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SHABOW OPEN M A l l E T COMMITTEE
Policy Statement and
Position Papers
September 22-23, 1985
PPS-85-2
Graduate School of Management
University of Rochester
SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers
September 22-23, 1985
PPS-85-2
1.
2.
3.
Shadow Open Market Committee Members - September 1985
SOMC Policy Statement, September 23, 1985
Position papers prepared for the September 1985 meeting:
Economic Outlook, Jerry L. Jordan, First Interstate Bancorp
The Money Markets, William Poole, Brown University
Recent Budget Policy and Economic Impact, Mickey D. Levy, Fidelity Bank
Where is the Mystery in the Behavior of the Monetary Aggregates?, Robert H.
Rasche, Michigan State University
Update to the September, 1985 Shadow Open Market Committee Report: The Behavior
of the Monetary Aggregates in August, 1985, or "The Grineh That Stole
Christmas", Robert H. Rasche, Michigan State University
Commentary on Prospects For Money and the Economy, H. Erich Heinemann,
Ladenburg, Thalmann & Co., Inc.
SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. .to 7:30 p.m. on Sunday, September 22, J 985.
Members of SOMC:
PROFESSOR KARL BRUNNER, Director of the Center for Research in Government
Policy and Business, Graduate School of Management, University of
Rochester, Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration,
Carnegie-Mellon University, Pittsburgh, Pennsylvania.
MR. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann & Company, Inc.,
New York, New York.
DR. JERRY L. JORDAN, Senior Vice President and Economist, First Interstate
Bancorp, Los Angeles, California.
DR. MICKEY D. LEVY, Chief Economist, Fidelity Bank, Philadelphia,
Pennsylvania.
PROFESSOR WILLIAM POOLE, Department of Economics, Brown University,
Providence, Rhode Island.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State
University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York, New
York.
DR. BERYL SPRINKEL, On leave from the SOMC; currently Chairman of the
Council of Economic Advisers.
The Committee noted with sadness the death of its friend and colleague,
Jan Tumlir. His important contributions to the preservation of a liberal
trading system are sorely missed in the current protectionist climate.
POLICY STATEMENT
Shadow Open Market Committee
September 23, 1985
The economy appears poised for renewed expansion and faster growth. The
short-term outlook is promising but long-term problems including inflation
threaten economic stability. Four problems require attention.
Stop and Go Once Again
First, the Administration and the Federal Reserve have resumed the stop and
go policies that produced stagnation and inflation. Recently both money growth
and the growth of government spending have been excessive. Growth of money —
currency and checkable deposits -- is likely to set a postwar record in 1985.
Since early 1984, real government spending -- government spending adjusted for
inflation as measured in the national income accounts -- has increased at an
average rate more than twice the rate of growth of real output.
The recent budget compromise reduces spending too little and does not face
up to the necessary structural changes. Many of the reductions are overestimated. Others are postponements of spending rather than genuine program
reductions. Most of the proposals by the Administration and/or the Senate to
eliminate programs have disappeared. New spending for agriculture and bailouts
for public and private financial institutions not included in the Budget
Resolution threaten to cancel most of the reduction and increase spending now or
later.
Recent trends in government purchases and private investment have reversed
the trends at the start of this expansion. During the first five quarters of the
current expansion, real government purchases, adjusted for inflation fell at a 3
1
percent annual rate, while real investment rose at a 46 percent annual rate. The
share of resources used for investment rose, while the share used by government
fell. During the next five quarters, ending in June 1985, real investment rose
at only 0.6 percent annual rate and real government purchases rose by 6.6
percent. The latter rate is more than twice the rate of growth of real output
during the same period. As a result, the share of current resources used for
investment has fallen while the share spent by government has increased.
Money growth has shifted from high to low every three to five months since
early 1984. This pattern increases uncertainty and discourages long-term
planning. Further, the trend rate of money growth is rising, reopening the
prospect of another round of inflation.
Three of the main justifications for current monetary policy repeat old
errors. One is that financial deregulation has distorted the monetary
aggregates. A second claim is that indicators other than money growth do not
signal inflationary pressure. The third is that faster money growth is needed to
bring down the exchange rate and aid manufacturing.
The driving force behind money growth is Federal Reserve policy, as shown by
the growth of the monetary base. Our monthly forecasts of money growth, given
base growth, remain highly accurate and show little evidence of distortion. Conjectures about effects on money growth of E.F. Mutton's management practices, the
decline of the dollar or failures of thrift institutions have have no foundation.
The claim that money growth alone gives evidence of inflationary pressure is
heard at the start of every new round of inflation. Each time, the high costs of
previous inflation and disinflation are dismissed so that policymakers can pursue
some short-term goal. Usually, the short-term goals are inconsistent with longterm stability. In the sixties and seventies, pursuit of employment goals or
attempts to stimulate housing production produced high inflation accompanied by
stagnation and left a residue of problems in agriculture, among thrift institu-
2
tions and in banking. These experiences should have convinced us that there is no
permanent tradeoff between long-term price stability and growth.
Federal Reserve attempts to raise real growth or increase manufacturing
output can at best succeed only temporarily. Monetary policy can lower the real
value of the dollar only by reducing real after-tax rates of return on dollardenominated assets. The strength of the dollar is a real, not a monetary,
phenomenon arising from the higher anticipated real, risk adjusted returns on
investment in the U.S. The Federal Reserve can reduce the real rate of interest
and the real value of the dollar only temporarily. The longer-term effect of
rapid monetary expansion will be a renewed flight from the dollar in anticipation
of more rapid inflation. A decline in the dollar in response to inflation brings
no benefit to U.S. producers and is costly for both consumers and producers.
The only way to avoid the high costs of inflation and disinflation is to
avoid inflation. Inflation will not be avoided unless the Federal Reserve and
the pro-inflationists in Congress and the Administration accept a long-term
commitment to achieve stability. The Administration came into office with
announced policies to achieve slow, steady and predictable money growth and to
reduce the size of government. Neither has been achieved and these goals appear
to have been abandoned.
We urge the Federal Reserve to end the erratic swings in money growth and
turn to a stable non-inflationary growth path. The recent budget compromise
does not reduce spending enough. We urge Congress and the Administration to
adopt genuine and substantial reductions in spending sufficient to reduce
permanently the growth of total government spending below the growth of total
output.
3
The Heritage of Past Inflation
Second, policymakers have neglected or mismanaged several problems resulting
from faulty policies and past inflation and disinflation. Inflation and mistaken government agricultural policies are the root of current problems of
agriculture and agricultural lending. The precarious position of the thrift
industry, as evidenced by a large number of forced mergers, failures and
insolvent institutions that continue to operate, is the result of inflation,
disinflation, mismanagement and mistaken regulatory policies. The belief that
high inflation would continue encouraged large-scale borrowing by Latin American
governments and other current, large debtors. The same belief encouraged the
large-scale lending by U.S. banks that now weakens the financial structure.
Policies of the lending and borrowing countries have done little to restore the
conditions for economic progress in the debtor countries.
Rapid money growth in 1985 poses a dilemma. One choice would be to continue
rapid money growth which would bring back the high rates of inflation experienced
in the seventies. Market interest rates would rise, the dollar would fall and
demands to stop inflation would grow. A new round of anti-inflation policy would
then produce a new recession. The painful process of disinflation would start
again. The costs of past inflation and disinflation are so large and visible
that higher or even continued inflation should be unthinkable. Yet, the
Administration, Congress and the Federal Reserve ignore current inflation of 4
percent or more and run large risks of increased inflation.
A second choice would be to reduce money growth gradually to a noninflatiosary rate. We have recommended a gradual policy many times, but the
Federal Reserve, while giving lip service, has never implemented such a policy.
It has typically waited too long until inflation was well entrenched. Then, it
has overreacted, pushing the economy into, at times, severe recessions.
4
A third choice would be to reduce money growth promptly. This choice would
run the risk of a small recession now so as to avoid higher inflation and a
bigger recession later. This course seems to us least costly at present. It
avoids the costs of higher inflation and subsequent disinflation. The urgent
task for the Federal Reserve is to return to a less inflationary path promptly
and remain on a disinflation path.
We urge the Federal Reserve to achieve its targets, to stop rebasing and to
return the money stock to a growth path of 5.5 percent from the second quarter of
1985 through the fourth quarter of 1986 as had been announced. The target for
policy should be M-l, and other monetary and credit aggregates should be
discarded.
International Debt and Protectionism
Third, world prosperity and the payment of interest on outstanding
international debt are threatened by existing protectionist policies and demands
for increased protection. Debtors can only service debt by exporting more than
they import. Restrictions on imports by the United States and other developed
countries increase financial instability and are contrary to the interests of
consumers. Fear of default by debtors and the burden of outstanding debt reduce
borrowing and lending and the ability of debtor countries to return to
prosperity.
The U.S. and the IMF have no effective policies for reducing the burden of
the debt for debtor countries. New non-inflationary approaches are needed to
reduce the instability of the world financial system.
We urge the Administration and the Federal Reserve to promote a
restructuring of international debt by encouraging banks (1) to sell within a
reasonable time period a sufficient amount of their developing country loans to
establish market values; (2) to encourage foreign governments to convert a
5
portion of their debt to equity in firms in the developing countries, including
nationalized firms, at the current market value of the debt: and (3) to encourage
banks to acknowledge their losses.
Tax Policy and Protectionism
Fourth, there are only two ways to change the competitive position of the
U.S. world economy. Either productivity growth permits U.S. producers to compete
effectively in world markets while maintaining or increasing the real incomes and
employment opportunities of American workers or American incomes and costs of
production must fall. There is no doubt about which choice is preferable.
The current capital inflow to the United States provides the opportunity to
rebuild and renew our productive capital without reducing current consumption.
Foreigners have be%n lending us billions of dollars that can be invested in new
and old industries. This capital inflow from abroad is the driving force in the
balance of payments. It permits us to raise our current standard of living while
investing to improve our future.
The offset to the capital inflow is the current account deficit. Excessive
concentration on the deficits in trade and current accounts ignores the beneficial
effects of the capital inflow and ignores the main cause of these deficits -- the
relatively attractive opportunities for investment that appeals to investors in
the U.S. and the rest of the world.
Many, particularly in 'the Congress, share the mistaken belief that American
industry cannot compete without higher tariffs, smaller quotas and other forms of
protection against imports. Their proposals call for more protection.
Protectionist policies reduce the trade deficit by lowering living standards.
The more protection we give to our industry, the lower our standards of living.
There is a better way. The government can choose higher productivity and
increased standards of living by reducing taxes on capital and lowering the cost
6
of capital to American firms. Although the Administration's tax reforms have
many desirable features, they do not respond to the protectionist challenge and
do not give sufficient weight to productivity, investment and the competitive
position of the U.S. in the world economy.
We urge the Administration and the Congress, as a minimum program, to reduce
the cost of capital to American corporations by reducing corporate tax rates,
indexing depreciation and permitting dividend payments to be treated as an
expense. The Administration's tax program fails in this respect. It is the
wrong program for the United States at this time..
7
ECONOMIC OUTLOOK
Jerry L. JORDAN
First Interstate Bancorp
It now appears that monetary growth in 1985 will be the most rapid for any
year yet recorded, exceeding even the extremely rapid 10.4 percent increase in
1983. Consensus forecasts that extrapolate recent sluggish pace of economic
growth, in spite of extremely rapid monetary growth, suggests we will replay the
experience of the spring of 1983. At that time both the Federal Reserve and the
Administration were surprised by the sharp acceleration in the pace of economic
activity even though the SOMC had signalled at the March '83 meeting that such a
development was highly probable.
