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February 1983
Vol. 65, No. 2
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5 Monetary Policy and the Price Rule:
The Newest Odd Couple
14 Outlook for Agriculture in 1983
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Federal Reserve Bank of St. Louis
Review
February 1983
In This Issue . . .
The first article in this Review, by R. W. Hafer, investigates the potential of
using some kind of “price rule” to implement short-run monetary policy. In
“Monetary Policy and the Price Rule: The Newest Odd Couple,” Hafer notes that
there is growing support for the adoption of a policy price rule, under which the
monetary authority would vary the short-run growth in money in an attempt to
stabilize some specific price index.
When Hafer investigates the potential usefulness of a price rule for monetary
policy purposes, he finds two results that weaken considerably the intuitive appeal
of the price rule concept. First, the various price indexes he investigates do not
necessarily move together over short-run periods. For example, from 1/1960 to
IV/1964, quarter-to-quarter movements in the GNP deflator, Consumer Price
Index, Producer Price Index and the Raw Industrial Commodities Price Index
were uncorrelated with each other; in other words, there was essentially no
common movement in these indexes. Moreover, even during periods when there
was significant correlation between short-run movements in some of these in
dexes, there was considerable fluctuation in the strength of the relationship over
time. These results indicate that the problem of choosing the appropriate price
index for policy actions is not easily solved.
More important, Hafer also found that the presumed link between short-run
money growth and movements in these price indexes is nonexistent. When the
period from 1/1960 to III/1982 is divided into four, roughly equal subperiods, the
correlation between quarter-to-quarter changes in the four price indexes studied
and the previous quarter’s money growth was zero in virtually all cases.
When Hafer investigated the longer-run relationship between money growth
and movements in the various price indexes, he found that money growth is
correlated positively and significantly with inflation, however measured. Thus, his
results indicate that, while attempts to achieve short-run price stability via a price
rule for money growth would be unsuccessful, price stability in the long run can be
achieved through appropriate monetary policy actions.
In the second article in this Review, “Outlook for Agriculture in 1983, ” Michael
T. Relongia summarizes the USDA’s estimates for agricultural production and
prices for 1983 and analyzes the major agricultural problem area — low grain
prices and large grain surpluses.
The USDA’s forecasts indicate that farm incomes will remain at low levels in
1983 for the fourth consecutive year. The primary reason for the relatively poor
farm income levels is the grain surplus problem that continues to depress grain
prices and farm income.
In analyzing the sources of the continuing grain problem, Belongia finds that it
has been produced chiefly by conflicting incentives in U. S. agricultural programs.
In most cases, the intent of the programs has been to raise the relatively low levels
of farm prices and income by decreasing production and surpluses. On average,
3
In This Issue . . .
4
however, the net impact of commodity programs has been characterized by
increased production and surpluses, and still lower prices and income.
Belongia examines the recent attempts to solve the grain problem, for example,
the Farmer-Owned Reserve (FOR) and the Payment-in-Kind program (PIK), and
concludes that neither is likely to be successful. FO R ’s effects on grain price
stability have actually been contrary to its stated objectives; PIK’s success in
raising grain prices even marginally above their support levels requires farmer
participation rates that seem overly optimistic.
Monetary Policy and the Price Rule
The Newest Odd Couple
R. W . H A F E R
^ ^ O N E T A R Y policy is not form ulated in a
vacuum; it always follows som e guideline. Over the
years, monetary policy guidelines have taken many
forms: controlling the quantity of money as a set ratio to
the stock of gold, pegging a specific interest rate and,
currently, targeting directly on the growth of one or
more monetary aggregates.
During the past few years, detractors of the mone
tary targeting approach have called for alternative con
trol procedures. Some have argued for the use of
broader measures of money and credit.1 Others have
urged that “real” interest rate targets be used in formu
lating monetary policy.2 Still others have called for the
re-introduction of a gold-standard type of policy.3
Another recommendation gaining popularity is for
monetary policymakers to vary the stock of money to
offset short-run changes in some measure of prices.
