Full text of Policy Statement and Position Papers : September 19, 1988

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W^
SHADOW OPEN MARKET COMMITTEE

Policy Statement and
Position Papers

September 18-19, 1988

PPS 88-02

THE BRADLEY
POLICY
RESEARCH
CENTER
Public Policy Working Paper Series

U N I V E R S I T Y

ROCHESTER

CONTENTS
Page
Table of Contents

SOMC Members

SOMC Policy Statement Summary

Policy Statement

Economic Outlook
Jerry L. Jordan

The U.S. Economy
Jerry L. Jordan

Refocussing Fiscal Priorities
Mickey Levy

Recent Behavior of Monetary Base Velocity
Robert H. Rasche

Official Intervention in the Foreign Exchange Markets
William Poole

A "Failure" of Monetarism?
Karl Brunner

The Control of the Monetary Base and Its Purpose
Karl Brunner

Tables
Karl Brunner

SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. to 7:00 p.m. on Sunday, September
18, 1988 in Washington, D.C.
Members of the SOMC:
PROFESSOR KARL BRUNNER, Director of the Bradley Policy Research
Center, William E. Simon Graduate School of Business Administration,
University of Rochester, Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration, Carnegie Mellon University, Pittsburgh, Pennsylvania.*
MR. H. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann
&; Co., Inc., New York, New York.
DR. JERRY L. JORDAN, Senior Vice President and Economist, First
Interstate BanCorp., Los Angeles, California.
DR. MICKEY D. LEVY, Chief Economist, First Fidelity Bancorporation,
Philadelphia, Pennsylvania.
PROFESSOR WILLIAM POOLE, Department of Economics, Brown University, Providence, Rhode Island.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New
York, New York.
*On leave at the Council of Economic Advisers

1
SOMC POLICY STATEMENT S U M M A R Y
Washington, September 18 — The Shadow Open Market Committee called
on the federal government to adopt a three-point program to ensure continued economic expansion:
FIRST, the Federal Reserve should reduce the growth rate of the monetary base over the next five years to 3 percent. Ultimately, this will reduce
inflation to zero.
S E C O N D , the United States should cease and desist from trying to
manipulate foreign exchange rates and pressuring other nations to do the
same. Such intervention is ineffective and counterproductive.
T H I R D . Congress and the new administration should hold the rate of
increase in total nominal federal expenditures to an average of no more than
3 percent a year. If such a policy is adopted, the budget can be balanced
without an increase in taxes.
The SOMC is a group of academic and business economists who meet
regularly to comment on public policy (list attached). It was founded in
1973 by Professor Karl Brunner of the University of Rochester and Allan
H. Meltzer of Carnegie Mellon University.
In its Statement, the SOMC called on the Federal Reserve to abandon its traditional approach of "fine-tuning" monetary policy to short-run
changes in business activity. Instead, the Fed should focus on implementing a long-run non-inflationary policy. The Committee said that the Fed
should resist political pressures to alter levels of interest rates from what
freely competitive financial markets would produce. The price of credit
should be determined solely by private competition.
The Committee warned that intervention by central banks in the foreign
exchange market has no lasting effect. Slower monetary growth, whether
caused by foreign currency intervention or domestic open market operations, leads to a stronger currency. Accelerations of monetary growth,
whether produced by intervention or domestic policy actions, lead to a
weakening of the currency.
The Committee flatly rejected any and all proposals to increase federal
revenue as a share of GNP. The U.S. is now in a position, the Committee
said, to move toward balance in the Federal budget with present tax rates.

SHADOW OPEN MARKET COMMITTEE

Monetary policy actions should aim to achieve goals consistent with the
nation's fiscal priorities. However, if mistakes are made in budget policy,
the monetary authorities should neither accommodate nor compensate for
such disturbances.

SEPTEMBER

18-19, 1988

SHADOW OPEN MARKET COMMITTEE
Policy Statement
September 19, 1988
Rising inflation threatens continued economic expansion. As 1988 has
progressed, concern has shifted from recession to inflation. If policymakers
allow monetary growth to accelerate, the risk of higher inflation increases.
A cycle of boom and bust could result. To avoid such an outcome and
provide for a stable economy in the 1990s, the Shadow Open Market Committee recommends a three-point program:
FIRST, the Federal Reserve must adopt a substantive, longrun strategy for monetary policy that is consistent with reducing inflation toward zero. The Federal Reserve should
reduce the growth rate of the monetary base steadily over
the next five years to a 3 percent rate.
S E C O N D , the United States should cease and desist from
trying to manipulate foreign exchange rates and pressuring
other nations to do the same. Such intervention is ineffective
and counterproductive.
T H I R D . Congress and the new administration should hold the
rate of increase in total nominal federal expenditures to an
average of no more than 3 percent a year. If such a policy
is adopted, the budget can be balanced without an increase
in taxes.
M o n e t a r y Policy Actions: 1988 a n d Beyond
The capital stock of any central bank is the credibility of its long-run
commitment to contain inflation. Once such capital is squandered, society
pays a high cost over a long period as the central bank seeks to restore
its reputation. As we anticipated at the time of our meeting last March,
monetary policy actions in 1988 are quite generous. As a consequence, the
growth rates of the monetary aggregates accelerated this year. Excessive
growth of the monetary base through the first three quarters of this year
has raised inflation and fostered expectations of further price increases to
come.

SHADOW OPEN MARKET COMMITTEE

A high rate of capacity utilization in industry will not trigger inflation. High capacity utilization is fully compatible with low inflation, given
restraint in monetary growth. High capacity utilization may lead to an
increase in the price of one product relative to others, or of one factor of
production relative to others, but not in the average price level. Changes
in relative prices are desirable in order to shift resources from slack sectors
to sectors experiencing tight supply conditions. Relative price changes,
however, should not be mistaken as signs of inflation. Excessive monetary
growth is far more important than capacity utilization as a determinant of
inflation.
The monetary stimulus of 1988 will inevitably result in a compensating
period of monetary stringency, probably in 1989. Once rapid monetary
growth is tolerated, there is little possibility that a subsequent economic
contraction can be avoided. The lagged effects of monetary growth over
the prior two to three years gradually increase the inflation rate, while an
anti-inflationary monetary policy restrains growth of final demand. This
temporarily squeezes real output growth, frequently producing a recession.
The Federal Reserve will make a serious error if it resists a transitory
increase in unemployment and thus loses the credibility of its stand as
an inflation fighter. To be successful, monetary policy must be stable and
predictable. The Federal Reserve must not attempt to "fine-tune" its policy
in response to short-run fluctuations in business activity.
We urge the Federal Reserve to resist political pressures to do the impossible — namely, to attempt to alter levels of interest rates from what
freely competitive financial markets would produce. The Federal Reserve
should declare its intent to focus exclusively on quantitative measures of reserves and monetary growth, and allow the price of credit to be determined
by private competition.
The Federal Open Market Committee, which implements central bank
policy, should adopt a long-term, five-year strategy of reducing the growth
of the monetary base to a non-inflationary rate. Under present circumstances, this means that ultimately the base should increase no more than
3 percent annually — the expected long-run sustainable growth of real
GNP.
The Federal Reserve argues in its most recent monetary report to Congress that the relationship between the monetary base and nominal income

SEPTEMBER

18-19, 1988

is too unreliable to be useful in monetary policy. The Federal Reserve,
however, has not produced any evidence that a more reliable link exists between its preferred operating and instruments of borrowed reserves and/or
the federal funds rate and nominal income.
Foreign Exchange Intervention
Intervention by central banks in the foreign exchange market has no
lasting effect. Exchange rate trends in recent years are not a result of
central bank intervention policy. Rather, they are consistent with changes
in monetary growth rates and economic fundamentals in the U.S. and other
countries.
Slower monetary growth, whether caused by foreign currency intervention or domestic open market operations, leads to a stronger currency.
Accelerations of monetary growth, whether produced by intervention or
domestic policy actions, lead to a weakening of the currency. If the monetary authorities pursue a steady non-inflationary domestic monetary policy,
foreign exchange intervention will not be necessary; if they do not, intervention is futile.
The U.S. should declare its commitment to return to the status of the
"Nth currency country" in a world where there is one less set of exchange
rates than there are currencies. The dominant currency country cannot
seek competitive advantage over its trading partners through currency manipulation, and we should set an example for others to follow by focussing
on the achievement of sustainable domestic policies without distraction by
short-run currency movements.
B u d g e t a r y Policy
The nearly exclusive focus of federal budget policy on the deficit diverts
attention away from other important fiscal objectives. The fiscal debate
should refocus on four areas: a) the level and mix of federal spending;
b) the economic rationale for specific programs; c) the optimal method of
financing federal government spending; and d) the impact of spending and
financing on saving, investment and economic growth.
The Budget Control Act of 1985 (Gramm-Rudman-Hollings) and its
revised version are political manifestations of the lack of understanding of

SHADOW OPEN MARKET COMMITTEE

the role budget policy plays in the economy. By reinforcing the narrow focus
of budget policy on deficits and accentuating its flaws, Gramm-Rudman
allows economic policymakers to avoid crucial spending and tax decisions.
The objectives of fiscal policy should be to establish a set of tax and
spending policies conducive to long-run economic growth and consistent
with a desired allocation of national resources. Since fiscal year 1986,
Congress and the Administration have successfully slowed growth in federal spending. Spending as a share of GNP has receded. This trend must
continue.
We oppose any and all proposals to increase federal revenue as a share
of GNP. The U.S. is now in a position to move toward ultimate balance in
the Federal budget with present tax rates. If total federal outlays are held
to an average 3 percent annual increase for the next five years, expenditures
decline to under 20 percent of GNP. The deficit would simply disappear.
Monetary policy actions should aim to achieve nominal income and
inflation goals consistent with the nation's fiscal priorities. If mistakes
are made in the setting of budget policy, the monetary authorities should
neither accommodate nor compensate for such fiscal disturbances.