In another context, it now appears that economic policies overall are
destined to create conditions similar to the late 1970s. The initial rebound in
economic activity and the recovery of 1975 was very strong, only to be followed
by the "pause" or "plateau" of 1976 (subsequent to the New York City financial
crisis). Concerns about the economy slipping into recession at the time of, or
shortly after, the 1976 elections caused economic policies to become extremely
stimulative, producing substantial overheating of the economy by 1978.
In the current cycle, the vigorous recovery from the spring of 1983 to the
summer of 1984 was followed by a four-quarter "pause" or "plateau" (subsequent to
the Continental Bank financial crisis). Now, post-election year concerns about
"growth recession" have once again produced highly stimulative economic policies
which, if sustained, would produce significant overheating of final demand
sometime in the next couple of years.
9
Rebasing Money Targets
At the March '85 meeting of the SOMC we raised the possibility that "the
probability is rising that '85 could see a repeat of '83 as far as monetary
targeting is concerned. Two years ago, money growth was so far above target by
mid-year the FOMC reset the base period to the second quarter and did not try to
offset. Such a possibility has already been signalled by Vice Chairman, Preston
Martin when he acknowledged the possibility that Ml might be allowed to grow 8-10
percent in 1985, with the justification that velocity growth might be low".
Also at the March meeting, we noted the possibility that if the 11 percent
growth of money recorded for the first quarter were to be continued through the
second quarter then it would be necessary for the Fed to cut money growth to zero
during the second half in order to return to the mid-point of the original target
range. As it turned out, the Fed did rebase monetary targets in July essentially
because they saw no good alternative. The Open Market Committee obviously
realized that had they announced in July of this year that they were going to
maintain the original target range it would have been very upsetting to financial
market participants as1 well as members of the U.S. Congress to know that the
intention of the central bank was to achieve essentially zero money growth for
the balance of the year.
On the other hand, the Federal Reserve has never overtly raised the monetary
growth targets during the previous ten-year experience with targetting. As of
the middle of this year, had they simply announced that they were substantially
increasing the target range for the whole year, it potentially could have had an
adverse affect on long-term inflation psychology. By rebasing the target to the
second half of the year, they were able to maintain the appearance of a long-run
determination to produce a lower trend of money growth, ultimately achieving
10
stable prices, but forgive the substantial overshoot of actual money growth
during the first half of the year.
Accompanying charts show the monetary growth so far in 1985 plotted against
the original target cone and corridor and also illustrate the effects of the
rebasing of targets as of midyear. In effect, the announcement by Chairman
Volcker in July that the Committee would now seek growth of Ml in the second half
of '85 in the range of 3-8 percent was identical to raising the target range for
the entire year to a 6.8 percent to 9.4 percent band. Nevertheless, even with
the substantial increase in the effective targets for this year, they continue to
exceed the target range by a wide margin. Available data suggest that Ml growth
for the third calendar quarter is going to be approximately 15 percent, resulting
in growth for money for the first three-fourths of this year at 12.9 percent
annual rate. Even if money growth now dropped to only 6 percent during the
fourth quarter, growth of money for all of 1985 would be about 10.6 percent.
At the July midyear review, Chairman Volcker announced a tentative
indication of a target range for 1986 of 4-7 percent, effectively setting a
target of 5.5 percent plus or minus one-and-a-half percent. That tentative
taTget range for 1986 implies a 50 percent reduction in money growth from this
year to the next year which, at this point, looks highly unlikely and if it were
to occur would be expected to have at least a short-run adverse effect on real
output growth.
Once again the Fed's policy actions have created conditions under which
there are no good alternatives available. If they sustain the extremely rapid
money growth that we have seen so far this year, then inevitably inflation will
accelerate. On the other hand, if they sharply curtail monetary growth in order
to offset the overshoot of the recent past, their actions would probably produce
at least a sharp slowing in economic growth, if not an actual contraction in output. Table 1 shows Ml and monetary base growth for intervals since 1976.
11
Monetary growth had contracted sharply in 1984 compared to the longer-term trend,
but now the rapid monetary growth during the first three quarters of 1985 has
been sufficient to restore the longer-term 7-8 percent trend rate.
Table 1
JxUl
JjyyyL
Q4/76 - Q4/80:
Q4/80 - Q4/84:
Q4/76 - Q4/84:
7.8%
7.4
7.6
g.7%
73
8.0
Q4/84 - Q4/84:
Q4/84 - Q3/85:
5.2
12.9
7.38.4
Strong Final Demand
Spending by businesses and households in the U.S. economy so far in 1985,
has been quite strong and should be expected to continue to be strong in view of
the monetary stimulus. As measured by gross domestic purchases or final sales
and illustrated in the accompanying charts, spending has gained strength with a
relatively short lag following the acceleration in monetary growth that began
late in 1984. The initial phase of the "pause" or "plateau" of economic growth
in the second half of '84 and early '85 followed the significant deceleration in
money growth that occurred in '84 compared to 1983. In the second quarter of '85
nominal final sales, retail sales, and gross domestic purchases rose at annual
rates of 7.3 percent, 10.7 percent, and 6.7 percent, respectively, suggesting
that the apparent weakness of the economy in the spring and summer was not due to
a lack of demand. Another accompanying chart shows the growth of domestic
purchases versus GNP, illustrating the point that the decline of net exports and
the slower rate of inventory accumulation were the reasons that this strong final
demand was not reflected in domestic production. For the balance of 1985 and
12
continuing into 1986, the extremely rapid monetary growth that is continuing at
the present time suggests that demand will remain strong and most likely domestic
production will strengthen as a faster pace of inventory accumulation resumes and
net exports contract at a slower rate.
FOMC Projections
Table 2 shows the most recent FOMC projections for 1985 compared with the
projections of last February. In addition, projections for 1986 are reproduced.
Table 2
•FOMC Projections^
For 1985:
GNP:
Output
Prices:
Unemployment*5:
February '85
July '85
7-1/2 - 8%
3-1/2 - 4%
3-1/2 - 4%
6-3/4 - 1 %
6-1/2 - 7%
2-3/4 - 3%
3-3/4 - 4%
7 - 7-1/4%
For 1986:
Alff^/ii
i
7 - 7-1/2%
3-1/2 -3-1/4%
3-3/4 - 4-3/4%
6-3/4 - 7-1/4%
GNP:
Output:
Prices:
Unemployment1*:
.Central tendencies;
lear-end
For next year, the Fed has a target for Ml centering on 5-1/2 percent and
projections of nominal GNP centering on about 7 percent, suggesting an increase
in Ml velocity of about 1-1/2 percentage points for the year. While that
implicit forecast for velocity is faster than what has been recorded so far in
13
1985, it is only about one-half of the long-run trend of velocity growth. For
the four quarters of 1984, Ml velocity increased 4.5 percent which is substantially above the long-run trend. In 1985, Ml velocity as conventionally measured
has appeared to decline by a significant amount. However, measuring velocity as
the ratio of GNP to Ml and ignoring lags creates a misinterpretation of the
concept that could lead to erroneous conclusions about future prospects. A
separate memorandum made available to the Committee by Alison Lynn Reaser of the
First Interstate staff explains why there are problems in measuring velocity
in the conventional way.
Following the three quarters of explosive money growth recorded for 1985,
past experience would suggest that nominal GNP growth will accelerate significantly. If monetary growth should be curtailed simultaneously, then the ratio of
GNP/Ml would jump up sharply, giving the appearance of a substantial reacceleration of velocity growth. The above trend velocity growth recorded for 1984 was
produced by a similar set of circumstances. The highly stimulative monetary
policy of 1983 produced rapid GNP growth for at least a part of 1984. However,
since monetary growth was decelerating as 1984 progressed, the ratio of GNP/Ml
rose sharply. Subsequently, the deceleration of monetary growth was followed by
a deceleration of GNP growth, yet Ml growth reaccelerated thereby producing a dip
of the ratio.
In view of this past experience, it would be very surprising if nominal GNP
growth did not accelerate sharply in the near future making it appear that
velocity was starting to accelerate again.
Outlook
For the second half of 1985, it now appears highly likely that both nominal
and real GNP growth will be substantially faster than during the first half of the
year. Specifically, real output growth of around 5 percent for the half with
14
nominal GNP increasing by more than 9 percent should be expected. In the early
part of 1986, this momentum should be expected to continue. However, should a
sharp deceleration of monetary growth, get underway near the beginning of next
year, then later in '86 another "pause* or "plateau" could emerge.
Table 3
fiME Outsit
Eira
Ml
Yl
MB
Y&
Q4!M-Q4iiSi
7-8% 3-4% 4-4-1/2%
10-12% -3to=4%
9-11% -2to-3%
Q4/SS-Q4/86:
8-10% 3-4% 5-6%
6-8%
6-8%
2-3%
It is tempting to view the 5.2 percent increase of Ml in 1984 as having been
appropriate in order to offset the 10.4 percent increase of 1983. Similarly, for
1986 a growth of only about 5 percent could be averaged against the explosive
double-digit money growth in '85 to sustain the long-run trend range of 7-8
percent.
This is the eleventh year of monetary growth targeting by the Federal
Reserve and for the entire period money growth has averaged 7.5 percent.
Especially in view of the fiscal environment, there is little reason to expect
that future average monetray growth will be any less than it has been in the past.
However, it is also true that monetary growth has become increasingly volatile
over two and three quarter intervals. Consequently, the three quarter monetary
explosion such as we have recently experienced could be followed by a severe
monetary contraction possibly lasting two or three quarters. In other words, the
go-stop, go-stop policies of recent years are likely to be repeated in the
future, making it virtually impossible to provide near-term economic forecasts in
which anyone has any confidence. Over the longer-run, it seems safe to expect
that a sustained trend rate of inflation in the 6-7 percent range is likely.
15
2-3%
MONETARY BASE & M1 GROWTH
TWO QUARTER MOMNG AVERAGE
0\
»
1979
»
6
«
»
1980
»
i
t
i
1981
t___j___<
a
1982
n
i
i
i
1983
l
I
t
i
.,..,..J
1984
...J
»
_ J
—I
1985
"03PCST
FIRST INTERSTATE ECONOMICS
SEPT. 12,1985
WEEKLY MONEY SUPPLY (Ml) V& FED TARGEfS
BILLIONS OF $
1985
£20 T
610 4*
600
+
S90 **f-
no
570 +•
SW T
550
FIRST INTERSTATE ECONOMICS
SEP. 12,1985
WEEKLY MONEY SUPPLY (Ml) V& FED TARGETS
BfUJONSOFf
620
1985
660 "fc
K©
M
TOST INTERSTATE ECONOMICS
Qe3
SEP. 9,1985
THE MONEY MA1KETS
William POOLE
Brown University
Money market interest rates have fluctuated in a relatively narrow range
since the last meeting of the SOMC on March 24-25, 1985. The weekly average
federal funds rate has ranged between a high of 8.68 percent for the week ending
April 3 and a low of 7.13 percent for the week ending June 19. Three-month
Treasury bills have fluctuated between a high of 8.29 percent for the week ending
March 29 and a low of 6.81 percent for the week ending June 21. In late August
and early September federal funds traded generally in the 7.5-8 percent range and
Treasury bills in the 7-7.5 percent range.