Advocates of such a short-run “price rule” maintain
that the procedure ensures a better control over infla
tion and concomitantly decreases the public’s uncer
tainty about the future direction of monetary policy.4
'S ee the recent arguments of Benjamin Friedman, “
Time to Reex
amine the Monetary Targets Framework, ” New England Economic
Review (March/April 1982), pp. 15-23, and Benjamin Friedman,
“A Two-Target Strategy for Monetary Policy,” Wall Street Journal,
January 27, 1983.
2For a discussion of this issue, see G. J. Santoni and Courtenay C.
Stone, “The Fed and the Real Rate of Interest,” this Review
(Decem ber 1982), pp. 8-18.
3For a look at the arguments, see R eport to the Congress o f the
Commission on the Role o f G old in the Domestic and International
Monetary Systems (U .S. Government Printing Office, March
1982). For a useful retrospect of the commission and its report, see
Anna J. Schwartz, “Reflections on the Gold Commission Report,"
Journal o f Money, Credit and Banking (November 1982, pt. 1), pp.
538-51.
4Recent arguments favoring this form of price rule are found in
Robert Genetski, “The Benefits of a Price Rule,” Wall Street
Journal, D ecem ber 10, 1982; “Unraveling?” W all Street Journal,
January 21, 1983; Robert Mundell, “The D ebt Crisis: Causes and
Solutions,” Wall Street Jou rn al, January 31, 1983; and Alan
Reynolds, “The Trouble with Monetarism,” Policy Review (Sum
mer 1982), pp. 19-42.
Although the alleged benefits of this proposal have
been discussed in the popular press, its disadvantages
have not been examined in any great detail. The pur
pose of this article is to examine the current feasibility
of a short-run price rule for monetary policy.
WHAT IS A PR IC E R U LE?
In essence, a price rule requires that the monetary
authority attempt to maintain a chosen price index at a
particular level by varying the stock of money. In other
words, the sole function of policy is to prevent the price
index from deviating substantially from a predeter
mined level. This is equivalent to keeping the relevant
inflation rate at zero.
The theoretical attraction of this approach is that, if
successful, it would maintain the purchasing power of
the dollar. Consider, for example, the decade of the
1970s in which prices rose considerably. If we compare
the purchasing power of today’s dollar with the 1972
dollar, today’s dollar buys less than half of the goods
and services that one dollar bought at 1972 prices. For
instance, the GNP deflator — a broad measure of
prices — stood at 208.51 in III/1982, compared with its
level of 100 in 1972 (the base year). This means that a
dollar today buys only 48 cents worth (100 -f- 208.51) of
goods and services compared to what it bought in 1972.
The desirability of knowing the dollar’s future pur
chasing power is obvious. This knowledge would sim
plify activities such as planning an investment strategy
or contracting. Stable prices also would result in lower
market rates of interest; the cost of borrowing against
future income is reduced when there is less uncertain
ty about future prices.
There are two approaches to maintaining the level of
prices. The major difference between the two is the
time frame used to implement policy. One approach
emphasizes the importance of controlling and reducing
the trend or long-run money growth in order to reduce
the trend or long-run rate of inflation to zero. This
5
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
Table 1
Selected Price Indexes and Their Major Components1
GNP
CPI
Personal Consumption Expenditures
Durable
Nondurable
Services
Fixed Investment
Nonresidential
Structures
Producers Durable Equipment
Residential
Nonfarm Structures
Farm Structures
Producers Durable Equipment
Exports
Imports
Government Purchases of Goods and
Services
Federal
National Defense
Nondefense
State and Local
Food and Beverages
Food
Food at Home
Food Away from Home
Alcoholic Beverages
Housing
Shelter
Fuel and Other Utilities
Household Furnishings
and Operations
Apparel and Upkeep
Transportation
Private
Public
Medical Care
Medical Care Commodities
Medical Care Services
Entertainment
Entertainment Commodities
Entertainment Services
Tobacco Products
Personal Care
Personal Care and Educational
Expenses
PPI
Farm Products and Processed
Foods and Feeds
Textile Products and Apparel
Hides, Skins, Leathers and
Related Products
Fuels and Related Products
and Power
Chemicals and Allied Products
Rubber and Plastic Products
Pulp, Paper and Allied Products
Metals and Metal Products
Machinery and Equipment
Furniture and Household
Durables
Nonmetallic Mineral Products
Transportation Equipment
Miscellaneous Equipment
RICP
Copper Scrap
Lead Scrap
Steel Scrap
Tin
Zinc
Burlap
Cotton
Print Cloth
Wool Taps
Cow Hides
Rosin, Window
Glass
Rubber
Tallow
1GNP represents the GNP deflator; CPI is the Consumer Price Index; PPI is the Producer Price Index, and RICP is the Raw Industrial
Commodity Price Index.