SEPTEMBER

18-19, 1988

ECONOMIC OUTLOOK
Jerry L. JORDAN
First Interstate BanCorp.
As 1988 has progressed, concern has shifted from recession to inflation.
This year could be an important turning point for the trend of prices, the
response of the Federal Reserve, and economic priorities as a result of this
November's election.
Recession this year was not a part of the SOMC forecast, either before
or after the October 1987 stock market crash. However, we now project a
mild downturn beginning by mid-1989 and lasting two or three quarters.
This forecast results from two key assumptions. One is that monetary
growth has been excessive in 1988, helping to push inflation into the 5
percent - 6 percent range next year. The second assumption is that once
inflation reaches such levels monetary policy will become quite restrictive
and a transitory contraction of the national economy will follow.
In an environment of higher inflation, continued rapid monetary growth
next year could postpone, but not prevent, an ultimate recession. Recessions are not the result of a lack of stimulus; economic expansions do not
die of old age. "Pump-priming" actions by government are not necessary
to prolong an expansion. The way to avoid a recession next year is not
by assuring adequate stimulus in 1989, but by avoiding excessive monetary
growth in 1988. The time to combat next year's recession was during this
year's expansion.
T H E U.S. E C O N O M Y
Most forecasters have now discounted about a possible recession in 1988.
We are maintaining our forecast of a solid economic gain this year, raising
slightly the projected growth in real GNP. On a year-end-to-year-end basis,
we continue to expect real GNP to advance over 3 percent this year.
A recovery in consumer spending, an upswing in business outlays for
computers and other capital equipment, and a surge in exports accounted
for the expansion of output in the first part of 1988. Several sectors will
support growth during the remainder of 1988. Gains can be expected as:
(1) exports continue to rise, (2) American companies capture larger shares

SHADOW OPEN MARKET COMMITTEE

of domestic business with imports easing, and (3) capital spending plans,
which have been revised upward, are put into effect.
The deceleration of growth during 1989 will be reflected in: (1) a deceleration of consumer spending growth, (2) a softening in both residential
and non-residential building, and (3) inventories at higher-than-desired levels with a subsequent correction and cutback in production.
Federal Reserve actions in 1988 have been intended to help sustain the
expansion. However, the nearly 8 percent rate of growth of the monetary
base, now estimated for the first three quarters of 1988, has added to inflation concerns. Once the inflation rate moves into the 5 percent - 6 percent
range, we expect a tightening in monetary policy.
Inflation Concerns Revived. The economic outlook for 1989 thus
hinges on the actual inflation rate in the closing months of 1988. Unfortunately, a number of forces are coming together to push up prices at a
faster pace. The root cause of inflation is monetary stimulus that is too
rapid relative to the economy's capacity to produce. Much debate has developed over the "best" measure of "money," but at least some important
measures have exhibited high growth rates. The monetary base, consisting
of currency and bank reserves, is the raw material for all of the monetary
aggregates. During the past four years, the base has grown at an average
rate of 8.5 percent, and we expect an increase of about 8 percent this year.
This represents a relatively high growth trend, with inflationary potential.
While monetary stimulus continues to fuel demand, the economy has
begun to run into capacity constraints in industry and tightening employment conditions in labor markets. Factories are now operating at an average of about 83 percent of capacity, the highest level since early 1980.
The unemployment rate is close to 5 percent, which may be the effective
full-employment level in the United States. Consequently, prices and wages
have been under increasing upward pressure.
Some forecasters have argued that excess capacity in other countries
will mitigate inflationary pressures. However, the decline in the dollar's
value on foreign exchange markets has diminished the ability of imported
goods to restrain domestic inflationary pressures. As more of the dollar's
decline is passed through by exporters to consumers, prices of imported
goods excluding fuel are expected to climb by about 10 percent this year.
With respect to oil and food price shocks, oil prices are likely to hold

SEPTEMBER

18-19, 1988

relatively stable or ease slightly during the coming year in view of OPEC's
inability to agree on and enforce cutbacks in production. The drought in
parts of the United States, on the other hand, could push food prices up
more rapidly, especially in 1989.
The net result is likely to be a year-to-year increase in consumer prices
of nearly 5 percent by the end of 1988, followed by a rise of about 6 percent
in 1989. In 1987, consumer prices increased 4.5 percent.
Financial Markets. A stronger-than-expected economy and inflation concerns have been the major forces pushing up interest rates since
early this year. The Federal Reserve has moved their Fed funds target up
grudgingly, but steadily, this summer, hoping that economic growth will
moderate, inflation will not accelerate, and that the foreign exchange value
of the dollar will hold relatively stable.
We expect short-term credit demands to continue to rise during the
coming months, while the Federal Reserve may in effect hold interest rates
below market-clearing levels. This will result in continued rapid growth
rates of the various monetary aggregates. If inflation accelerates, as we
expect, the Fed would then tighten reserve availability substantially, beginning in late 1988 or early 1989. Short-term interest rates could rise 100 to
150 basis points between the end of this year and the middle of 1989.
The bond market has reacted quickly to changes in recession/inflation
concerns. The yield on 30-year government bonds fell to a low of about 8.3
percent early this year from a peak of 10.5 percent on the Friday before
last October's stock market plunge. It has since climbed back to about 9.4
percent. Long-term rates are unlikely to climb sharply from current levels.
The yield curve should flatten further in the first half of 1989, as shortterm interest rates rise much faster than long-term rates. Most recessions
since World War II have been preceded by an actual inversion of the yield
curve, with short-term interest rates above long-term rates. Compared with
the steepness of the yield curve last year, yield spreads are expected to narrow, but not invert, in 1989. The long-bond rate is projected to peak at
about 9.75 percent in early 1989 before declining on expectations of lower
future inflation and a weaker economy.
If the Federal Reserve reacts before inflation moves above the 5 percent
- 6 percent range, a recession would be relatively mild and brief. We

SHADOW OPEN MARKET COMMITTEE

expect real GNP to decline about 1 percent next year on a fourth-quarterto-fourth-quarter basis, with an upturn beginning in the first half of 1990.
The U . S . Dollar. While fluctuating considerably on a day-to-day basis, the dollar has generally appreciated on balance in 1988 — regardless
of Central Bank intervention. Actions by foreign exchange market participants will determine whether the dollar depreciates further or appreciates,
regardless of the desires of central bankers. That raises important questions about economic and political events that would persuade the market
to override intervention efforts by the central bankers.
Three factors, however, are likely to support the dollar in at least the
next 9-12 months. First, as discussed below, we expect both the U.S. trade
and current account deficits to decline in 1988 and 1989, which should
contribute strength to the dollar. Second, we expect interest rates to rise,
with increases generally faster than the increase in inflation. Thus, real
interest rates are likely to be a positive factor for the dollar next year, as
the real interest-rate differential between the United States and elsewhere
widens.
The forecast of a U.S. recession, beginning in 1989, should be a third
positive factor for the dollar, as the external deficits should improve faster
than otherwise and expected U.S. inflation rates should decline. Recent
data suggest, however, that countries with a substantially larger share of
real economic growth coming from stronger domestic demand, as opposed
to net exports (especially Japan), will find their currencies depreciating less
against the dollar than would have been expected.
Excepting political considerations, we look for the dollar to strengthen
modestly until early November. After the election, we expect the dollar to
appreciate more rapidly, especially during the recession.
U . S . Current Account Deficit. After recording new highs in 1987,
both the U.S. trade and current account deficits are poised for declines in
1988 and 1989. First half 1988 results show that merchandise exports on
a volume, or inflation-adjusted basis, rose over 30 percent from their yearearlier level, while imports increased only 10 percent. The depreciation of
the U.S. dollar since early 1985 and improved export markets have added
an undeniable breath of life to U.S. exports, just as the dollar's decline has
made imports less competitive.
In 1988, we are looking for a $30 billion improvement in the trade deficit.

SEPTEMBER

18-19, 1988

Through the first six months of the year, we have already seen exports
increase 33 percent from their level for the same period in 1987 on a nominal
basis, while imports have risen only 12 percent. On an annual rate basis,
the cumulative deficit for the first half of 1988 was $30 billion less than that
for all of 1987.
In 1989, we anticipate a larger improvement in the trade and current
account deficits than is occurring in 1988 because of the forecast U.S. recession. The decline in the trade deficit, however will be offset to a large degree
by a continuing increase in the outflow of funds on the services account,
reflecting the net increase in foreign ownership of U.S. assets. Current account deficits have to be offset by either net direct investment by foreigners
in the United States and/or by increased holdings of other U.S. assets by
foreigners. In 1987, the negative U.S. net investment position grew as net
foreign holdings of U.S. assets rose about $154 billion. In 1988, they will
rise another $145 billion. As a consequence, earnings on the net position
of U.S. holdings of foreign assets and foreign holdings of U.S. assets will
erode the traditional U.S. surplus earned on the net services account. Net
services may record a small deficit by 1989 (or even 1988). In 1989, we
forecast a current account deficit totaling $120 billion — the equivalent of
2.3 percent of GNP, down substantially from 3.4 percent in 1987.

SEPTEMBER

18-19, 1988

T H E U.S. E C O N O M Y
Shadow Open Market Committee

Jerry L. Jordan
Senior Vice President and Chief Economist
First Interstate Bancorp

Washington, D.C.
September 18-19, 1988

MONETARY BASE
(Quarterly rates of change, s.a.ir.)

TOTAL BANK RESERVES
(4-week moving avg., percent change from 13 weete ago, SAAR)

40 T
FRBBase

12
10
8
6
w

s
a

o
o

4
2
0

1 l l l 11l ) 1l I 1I 11 I 111t l 1I l 1l 1l l l l
1
82
83
84
85
86
87
88

io I in m i n m m m m i i n m i i m i m i n i nn ii m i ii i
33

41 49 4
1986

28 36 44 52
1887-

16 24 32
1983

S
z
w
a.
O

NOMINAL GNP
(Percent change from prior quarter, annual rate)

REAL GNP
(Percent change, 4th quarter to 4th quarter)

w
CO

88e

891

901

First Interstate Economics

REAL CONSUMER SPENDING AS A SHARE OF GNP

FOREIGN TRADE DEFICIT

(Quarterly, percent)

(Simons oi dollars, balance oi payments basis)

67 T

61 j i i i n m

i n m i i
82

iiiiiiniiiiiiHimiiiiiiH
84

88e 89f

-200
84

90f

AUTO AND TRUCK SALES

1986

1987

839

891

90(

(Millions of units, seasonally adjusted annual rats)
2.0

1985

HOUSING STARTS

(Millions of units)

1984

&&SS3 ! Ss^Ksl *

19838

1989f

1990(

1984

1985

1988

1987

1988

19891

19901

First Interstate Economics

CHANGES IN EMPLOYMENT

U N E M P L O Y M E N T RATE

(Millions, 4th quarter to 4th quarter)

(Percent, quarterly averages)

12T

W
W
H
H

a
a
o

o
H
W

<
z
w

CONSUMER AND EMPLOYEE COSTS

CRUOE OIL PRICES
(West Texas intermediate,
Ooiiars p%t Barrel, Weekly Averages)

(Percent changes, 4th quarter to 4th quarter)

o
135
CO

1983

1984

1985

1986

1987

1988*

19891

1990f

lOhiniiiiiHiHiiiiiiuiiniiiiiiiiiiiiHiiiiiiinmmimHiumiiiniimi
M A M J J A S O N O J F M A M J
J A S
1987

198a

First Interstate Economics

EXCHANGE RATE - DM/$

EXCHANGE RATE • YEN/$

(Weekly Averages')

(Weekly Averages*)
180 -r

2.2-r

2.0 i
September 8 Spot Rata
S^p'jimbar 8 Spot Rate

1.84

1.64

1.4
co

* U s t point is spot ma

1987

1988

110 iiiiuiMiimiiiiuiiiiiimntiiitininnmmnimnnnitHnmimnmi
M A M J J A S O N 0 J F M A M J J A S
*Ust point is spot rale

1987

1988

o
o
l

YIELD CURVE, 3-MONTHS TO 10 YEARS

YIELD CURVE, ANNUALLY 1 TO 30 YEARS

(Percent)
(S3

11 T

w
a.