This sideways movement of money market interest rates reflects a standoff of
opposing forces. On the one hand, the high rate of money growth has made the
Federal Reserve reluctant to press interest rates down further; and the market,
understanding both the Fed's reluctance and the danger that high money growth
will lead to upward pressures on the inflation rate, has also been reluctant to
push interest rates down.
On the other hand, a number of policy concerns have been pointing in the
direction of holding interest rates down. Concern over slow growth of economic
activity and the effects of higher interest rates on activity have suggested to
the market that the Federal Reserve would be unlikely to permit rates to rise to
any appreciable extent. Moreover, certain sectors of the economy -- notably
agriculture and manufacturing industries suffering from intense import
competition ~ have appeared especially vulnerable to higher interest rates.
Higher rates would have the direct effect of raising costs as seen by individual
19
firms and the indirect effect of strengthening the dollar, creating the prospect
of a further loss of market position by U.S. farms and manufacturers to foreign
producers in both foreign and domestic, markets.
For these reasons, the Federal Reserve has been unwilling to permit interest
rates to rise as necessary to choke off explosive money growth. (So far this
year, Ml has been growing at a rate of about 12 percent, which may be compared
with the approximately 8 percent rate that set off the late 1970s inflation.) The
Fed's position has been reinforced by attitudes, sometimes expressed publicly,
within the Reagan Administration and Congress. The policy environment is
remiEiscent of that in 1967, 1972 and 1977 just prior to the bursts of inflation
in the late 1960s, the mid 1970s and the late 1970s.
Federal Reserve Money Market Targets
The Federal Reserve has described its short-run operating procedure as
involving maintenance of a certain degree of "pressure" on bank reserve positions.
This vague notion is given more concreteness by the Fed's target for the level of
free reserves (when negative, sometimes called "net borrowed reserves"), and/or
for the level of bank borrowing at the discount window.
As is well known, a free reserves target is essentially equivalent to a
federal funds rate target. Free reserves are the difference between excess
reserves and discount window borrowings. Other than when interest rates are
extremely low, banks' holdings of excess reserves are insensitive to the rate of
interest in the money markets. Borrowed reserves, however, depend on the spread
between the federal funds rate and the discount rate; the higher is this spread
the more willing are banks to borrow at the discount window.
If excess reserves were constant, and if the borrowing function were
perfectly stable, then there would be a perfect one-to-one correspondence between
a borrowed reserves or free reserves target and the federal funds rate. However,
20
because the excess reserves and borrowed reserves functions are not perfectly
stable noise in these functions will transmit noise to the funds rate if the Fed
maintains a free reserves target.
The Federal Reserve does, in fact, permit some of the noise in the excess
reserves and borrowing functions to be transmitted in money market interest
rates. However, the Fed also smooths out some of this noise in order to
stabilize the federal funds rate. The Fed can also smooth rates by adjusting its
free reserves target as necessary to keep the funds rate in a desired range.
To my knowledge, in recent years there has been no published justification
going beyond pure description of a free reserves operating target by the Fed on
an official basis or by a Fed Board or staff member on an individual basis.
There can be little doubt that the Fed thinks of a free reserves target as a
proxy for a federal funds rate target.
A free reserves target has the minor advantage to the Fed of making its
views concerning the appropriate federal funds rate somewhat ambiguous to the
market, thereby increasing operating flexibility to some extent. The underlying
funds rate target can be adjusted somewhat more easily than under a pure funds
rate targeting system such as that maintained in the 1970s because an adjustment,
being less clear to financial analysts, is less likely to provoke an undesirable
speculative response in the markets.
That the Fed's real target is the federal funds rate rather than free
reserves is easily seen. Suppose that next week the banks9 discount window
borrowing function were to shift out and to the right by, say $3 billion. To hit
a free reserves target in these circumstances the Fed would have to push the
federal runds rate up by several hundred basis points. Almost certainly, the Fed
would accommodate the borrowing demand; it would keep the funds rate from rising
by more than 50-75 basis points, and would instead either accept a missed free
reserves target or revise the target.
21
Without question, the major advantage of a free reserves operating target to
the Fed is purely political. In recent years a number of bills have been
introduced in Congress that would require the Fed to target interest rates. The
Fed regards these bills as unsound, which they are. But the Fed knows that it
would be on weak ground in opposing such legislation if it were explicitly
pegging the federal funds rate as it did during the 1970s. Thus, given the
failure of its poorly-designed system of controlling non-borrowed reserves after
October 1979, the Fed has found it convenient to revert to the free reserves and
borrowed reserves targeting system used in the 1920s and 1950s.
The Federal Reserve is more or less active in cushioning pressures in the
money market depending on its view as to the appropriate direction of interest
rates in the light of the real economy, liquidity pressures in the financial
markets, and a host of other considerations. Most unfortunately, controlling
money growth has come far down the list of relevant considerations this year.
Well above controlling money on this list has been the Fed's sensitivity to
political pressures from the Administration and Congress.
The Asymmetry of Federal Reserve Policy
Because the Federal Reserve simultaneously leans against the economic winds
and with the political winds in its stance toward interest rates, at certain
times policy becomes asymmetric with respect to the direction of interest rate
changes. There is at present practically no political concern whatever about
inflation, but considerable concern about real economic activity and the level of
the exchange rate. The arrival of economic statistics suggesting a stagnant
economy tends to push the Fed toward prompt reduction in interest rates to
stimulate activity. The main constraint is concern that falling interest rates
today might have to be followed by a policy reversal in the near future, and
concern that money growth has been excessively high this year.
22
A policy asymmetry exists, however, because the arrival of economic
statistics suggesting a strong economy will not push the Fed toward a more
restrictive stand involving higher interest rates. If interest rates come under
upward pressure, the Fed is likely to give ground slowly; as we have seen this
year, money will be permitted to grow at whatever rate is necessary to hold
interest rates down. Under these conditions, it seems unlikely that the Fed will
restrain money growth until it can make the case politically that action is
required. Unfortunately, leaning with the political wind means that the case
will not be made until inflation and the public's inflation fears revive.
Under present Federal Reserve policy another serious outbreak of inflation
seems all but guaranteed. A policy of permitting money growth to proceed at a
"normal" rate when interest rates are tending to fall and at an excessive level
when interest rates are tending to rise is a recipe for disaster.
The Interest Rate Outlook
It is hard to see how the next major change of direction for interest rates
can be anything but up; the upward-sloping yield curve indicates that the market
shares this view. Since the last SOMC meeting, rates have declined only a little
in the face of very rapid money growth. If the Fed acts to reduce money growth
in the near future, rates are likely to rise temporarily. If the Fed does not
act in the near future, continued high money growth will, sooner or later, boost
economic activity and the inflation rate, both of which will raise credit demands
and interest rates.
The only surprising feature of the present situation is the apparent
complacency in the credit markets about the prospects for interest rate increases.
Despite continuing high money growth bond yields are at about the same level as
the beginning of the summer. If I were a bond investor, I'd be increasingly
nervous.
23
RECENT BUDGET POLICY AND
ECONOMIC IMPACT
Mickey D. LEVY
Fidelity Bank
The spending cut compromise incorporated into the First Concurrent
Resolution on the FY 1986 Budget substantially improves the budget outlook.
Cyclically-adjusted deficits are forecast to recede in the next several years
and, under a continuing economic growth scenario, the dramatic rise in the
federal debt-to-GNP ratio should slow. The spending cuts will have only a minor
near-term impact on the economy and are positive for long-run capital formation
and economic growth. Certainly, federal outlays remain too high as a portion of
GNP, and deficits would be much higher than official forecasts under a less
optimistic economic path, but these spending cuts represent a step in the right
direction.
In contrast to the positive impact of the spending compromise, the tax
reform package proposed by the Reagan Administration would have a distinctly
negative impact on capital spending and economic growth in both the short and
long runs. Unfortunately, Congress and the Administration are concerned
primarily that any tax package be "revenue neutral", a relatively unimportant
issue. The potential economic impact of proposed tax reform deserves more
attention.
The Budget Outlook
The savings generated from the budget compromise reached this summer are
large, but significantly smaller than the advertised savings of the earlier House
or Senate spending cut versions. According to the CBO, savings are approximately
$37 billion in FY1986, and $203 billion in the three year period FY1986-FY1988,
25
compared to original House and Senate estimated savings of $56 billion in FY1988
and either $259 billion (House) or $295 billion (Senate) for FY1986-FY1988. Half
of the forecast savings occur in FY1988- Also, nearly two-fifths of the proposed
cuts are in defense spending (see Table 1); the First Concurrent Resolution calls
for zero real growth in FY 1986 and approximately 2 percent real growth in later
years, compared to inflation plus 5 1/2 percent growth under current services.
(The defense budget compromise was achieved by taking the Senate's originally
proposed Budget Authority for defense and the House's proposed budget outlays.)
The conference resolution also includes large spending cuts in non-defence discretionary programs (particularly, a one-year civil service employment pay freeze
and cuts in Farmers Home Administration, rural housing programs, the strategic
petroleum reserve, and the Small Business Administration). Nearly half of these
Table 1
SPENDING REDUCTIONS IN FIRST CONCURRENT RESOLUTION ON FISCAL YEAR 1986 BUDGET
FOR THE COMBINED THREE YEAR PERIOD FY1986 TO FY1988
Defense
Entitlements
1P405
38
18.7
2.7
Nondefense Discretionary
525
55
&> 1 » 4»
10.5
interest
447
14
6.9
W
-166
4
2.0
4> © H
—
16
203
Offsetting Receipts
Revenue Increases
Total Deficit Reduction
Source;
Notes
Proposed
Saving
% Bil
77
Savings as a percent oft
Current
Proposed
Service
Savings
Outlays
9.0
37.9
Total
Outlays
% Bil
856
7.9
100.0
Congressional Budget Office, The Budget Outlook; August 1985.
Figures may not add due to rounding.
26
—
® flf
cuts involve reconciliation instructions for numerous authorizing committees.
COLAs for social security and indexed transfer payments were not modified, and
entitlement programs incur only modest cuts relative to their size. However,
elimination of general revenue sharing in FY1988 and cuts in Medicare will provide approximately $19 billion savings in FY1986-FY1988.
Under a scenario of 3 1/2 percent real GNP growth and relatively stable
inflation and real interest rates, assuming all of the spending cuts in the
Concurrent Resolution are realized, these savings would generate several positive
budget outcomes: from FY1985 to FY1988, total federal outlays would rise 4.6
percent annually, less than half the 9.9 percent annual growth rate from FY1980FY1985. Consequently, the ratio of outlays-to-GNP would decline from nearly 25
percent in FY1985 to 22 1/2 percent by FY1988. With little change in revenues as
a percent of GNP, the ratio of budget deficit-to-GNP would shrink, from 5.5
percent in FY1985 to approximately 3 percent in FY1988. Associated with this
spending slowdown, the cyclically, adjusted deficit also would be reduced
significantly, in absolute terms and as a percent of GNP.
