americanization of the U.S.

economy is substantial indeed.

This cost is distributed over the

future, however, and policy-making appears to operate with a prcmounced
myopic bias.

The disregard of future costs will not exorcise them and

most of us would still experience the unfortunate consequences of an
inflationist policy.

The U.S. economy and our welfare would be better

served with a determined program initiated now and maintained over
four years to lower monetary growth to a level compatible with a
stable price level.

This was, at some occasion, the intention of

House Concurrent Resolution 133.