10 +

i M n i i i i i i M i i m i i i i i i i i i i i i i i i i i n n
10 Yr
3Yr
7Yr

3Mo 1Yr

First Interstate Economics

SHORT-TERM INTEREST RATES
(Percent, qua/tarly averages)

LONG-TERM INTEREST RATES
(Percent, quarterly averages)

16-r

16
134

Fixed-Rale Mortgage

Prime
&3

s"\

104

,(|,,,,M|,,,

«»(.o-

a
s
o
o

30-Year Government Send

74
90-Day T-Blil
4 1 M
84

I I I I I I I I I I I i I I I I I I I I I I I i I I
85
86
87
88e
89f
90f

4i l I I t l i i t i i i f I i i > t i i I l I l i l l I 1
84

' 88e

89!

901

a,
O
O
D

STOCK AND BOND YIELDS

ASSET ANO GOODS PRICES
(Percent changes, annual averages)

(Monthly, percent)

16T

30-Year Bond Yield

Home Prices lagged one year

12 +

0
70

4—f-H—I—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i
72
74
76
78
80
82
84
86 88e

First Interstate Economics

MAJOR ECONOMIC INDICATORS

CROSS NATONALPRCOUCT
(Billions o! 9. annual a w )

4th QUARTER

J
Aaual
4724.5

1999
11
4419.7

For*ca*t
4914.1

4179.1 922?.9

9029.7

Forecael
9279.9

1974.9

1494.9
4.2

1981

%Change
'6i/'87

9994.7

9797.4

5029.7

7.9

% Chang*
% Chang*
't9/'»a
18QQ ' J Q / ' I O
Foreeaet
5275.9
4.9 5707.4
4.2

4054.9

3.4

4039.0

124.0

4.3

130.7

5.4

135.7

4.4

120.4

4.7

127.5

5.4

133.5

4.7

1999

3959.1

3944.1

4024.9

4056.9

4079.*

4044.7

4050.2

4034.9

7.7
4045.0

4109.0

4143.9

7.9
4174.2

3.4
119.4

3.3
120.9

4.2
122.4

124.0

2.2
125.4

• 1.0
127.5

•1.4*
129.9

•1.2
130.7

2.7
132.2

4.4
133.7

3.9
135.2

3.9
139.7

1.7

5.1

9.0

5.3

5.4

5.5

5,4

5.3

4.9

4.4

4.5

4.4

114.2

117.5

119.1

120.9

122.4

124.1

129.9

127.4

129.1

139.4

132.9

133.4

3.4

4.9

5.2

5.7

5.9

5.4

5.0

4.7

4.4

4.9

AUTO SALES
(Million*, annual rat*)

10.9

10.7

10.3

9.4

9.2

9.9

4.4

9.1

4.9

10.9

19.9

10.4*

3.1

9.1*

•14.4

10.0*

10.5

HCUSNQ STARTS
(Millions, annual rat*)
INDUSTRIAL
PRCCUCTEN
(1977-100)
% Chano*. annual rat*
NONFARM
EMRJOYMENT
/Million*)
LNEMPLOYMENT
RATE. ALL WORKERS {Percora)

1.49

1.44

1.41

1.39

1.41

1.42

1.49

1.99

1.17

i.4t

1.44*

•9.4

1.41 *

•3.4

1.55*

10.0

134.5

135.0

1J7.9

139.4

140.7

140.3

139.5

134.7

139.9

141.9

143.1

144.9

4.0

4.5

5.9

4.3

3.4

•1.0

•2.5

-2.1

3.3

5.2

4.4

4,9

104.7

105.5

109.4

107.3

107.9

107.3

107.9

109.9

5.9

5.4

9.2

5.2

5.9

5.7

4.1

9.9

242.0

247.0

271.4

274.9

279.2

292.9

299.1

291.9

299.0

4.5

7.4

4.4

9.7

9.0

4.9

9.9

7.9

10.0

REALGNP
(Billion* of 1992 S. a x )
% Chang*, annual rat*
GISPOEFLATGR
(1952-100)
% Chano*. annual rat*
CONSUMER FREE
INDEX
(1962-44-100)
% Chano*. annual rat*

MONETARY BASE
(Billion* at t,r*.t.)
% Chang*, annual rata

4.4

1.5

•0.5 4176.2

139.4

4.9

134.7

•0.5

144.4

4.4

119.3

, 107.3

3.5

107.3

0.0

110.3

2.4

9.9

9.4

5.2

N/A

9.1

N/A

S.4

N/A

303.9

309.9

313.9

275.9

5.5

313.9

9.0

7.9

9.9

NOTE: All quantity sari** art seasonally adjusted; % chang*. annual rata calculated from prior quartan
cateuWon* based on unrounded data: a.f. » annual rat*.

•Annual total; N/A • Not appftcabto.

FORECAST OF INTEREST RATES
(Quarterly Average*)

III

111

Short*T«rm
F*d Funds (Overnight)

4.55

7.16

4.00

9.54

9.35

9.30

4.10

7.30

7.85

7.39

7.40

7.94

Treasury Bills (3 month)(1)

5.72

6.21

7.00

7.45

4.34

9.30

7.10

9.35

9.10

9.49

9.56

9.75

CO* (3 month. Secondary)

6.72

7.22

4.25

4.74

4.40

9.30

9.10

7.45

7.20

7.49

7.54

7.99

Eurodollar (3 month)

5.45

7.35

4.34

4.90

9.50

9.41

9.22

7.37

7.33

7.41

7.74

7.99

Prim* Rale

4.59

9.75

9.70

10.30

10.90

11.00

9.99

9.19

9.90

9.00

9.29

9.40

Long«T*rm
OS. Government Bonds
(30 years) (2)
Corporal* Aaa (Moody's)
Mortgag* Rat* (FU*d)(3)

9.56

9.91

10.05

10.35

10.55

10.45

10.05

9.90

9.40

9.99

9.79

9.75

10.09

10.37

10.55

11.10

11.00

10.50

10.34

16.09

10.24

10.39

10.40

(1) Bank discount basis.
(2) Yieida adjusted to oonatant maturities.
(3) Contract rates on first mortgages, conventional marital

3.4

F i r s t I n t e r s t a t e Economics

SEPTEMBER

18-19, 1988

R E F O C U S S I N G FISCAL PRIORITIES
Mickey D. LEVY
First Fidelity Bancorporation
The good news on the budget is that real federal spending has slowed.
The bad news is that recent and expected federal legislation threaten to
reverse this trend and raise pressure to increase taxes. Budget actions and
the debate surrounding the budget process have focussed nearly exclusively
on the deficit. Fixation on deficits diverts attention away from the economic
rationale for the level and types of spending, from the optimal method of
financing the spending, and away from the impact of spending and financing
methods on saving, investment and growth. This fixation is all the more
absurd because of the uncertainty and controversy about the economic and
financial effects of deficits and about how to measure the deficit. The
current budget process has lost sight of the broader objectives of fiscal
policy, is misleading to policymakers, and especially misleads the public. A
reassessment of fiscal priorities and the policy process is required.
P r o b l e m s w i t h C u r r e n t Focus
The Budget Control Act of 1985 (Gramm-Rudman-Hollings, or GRH)
and its revised version have focussed nearly exclusively on the deficit to the
exclusion of other important objectives of fiscal policy. The report of the
National Economic Commission has not been issued yet, but is likely to have
the same thrust. More attention must be paid to the benefits of specific
federal programs relative to their costs or alternative uses of resources. The
deficit debate largely ignores the fact that several large structurally flawed
federal spending programs are the true sources of rising outlays and high
deficits. Recent budget debates have excluded serious examination of key
spending programs in terms of the economic rationale of their objectives or
the efficiency of their structures in achieving those objectives.
Total federal spending, which has been rising as a percent of GNP, represents the amount of national output absorbed by the public sector. This
allocation of resources to the public sector reduces private investment, regardless of how it is financed. Investment and economic output is further
suppressed by taxes that discourage saving, investment and productive effort. As federal spending has increased as a percent of GNP, the share of
net investment has receded.

SHADOW OPEN MARKET COMMITTEE

Recent high deficits simply reflect the revealed preference of economic
policymakers to raise spending but not raise current taxes. As endogenous ly determined residuals, deficits do not convey the national priorities
or costs implied by the size and mix of federal spending. Contrary to the
commonly-held perception that the Reagan Administration's tax cuts in
the early 1980s "caused" the deficits, virtually all of the rise in the cyclically adjusted deficits as a percent of GNP in the 1980s is attributable to
escalating federal spending. As a percent of GNP, outlays have risen from
19.0 percent in the 1960s and 20.4 percent in the 1970s to 23.1 percent in
the 1980s. They peaked at 24.3 percent in FY 1983 and have since receded
to approximately 22.3 percent in FY 1988 (see Table 1). Besides net interest outlays, most of the increase in federal spending is due to increased
outlays for social security, health, and non-means-tested entitlement programs. Defense outlays, after rising from 4.7 percent of GNP in FY 1979
to 6.3 percent in FY 1986, have remained flat in real terms since FY 1986,
and have begun to recede as a share of GNP.
The riveting attention on deficits persists despite a general lack of understanding about the economic and financial market effects of changes in
the deficit. While conventional debate about fiscal policy in the 1970s centered on the magnitude and timing of fiscal multipliers, attempts to manage
aggregate demand through discretionary changes in the deficit failed. In
the 1980s, periodic recommendations to increase taxes to stimulate the
economy call into question the sign as well as the magnitude of the fiscal
policy multipliers. Also, earlier presumptions about the effects of deficits
on interest rates and exchange rates have proved incorrect. In contrast to
this uncertainty, there is a growing body of evidence that suggests adverse
long-run effects of the mounting federal debt burden. This is another reason
why fiscal policy must be redirected from short-run stabilization objectives
toward creating an environment conducive to long-run economic growth.
Even though changes in the deficit (or changes in the cyclically-adjusted
deficit) have proved to be very poor and misleading measures of fiscal
thrust, and have been unrelated to changes in the prices of financial assets,
continued attention on such measures confuses the fiscal policy debate. Instead, fiscal impact studies should focus on the stock of federal debt relative
to the stock of other assets, rather than the flow of deficits, and should also
key on the economic responses to specific tax and spending changes. In-