According to the CBO, deficits would be $175 billion in FY1986, and would
decline to $143 billion by FY1988. (The FY1985 deficit will be approximately
$210 billion, reflecting the slowdown in economic growth and the one-time impact
of the shift to on-budget accounting of HUD loans.) The Administration, in its
Mid-Session Review, forecasts even lower deficits -- $100 billion by FY1988 —
but it assumes enactment of all of the non-defense spending reductions the
President proposed in February, which will not occur. (Also, it assumes sharp
declines in real interest rates despite continued 4 percent economic growth, a
seeming inconsistency.) Under either forecast, the federal debt-to-GNP ratio
would end its current sharp climb, peaking below 42 percent in 1987, and begin a
gradual descent. (That ratio has risen from 29 percent in 1981 to nearly 40
percent in 1985; under current services, it would approach 50 percent by 1990.)
27
The improvement in official budget forecasts must be tempered by the
uncertainty of the underlying economic assumptions and uncertainty about whether
all of the spending cut instructions included in the budget resolution will be
implemented. Weaker economic growth or periods of higher Interest rates would
add substantially to the deficit forecasts. For example8 the CBO assumes a 3month Treasury bill rate of 7.4 percent in 1986 and 7.2 percent in later years; a
one percentage point higher rate would add to spending and deficits $4 billion in
FY1986 and $16 billion in FY1988. This would occur if inflation rises above the
4.2 to 4.4 percent range that the CBO assumes for 1986-1988. Also, tax revenues
are very sensitive to slower economic growth, as evidenced in 1985; a one
percentage point slower real GNP growth would reduce revenues by approximately
$3.4 billion in FY 1986 and $26 billion in FY 1988; its net impact on deficits
would depend on the interest rate movement associated with the slower growth.
Over the forecast period, a more conservative economic forecast would involve slightly slower real GNP growth (3 percent) and higher inflation (5-5 1/2
percent). This would raise the deficit projections to approximately $182 billion
in FY1988. These figures may be even higher if authorizing committees in
Congress do not fully implement the reconciliation instructions of the First
Concurrent Resolution in the FY 1986 Budget, or if a portion of the proposed
spending reductions lack permanence. It already looks as if outlays in certain
programs — for example, agriculture — will be higher than proposed.
The budget outcome under these assumptions would be less optimistic than
official forecasts: deficits would decline from FY1985 levels, but not significantly (see Table 2). The primary deficit (deficit less interest expenses
adjusted for Federal Reserve payments to the Treasury) would decline toward zero,
but would not become negative, as forecast by both the CBO and Administration.
Consequently, under reasonable interest rate assumptions, the federal debt-to-GNP
ratio would continue to rise, but at a much slower pace than its current path.
28
Table 2
ALTERNATIVE BUDGET PROJECTIONS
In $ Billions
1985
Outlays
CBO
Admini st rat ion
Alternative*
Revenues
CBO
Administration
Alternative
Deficit
CBO
Administration
Alternative
Notes
Fiscal Years
1987
1986
.
1988
946
947
965
958
970
1,021
989
1,030
1,082
1,037
1,102
737
736
790
780
788
858
850
855
939
937
934
210
211
175
178
182
163
139
175
143
99
168
Alternative projection assumes 3% r e a l GNP growth (compared to CBO'a 3*5% and
the Administration's 4%), and assumes one percentage point higher i n f l a t i o n and
i n t e r e s t r a t e s than the CBO (The CBO assumes t h a t the CPI r i s e s to 4.2% and
3-roonth Treasury b i l l averages 7.2% in 1987-1988? the Administration 8 ® i n f l a t i o n
assumption i s similar to the CBO's, but i t assumes t h a t the yield on 3-month
Treasury b i l l s drops to 5.9% in 1988, which i s seemingly inconsistent with
respect to i t s 4% r e a l GNP growth r a t e ) . Furthermore, the a l t e r n a t i v e
projection assumes t h a t not a l l of the spending cuts embodied in the Concurrent
Resolution on the FY1986 Budget are r e a l i z e d .
Economic Effects
The spending reductions would have very little near-term impact on the
economy and are positive for longer-run capital formation and economic growth.
Government purchases of goods and services will be lower than they would be otherwise, modestly reducing GNP. The near-term impact will be minor, however, since
the slowdown in defense purchases will lag legislated cuts in defense budget
authority. The elimination of general revenue sharing (in 1987) will reduce
incentives for state and local governments to spend, which will slow state and
local purchases, also reducing GNP. Other spending reductions will have a
negligible impact on the path of economic growth; the cuts are dwarfed by the
$1.7 trillion economy. Also, many public and private activities are
29
substitutable, so a cutback in some federal spending programs would be offset by
increased private provision, leaving GNP unchanged. This is particularly true of
goods and services whose demand is price inelastic.
The largest impact of the spending legislation will be to change the composition of economic activity rather than the growth path. In the longer run,
slowing spending growth and limiting the rise in the federal debt-to-GNP ratio
will increase investment, a positive factor for productivity and long-run
economic growth.
Tax Reform
The Administration's tax reform proposal has many merits: it reduces
marginal tax rates and eliminates certain deductions, credits and exemptions that
have eroded the personal income tax base and distorted economic behavior. However, the entire tax package potentially would have a distinct adverse impact on
economic activity, reducing investment and economic growth in the short and long
run. President Reagan has advertised the Administration's plan as pro-savings
and pro-growth, but neigher assessment is correct. The proposals would substantially reduce personal income tax burdens, but historical experience suggests
that rates of personal saving tend to be relatively insensitive to personal
income tax cuts. Regarding investment and economic growth, I am particularly
concerned about the potential adverse impact of the higher corporate tax burdens
proposed in Treasury II. Elected officials jockey around the issue of "revenue
neutrality", displaying their concern for the initial impact of the tax proposal
on the budget deficit, but they overlook the important distinction between
revenue neutrality and economic neutrality.
The provisions in the tax package that would adversely impact the economy
are the elimination of the Investment Tax Credit (ITC) and the Accelerated Cost
Recovery System (ACRS), and the recapture of some of the tax benefits from the
30
proposed reduction in marginal corporate tax rates to businesses that recently
have invested in plant and equipment. The corporate income tax rate would be
reduced from 46 percent to 33 percent, but these other proposals would lead to
higher corporate taxes and a shift in the corporate tax burden, (see Table 3).
Importantly, while the rate reduction provision would be provided to all
corporate taxpayers, the higher tax burden from eliminating the ITC and ACRS and
the recapture provision would fall on capital intensive firms — it would raise
the after-tax cost of investment in new plant and equipment and also reduce the
expected after-tax cash flow of businesses that recently have invested in plant
and equipment.
In response to the expected lower real after-tax rates of return on new
capital investment, and the weakened cash flow of capital intensive firms,
capital spending growth would slow, and possibly decline for several quarters.
Non-residential construction would follow a similar pattern in a response to the
elimination of the 10 percent ITC, the 25 percent ITC on rehabilitation of
historical structures, and the tax exempt status of industrial revenue bonds. In
Table 3
REVENUE IMPACT OF SELECTED CORPORATE TAX POLICY CHANGES,
iri Billions of Dollars, Fiscal Years 1986-1988
Proposal
1) Eliminate ITC
2) Eliminate ACRS Recapture
3)
Subtotal (1) + (2)
4) Lower Corp. Tax Rates
5) Net Higher Corp. Taxes
Source:
1986
1987
1988
15.7
8.0
23.7
•10.0
13.7
30.4
35.0
24.3
59.3
-35.9
49.7
"So© 7
The President's Tax Proposals to the Congress for Fairness, Growth, and
Simplicity, May 1985.
31
the short run, this could reduce real GNP growth by several percentage points
within a year, and could generate several quarters of flat or slightly negative
real GNP growth. Also, by lowering th.e capital intensity of production, the
long-run path of potential GNP growth would be reduced.
Associated with this policy-induced economic weakness and lower real aftertax rates of return on capital investments real interest rates and the exchange
value of the U.S. dollar would recede. The weaker U.S. dollar would exert upward
pressure on inflation and inflationary expectations. The subsequent composition
of market interest rates, reflecting lower real rates and higher inflation and
inflationary expectations, would be consistent with the weakened economic
environment.
According to these results, the Administration unknowingly is advocating a
policy that is the antithesis of "Reaganomics" — a shift in incentives away from
investment and toward consumption, and slower capital formation that could
potentially impact future economic growth. This is particularly ironic, in that
the capital spending response to the pro-investment provisions of the Economic
Recovery Tax Act (ERTA) of 1981 stands out as one of the most visible and
positive consequences of Reagan's original economic platform. Also, eliminating
the ITC and modifying ACRS would place particular hardship on the traditional
manufacturing sector that tends to be very capital intensive, and is currently
feeling the largest pinch from foreign import competition.
The recent spending cut legislation represents a necessary first step toward
fiscal responsibility. By slowing the ratio of spending-to-GNP and halting the
dramatic rise in federal debt-to-GNP, it is long-term growth-oriented. Importantly, while some may argue that it was not enough -- entitlement programs were
barely touched -- it has reduced political pressure for a tax increase. In stark
contrast, enactment of the Treasury's tax package would not be conducive to longrun economic growth, and may accelerate the rise in federal debt-to-GNP by
32
generating a weak economic environment. Some of the politically sensitive issues
of fairness and redistribution (i.e., eliminating the deductibility of state and
local taxes) will delay its enactment, but passage of a watered-down version
should not be ruled out for 1986.
33
WHERE IS THE MYSTERY IN THE BEHAVIOR OF THE MONETARY
AGGREGATES?
Robert H. RASCHE
Michigan State University
About the only statistic that has been growing more rapidly than Ml in the
past several months is the amount of speculation about why Ml is growing so
rapidly. Once again, private analysts and Federal Reserve sources are quick with •
public statements that "special circumstances" are at work that make the growth
of Ml over recent months atypical, if not unique, and therefore devoid of any
predictive content. Among the "special circumstances" that have been cited in
recent weeks are:
1) lower market rates of interest relative to rates paid on interest bearing
checkable deposits,
2) widely publicized problems at savings and loan associations and savings
banks,
3) fallout from charges that E.F. Hutton engaged in check kiting, and
4) the decline in the dollar in foreign exchange markets.(*)
All of these statements appear to be long on speculation and short on analysis.
Most of the proposed explanations of the rapid Ml growth appear to be wide of the
mark, and if not erroneous, are grossly misleading.
This position paper is divided into three parts. In the first part an
analysis is present indicating the extent to which various forces have affected
the growth of Ml since last November. (At the time of this writing August data are
not yet available. I expect that the analysis can be updated to include August
v
'See for example, Business Week, Economic Diary, "What's Really Fueling the MoneySupply Spiral", September 9, 1985, p. 22 and The Wall Street Journal, "Money Supply's
Rapid Growth Raises Odds of Interest Rate Surge, Many Say", September 3, 1985, p. 28.
35
data by the time the Committee meets.) In the second part the forecasts of the
money multiplier that were presented at the meeting of the Committee last March,
and forecasts which have been made o.n a regular basis since that meeting are
reviewed to determine the extent that the growth of Ml that has been observed was
predictable. The absence of large ex-ante forecast errors casts considerable
doubt on the "special circumstances* hypothesis. Finally, the third section
presents our current forecasts for the behavior of the Ml-Adjusted Monetary Base
Multiplier into early 1985.
The Sources of Ml Growth Since November, 1984
The data on the behavior of the Adjusted Monetary Base and Ml since
November, 1984 are presented in Table 1. November was chosen as an appropriate
starting point since it approximates the base from which the original FOMC Ml
ranges were established. While we have chosen to present the St. Louis base
numbers to be consistent with past practice, there would be no substantive difference if the Board of Governors base had been chosen, since the growth rates of
the two measures are essentially identical during the past year.