approach — essentially that advocated by monetarists
— is presumed to underlie current monetary policy
actions.
The other approach emphasizes varying the stock of
money to offset short-term price changes (e.g., less
than a year). The problems inherent in this latter
approach are the focus of this article.
T H E PRO BLEM O F CHOOSING AN
IN D EX
Before one can establish a price rule for monetary
policy, one must determine which price index to use as
a guide. This selection can be quite difficult because it
involves answering the following questions: How
broad should the index be? Should it include only final
goods? Interm ediate goods? Raw materials? How
closely should changes in the index parallel changes in
the money stock? Over what time period should the
comparisons be made?
There Are a Wide Variety o f Indexes. . .
Numerous price indexes currently are calculated for
6
the U.S. economy. They range from the broadly inclu
sive and widely used GNP deflator to the highly spe
cialized Raw Industrial Commodity Price (RICP) in
dex. Somewhere between these two in coverage are
the Consumer Price Index (CPI) and the Producer
Price Index (PPI). Table 1 provides a breakdown of
each index into its major components.
As seen in table 1, the coverage of the indexes does
not always overlap. Some indexes, like the CPI, repre
sent prices for final goods — that is, goods that have
completed the production process — and include non
commodity items like services, rent, interest charges
and entertainment. The RICP index, however, mea
sures prices during or before the production process.
C onsequently, this index represents the prices
charged to producers of goods and services which,
when sold to the final consumer, will appear in the
CPI.
. . .That Behave Differently. . .
Table 2, which presents the simple correlation
among growth rates for each index over a variety of
time periods, shows just how closely the different
FEBRUARY 1983
FEDERAL RESERVE BANK OF ST. LOUIS
Table 2
Simple Correlations Between Growth Rates of Price Indexes
1/1960-111/1982
GNP-CPI
0.902
—0.18
0.812
0.902
GNP-PPI
0.652
-0 .0 2
0.28
0.622
GNP-RICP
0.07
0.18
0.44
CPI-PPI
0.732
0,39
0.712
0.672
CPI-RICP
0.16
-0 .1 6
0.452
0.09
0.12
PPI-RICP
0.462
-0 .0 4
0.682
0.43
0.492
1/1960—
IV/1964
0.40
1/1965—
IV/1969
1/1970—
IV/1974
1/1975-111/1982
Pairing1
-0 .1 1
0.762
0.462
-0 .1 1
1GNP denotes the GNP deflator, CPI is the Consumer Price Index, PPI is the Producer Price Index and RICP is the Raw Industrial
Commodities Price Index. All growth rates are compounded annual rates of change.
Statistically different from zero at the 95 percent level of significance.
indexes move together.5 Looking first at the left-hand
column, which shows the correlation coefficients for
the 1/1960—
III/1982 period, we see that the size of the
correlations declines as the disparate nature of the
indexes increases. For example, over the full period,
the simple correlation between the GNP deflator and
the CPI is 0.90. This drops to 0.65 for the GNP
deflator-PPI comparison and to 0.07 — a value not
statistically different from zero — when we compare
the deflator’s movements to those of the RICP index.
Not unexpectedly, the correlations reveal a closer rela
tionship between movements in the PPI and the RICP
(0.46), because the coverage of these two measures is
more similar. Thus, as a rule, the more closely the two
indexes are defined, the greater the correlation be
tween them.