SEPTEMBER

18-19, 1988

deed, one of the key lessons of the 1980s is that the economic responses to
the changes in the tax and spending structures underlying the deficit have
overwhelmed the aggregate demand impact on changes in the deficit. The
allocative effects of the Tax Reform Act of 1986 exemplify the significant
economic and financial impacts of a revenue neutral change in tax policy.
This suggests that there is a right way and a wrong way to lower deficits.
The budget process induces fiscal actions independent of the economic
environment. Official budget forecasts are extremely sensitive to economic
and interest rate changes and, although large revisions tend to occur in
each new official budget document, the forecasts unduly influence fiscal
legislation. In particular, under GRH, a forecast of weaker economic growth
raises projected deficits which requires larger deficit cuts. Tax increases to
achieve such deficit targets may be counterproductive by reducing short-run
economic growth, and also may lower long-run potential growth through
investment and production disincentives.
GRH has served a useful purpose of imposing a political constraint
that has contributed to actions to lower the deficit, but it has reinforced
and accentuated some of the flawed emphasis of the budget process. Its
target deficits are both arbitrary and without economic meaning. While
well-intended, GRH has turned the budget process into a bean-counting
exercise. It fails to differentiate between achieving its deficit goals through
spending cuts or tax increases, and has elicited hefty tax hikes. Also, it has
led to spending cuts that have tended to generate short-term saving, while
precluding or postponing meaningful structural changes in some flawed programs. The tendency toward a poorly designed and skewed mix of spending
restraint is reinforced by GRH's porous sequestration process. Over onehalf of total federal spending is excluded from its consideration, including
several large spending programs whose rapid spending growth are at the
root of the deficit problem.
Refocussing Fiscal Policy
The objectives of fiscal policy should be to establish a set of tax and
spending policies conducive to long-run economic growth and consistent
with a desired allocation of national resources. Recent efforts to reduce
deficits have made progress in slowing spending growth, but they have

SHADOW OPEN MARKET COMMITTEE

relied too much on tax increases. Now that the federal debt-to-GNP ratio is
forecast to peak only slightly above its FY 1988 level of 42.6 percent before
receding, reducing the deficit through tax increases would be a mistaken
policy — even more so than it was in the mid-1980s.
Reducing federal spending should be the top fiscal priority. In this effort, all programs should come under careful scrutiny. Several areas stand
out. We can no longer afford to ignore social security, Medicare, and other
non-means-tested entitlement programs. Their outlays have increased as
a share of total federal spending and GNP, and a sizeable portion of their
benefits go to non-poor households. Eliminating some of their structural
flaws would generate cost savings, redistribute a larger share of the benefits toward lower income households, eliminate some undesired economic
inefficiencies, including disincentives to work and save, and reduce pressure
to cut spending in other programs for the sole purpose of meeting deficit
targets. Recent fallacious and misleading revelations about the projected
"surplus" in social security's OASI and DI trust funds should not overshadow the fact that social security cash payments and Medicare outlays
will continue to rise as a share of total outlays and GNP.
In addition, agricultural programs are expensive and generate substantial distortive effects on production, and should be subject to complete
restructuring. Unfortunately, recent passage of the Disaster Assistance
Act and Medicare Catastrophic Coverage Act of 1988 illustrate the high
costs of legislative slippage. The Medicare legislation raises spending and
taxes substantially, but by approximately the same amounts. The CBO
estimates the cost of the emergency farm legislation at $5.1 billion; the
Administration measures the cost at $3.9 billion. Defense programs also
should be considered candidates for cost savings. However, changes in the
defense budget must be based on national security objectives as well as
federal budget objectives.
Unfortunately, there is a general presumption that taxes need to be
raised to lower the deficit, but higher taxes represent an inefficient solution.
Higher personal and corporate tax rates, higher capital gains taxes, and a
value-added tax are already being mentioned as part of a new tax package.
The worst outcome would be higher taxes that erect further disincentives to
save and invest, and reduce out international competitiveness. This would
be counterproductive to economic growth and efforts to lower the federal

SEPTEMBER

18-19, 1988

debt-to-GNP ratio. Although higher taxes on consumption are preferable
to higher taxes on capital, they would ease the political pressure to slow
spending growth and only validate the structural flaws of existing spending
programs.
The Budget Outlook
Real federal spending growth has slowed significantly, spending and
deficits as a percent of GNP have receded from their mid-1980s levels
and, under current law and with further economic expansion, these healthy
trends should continue. The potential bad news is three-fold: 1) recently enacted expensive health and farm legislation, and backlog of other spending
legislation threaten to reverse the recent trend of slower spending growth,
2) there is rising political pressure to increase taxes, and 3) there is no
strategy for how to conduct fiscal policy during or following a recession.
Real federal spending growth has slowed to approximately 0.2 percent
annually from FY 1986 to FY 1988, compared to 3.2 percent from 1970 to
1980 and 3.6 percent from 1980 to 1986. With strong economic growth,
spending has receded from a peak of 24.3 percent of GNP in FY 1983 to an
estimated 22.3 percent in FY 1988. There has been a significant slowdown
in defense spending and declines in non-defense discretionary programs
and grants to state and local governments, excluding those for payments to
individuals. Outlays for social security, Medicare and Medicaid, retirement
programs, and other payments to individuals have continued to increase in
real terms and as a share of GNP. Excluding the sharp rise in net interest
outlays, the recent slowdown in spending is even more impressive. With net
interest outlays rising to an estimated $148 billion in FY 1988, the so-called
primary deficit (deficit minus net interest outlays) is nearly in balance.
The reduction in deficits from 6.3 percent of GNP in FY 1983 to an
estimated 3.2 percent in FY 1988 has been due to strong economic growth,
slower spending growth, and higher taxes. Tax receipts have increased
from 18.1 percent of GNP in FY 1983 to an estimated 19.0 percent of GNP
in FY 1988, reflecting a series of legislated tax increases, including the
Social Security Amendments of 1983, the Consolidated Omnibus Budget
Reconciliation Act of 1985, the Budget Reconciliation Act of 1986, and the
Bipartisan Budget Agreement of 1987.

SHADOW OPEN MARKET COMMITTEE

The official budget outlook is favorable insofar as under current law,
spending and deficits are projected to continue to recede as a percent of
GNP. According to the CBO baseline forecast, the decline in the deficit
as a percent of GNP through FY 1991 will be approximately evenly split
between higher revenues and lower spending. Projected higher tax revenues reflect higher health insurance premiums scheduled under the Medicare Catastrophic Coverage Act of 1988 and a scheduled hike in payroll tax
rates in 1990. Recent trends in the mix of federal spending should continue,
with non-means-tested entitlements rising as a share of total outlays, and
defense and non-defense discretionary outlays receding. The CBO forecasts
that based on current law, average annual growth of outlays for Medicare
and Medicaid between FY 1988 and FY 1994 will exceed 12 percent annually (approximately 3 times faster than CBOs average inflation forecast),
and social security outlays will climb 6.5 percent annually. The increased
outlays for Medicare and Medicaid will be generated by growth of the eligible population, high medical care inflation, greater use of medical services
by eligible beneficiaries, and expanded coverage under the Medicare Catastrophic Coverage Act of 1988. Under current law, outlays for defense and
non-defense discretionary appropriations are projected to decline in real
terms and recede modestly as a share of total spending and GNP.
In its "Initial Sequester Report to the President and Congress for Fiscal
Year 1989" (released August 25th), OMB raised its GRH deficit forecast for
FY 1989 to $144 billion, up from $140.1 billion GRH Baseline projection
provided in the Mid-Session Review of the 1989 Budget (released July 28,
1988) to reflect the enactment of the Disaster Assistance Act. This deficit
projection is below the allowable $146 billion ceiling imposed by GRH ($136
billion target plus $10 billion leeway), so that GRH's automatic spending
cuts would not be triggered (no surprise). The President's budget forecasts
deficits that decline approximately in line with the revised GRH targets.
The usual caveats to these forecasts apply. The Administration assumes
sustained above average economic growth, receding inflation, and declining
nominal and real interest rates. The CBO also projects lower deficits, but
is more cautious in its economic assumptions, particularly as they apply to
the FY 1989 budget. A recession would generate a sharp deterioration in
the budget outlook for FY 1990, with significantly Jiigher deficits. While
a recession would suspend the GRH sequestration process, Congress would

SEPTEMBER

18-19, 1988

be forced once again to re-base (increase) the GRH deficit targets. Basing
fiscal decisions on deficit objectives in a recessionary environment would
highlight and accentuate the flaws in the current budget process.
In addition, these current services and baseline forecasts may be underestimating the costs of certain laws, such as outlays of the FDIC and
FSLIC bailouts of problem depository institutions and, by definition, they
do not include any new spending legislation. Unfortunately, the present
legislative backlog, including welfare reform, the war on drugs, and the environment, may be expensive. The political pressure to raise taxes is high.
Unfortunately, in response to its mandate to recommend ways to reduce the
deficit, the National Economic Commission may add to this pressure. In
consideration of the broader and equally important objectives of sound fiscal policy, economic policymakers should reject such recommendations and
instead seek methods of improving the efficiency of certain federal spending
programs that would yield further reductions in federal spending growth.

SHADOW OPEN MARKET COMMITTEE

TABLE 1
Federal Revenues, Outlays and Deficits as a Percent of GNP

1951-55
56-60
61-65
66-70
71-75
76-80
81-85
86-87
1988-est

Revenues
181
17.7
17.9
18.8
18.1
18.5
18.9
18.6
19.4

Outlays*
ISA
18.0
18.7
19.7
20.0
21.4
23.6
22.6
22.3

Measures on and off-budget revenue and outlays.