The pattern in these data is the familiar one. Ml has grown at very rapid
rates., the base has grown rapidly, but not as fast as Ml, and accordingly there
has been a steady upward trend in the base multiplier. The rampant speculation
is about the cause of this upward trend in the multiplier.
Three significant features emerge from an examination of the behavior of the
component ratios of the base multiplier. First, there has been a steady drift
downward in the currency-deposit ratio (k) throughout the period. Second, the
ratio of small time deposits to checkable deposits (t.) remained relatively
steady through March, drifted sharply Sower in April through June, and then
stabilized in July. Third, the ratio of large negotiable time deposits to
checkable deposits (t_) fell somewhat in February, stabilized through April, then
36
dropped steadily through July. In contrast, the reserve ratio (r+1) has bounced
around considerably, but has not exhibited any distinct trend over the entire
period. The behavior of the two time -deposit ratios is consistent with some
elements of the speculation cited above. The real question is what quantative
significance do all of these features have for the growth of the base multiplier
and Ml.
In Table 2 the growth rate of Ml has been decomposed into the growth rate of
the adjusted monetary base and the base multiplier, with the latter further
allocated to the component ratios. All growth rates have been expressed at
percentage annual rates to allow comparisons across periods of different lengths
(note that the growth rate is from November, 1984 to the indicated month in each
line). The sum across each row of the growth rate of the base and the growth
allocated to each component ratio equals the growth rate of Ml. The component
"resid" is the approximation error in the linearization of the formula for the
growth rate of the base multiplier in terms of the growth of its component
ratios. It is immediately apparent that this error is an insignificant element
in the behavior of Ml since last fall.
The data in Table 2 do not support any of the speculative attacks on recent
Ml growth. It is only since June that the behavior of the time deposit ratios
collectively accounts for more than one percent (at annual rates) of the growth
of Ml since last November. Even in these two months, the combined contribution
of the two time deposit ratios to Ml growth has been only about 1.2 percent at
annual rates. This contrasts with the contribution of the currency ratio, which
consistently accounts for over two percent (annual rates) of the growth of Ml
over the entire period December through July! Indeed, since February, the
combined contribution of the monetary base and the currency ratio to Ml growth
relative to the actual growth rate of Ml has been between .94 and 1.05. In
January and February, the net contribution of the remaining component ratios was
37
larger, primarily because of a large contribution from the reserve ratio, but
even then the combined contribution of base growth plus the currency ratio
relative to observed Ml growth exceeded .75.
These data do not support the proposition that portfolio shifts out of time
deposits, or other assets that are in M2 and M3, into checkable deposits by
either consumers or firms has been a major influence on Ml growth at least
through July. Furthermore, the major influence on the base multiplier coming
from a decline In the currency ratio hardly seems consistent with a sharp
deterioration in confidence in the financial system. Nor do the data seem
consistent with an effect (perhaps lagged) from lower interest rates.
Econometric studies of the interest elasticity of the currency-deposit ratio
consistently suggest that it is quite small in absolute value. Furthermore, most
such studies tend to find a larger (in absolute value) Interest elasticity of the
demand for currency than for checkable deposits, at least in the short run. This
would suggest that a sharp decline in interest rates would be followed by an
increase in the quantity demanded of both currency and checkable deposits, but
that the formejr would increase proportionally more than the latter, so that the
currency-deposit ratio would rise as a result. This is exactly the opposite of
the result that has been observed.
There remains the possibility that the behavior of the base multiplier
during this period has been unique, and hence unpredictable. To address this
question, we turn to an examination of our past ex-ante forecasts of the base
multiplier.
A Review of Recent Ex-Ante Base Multiplier Forecasts
The ex-ante Ml-Adjusted Monetary Base Multiplier forecasts that we have
constructed since the last meeting of this Committee are given in Table 3. The
rows of this table indicate the data base on which the forecasts were based, and
38
the columns of the table indicate the months for which the forecasts were
constructed. The actual data as of the August 22, 1985 H.6 Statistical Release
are given in the final row of the table.. The numbers in parentheses below each
forecast are the percentage forecast errors relative to the actual values at the
bottom of the table.
The first row of Table 3 gives the forecasts that were presented at the last
meeting of this Committee. The forecasts proved highly accurate through May, and
then failed to catch the upward drift of the multiplier that occurred throughout
the summer. Nevertheless, the forecast errors are still well within a 95 percent confidence limit, which becomes quite wide for forecasts on such extended
horizons (see Table 3 of the forecasts prepared for the last Committee meeting
for estimates of the confidence interval of such forecasts).
The forecasts of the component ratios which are used to produce the forecasts
in Table 3 are given in Table 4. These ratios can be used, along with the data
in Table 1, for the actual values of the ratios to allocate the multiplier
forecast error among the component ratios. This allocation is presented in Table
5. Once again, the major actor on the scene is the currency ratio. The second
most important contributor to the forecast errors during this period is the
reserve ratio, with the small time deposit ratio running a poor third. Indeed,
the t. ratio is of little consequence until June and July. Finally, the contribution of the large time deposit ratio, t~8 to the multiplier forecast error is
of little consequence during the entire period.
Our conclusion, therefore, is that not only was the decline of the currency
ratio the major influence on the observed behavior of the multiplier throughout
1985 to date, but it was the forecasting errors for the currency ratio on an
extended time horizon that were primarily responsible for our failure last
February to catch the upward drift of the multiplier that subsequently occurred
in June through July.
39
While our forecasts for four to six months ahead last spring did not catch
the movement of the multiplier correctly, it is inappropriate to conclude from
this that the multiplier, or more precisely the currency ratio, has been
influenced by some special factors. It can be seen from Table 3 that as we
updated our ex-ante forecasts for new information, we tracked the behavior of the
multiplier or short forecasting horizons with a great deal of accuracy. The
root-mean-squared-percentage-errors for the five one-month ahead forecasts in
Table 3 is .22 percent. The corresponding statistic for the four two-month ahead
forecasts 'S .61 percent. These error statistics are quite small compared with
the historical performance of these models, which suggests that none of the
componeat models experienced large shocks during the period. This effectively
rules out the "special circumstances" hypothesis.
While the actual data for the entire month of August are not available at
the time of this writing, a comparison of the available weekly data with our June
and July based forecast for August suggests that the one-month, or even twomonth, ahead forecasts for August should be quite accurate.
The Outlook for the Multiplier Behavior for the Rest of 1985
The forecasts for the Ml-Adjusted Monetary Base Multiplier based on data
through July, for the period August through March, 1986 are given in Table 6.
There a sharp increase from July to August is predicted, which seems likely to be
realized; the multiplier drops in September and October, and then stabilizes
around the present July value toward the end of the year and the beginning of
next year. The percentage changes (at annual rates) from the July base are
given in the second column of Table 6.
The allocation of the year-over-year percentage changes in these forecasts,
on a net-seasonally adjusted basis, is given in Table 7. This again demonstrates
that the major difference in the level of the multiplier during the forecast
40
period, compared with the level at the end of 1984 and the beginning of 1985 is
in large part due to the decline in the currency ratio that has occurred in late
1984 and the first half of 1985. The stabilization of the multiplier toward the
end of the year near its July level is the result of: 1) a sharp deceleration in
the decline of the currency ratio, and 2) a stabilization of the t. ratio. The
t. ratio is predicted to continue to decline through the end of the year on a notseasonally adjusted basis.
41
TABLE 1
DATA FOR NOVEMBER, 1984 - JULY,1985
{Seasonally »djust«d>
Month
©CISC
Ml
11/84
12/84
i/es
2/85
3/85
ml
k
t
t0
g
1.57051
1.57983
1.56167
1.53656
1.54427
.026363
.031678
.046722
-039157
.025401
*
r+1
tc
X & C^ 0 A
«& I
/ ffl c^
218.2
219. 2
221.7
4/85
5/85
6-/85
224.0
7/65
227.8
^gi>C^L^^
^Ht&K f
O
% ^
D C?
553.9
558.5
562.7
569.4
572.1
2.56317
2.56664
2.57883
2.59763
2.58051
.40*415
.40218
.40040
.39777
.39778
574.9
581.6
591.2
2.58266
2.59643
2.59754
595.9
2.61589
. 0 5 I I 9 6 .020584
.051191 .020566
.049234 „©20317
» © 4 7 8 3 i ,,©2017©
.044390 .020705
.,©32299
,,©3276.6
„©332SO
P©33©22
®©33478
.39652 4.54242
.39482 4.50980
.39074 4.46888
1 . 5 4 2 1 8 . 0 3 7 7 6 4 ,,©44139 . , 0 2 0 8 3 9
1.52796 .050593 .044299 „©20669
1.49786 .035154 .042755 -021341
.034014
a©33722
„O346S0
.38978 4.46185
1.46915 .054404 .042393 „©20879
.035650
<Not
4.58766
4.59503
4.61241
4.58885
4.58002
S « a s © n « , l 1y
Adjusted)
3/85
2.58062
.39960 4.66292
1*56939 „©32008 .045011 „©20219
.©31915
4/65
5/85
6/85
2.61840
2.57797
2.60993
.38825 4.47399
.40039 4.57434
.39231 4.47400
IoS1469 *©37©9l „ 0 * 3 3 5 2 . 0 2 0 7 5 6
I o S 3 2 9 9 . 0 5 1 2 7 6 sO*#S97 . © 2 0 4 8 3
1 „ # 9 5 1 3 .,035146 . 0 4 2 7 4 5 . 0 2 0 8 0 6
.032258.
.033088
.©36320
7/85
2.61425
.39197 #.45561
1 . 4 5 6 0 © „<0>5425i . 0 4 2 2 7 3 „€>2088©
.©39545
Sourctfi
F e d e r a l f l e s o r v * B a n k o f St® L © u i * t M o n e t a r y T r « n d s , J u l y , 1.985
Hom.r-4 © f © o v t r n o r s o f t h e F e d e r a l R # » « r v « S y s t e m , S t a t i s t i c a l R e l e a s e
ftygust
22„ 1985
H.6V
TABLE 2
PERCENT CHANGES FROM NOVEMBER, 1984
(Seasonally Adjusted »t Annual Ratos)
B»## Multiplier
Month
Ml
Base
12/84
9*96
8> 2 8
1/65
3/85
9.48
11.04
9-69
5.62'
5.68
7.66
2.40
2.76
2.07
4/85
5/85
4/85 "
8.93
9*76
1 1 . 17
7 . 10
7.18
So © 8
1.99
2® 0 2
2.52
7/85
t O . 97
7.91
^£. © w^sS*
Jjr.ff
<0"-3*
S©urc«s
J
C<o>M»p>ut#d f r*on d a t a
log ^iff#r«nc«So
k
t
^ 1
*™ © ^ > o
in
—.4-0
-.04
„06
& ^3^*Cr
t
*7 n
T»b1«
tc
B&H?
„O0
.24
© J * i£fc
© J , C?
© ^3*%?
.oo
2.10
gg £ S&
o #8
©03
—. 1 6
.00
© 24
— . SO
- „ 14
-.03
-.46
58
" 7 ^
jp+f
z
9
' . 46
""""a
@
1 . 'Percent
^
lM*m
.04
dC 0 X O
© v 6
—a 46
© *L™ w
«- o ©2
-.24
—1.68
.05
-.59
.05
.04
c h ia n g e s e . r e
„08
.09
re* Id
^
^
f^j^
—. 1 8
,o4
© J! Q*
. 10
„02
• 06 —.06
a 10.