The most interesting aspect of table 2 is the variety of
correlations over the shorter time spans. For instance,
the correlation between the GNP deflator and the CPI
ranges from —0.18 to 0.90. Similarly, the correlation
between the GNP deflator and the RICP index varies
from a high of 0.44 to a low of —0.11. The correlations
over shorter periods are quite volatile and, in many
instances, not statistically different from zero. This
indicates that, except perhaps for the GNP-CPI link
since 1965, no easily discernible relationship what
soever exists between the indexes shown. This result
arises, in part, because the indexes differ in their
coverage of goods and services.
T h e correlation coefficient captures the degree of closeness in the
movements of two series. It ranges from —1.0 to 1.0, indicating,
respectively, perfectly opposing and perfectly coordinated move
ments. Thus, if the two series are unrelated, the correlation coef
ficient will be close to zero. For a description of the statistic, see
Paul G. Hoel, Introduction to M athematical Statistics (John G.
Wiley & Sons, Inc., 1962), pp. 163-68.
. . .Because Different “Weights’' Are
Used. . .
We have seen that the coverage of the indexes is
different. At the same time, their construction necessi
tates that the various components be assigned some
“weight. ” This weight helps to determine the relative
importance of the item in the “basket” of goods and
services represented by the index. This differential
treatment of components can produce a dilemma for
policymakers if movements in the overall index are
dominated, temporarily at least, by fluctuations in one
or two component prices. For example, if one compo
nent increases sharply an d it has a relatively large
weight, the index will increase even though other
prices have not changed. This effect — called a relative
price shock — will cause the index to increase rapidly,
giving the appearance of a general increase in prices.6
To illustrate this, chart 1 plots the rate of inflation
measured two ways: one by the CPI, the other by the
CPI minus energy prices. Notice how different the two
inflation rate series are during periods when energy
prices increased more rapidly than other prices in the
CPI. During the oil price shocks of 1974 and 1979, the
CPI inflation rate is noticeably higher when energy
prices are included than when they are excluded.
6Analy ses of the impact of “relative price shocks” on measured price
indexes are provided in Alan S. Blinder, “The Consumer Price
Index and the M easurement of Recent Inflation,” Brookings
Papers on Economic Activity (2: 1980), pp. 539-65; Stanley Fisch
er, “Relative Shocks, Relative Price Variability, and Inflation,”
Brookings Papers on Economic Activity (2:1981), pp. 381—
131; and
Lawrence S. Davidson, “Inflation Misinformation and Monetary
Policy,” this Review (June/July 1982), pp. 15-26.
7
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
C ha rt 1
Inflation Rates of the CPI and the
CPI Less Energy Pricesu
1970
71
72
73
74
75
76
77
78
79
80
81
1982
Q. I n f la tio n ra te s a r e c o m p o u n d e d a n n u a l ra te s o f c h a n g e .
S h a d e d a r e a s r e p r e s e n t p e r io d s w h e n th e CPI e x c e e d e d th e CPI less e n e r g y
To further demonstrate the impact that changes in
the price of one important commodity group can have
on an index, chart 2 plots the inflation rates of the PPI
and the PPI minus fuels and related products and
power. Again, there is a noticeable difference in the
8
two series during periods of rapidly rising energy
prices.
To illustrate the problem that this data might pose
for policy, suppose the monetary authority used the
PPI on which to base its decision about future money
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
C h a rt 2
Inflation Rates of the PPI and the PPI Less Fuels
and Related Products and Pow er a
1970
71
72
73
74
75
76
77
78
79
80
81
1982
|_ _ I n f la tio n ra te s a r e c o m p o u n d e d a n n u a l ra te s o f c h a n g e .
1
S h a d e d a re a s r e p r e s e n t p e r io d s w h e n th e PPI e x c e e d e d th e PPI less fu e ls a n d r e la te d
p ro d u c ts a n d p o w e r.
growth. In 1/1980, it would have faced an inflation rate
during the preceding year of over 16 percent. Under a
short-term price rule, this clearly would call for a dras
tic reduction in money growth. If the authority instead
used the PPI “minus energy” as its yardstick of price
change, the average rate of increase during the preced
ing year would have been only 2 percent. This would
call for a totally different monetary policy response.