Deficit
03
0.3
0.8
0.9
1.9
2.8
4.7
4.0
3.2

SEPTEMBER

18-19, 1988

TABLE 2
Selected Budget Projections

1988

1989

1990

1991

1992

Receipts
President's Budget
CBO Baseline

913.4
908.0

974.0
980.0

1054.4
1064.0

1132.1
1134.0

1193.8
1202.0

Outlays
President's Budget
CBO Baseline

1065.8
1063.0

1096.7
1127.0

1156.7
1200.0

1217.5
1265.0

1258.8
1329.0

Deficits Projections
President's Budget
CBO Baseline

152.3
155.0

122.7
148.0

102.3
136.0

85.4
131.0

64.9
126.0

Memo:
New GRH Targets
Original GRH Targets

144.0
108.0

136.0
72.0

100.0
36.0

64.0
0.0

28.0
0.0

Receipts, % change
President's Budget
CBO Baseline

6.9
6.3

6.6
7.9

8.2
8.6

7.4
6.6

5.4
6.0

Outlays, % change
President's Budget
CBO Baseline

6.1
5.8

2.9
6.0

5.5
6.4

5.3
5.4

3.4
5.1

Revenues
President's Budget
CBO Baseline

19.4
19.0

19.3
19.2

19.5
19.6

19.7
19.6

19.6
19.5

Outlays
President's Budget
CBO Baseline

22.6
22.3

21.8
22.1

21.4
22.1

21.2
21.8

20.6
21.5

Deficit
President's Budget
CBO Baseline

3.2
3.2

2.4
2.9

1.9
2.5

1.5
2.3

1.1
2.0

Publicly-held debt
President's Budget
CBO Baseline

42.6

42.7

42.5

42.2

41.6

As a Percentage of GNP:

SHADOW OPEN MARKET COMMITTEE

TABLE 3
Administration and CBO Projections

1987(act)

1988

1989

1990

1991

1992

Percent change, fourth
quarter over fourth quarter:
Real GNP
Administration

CBO
Nominal GNP
Administration

CBO
CPI-W
Adminis trat ion

CBO

5.0
5.0

3.0
2.6

3.3
2.7

3.3

3.2

8.3
8.3

6.6
6.4

7.1
7.0

6.9

6.3

5.3

4.5
4.5

4.3
4.4

3.9
5.0

3.5

3.0

2.5

6.8
6.8

6.6
7.0

7.1
7.1

7.0
6.5

6.5
6.5

6.0
6.5

3.4
3.4

3.5
3,8

3.1
2.7

3.3
2.3

i.:>

J. 2

2.3

3.3
3.3

3.0
3.1

3.9
4.3

3.6
4.1

3.2
4.1

2.7
4.1

3.6
3.6

4.1
4.1

4.2
4.9

3.6
4.6

3.2
4.4

2.7
4.1

5.8
5.8

6.0
6.3

5.5
7,1

5.0
6.8

4.5
6.6

4.0
6.3

8.4
8.4

8.5
8.9

8.1
9.1

7.0
8./

6.0
8.3

5.0
8.0

2.2

2.1
2.2

1.3
2.2

1.4
2.2

1.3
2.2

1.3
1.9

4.8
4.8

4.6
4.8

3.9
4.2

3.4
4.1

2.8
3.9

Percent change, calendar years:
Nominal GNP
Administration

CBO
Real GNP
Administration

CBO
GNP Deflator
Administration

CBO
CPI-W
Administration

CBO
Interest Rates, percent,
Calendar Year Averages:
3-Month T-Bill
Administration

CBO
10-Year Government Bond
Administration

CBO

Memo:
Inflation-Adjusted Rates (CPI)
3-Month T-Bill
2.2
Administration

CBO
10-Year Government Bond
Administration

CBO

2.3
3.6

SEPTEMBER

18-19, 1988

R E C E N T BEHAVIOR OF MONETARY B A S E VELOCITY
Robert H. RASCHE
Michigan State University
At the last meeting of the Shadow Committee, I reported on research
then underway concerning demand functions for the monetary base. In the
interim, the staff of the Board of Governors has investigated the question of
using the monetary base as target for monetary policy. A summary of that
research is published as an appendix to the July 1988 "Monetary Policy
Report to Congress [Federal Reserve Bulletin, August 1988, pp. 530-33].
Apparently on the basis of this latter research, the FOMC has dismissed
the possibility of any role for the monetary base in the implementation of
money policy at the present time. "The Committee decided against establishing a range for the monetary base because it seemed unlikely to provide
a more reliable guide for policy that the aggregates for which ranges already
are established. Although the base has been less variable in relation to economic activity than Ml, its velocity nonetheless has fluctuated appreciably
and rather unpredictably from year to year" ["Monetary Policy Report to
Congress," July 13, 1988; Federal Reserve Bulletin, August 1988, p. 519].
Unfortunately, the staff research that is the basis for this conclusion is
classified FOMC material at the present time, so we apparently have to wait
at least five years before there is an opportunity to review the studies in
detail. At the present time, all that is available is the published appendix
to the monetary policy report. Approximately 1/3 of that appendix is
devoted to describing the differences between the Board measure of the
monetary base and the St. Louis Federal Reserve Bank measure of the
monetary base (Adjusted Monetary Base). The remainder of the appendix
states four major conclusions:
1. [Statistical] techniques that allow for a break in behavior [of base
velocity] in the early 1980s . . . make somewhat smaller but still large
errors in the 1980s and leave unanswered questions about the potential for additional shifts in the relationships.
2. The demand for the base has substantial interest sensitivity. . . . The
base probably is less interest sensitive than are the other monetary
aggregates.

SHADOW OPEN MARKET COMMITTEE

3. Over long periods of time, the demand for the base appears to be
fairly predictable, especially compared with MIA and M l .
4. It is likely that the base, or for that matter any of the broader aggregates, could be controlled reasonably well over a span of several
quarters — a period that would be meaningful in terms of the effects of monetary policy. However, the degree of interest rate volatility under base targeting could be quite substantial, especially in the
short-to-intermediate run.
The remainder of this report will examine these major conclusions, particularly in light of our own research into the demand for the monetary
base. The data presented here use both the Board and St. Louis Federal
Reserve Bank monetary base concepts, and personal income. Since personal
income is available on a monthly basis, this gives a substantial number of
observations during the controversial 1980s period. Results available elsewhere [Rasche, 1988] suggest that the conclusions drawn from these data
are consistent with those derived from other measures of aggregate economic activity such ELS GNP or final sales to domestic purchasers, and with
other levels of time aggregation.
Any analysis of the demand for the monetary base, or monetary base
velocity, has to recognize that while the experience of 1980s is not identical
to that of the previous three decades, the similarities far exceed the differences. Emphasizing the similarities is more productive than emphasizing
the differences. The primary lesson from the 50s—70s is that base velocity
behaves like a random walk. That characterization of base velocity, and
its implication for monetary policy, has been discussed many times by this
committee. That fundamental property of base velocity has not changed
in the 1980s. This is seen most easily in Figure 1, which presents the
first twelve autocorrelation coefficients of the month-to-month percentage
change of the velocity of both monetary base concepts. These autocorrelations are all very close to zero. Past changes of base velocity are of little, if
any use, in predicting future changes in base velocity. The only significant
difference in the behavior of base velocity between the 1980s and the previous three decades is the average month-to-month percentage change, or
drift. Through 1981 the drift in the random walk of velocity was around
2.5 percent at annual rates; during the 1980s it is zero. After allowing for

SEPTEMBER 1 8 - 1 9 ,

1988

this break in the drift of base velocity, there is no evidence of increased
variability in the 1980s compared with the previous experience.
Thus, the first of the conclusions cited above is somewhat misleading.
To my knowledge it is correct that no one has a convincing explanation
for the shift in the drift of base (and Ml) velocity that occurred abruptly
in late 1981. This leaves us uncertain as to when, if ever, such a change
might occur in the future. It would be nice to live without such uncertainty.
Unfortunately, this is beyond our present understanding. Yet this does not
have to be a matter of major concern to monetary policymakers. First,
the fact that over 80 months have passed with no reoccurrence of such a
shift suggests that such shifts are not an everyday phenomenon but rather
low probability events. Second, even if such shifts occur from time to time,
base growth rules that incorporate feedbacks such as proposed by Meltzer
[1986] or McCallum [1988], insulate the growth of nominal income from
their effects. Thus, the occurrence of infrequent and unpredictable shifts in
the drift of base velocity are not a basis for dismissing the monetary base
and an operating guide for monetary policy.
The second and third conclusions cited above are consistent with our
own research into the demand for the monetary base. As reported at the
last Shadow meeting, our preferred specification for the demand for the
monetary base is:

[AlnBt - AlnYt] = <* + / ? * £ ARTBt^/{n
- 0* J2 Aln{Y/P)t-i/n

+ 1) +

0*Aln(Y/P)t

+ 0*DINFUt + <j>*D82t + et

(1)

t=i

where B is the monetary base, Y is nominal personal income, P is the deflator for personal income, RTB is the Treasury bill rate, DINFU is a measure
on unexpected inflation and D82 is a dummy variable that is zero through
1981, 12 and 1.0 thereafter. Estimates of the parameters of equation (1) for
the St. Louis Adjusted Monetary Base are presented in Table 1 and for the
Board Monetary Base are presented in Table 2. Estimates are presented
for a full sample period, and for sample periods through and subsequent to
December 1981.

SHADOW OPEN MARKET COMMITTEE

The estimates for the Adjusted Monetary Base in Table 1 indicate that,
aside from the shift in the drift at the end of 1981, there is absolutely no difference in the estimated parameters or the standard error of the residuals,
regardless of the sample period that is used in the estimation. In particular, the interest sensitivity and short-run real income elasticity parameter
estimates from the 1982-88 sample for all practical purposes reproduce the
estimates from the 50s—70s.
The results from the estimation for the Monetary Base in Table 2 are
quite similar to the results for the Adjusted Monetary Base. In this case
there is some slight variation in the estimated parameter values from the
pre-82 to the post-81 sample periods, and the standard error of the residuals
is somewhat higher in the latter sample period. These differences are far
too small to have any economic significance.
The residual standard errors in both of these tables are considerably
smaller than those from the corresponding specifications in terms of M l
or MlA, which provides support for the conclusion that monetary base
velocity is more predictable than that of either measure of transactions
money.
At first glance, the long-run interest elasticity of the demand for the
monetary base, computed as /? times the level of the Treasury bill rate,
appears quite small in absolute value. This is an inference that should
be treated with great caution. It may not be appropriate to construct an
estimate of the long-run interest elasticity of the monetary base, given the
random walk nature of velocity are complex and highly technical. The
highly preliminary results of other research that is currently underway into
this question suggest a long-run interest elasticity of the monetary base
of the order of -.3 to -.5. The corresponding long-run interest elasticities
of M l demand are somewhat larger in absolute value, and appear to be
consistent with the estimate of Poole [1987].
It is not at all clear that the demand for the monetary base is less
interest sensitive than the demand for broader monetary aggregates such
as M2 or M3. In the case of the broad aggregates, it is not possible to
reject the hypothesis that the long-run interest elasticity is zero, computed
under the assumption that own rates of return on deposits are fully adjusted
to changes in market rates of interest. The size of the short-run interest
elasticity of the broader aggregates is critically dependent upon how fast