EH
• 02 •
©1» ^SSff
.08
M e a s u r e d QD
TABLE 3
EX-ANTE M U L T I P L I E R FORECASTS
<S#a.s@nal l y A d j w » t « d l
2/85
3/85
4/85
5/85
4/65
7/65
©/©5
2.5831
<-.10>
2.5916
<—#34>
2.5883
<.3l >
2*5849
(1.19)
2a 5 9 3 7
<.97>
<•&. o ^p> ^ < < 5 2
2, # >9w<&v
3/65
.flfr @ ^P'GPjfc t j *
(-.24)
4/©5
C.54)
2# 5*931
1 . 13>
5/84
11*15)
iaaS7>_
2#S783
C . 7 4 3*
2-5867
11.13)
2.S934
2„5e77
C.38)
2.5969
€.73)
2„.<§#45
2*6171
<-.05>
2.A253
<fc/©4
2-A305
7/©#
actual
2.580S
2-5827
2-55»6>4
2i5975
2„<§,t5^
TABLE 4
COMPONENT RATIOS FOR 3/65 SHADOW COMMITTEE MULTIPLIER FORECASTS
CN@t S««*on*11y Adju»t«d>
Month
Ml
k
t
t„
1
9
z
r+1
tc
3/85 '
J^. Q
. 39985 4® 67432
1 ."55494
.038961
.047407
„020l49
'.031946
4/85
5/85
6/85
2.6269' . 38964 4.52867
2.5694 .4O505 4.68658
2-5848. •4O140 4*63072
1.49523
1.56309
1.53709
.038167
„©335St
„031902
.-04S365
,047546
.047350
.020270
.020040
.020170
.031730
.032446
*034782
7/85
2.5837
2.5724
4.62842 ' i.54065
'4.68860 1.59042
.033965
.029172
.047186
.046765
.020135
.019849
.036749
.036199
e/es
\ 5 T T » T <§» %|r
.40262
.40>649
TABLE 5
ALLOCATION OF a/es MOI.TIPL.IER FORECAST ERRORS TO COMPONENT RATIOS
CNot Seasonally AdJusto<f| percent>
Month
Ml
k
g"»«fr1
#
z
-.©6
.©2
• OO
—. l O
-.08
.03
.15
.00
—.06
—„©2
..<x>
-.64
-.59
eja ^ 9 Ji
-.06
m vjt
*2
*t C
resid
—.Ol
.#6
4
3/85
4/85
5/85
6/65
7/85
-.03
© <SJBC.
#02
®
Ji 5ta?
.04
CS9
^aa»
«er
.41
.97
.50
l.OO
la 18
J ©H#
.*>#
<P
*ts3*'«raS'
^j 9 o
.OO
• Ol
• Ol
.©4
.#3
* * « «$*£?
.01
• ©4
.#4
•».9?
.©7
.Ol
TABLE 6
Ml - ADJUSTED MONETARY BASE MULTIPLIER FORECASTS
1965-86
(S«*son*1ly Aaju*t*d>
X ch*ng« from July, 1985
Honth
August
S*pt*mt>*r
^ ®@S1/
October
Nov#wb#r
D«c«ab*r
2.6050
<%> @ © J> r m&
© ^ ^fi
vHt n u * r y
F*t>ru4try
M*rch
2o6190
@ *fi^%flii*
7.23
1 o 6*5
^5 ® O v w 4
" I ©67
& ©
.fe ® C^^» ^ if
«s& © ^r X 7 J*
^P%P
© *^T
2 o9966
J^ ©
46
^
gl» t i l
TABLE 7
Mi - ftDJOSTED MONETARY BASE MULTIPLIER FORECASTS
«Hi.1yt 1985 B e t e , Not S**s©n»tiy Ad j u t t e d
Month
65-64
84-85
X enmnge
k
Aug
Sept
2.6100
2.6148
2.5589
Oct
Nov
0#c
-2.4237
2.6241
2.6318
Feb
War
2.6320
2.6005
2.5948
1
ratio
2.17
2© 2.^1
1.45
1.48
2.5589
2.5586
2.5798
2.TO
1.75.
1.54
1.24
2.5801
.79
1.14
tI
ratio
© tap©
„42
.40
.39
.19
.10
X chan§« due t o 'C f t M f C f i n t h e i
t - r a t i * § r a t i o i r e t I0 r * l r a t i ©
2
.#3
-.64
@Aw
.04
-.03
„40
„39
s39
a 24
-.07
p e r c e n t jEhenge
retio
• 06
-.07
„#5
-.10
.06
—.03
.04
.04
,©3
-.04
-.05
-.05
• ©3
„©3
a #2
-.39
—.39
-.39
„#4
0
yeer
tc
.04
.04
UPDATE TO THE SEPTEMBER, 1985 SHADOW OPEN MARKET COMMITTEE lEPORT
THE BEHAVIOR OF THE MONETARY AGGREGATES IN AUGUST, 1985
or
"THE GMNCH THAT STOLE CHRISTMAS"
Robert H. Rasche
Michigan State University
In the report that I prepared for this meeting of the Committee two weeks .
ago, I reviewed in detail the behavior of Ml, the Adjusted Monetary Base, the
base multiplier and its components over the period November, 1984 through July,
1985. The data that became available this week show little if any revision in
the numbers over this period of time, so 1 will not add to the confusion by
redoing that analysis, since the major conclusions reached there still hold.
Instead, I will concentrate on the August numbers.
I am sure that you are all well aware of the "explosion" in Ml that has been
announced for August. Again, the explosion, while dramatic was predictable. In
Table 3 of the report prepared two weeks ago, you will find that I predicted that
the Ml — Adjusted Monetary Base multiplier would rise to a value of 2.6305 in
August, from a value of 2.6159 then reported for July (on a seasonally adjusted
basis). The currently available numbers for July and August are 2.6132 and
2.6428, respectively. This gives a one month ahead forecast error in August of
.47 percent, which is well within one standard forecast error for one month ahead
forecasts. This leaves the question, if the jump was so predictable, just what
is going on?
The August behavior seems to be considerably different from what was observed
earlier this year. One way of looking at what happened is to express the
percentage change in Ml (seasonally adjusted) as the sum of the percentage
change in Ml (not seasonally adjusted) plus the percentage change in the implicit
49
Ml seasonal factor from July to August (measuring percentage changes as first
differences in the logs). The percentage change in Ml (not seasonally adjusted)
can be further decomposed into the percentage change in the adjusted monetary
base (not seasonally adjusted) plus the percentage change in the base multiplier
(not seasonally adjusted). The result is quite remarkable:
%change Ml (SA)
-
20.36% (annual rates)
%change Base (NSA)
•
1.35%
%change multiplier (NSA)
«
3.65%
%change implicit seasonal
«
15.36%
The effect of the seasonal adjustment is truly amazing. While Ml (NSA)
increased by 2.5 billion from July to August, Ml (SA) increased by 10.2 billion.
To try to trace this down, I went back to the seasonal factors published in the
February 14, 1985 H.6 Statistical Release. There we find that the seasonal
factor for transactions deposits dropped by .0159 from July to August. In
comparison, the seasonal factor for transactions deposits will increase .0214 from
November to December. In effect the current seasonal adjustments for transactions deposits are coming close to indicating an "anti-Christmas" effect
between July and August. The same effect is present in the 1984 seasonal factors
for transactions deposits, but I have not had the opportunity to trace back in
the data to find out when it originated.
This effect seems to be unique to the seasonal for transaction deposits. It
is interesting to perform the same decomposition as above on the M2 and M3
monetary aggregates for the change from July to August:
i «
1
%change Mi (SA)
2
3
20.36
11.18
8.60
%change Base (NSA)
1.35
1.35
1.35
%change multiplier (NSA)
3.65
3.69
4.41
15.36
6.14
2.84
%change implicit seasonal factor
50
The percent change in the base is the same for all three money stock
concepts by construction. Note, however, that the percent change in the
multiplier for each of the three money.stock concepts was almost identical for
the July-August period, and thus the differential growth rates in the past month
can be accounted for almost exclusively by differential behavior of the implicit
seasonal factors. Apparently, we are in some danger of being confused in the
very short run by the ghost of some X-ll process. In spite of all this, 1 have
gone ahead and updated Tables 6 and 7 of my previous report to reflect the data
that are now available for August in the forecasts of the multiplier for the rest
of the year. These updates are attached in Tables 6(r) and 7(r).
51
TABLE 6<r)
Ml - ADJUSTED MONETARY BASE MULTIPLIER FORECASTS
1995-&6
($*>%• on%1 \y Aojyst«<ai
% changt from
July* 1985
(*nnu*l p«.t*s)
Month
I
August
S#pt#afi»«r
Octootr
Nov#iiso«r
£idc#f!t»«r
January
F*oruary
mar en
2s 6428
2*6403
J,tei»©W i
6a 11?
^B 0 0«*» X w
Ja © ^l»%9*
2 m 6431
2 a 6334
3* 4 1
1 o 84
2.6345
kfa 6-^34
^ t Q %Ef &
^
^X
)J)
^
@
£1
^BP^J^,
%Er<$&
""* o 1 V
I
Actual
X eh»ng# from
August, 1985
i»nny»l r*tt#)
52
^£ 0 ^ %gp
^4^• 8 3
i, 0 9
106
A i
mm £
-,•
71
3 igPw
TABLE 7 < r >
Mi - ADJUSTED MONETARY BASE MULTIPLIER FORECASTS
August,
85-66
64-85
1985 Base, Wot S e a s o n a l l y A d j u s t e d
X charter
k ra'
t
ratio
Z ch»nes« du« t o ch*r»|i#s in
t^ ratio § ratio z ratio
2.5589
2.58
2.89
1.79
1.90
2.4405
2.6394
2.6468
2.5589
2.5586
2.5798
3.14
3.11
2.56
'1.96
2.6478
2.6147
2.6095
2 © 5 9 1 <J
m& 0 M> \=f
«l O \ t ? 0
2.5801
2.5802
1.33
1.14
• 46
#37
»t © m ^in?
S. a
".36
® ^^fe?
2.4205
2..63S8
d&L o ^j Ji&r
a
F«ar ©v#r y#«r p#rc#nt cftano*
"> I T
tit o S J <S
^H'
&
.© ^ar to?
© HS- y
.35
.64
„68
.-•66
@a ^^y JL
« w«&
-.02
-.01
*©3
.04
-.06
-.01
.04
„04
»03
& H»f <£»
a49
o SoP<sS
-.04
-.04
.03
© HSJT W
Q
%r^s
COMMENTARY ON PROSPECTS FOM MONEY AND THE ECONOMY
H. Erich HEINEMANN
Ladenburg, Thalmann & Co., Inc.
HIGHLIGHTS
Aninal spirits in the bond marital are
misplaced. The Fed will have to tighten
and interest r a t e s will go u p . The economy
is stronger than appears on the surface.
The main industrial nations a r e islands of
price stability in a world where inflation
is still rising close to 16 percent.
A key report on the thrift industry shows
that about 45 percent of insured S&Ls are
"insolvent or nearly-insolvent."