SEPTEMBER

18-19, 1988

deposit rates are adjusted to changes in market rates of interest. Given
Regulation Q controls into 1985 on at least some types of deposit rates,
there is very little experience from which to infer how unregulated deposit
rates adjust to changes in market rates of interest.
When all the dust settles, the ultimate reason for the rejection by the
FOMC of either measure of the monetary base as an operating instrument
or target for monetary policy is the fourth conclusion above, namely that
such an operating instrument would produce intolerable interest rate fluctuations. This is the historical basis of objections by the Federal Reserve
to any monetary aggregate that has been proposed as a target or operating
instrument for monetary policy. The substantive basis for this position is
extremely weak. The experience with the New Operating Procedures in
1979-82 is typically cited as support. However, the experience of 1979-80
is contaminated by (l) the uncertainty of market participants (and perhaps
also Federal Reserve officials) in the fall of 1979 about exactly how the New
Operating Procedures would be implemented and (2) the credit controls fiasco in the spring of 1980. Analysis of the experience in 1981 and 1982
under the New Operating Procedures suggests that interest rate variability
during this period was no greater than prior to 1979 or subsequent to 1982
[Rasche, 1985].
A second justification for this conclusion is the implication for interest
rate variability of simulation studies of various econometric models under
various operating procedures. The validity of this inference depends upon
the appropriateness of the econometric model structure to the operating
regime in question. While many of the models that are used for these simulation experiments have proven to be useful short-run forecasting devices,
their structures have proven quite sensitive to the unfolding of economic
history. This suggests that they may not be a reliable basis for projections
much beyond the sample experience.
The third problem with this conclusion is that neither the Federal Reserve nor the FOMC have defined what they consider to be an acceptable
amount of interest rate variability and the rational for a particular limit on
such variability. If there are benefits in terms of achieving non-inflationary
rates of nominal income growth by successfully controlling the long-run
growth of aggregates such as the monetary base, but costs in terms of
interest rate variability, then good economic analysis requires the identifi-

SHADOW OPEN MARKET COMMITTEE

cation and measurement of both costs and benefits. Both the Shadow Committee and the FOMC agree on the benefits of achieving non-inflationary
growth rates of nominal income and the necessity of controlling the growth
of monetary aggregates to achieve this end. The Federal Reserve has never
provided any general analysis of the magnitude of the cost of anticipated
interest rate variability.
The fourth problem with this conclusion is that there may not be any
feasible alternative to using the monetary base as a target and operating
instrument. Recently Governor Heller has provided a concise description
of the borrowed reserves operating procedure that has been used by the
FOMC since late 1982 [Federal Reserve Bulletin, July 1988, pp. 426-28].
He asserts that this operating procedure has been "a useful tool in implementing monetary policy" but acknowledges that under such a procedure
there is "no automatic mechanism for controlling monetary growth." He
does not define his criterion for the conclusion that the borrowed reserves
operating procedure is a useful tool in implementing monetary policy. In
particular while he maintains that the ultimate objective of Federal Reserve policy is to foster economic growth in a framework of price stability,
he does not indicate how this "useful tool" has fostered this objective. Indeed, there is little evidence that any progress has been made toward price
stability since this "useful tool" was adopted in 1982.
Neither the borrowed reserves operating procedure nor this criticism of
it are new. The borrowed reserves operating procedure is a hallowed Federal
Reserve tradition dating back at least to the 1920s [Burgess, 1946]. Critics
of this approach have demonstrated repeatedly that there is no evidence of
a reliable link between borrowed reserves and the growth rate of monetary
aggregates and/or nominal income. Thus, there is no known reliable basis
for the FOMC to set "a borrowing object that it views as consistent with
progress toward its goals for the monetary aggregates and the economy."

SEPTEMBER

18-19, 1988

FIGURE 1

Autocorrelations: Base Velocity
Peraonal Income Monthly 1982—88

-HN

£h

H-i-"

Jkd

PhR

TZF*

N
m
"W"^^l

^
Order of Autocorrelation
1771 St. Louis Bade
l y S ) Board Boap

SHADOW OPEN MARKET COMMITTEE

TABLE 1
Estimates of Adjusted Monetary Base Demand Equations
Monthly Seasonally Adjusted Data at Annual Rates
[Dependent variable = AlnBt -

AlnYt]

Semi-Log Specification
Sample

53,1-88,4

53,1-«1,12

82,1-88,4

-2.4499
(.2184)

-2.5128
(.2129)

0.000

-.0080
(.0010)

-.0080
(.0012)

-.0077
(.0017)

-.8835
(.0342)

-.8813
(.0362)

-.8993
(.0849)

-2.4499

.65
3.97
1.86

.65
3.86
1.91

.62
3.91
1.72

R
se
d-w

TABLE 2
Estimates of Monetary Base Demand Equations Monthly
Seasonally Adjusted Data at Annual Rates
[Dependent variable = AlnBt — AlnYt)
Semi-Log Specification
Sample

59,2-88,4

59,2-81,12

82,1-88,4

-2.4787
(.1943)

-2.5721
(.1908)

0.0000

-.0054
(.0008)

-.0045
(.0010)

-.0067
(.0015)

-.8445
(.0297)

-.8374
(.0322)

-.8683
(.0732)

-2.4787

R2
se
d-w

.73
3.12
1.62

.72
3.04
1.67

.66
3.37
1.50

SEPTEMBER

18-19, 1988

OFFICIAL I N T E R V E N T I O N I N T H E F O R E I G N
EXCHANGE MARKETS
William POOLE
Brown University
Intervention policy in the foreign exchange markets during the second
Reagan Administration has been completely different from that during the
first Reagan Administration. During the first administration the policy was
not to intervene except to calm disorderly markets, and there was in fact
very little intervention. During the second administration, and especially
since the Plaza Agreement of September 1985, the scale of intervention has
been very substantial. The purpose of this memorandum is to review what
has happened and to evaluate where we stand now.
OFFICIAL CAPITAL FLOWS
U.S. balance-of-payments statistics for the second quarter of 1988 became available on 13 September. A chart at the end of this memo shows
that the total capital inflow, which equals the current account deficit if we
ignore errors and omissions in the data, fell slightly in the second quarter
as a percentage of GNP. The net official capital inflow fell substantially,
from 2.2 percent of GNP in the first quarter to 0.5 percent in the second
quarter. The inflow of official capital declined because the dollar stopped
sinking. As can be seen in the chart, the index of the value of the U.S.
dollar in the foreign exchange markets rose slightly in the second quarter.
My original intention in writing this memo was to supplement the
balance-of-payments data on official capital flows with reserves data for
some major countries in order to provide more up-to-date information on
intervention. It is, however, extremely difficult to obtain accurate information on intervention. Central banks make a point of obfuscating their
intervention policies and of releasing partial and misleading data on the
scale of intervention. Indeed, the scale and timing of intervention may not
show up accurately in U.S. balance-of-payments statistics when foreign central banks accumulate Eurodollars rather than U.S. Treasury securities, or
when intervention takes the form of positions in currency futures markets.
The more I looked into available series measuring foreign reserves the
more convinced I became that attempts to measure intervention might well

SHADOW OPEN MARKET COMMITTEE

be misleading rather than enlightening. Countries hold foreign reserves
mostly in dollars but also in other currencies. The data may be reported
in units of local currency or in SDRs, which means that the reported value
of dollar reserves changes when the dollar vaule of the local currency unit
or of the SDR changes. And, as already mentioned, countries in some cases
deliberately distort their reserves data.
But we also know that the scale of intervention per se is of limited
importance and that there is, therefore, little reason to chase after elusive
foreign reserves data. Sterilized intervention has little effect on exchange
rates and so the issue is the extent to which central banks have altered
domestic monetary policies in response to exchange rate changes. The
issue can be addressed through an examination of money growth.
M O N E Y G R O W T H I N THE U N I T E D STATE, G E R M A N Y
AND JAPAN
The next chart, which uses monthly data, shows M l and M2 growth for
the United States through July. (All money growth rates discussed in this
section are continuously compounded.) Money growth declined markedly
in 1987 as the Federal Reserve became concerned that the dollar was depreciating too much. The dollar bottomed out at the end of 1987, and the
pressure on the Fed to constrain money growth eased. The chart on the
monthly DM/dollar and yen/dollar exchange rates shows the timing of the
change in the fortunes of the dollar on the foreign exchanges more precisely
than does the quarterly dollar index shown earlier. The most recent M l
and M2 weekly data shown in the chart from the St. Louis Fed suggests
that U.S. money growth may be slowing again, but we obviously should
not put much weight on a few weeks of data.
Money growth in Germany, however measured, accelerated substantially
after the Plaza Agreement (see chart) and remains high. Germany resisted
the depreciation of the dollar in 1986 and 1987, and did not sterilize all of
its exchange market intervention. Although German M2 growth declined
to about 6 percent in 1987, and has remained at that rate in 1988, the main
target of German monetary policy, central bank money (MO), continues to
grow at a substantially higher rate than earlier. The 1987-88 rate of growth
is about 8 percent compared with 4-5 percent rate of growth in 1985-86.

SEPTEMBER

18-19, 1988

Japan has targeted M2+CDs ("M2" for short). Growth in M2 crept up a
little after 1983, but held close to 8 percent through 1986. By the beginning
of 1988 12-month M2 growth has declined a bit, but only a bit. Japan has
not been able to sterilize its foreign exchange market intervention.
FALLOUT
Very little of the fallout from the U.S. policy of extensive exchange market manipulation has yet hit the ground. The United States has not itself
intervened heavily in the market but has encouraged other countries to do
so. The United States has relied on not-so-subtle hints as to the appropriate direction of change for the dollar and has left foreign governments to
deal with the resulting exchange market pressures. Rapid money growth
in the United States in 1985-86 was transmitted abroad as other countries
intervened to keep the dollar from sinking too rapidly. The decline in U.S.
money growth in 1988 was fully appropriate but money growth in Germany
and Japan has not yet declined very much.
If the United States could now withdraw from efforts to push the exchange rate in the "right" direction, the fallout from the Plaza policy would
be limited. But it is very difficult to let go of a policy that on the surface
looks good so far. Problems will arise when pressures develop for the dollar
exchange rate to adjust substantially in one direction or the other. Will
central banks and treasuries be able to let go or will they instead permit
monetary policy to be warped by efforts to keep the exchange rate from
rising or falling?
Officials have so far been successful in intervening without disclosing
to the market an intervention range. My guess is that there is no target
for the DM/dollar rate or the yen/dollar rate that has much operational
significance. Market participants discuss such target ranges but there is
no agreement on what they are. If central banks did intervene to hold the
dollar within a target range smart market professionals would by now have
uncovered the targets from observing intervention patterns. Official talk
suggesting target ranges seems more designed to persuade the market not
to move exchange rates too rapidly than to guide actual intervention policy.
Given that there seems to be no exchange rate targets with operational
significance, it might be possible for central banks to withdraw from the

SHADOW OPEN MARKET COMMITTEE

markets without anyone really noticing. There would be a great advantage
to doing so to avoid an awkward decision in the future on whether to
support a particular dollar range when market fundamentals would push
the dollar decisively to a new level. The market will adjust more easily to
changed fundamentals in the absence of speculation over how official policy
might or might not change and speculation over how the course of domestic
monetary policy may be affected by an exchange rate target.

U.S. TOTAL AND OFFICIAL CAPITAL INFLOWS
AS PERCENTAGES OF GNP
AND DOLLAR EXCHANGE RATE INDEX

Percent of GNP

Dollar Index
180

Total Capital Inflow
(Scale at left)

,- -

\* ' \

160

140
00
00

120
I
oo
W
CQ

(3
H

100

-1

a.
w
CO

-2

^9ftO'A

A 9QV-

Data through 1988:2

^ 6 ^

^&*

tfH*

^&*

^o&^

tftf*

^ 9 g,6-• \

UNITED STATES
MONEY GROWTH
FROM SAME MONTH ONE YEAR EARLIER
ca
H

2
o

o
Ed

M
{Si

<
2:
w
0,

O
o
Q

<
CO

1981:1

1982:1

Data through July 1988

1983:1

1984:1

1985:1

1986:1

1987:1

1988:1

MONEY STOCK ( M l )

MONEY STOCK ( M2 )

y
1/ I

I
00
rH
cd
W
133

II1I1UII

fy V

t -T A U
,KA
C
G .. ?S1
U
«
F
13
F
22

J 1l

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JAN

SEP OCT
1987

NOV

U l l JJ-L JUJ.J U ! I. 111
ii t* i4 » ii *s • » • »
FES
MAR APR

i l l i.

i» »

±uJ
ii »

CURRENT OATA APPEAR IN THE BOARD OF GOVERNORS'

i ....

jf—-

j^r,

J J i J j 111 111 U 1,1 111

M i l _U 1 L.lI l l
39

JJjJ 1111; -UjJ m l
• u

MAY

XLi}

1 ! 1J
ii i t it ;
AOQ
SEP

M2 IS THE S
SUM
UM OF
OF Ml
Ml. OVERNIGHT RPS ISSUED 8Y ALL COMMERCIAL BANKS, OVERNIGHT EURODOLLARS ISSUED
TO U.3 . RESIOENTS BY FOREIGN 9RANCHES OF U.S. 9ANXS. MONEY MARKET OEPOSIT ACCOUNTS. SAVINGSA*0
SMALL TIME 0EPOSIT3,
_
AND GENERAL
_
PURPOSE AND BROKER/DEALER MONEY MARKET MUTUAL FUNDS. FOR MORE
OETAIL, SEE" THE'H i 8' RELEASE."

MONEY STOCK (Ml )

MONEY STOCK ( H Z )

COMPOUNDED AKNUAL RATES OF CHANGE , AVERAGE OF FOUR VEEX3 ENDINGt
2 / l / M 2/29/89 3/29/99
S/2/99 S/30/99 6/27/89
9/41/97 11/30/97
TO THE AVERAGE
OF FOUR WEEKS
ENDINGt
2/ 1/88
2/29/89
3/28/89
9 / 2/89
S/30/88
9/27/89
9 / 1/86
9/29/99

CURRENT OATA APPEAR IN THE 80AR0 OF GOVERNORS* H.9 RELEASE

C SUM OP CURRENCY HELO
I AND fRAVELERS CHECKS.

IS
ir 31 14 2S II M • 33
FEB
SEP OCT NOV
1997
LATEST OATA PLOTTED «EEK EN9IN9i AUOUST 29, 1999

SEP

LATEST DATA PLOTTED »EEK ENDIN8. AUOUST 29. 191

H
w

AUG

l/M"

ILUJ M M J.LL JLUJ L i J 1 J111
a ir >i M ami M • »

3023.7
3029.7
3029.6
3028.6
3034.1

i/"

\y If

o
»-»

3
2
4
5
5

oo
00

784
782
780
783
782

~ ~

1
8
IS
22
29

AUG.

Illilllll

t
F

BILLIONS OF DOLLARS
3050

h 1jJfi 1 1
E
* BILLIONS

E"T
1 1
a i L i • IONS
E -"** 781
7

AVERAGES OF OAILY FIGURES
SEASONALLY ADJUSTED

BILLIONS OF DOLLARS
3090

IONS OF DOLLARS
790

iiiiiini

BILLIONS Of 0OLLAR3
790

TTTT]

AVERAGES OF DAILY FIGURES
SEASONALLY ADJUSTED

COMPOUNDED ANNUAL RATES OF CHANGE, AVERAGE OF FOUR 9EEKS ENDING.
2/1/89 2/29/99 V 2 9 / 9 9
9/31/97 11/90/97
5/2/88 S/30/99 9/27/99
TO THE AVERAGE
OF FOUR WEEKS
ENOINGI

4.4
3.4
3.7
5.0
4.1
4.7
3.3
4.9

3.7
4.1
0.1
4.0
5.5
8.1
S.3

1.7
6.0
3.7
S.I
0.1
3.0

9.7
5.5
6.8
7.6
6.1

5.3
7.2
6.0
6.2

3.6
6.1
4.3

10.7
6.6

4.9

PREPARED 8Y FEDERAL RESERVE SANK OF ST. LOUIS

2/1/89
2/29/89
3/29/69
S/ 2/88
5/30/88
6/27/88
9 / 1/89
8/29/89

4.9
5.4
5.9
6.4
8.2
6.2
5.9
5.6

7.0
7.5
6.0
7.5
7.3
6.7
6.3

8.6
9.1
7.9
7.6
6.6
6.2

9.5
7.9
7.4
6.5
5.9

7.3
6.9
5.9
5.3

S.I
4.5
4.0

4.6
3.9

5.0

PREPARED 9Y FEDERAL RESERVE BANK OF ST. LOUIS

EXCHANGE RATES
DM/DOLLAR AND YEN/DOLLAR
&3

P
H
H

s
2
o

UM/DO
3.4

Yen/Dollar

liar

280

3.2

260

3
»
ctf
<

s55
Q«

O
£

o
<

X
CO

2.8
2.6 I
2.4
2.2
2
1.8
1.6
1.4 '

o
"<*<

tf&*

^8>vA ^ 9 ^

Data through August 1988

^9^"A

9 ^

^tf>^

^ 9 ^ 6 ' X ^9^1"•N \ 9 ^ ' "

DM/Dollar
Yen/Dollar

GERMANY
MONEY GROWTH
FROM SAME MONTH ONE YEAR EARLIER

1981:1

1982:1

1983:1

1984:1

Data through July 1988 (MO through May)

1985:1

1986:1

1987:1

1988:1

JAPAN
MONEY GROWTH
FROM SAME MONTH ONE YEAR EARLIER
w

Percent

s
s
o
o
H
W

2
z
w
a.
O
o
o
<

S3
CO

1981:1

1982:1

Data through July 1988

1983:1

1984:1

1985:1

1986:1

1987:1

1988:1

SEPTEMBER 1 8 - 1 9 ,

1988

A "FAILURE* OF MONETARISM?
Karl BRUNNER
University of Rochester
A consensus emerged on the public market during the early years of
the 1980s: "monetarism had failed." This consensus was remarkably incoherent and was not based on any systematic comparative assessment
of significant monetarist propositions. The subject of the consensus was
moreover frequently not well known (if at all) to many participants in the
consensus. A "failure" was discovered in the recession of 1981/82 produced
by disinflationary policy, in the decline of monetary velocity, a presumed
change in the relation between money and national income, and of course
in Milton Friedman's erroneous forecast of incipient inflations several years
ago. This error is hardly impressive when compared to the forecasting
record of a wide array of econometric models [See Karl Brunner/Allan H.
Meltzer, Money and Income, Macmillan, London, 1989] or even the Federal
Reserve's forecasting record [see Nicholas Karamouzis/Raymond Lombra,
"Federal Reserve Policymaking: An Overview and Analysis of the Policy
Process," Carnegie-Rochester Public Policy Conference, April 1988].
This note does not address the broad ramifications of the consensus.
One particular aspect deserves however some attention as it bears especially on the central concerns of the Shadow Open Market Committee.
The issue is the criterion frequently used in the public market to judge the
relevance of monetarist policy analysis. This criterion assumes that money
policy can and should control the short-run movements of the economy by
suitable activist manipulation. Consider for this purpose the climate of
the early Kennedy administration. Time Magazine published at the time
a lengthy piece glorifying the "new macroeconomics" and its promise for
economic stabilization. The President's Council of Economic Advisers peddled the theme, reinforced among the profession, that we had acquired the
knowledge and possessed the tools to hold the economy on a stable path
avoiding business cycles and recessions. The long expansion phase lasting
from early 1961 to the end of 1969 seemed to support the promise. The
Vietnam war contributed actually very little. Its impact on the economy
remained at a small proportion. Persistent political pressures to maintain
expansionary monetary policies, particularly under the Johnson adminis-

SHADOW OPEN MARKET COMMITTEE

tration, stimulated the economy. Inflation emerged as a result. President
Nixon was forced to impose a freeze on the prices at a time inflation did
not exceed our current "non-inflation." There was also the recession of
1970/71 and the mood gradually changed. The promise seemed to fail. Interest rates, exchange rates, prices and output performed less than desired.
Monetarist ideas meanwhile had gained some attention. Interest was
especially motivated by the hope that it will offer a better basis for finetuning the economy. This hope was rudely shattered, and unavoidably so.
Monetarists never made any claims or promises concerning "fine-tuning."
They warned from the beginning that this idea offered a deceptive and
dangerous illusion. Two reasons were advanced and elaborated in detail
in many papers. The first reason is closely related to an excuse for the
failure of "Keynesian fine-tuning" occasionally advanced. The result is
attributed to a failure of politicians to shift the gears at the right time,
in the right way. But this is precisely what we should expect once a wide
discretionary range of action is available to policymakers. This range will
in general not be used to pursue a socially optimal stabilization policy.
The incentives built into the political process usually induce politicians to
exploit the discretionary range for short-run politically motivated actions.
The undesired but unavoidably longer run consequences can then always
be attributed to evil men or evil forces. It is naive to expect that politicians
and policymakers are dominated by a desire to act in the social interest.
The other reason refers to our knowledge available as a basis of activist policymaking. A successful execution of activist, discretionary policy requires in general detailed information about an economy's response
structure. Nobody possesses, however, this knowledge, and the exercise
of discretion in the absence of such knowledge, threatens to create more
problems than it solves.
The search for a successful activist strategy remains thus a futile exercise, an illusion. The SOMC always argued therefore in favor of a long-run
strategy with a credible, stable and predictable course of a non-inflationary
monetary policy. Apart from defining a transition to such a long-term strategy the SOMC has no interest in relating policy to any particular current
situation. Our proposal for policymaking would require major changes in
the operations of the Fed's staff and the implementation of policy. The old
tradition of discretionary exercises, maintained over decades, still remains

SEPTEMBER

18-19, 1988

well entrenched at the time. Uncertainty about the Fed's course and the
problems experienced with the Fed's policymaking over the past 60 years
may well persist, even with a serious commitment to non-inflationary goals.