FOOL'S PARADISE
The bond market was in a happy mood last week. A big surge in the
money supply, a sharp drop in the dollar, clear evidence - if you choa© to
look beneath the surface of the "flash" estimate of third quarter GNP that the business expansion is alive and well: none of these could calm
the animal spirits.
Traders seemed relieved that the increase in money was "only" $3.7biliion, and they interpreted the flash estimate of a 2.8 percent gain in
GNP as an indication that the Fed will have ample excuse to continue to
push for easy money.
But serious questions lurk behind the festivities.
How long can the Federal Reserve hold down interest rates by pumping
Money into the economy? Not long. Despite a 17 percent rat© of
jfrowth in the money since last Juno, s h o r t - t e r n interest rates are
slightly higher today than they were then. This suggests that the
demand for credit is building up rapidly. The economy is stronger,
not weaker, than appears on the surface*
55
Eventually^ when the Pad r e v e r s e s cowri© and tightens up (which,
inevitably s it will), how will markets react? Aa w© said two weeks
ago, the longer t h e Fed lets the money supply r u n out of control, t h e
higher the risk of resurgent inflation and recession (see Prospects
for Money and the Economy, September 9, 1985)* i n our view, the
coming rebound in the economy will not be sustainable, and both
equity and debt markets may decline as business revives*
By trying to minimize changes in interest rates today, will the Fed
maximize interest r a t e changes in the future? Clearly, our answer is
"y®s.68 Eapid money growth over the past year has already locked in a
significant increase in the level of the yield curve (200 to 400
basis points) and a Material flattening in its ifaap© (short rates
should go u p • o r e than long)* The MOF© the Fed procrastinates, the
bigger the ultimate inci
If interest r a t e s do ahoot skyward in 1986 or 1887, what will happen
to the h u n d r e d s if not thousands of financial institutions (Mostly
savings and loans) that already a r e on the brink of failure?
Whatever else, it won*t be good. We'E hsv© « o r e to say on this
topic later in this issue*
WAS iSYMBS CORRECT?
There is always a possibility that the
that monetary policy has suddenly becone
inflationary implications in record r a t e s of
and that the money managers can continue
•arket® with impunity*
neo-Hsynwiuta are correct:
irrelevant! that there are no
expansion in the money stock,
to p u n p funds into the credit
WIIKLY MOtiBTABV DATA
(Billions of do • lars i ©scept is B©t@d)
Lataet
T©t®l cQm&Qrciml
Incite,
p@p@r ®ut®t&®di®gj
all largo bank!
16.03
11.1*
9/ 9/85
24.8
11.S
-6.B
9.2
2.6
19.9
6.4
1.0
0.0
-11.6
31.3
-1.6
1.0
17.4
12.8
9/
9/
9/
9/
9/
-298
246
18.t
HA
18.0
HA
14.3
NA
9/11/S5
9/11/iS
230.4
207.4
§4.7
-1.9
-2.2
-0.2
7.0
0.0
1.4
a.3
7.B
9.3
7.6
a.a
8.0
i/18/85
9/18/86
9/11/86
262.0
-1.0
24.7
16.2
17.8
9/11/86
264.2
1.4
-S.4
-0.6
3.0
13.7*
MA = Not applicable
Mot@®i
Boded
1.8
0.3
-S.S
-O.i
1.0
FIB reaoiryo aggregates
(alllieae ef dollars)
M©afeerr@Mad r#s@r^®s
42600
§©rr®!$£tg0i @3t. @gt©0£l©d credit (NiA)
723
CM
— D c t o o of Chaaj® 0 » @ r —
3 Mo®tfc© 1 Months 12 Months
»3.7
$613.4
Manny supply (M-l)
Weakly soBpoaesits of M-2:
Monay aerk®t deposit accounts (MSA) 321.3
124.6
S^sll ssviags deposit®
382.7
SaalJL tine deposits
176.0
MoDoy sorbet foods (MSA)
66.9
Other eoaposaote (MSA)
St. Louis reserve •(gr@(at@@
Adjuatsd donatory baa®
Adjusted Fad credit
Ch&Df® froa
Prevloua Hooh
D©£®, oitcept ®@ soted, are ®®®se®gll^ idjustad.
S@t®a of cgi®ag® ®r@ compound @®®u§l r^t#® @®®®d ®@ f@nr~^#®k m®%i©( M©r^g0s.
56
9/
9/85
9/85
9/85
9/B5
9/86
4/88
-3Fitfure 1
THE WORLD IS STILL AN INFLATIONARY PLACE
18%
F
§
16%1
Xv
§
A
R
T
1
R
C
H
N
G
S
12% i
Worldwide Index of
Money Supply (Lagged
Eight Quarters, Dot)
Worldwide Index
of Consumer Prices
(Line)
9%J
6%1
3%
1962
1965
1968
1971
Sources: International Monetary Fund;
1974
1977
1980
1983
Economic Research
Plainly* however* this is not our view* Of course, the linkages
between changes in the money supply, the level of economic activity and
ultimately the rate of inflation are v e r y loose over short time spans.
But over longer periods - say* three to five years - the relationship has
proven to be both stable and powerful.
WHAT THEY DESERVE
Sooner or later a sustained acceleration in growth in the money
supply will breed* firsts a sustained increase in total spending and*
second* a faster rate of climb in the general price level. Despite
fundamental changes in the financial system in recent years* this is one
of the mop© durable rules in economics. Portfolio naana^ers who ignore
this fact will get the investment results they deserve.
The International Monetary Fund's indexes of world money supply and
world inflation make plain that only a relative handful of major
industrial nations have monetary growth and inflation truly under control
at present. The rest of the world is still a very inflationary place. On
a worldwide basis consumer prices rose 13.9 percent last year* just about
the same as the average 13.5 percent rate of increase from 1981 through
1983 in the worldwide money supply (Figure 1). The weakness in dollar
prices of basic raw materials is a function of the overvalued dollar - not
of some mythical "deflation." If inflation is an excess of monetary
demand* then deflation is a deficiency of monetary demand. That s s hard
for ua to find in a world of double-digit increases in the money supply.
57
THE PRESIDENT'S DILEMMA
Meanwhile* the White House is face to face with a serious dilemma in
economic policy. The dilemma is hardly recognised as such by th© Potomac
pundits who set th© ton© of the national political debate. Nonetheless,
it is real and now, and its resolution - which is far from certain at
present - should largely determine th© course of th© economy and whether
the Republican Party will retain control of the Senate in 1986 and the
White l o u s e in 1988.
There are five principal elements to the problem. Individually, each
has been widely discussed* but only rarely a r e they linked together as
representing a critical threat to continued expansion in the American* and
hence also the global, economy.
Firsts as noted, Fed policy is far too expansionary and eventually
will have to tighten. Mr. Vokker will either r©v«r«e hie course or
risk losing his credibility as the leader of the hard money bloc in
Washington. Assuming he remains in office (that f 8 far from certain),
he wants to be remembered as an inflation fighter. On Mr. Volcker ? a
go-stop-go record, a «wing back to tight Honey is probable.
Seconds is Mr. Eeagan f 8 ever-changing program of tax "reform," which
seems to be based on the curious principle that close to $ ISO-billion
of tax cuts fenornously popular) can be precisely balanced by
$150-billion of tax increases (not popular at all). The obvious
danger is that the President could end up with much more in the way
of tax cuts than increases. Ware the plan to be passed as proposed,
the burden of taxation would shift from individuals to the largely
WBBELY ECONOMIC DATA
Latest
Meek
WtKKLY PiODUCTION INDEX
OUTPUT, Production:
Autos (units)
Truck© (units)
Paper (thousands of tons)
Psperfeoard (thousands of tons)
1
Flaw Steel (thsds of abort tons)
1
Bitua. Cool (thsds of short tons)
1
Crude oil (thousand® of bbls)
1
Electricity (ailliooo of ktsh)
j TlABSPOttTATIOM
1
Clooo 1 railroad fraight traffic
1
(billions of fcon-nileo)
183.4
-0.1
13S981
64548
646
§53.4
1651
16720
11460
48.37
-8169
-14300
-11
-9.2
-14
-313
283
IS.2
1 PRICES
I
M l conooditioo spot indoafS3S7 = 100) 228.8
§
Foodstuffs spot lode.'t
217.1
j
Saw industrials spot index
237.1
J
Ptweatic opot nkt crude oil price
28.00
1
Trade-weighted volue of the US
I
dollar (March 1973=100)
142.12
1
Coaaon stock prices SfcP 800
183.39
CNP10YNBMT
Initial unemployment claiaa (thsds)
C\aiaant level (thousands)
Kotea:
Change froa
Previous Beak
382
246S
—Rates of Change Over—
3 Months 6 Months 12 Month*
6.2*
3.0*
4.®%
9/ 7/85
-o.to
12.9
88.1
-2.6
17.0
-12.2
-22.8
-10.8
-7.4
-13.2
49.2
-0.4
8.1
3.8
-2.8
-3.2
8.4
5.6
10.3
-0.1
-3.1
7.3
-0.3
-3.7
3.4
9/ 7/85
9/ 7/85
9/ 7/85
9/ 7/85
9/14/85
9/ 7/85
9/14/85
9/14/85
-1.4
-20.6
-9.0
-7.7
9/ 7/85
-1.6
-1.8
-1.6
0.23
-21.9
-35.2
-11.1
7.5
-15.3
-23.3
-9.3
-2.0
-15.5
-18.3
-13.4
-4.7
9/17/86
t/17/85
9/17/85
9/13/85
-0.77
-0.3
-20.5
-6.7
-24.6
7.1
-2.1
11.6
9/18/85
0/19/85
-6
-78
-12.8
-7.8
-9.7
-10.9 ,
2.7
8.6
9/ 7/85
8/31/85
Dats, except for prices, are seasonally adjusted.
Bates of change are compound sn®usl rstes based ®n four-*@@k moving ®v#r®g@®.
58
^eek
Inded
-6invisible corporate tax. Ironically, this should make the task of
reducing the stee of the Federal government still more difficult.
Taxpayers are hardly likely to vote to restrict Federal services if
they believe that government can be purchased at a discount through
deficit spending or higher corporate taxes.
Third, is the international debt crisis, which is far closer to a
flash point than popular accounts would suggest. In recent weeks,
first Peru and then South Africa have apparently been successful in
thumbing their noses at the international banking community. Obviousl y , the "solution" to the debt crista (if there is one) will require
many facets. The debtor nations Bust control inflation, stabilise
their exchange rates* expand their economies, and the flight of
capital and promote domestic investment. Where appropriate, they
should consider exchanging a portion of their foreign debts for
equity participations in their state-owned enterprises. In the North
- in addition to Maintaining stable, non-inflationary growth so that
the LDC*s have open markets in which to sell their products Governments must also be willing to extend additional net credit.
THE PROTECTIONIST VIRUS
Fourth 9 is the spreading virus of protectionism. This has been
spawned by distortions that have resulted from the absence of a
coherent fiscal policy in Washington. The distress amonf American
manufacturers is real enough, but there are hujfe risks if the United
States closes its b o r d e r s to foreign goods. That could easily s t a r t
a trade war, which in t u r n would lead to a s h a r p contraction in the
volume of world t r a d e , not to mention a near-term resurgence of
domestic inflation. Even with relatively open markets today, unit
labor costs are already starting to move toward higher levels. There
are no simple answers, but renewed growth in domestic manufacturing
employment would be the best antidote, bar none, to the poison of
protectionism.
Fifth, is t h e ' precarious condition of financial institutions in the
U.S. According to a detailed report on the financial condition of
the thrift industry by a team of economists at the Federal Home Loan
Bank Board headed by James R. Barth, under generally accepted
accounting principles, 129Q institutions representing 45 percent of
the i n d u s t r y ' s assets were "insolvent" or "nearly insolvent" in
1984. Even under the more lenient "regulatory accounting
principles," 877 thrifts were insolvent or nearly insolvent. These
institutions have assets of more than $300-billion, or 31 percent of
all associations insured by the Federal Savings and Loan Insurance
Corp. At the same time* record numbers of thrifts have failed.
Michael Patriarca, Deputy Comptroller of the Currency, told a House
Banking subcommittee the other day that the "increasing number of problem
banks and bank failures...does not reflect a widespread deterioration of
the banking system. Rather, it reflects sharp declines in certain sectors
of the economy that are, in turn, adversely affecting a small percentage
of banks."
Whether or not Mr. Patriarca*s conclusions, and the relatively rosy
statistics that he presented to back them up, are correct is beside the
59
—€—
point* To quote E. Gerald Corr%an s president of the Federal Reserve Bank
of New York, "Public confidence in banking and financial institutions is
perhaps not as high as it should be as the cumulative effects of problems
in financial institutions have token a tolL"
The Barth Report concluded that the torge number of thrift failures
in 1982 (252 all told) was caused primarily by Maturity n i s n a t c h between
assets and liabilities. Institutions were holding relatively large
amounts of lontf-term mortgages yielding r a t e s of r e t u r n that ware fixed at
r a t e s below the rates paid on deposits. "Beginning in 1983, however,
thrift institutions became increasingly hampered by poor-quality assets.
The FSLIC considers two-thirds of its c u r r e n t c s s s s to b© primarily
asset-quality problems," th© r e p o r t said*
ONLY THE CONSPICUOUS OUTLIERS
The fact that the assets land hence also the deposit liabilities) of
insolvent or nearly-insolvent thrifts vastly exceed the PSLIC'a reserves
of $5o9-billion, the authors concluded, means that "only a few of the more
conspicuous outliers anong insolvent institutions could be closed by the
Bank Board due to t h e limited resources of the PSLIC."1
The common denominator underlying each of these "five uneasy pieces18
is th© Administration's — and th© country s s — need to maintain stable, n o n inflationary growth. Whatever else, renewed inflation and recession would
make Mr. Beagan's present problems pale by comparison. It ie true that
inflation seems far away.
Wholesale prices declined slightly in August and the rate of increase
in the GNP deflator this summer continued to be moderate. But keep in
mind that if the Federal Reserve were to maintain a 20 percent jjrowth r a t e
in the money supply, it would only be a n a t t e r of time until the rate of
increase in prices turned sharply higher.
At the sain© time, by pumping money into the banking system, the
Federal Reserve is also helping to alleviate th© thrift crisis for the
immediate future. But easy money can, and will, backfire if it is pressed
too long. No one knows when easy money will ignite rising inflationary
expectations. But that point snay not be far away. In a world of
financial fragility, it is a risk that the Fed dare not take. A small
rise in pates today may well avoid a big rise in rates - and severe
problems — later on.
There are no easy answers to the President's policy dilemma. One
thing1 is clear, however. An inflationary aonetary policy at the Federal
Reserve is not one of them.
60
f^l© 1
Of MWhQf-MH W f f l i l S
($ §4114@M)
iff?
1978
1979
IM0
MU
19M
MB
MM
IC3 r
118S r
fatal Debt
Pet Ckanaa
332.5
3M.4
10.02
"378.0
tt.1T
C3L0
£3.02
C3.6
10.E3
M7.0
13.M
MO.I
0.C3
BST.8
4.M
C3.3
4.OT
CSS.4
3.S3
Start-tan
rat Oiaai®
(3.X
71.8
U.TT
U.I
13.73
US.)
MM
8E3.3
C3.3J
1M.8
M.il
Wf.J
=11.2-0
MB. 9
O.0J
Mt.B
«I8.M
107.3
f.M
MB. 3
3M.S
31.14
£C3.Q
M.M
4BI.T
M.M
8M.4
£0.0
ttt.4
H.9V
M3.B
tt.Sl
W.t
7.10
TB8.4
8*44
1M.1
l.TT
G2.0
03.G
1S.8
Vt»4
50=3
8tȤ
M.f
W.f
C3.Q
URVICIM
M9.T
37S.0
M.M
M.7I
SE3.6
S.X
4§J.«
It.H
CE3.2
S3.£3
OTT.S
4.7B.
483. S
3.S3
103.2
t.03
1.33
ret
talis
Pet
tag-ten
KVIWIW ODUWSSIS wits
Total B*bt
Pet Ctamj®
gi.O
•cm m
UB.t
28.3
M.S
32.76
46.6
11.22
67.9
41.80
M.l
S3.E3
W<3
13.83
M.B
-tO.jl
§8.8
-13.88
43.0
-34.38
44.2
2.78
19i.8
190.8
22.SS
2M.4
M.M
MB.6
17.09
31B.3
M3.Q
M1.0
19.M
402.1
U.M
427. t
(.37
460.2
7.10
486.7
1.20
14.2
83.1
S3.4
78.1
TO.2
TO. I
M.I
H.7
91.§
81.3
BEVILQnNG CMWflHS WITHOUT •CTOT MtT SHVI61M
Total cast
147.3
M8.7
MB.8
Pet Cfcanf®
14,83
M.§8
228.8
M.T0
MT.2
12.GO
M0.8
113.£3
312.0
7.M
134.3
8.84
£32.1
0.32
3K.S
t.74
Short-lara
Pet Chug®
33.9
33.0
-2.GS
36.2
8.70
46.4
21.41
02.1
14.78
5 0 . <S
14.01
81.8
3.84
£9.0
-1.14
61.9
I.II
63.1
1.94
Lcna-Toro
113.4
135.7
159.6
183.1
206.1
231.4
251.4
273.5
300.2
323.4
IS.66
17.61
14.72
12.02
12.82
8.84
0.7S
9.76
7.73
£0.4
81.3
M.l
79.7
78.8
M.3
Ql.O
02.S
83.7
S3.4
13.90
122.8
20.03
103.4
122.1
13.11
174.8
24.02
1M.B
-7.M
134.«
(.46
SCO. 6
7.84
&o • fee!
107.S
18. K
140.4
14.61
112.7
|,M
146.0
10.12
214.0
13.33
C3.2
=3. £9
156.2
8.64
214.8
0.37
94.7
-3.86
S3.4
9.M
68. S
13.08
46.1
J5.33
110.7
11.37
£3.1
1=3.20
62.6
14. Ml
120.3
0.07
78.0
10.13
M.l
G.C5
132.0
9.73
82.6
10.13
03.9
4.M
147.2
11.32
SO. 2
9.20
62.6
0.02
158.4
7.61
£3.6
9.31
66.4
6.73
Pet Ckaaf*
__...
Pet Chang®
Pet Loaf-tan
Pet Ctong®
Pet ioaj-toro
77.0
HEW
O f f i c i a l with
C r e drecent
i t o r * problems,
51.0l o a f - t60.6
Countries
a n M>t 69.6
amd to: 62.0
- 18.12
Pet Cha
64.8
Financial I n s t i t u t i o n ®
» 46.7 \
38.76
Pet cba
0th@r P r i v a t e Cr®dltor@
M.2
65.4
12.37
Pet Ch« »
14.86
C3.2
31.46
„ 74.6
14.07
17.62
101.3
18.90
C3.3
14.34
Countries without recent problaaai l o a f - t a n <W>t matf
O f f i c i a l Crwiitora
70.2
79.4
sa.a
19.39
13.11 >
Pet ChB
46.0
Financial I n s t i t u t i o n s
34.8
26.2
29.31
32.82
Pet Ch|
30.7
36.2
Otter Prsuoto Crediloro
28.4
14. £5
8.10
Pet Chg
to;
£0.4
13.66
62.7
17.11
40.0
13.64
fs
61
iM.a
0.28
t
fable 2
8MT 8BRWCI § » W OF iBVBUmM OOUNTtttS
TOTAL BEST TO Of:
All developing c o u n t r i e s
Countries with n c e n t
debt s e n r i e c probic~o
Countries without r e c e n t
debt s e r v i c e p r o b l ^ n
TOTAL BEST TO EIP0RTS:
All developing c o u n t r i e s
Countries w i t h r e c e n t
debt s e r v i c e preSsleas
Seuatraeo t i i h o n t r e c e n t
<3sS»t s e r v i c e p r o f e l ^ s
DEBT SEWiCB:
M l developing eo«mtrie»
Value (S B i l l . )
ON
1977
1978
1979
1980
1981
1S82
SC33
19§4
1985 r
1986 P
24.9
25.6
25.4
25.7
28.8
32.9
E3.S
36.3
36.7
32.5
27.6'
29.9
29.6
30.8
35.1
41.2
47.0
46.1
44.8
37.5
^21 3
21.4
4»& •> i
20.7
»<&•«?
«&3 O &
26.1
&f
(V
29.3
27.6
126.7
132.4
119.4
110.4
JLgM$B «|}
14S.0
157.9
1^1 *t
141.5
141.5
171.7
195.8
178.1
167.1
1M.8
246.0
saa.a
256.S
245.8
J^S\j
£3.3
91.9
01 i 6
73.6
TS.3
91.1
ST.©
94.2
£3.8
39.8
56.4
Z1.6
34.8
18.8
7.2
11.6
74.7
111.9
63.8
48.1
20.9
11.9
9.0
12*. 0
72.3
61.7
24.5
M.3
10.2
JLJU-s J.
&<§»<# • A
67.4
43.1
71.0
42.5
19.0
S.2
10.8
0.5
45.7
42.8
17.3
t.9
t.4
n.i
13.8
•8.7
* 22.5
13.0
8.5
27.i
M.3
12.7
33.8
19.7
14.1
41.6
25.3
IS. 2
24.3
11.9
56.6
23.7
12.9
m.i
J. J o &
12.7
7.0
8.7
14.6
7.9
6.7
14.5
7.6
7.0
14.9
7.2
14.9
7.2
Interest
24.2
15.0
5.8
9.2
aaortisation*
• a t i o &• fepwt*
Interest
taort i z a t i e o *
mm
e%
feisntraco with recent
debt s e r v i c e p r e b l ^ w
Rati® ft© Exports
Interest
Aaor t i z a t i s o t
8.3
M.O
18.5
30.2
12.8
11.4
CottntriM without Fceeaft
d e b t s e r w i e * pFeble23
R a t i o t o Export*
Interest
A»ert i z a t ion*
10.0
4.1
5.9
11.8
4.7
7.1
11.7
8.2
6.5
29.6
Hal
.
S.S
5.6
F= f o r e c a s t
Hit.
Ssisrceo:
Paysents f o r 1985 and 2£3S Mljusted for expected rescheduling*.
ic
I n t e r n a t i o n al l Monetary Fwid; 1
mm m
mama m
134.5 .
74.0
SQ.S
23.1
12.7
10.4
1 3 a *&
• IS
93.6
139.8
72.5
67.0
11.4
10.6
36.8
20.3
16.5
14.1
6.7
7.4
@FedFRASER