SEPTEMBER

18-19, 1988

T H E CONTROL OF T H E MONETARY B A S E A N D ITS
PURPOSE
Karl BRUNNER
University of Rochester
This note addresses an issue recently raised in a statement prepared by
the staff of the Federal Reserve Board for some Congressional hearings. It
basically questioned the usefulness of the monetary base as an instrument
of monetary control.
The monetary base can be described in two distinct ways; from the uses
side (or demand side) and the sources side (or supply side). These two
sides correspond to the two sides of the consolidated statement of the Federal Reserve System and the Treasury's monetary account. The uses side
expresses the demand for base. It consists of two major components: the
public's demand for currency and the financial institutions' demand for reserves to be held against their liabilities. The public's currency component
is by far the larger component and dominates the use of the base. This
fact is supposed to undermine the use of the monetary base for purposes
of monetary control. The volume of currency seemed "obviously" demand
determined with a passive adjustment of the monetary base.
We need however to consider also the supply side. The sources base
emerges from the operation of asset accounts and some liability accounts of
the consolidated statement mentioned above. The Federal Reserve System's
earning assets (loans to banks and the portfolio of government securities)
dominate by far the supply of base money over longer periods. The sources
base is augmented by the "reserve adjustment magnitude" (RAM) to form
the monetary base. The RAM incorporates the effect of changing reserve
requirements on the banks' reserve position.
The supply side reveals that every change in the monetary base results
from corresponding actions of the Fed affecting some accounts of its balance
sheet. There will be no change in the volume of the base without some such
actions independent of the public's demand for currency. The arrangements
governing the supply of the monetary base allow the Fed, if it so wishes,
to determine its volume by adjusting suitably its portfolio of assets via
market operations. The volume of the monetary base is not inherently
demand determined. The Fed possesses both power and opportunity to

SHADOW OPEN MARKET COMMITTEE

set the monetary base at any level it desires, and can do so with a good
accuracy over a week. Should it choose such a strategy then the public's
demand for currency has no effect on the volume of the base. Its effect is
concentrated on the distribution of the base between reserve and currency
holding and consequently on the money stock. This pattern persists even
with the "passive conversion" of currency into deposits and deposits into
reserves by the Fed which maintains the constant exchange ratio.
The Fed may choose on the other hand arrangements which make the
volume of base money and currency actually demand determined. A strategy of controlling interest rates would produce this pattern. The prevalence
of such strategies in the Fed's history assures us, of course, that the monetary base was to some extent demand determined. It is in a way bitterly
ironic, given the Fed's insistence on the demand determined behavior of currency, that this did not hold when it was needed most in order to prevent
disaster in the period 1930-1933. The Fed expanded the base somewhat,
but failed miserably to adjust fully for the massive increase in currency
demand. Other experiences demonstrate moreover the Fed's potential to
control the movement of the base irrespective of the public's currency clearance. I mention here just the events of 1920/21, 1930/37 and 1960. The
experience of the German Bundesbank and the Swiss National Bank over
the past fifteen years also demonstrates a Central Bank's ability to control
the monetary base, if it so wishes.
The Fed suggests however that this strategy is not advisable. It argues
that control of the monetary base would (or may) produce volatile interest rates. We are apparently confronted with a trade off between stability
(or volatility) of monetary aggregates and stability (or volatility) of interest rates. The traditional IS/LM analysis supports this contention. But
this analysis disregards a feature of our financial markets of crucial importance in this context, i.e., the existence of a spectrum of interest rates.
This radically modifies the implication of the simple IS/LM analysis. More
or less transitory shocks concentrate their effects on the short end of the
yield curve. Volatile short rates actually function in this case to absorb
and smooth the effects of the shocks on the economy. Perceived transitory
shocks are not converted into impulses substantially affecting economic activity. More or less permanent shocks modify the position of the yield curve
and influence the whole spectrum of interest rates. Attempts to offset these

SEPTEMBER 1 8 - 1 9 ,

1988

shocks convert them into monetary shocks contributing to a short-run instability and long-term drift in monetary growth. The result is increased
uncertainty about shorter-run economic evolution and longer-term development of the price-level. Specific historical cases yield moreover little support
for the contention that comparatively stable and low monetary growth creates more volatile interest rates. A rough comparison of the 1950s or the
first half of the 1960s with the 1970s, supports my point. The experience of
Switzerland over the past fifteen years is also noteworthy, in particular as it
was achieved by a small economy highly interdependent with the European
and world economy. A non-inflationary and reliable strategy of a stable
monetary growth (with an exception in 1978/79) produced highly stable
interest rates at a low level ranging from short-term rates at a low level
ranging from short-term rates to interest rates on mortgages.
The final objection to be considered emphasizes that monetary control
exercised via the monetary base will yield quite unimpressive results when
assessed in terms of the movement in economic activity. This may be the
case. But the implicit criterion used in such judgments and the alternative
favored by the Fed need be examined. We should recognize that under the
first issue the policymakers pursue a dangerous illusion. Monetary policy as
an instrument for the short-run manipulation of economic activity suffers
from two severe limitations. First, it cannot permanently raise (or lower)
output and employment, nor permanently raise (or lower) the economy's
rate of real growth. The conventional wisdom on the public market which
juxtaposes "growth policy" via inflation and non-inflationary "anti-growth
policy" forms an important dimension of the prevalent illusion. Second, we
do not posess the detailed knowledge about the economy's response structure required for successful manipulation. Attempts at short-run manipulation necessarily fail in general under the circumstances of our incomplete
and unreliable knowledge. Control of the monetary base should address a
long-term goal. This control needs to produce a predictable, comparatively
stable and non-inflationary monetary growth. It should substantially lower
short-run uncertainty about monetary evolution and long-term uncertainty
about the price-level. This program seems modest when compared with
the ambitions of short-run manipulation. It can however be achieved and
will remove some of our problems (volatile and high interest rates, volatile
exchange rates, inflation).

SHADOW OPEN MARKET COMMITTEE

One major advantage of a monetary strategy executed via control of
the monetary base involves the reliable interpretation of monetary events.
The systematic misinterpretations guiding Federal Reserve policy on many
occasions in the past sixty years with some tragic consequences would be
impossible. The Fed favored in general a strategy relying in one form or
another on money market conditions. This framework misled the Fed into
believing in 1930 that it had done everything which it possibly could do
to stem the deflationary tide, when it actually had contributed to the tide.
Allan H. Meltzer and I prepared in 1963/64 a detailed study on Federal
Reserve Policymaking for the Committee on Banking and Currency of the
House of Representatives. We showed in this study how the Fed's favored
strategy produced systematic misinterpretations over many years of the
prevailing monetary state. We showed in particular that the Fed's actions and its interpretation of these actions are negatively correlated. Such
avoidable misconceptions deepened and lengthened the Great Depression,
produced the recession of 1937/38 and affected events in the postwar period. A strategy relying on the monetary base as an instrument of monetary
control would have avoided such misconceptions and the resulting errors in
policymaking.

SEPTEMBER

18-19, 1988

TABLES

Karl Brunner
University of Rochester

SHADOW OPEN MARKET COMMITTEE

TABLE 1
Regressions of General Price Level on Sensititve Commodity Prices
1. Percentage Change in GNP Deflator on Percentage Change on SCI
(backward and forward 4 quarters)
R-Square
Adj R-Sq.

0.1318
0.0987

Variable
Intercep
SCI
LI
L2
L3
L4
Durbin-Watson D
1st Order Autocorrelation

Parameter
Estimate
0.010646750
0.000055078
0.000444361
-0.000021010
0.000821504
0.001175130

T for HO:
Parameter=0
17.869
0.114
0.929
-0.043
1.709
2.445

0.580
0.703

SCI = Sensitive Crude and Interim Products Prices

2. Percengage Change in GNP Deflator on Percentage Change of SCI
(backward and forward 4 quarters)

R-Square
Adj R-Sq.

0.1546
0.0928

Variable
Intercep
SCI99
Bl
B2
B3
B4
Al
A2
A3
A4
Durbin-Watson D
1st Order Autocorrelation

0.602
0.696

SCI = Sensitive Commodity Prices

Parameter
Estimate
0.010616470
-0.000270981
0.000604610
0.000347276
0.001225862
0.002043219
0.000226186
0.000318271
0.000487775
0.000117320

T for HO:
Parameter=0
16.749
-0.359
0.779
0.447
1.616
2.798
0.293
0.413
0.652
0.162

SEPTEMBER

18-19, 1988

TABLE 2
Proportion of Federal Expenditures on Defense to GNP
A Comparison of Two "Postwar Wars:" Korea and Vietnam
1Q1950
3Q1952
4Q1954
4Q1955
1Q1965
3Q1967
4Q1971

.048
.135
.102
.092
.071
.091
.066

TABLE 3
Proportions of Various National Income Categories in Nominal Terms of
Nominal GNP
"fear
1946
1950
1960
1970
1980
1988
GPGS
FGPGS
FDE
TGE
TRE

=
=
=
=
=

Qtr.
1
1
1
1
1
1

GPGS
.165
.141
.189
.216
.190
.203

FGPGS
.120
.070
.103
.101
.074
.081

FDE
.109
.048
.087
.079
.051
.064

TGE
.221
.177
.176
.198
.216
.234

TRE
.065
.078
.043
.056
.087
.093

Government Purchases of Goods and Services
Federal Government Purchases of Goods and Services
Federal Defense Expenditures
Total Government Expenditures
Transfer Expenditures

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Full text of Policy Statement and Position Papers : September 19, 1988

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