9
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
Table 3
Simple Correlations Between Inflation Measures and Money Growth1
Price
Index2
Period
1/1960—11/1982
1
1/1960—
IV/1964
1/1965—
IV/196£I
1/1970—
IV/1974
1/1975-111/1982
0.593
LONG-RUN
GNP
0.833
-0 .0 7
0.763
0.493
CPI
0.823
0.30
0.893
0.623
0.683
PPI
0.643
-0 .0 2
0.35
0.653
0.633
RICP
0.263
0.43
0.623
0.13
0.773
SHORT-RUN
GNP
0.403
-0 .1 1
0.33
-0 .3 8
CPI
0.453
0.37
0.39
-0 .3 8
0.32
PPI
0.323
0.01
0.463
-0 .0 5
0.15
RICP
0.233
0.35
0.473
0.28
0.09
0.15
’ Long-run money growth is measured as a 12-quarter moving average of M1 growth. Short-run money growth is the money growth rate
lagged one quarter relative to prices.
2See notes accompanying table 2 for definition of price indexes.
Statistically different from zero at the 95 percent level of significance.
Thus, relative price shocks — the source of which
often lies beyond the power of monetary policymakers
to influence — have direct implications for policy ac
tions. Determining the source, magnitude and dura
tion of such aberrations — clearly no small task —
would be necessary under a short-run price rule.
. . .W h ich P ro d u ces a P ro b lem f o r
Policymakers
The point of the previous exercise is to illustrate the
difficulty in selecting a price index to guide monetary
policy actions. How should policymakers react to rela
tive price shocks that change the measured rate of
inflation? Should money growth be reduced in the face
of an increase in the price index when, in fact, the
increase can be traced directly to relative movements
in one component of the index?
Evidence presented elsewhere indicates that rela
tive price shocks are of short duration in their effect on
the overall inflation rate.7 Thus, if monetary policy
attempts to quell observed increases in a price index
caused by non-monetary relative price shocks, it will
serve only to exacerbate the problem of price stability
once the effects of the relative price shock abate.
In summary, the adoption of a price rule for mone
10
tary policy must first address the thorny issue of select
ing a specific price index. This selection is complicated
for several reasons. First, there are a variety of indexes
from which to choose; each has a different coverage and
a different pattern of behavior. Second, they are all
subject to temporary movements that represent the
effect of some relative price change; thus, policymak
ers must distinguish those movements in the index to
which they should respond from those movements
they should ignore.
MONEY GROWTH AND INFLATION
A necessary condition for a short-run price rule to
function properly is that the chosen price index re
spond quickly and reliably to changes in the money
stock. This is, after all, the very heart of the suggested
procedure. Because a price rule assumes that the
underlying cause of inflation is a change in the growth
of the money stock, it is important to examine just how
quickly movements in the price indexes respond to
money growth.
Table 3 presents evidence on the relationship be
tween the growth in money (M 1) and four measures of
inflation.8 A simple correlation between inflation and
“Em pirical support for the proposition that inflation reflects
changes in the growth of money is provided in Denis S. Kamosky,
“The Link Between Money and Prices — 1971-76,” this Review
FEDERAL RESERVE BANK OF ST. LOUIS
M l growth is used to capture the association. The
“long-term” rate of M l growth used to examine this
association is measured as a 12-quarter moving aver
age. These correlations appear in the upper half of
table 3. Correlations between the various inflation
measures and “short-term” M l growth, represented
by the one-quarter lagged growth rate, are used to
assess the short-run impact of M l growth on inflation.
These are shown in the lower half of table 3. The
correlations are calculated for the same time periods
used in table 2 .9
A comparison of the results reveals that inflation
generally exhibits a closer relationship to longer-term
movements in M l than to its short-term changes. The
full-period results (1/1960—
III/1982) indicate that the
correlation between inflation and M l growth is about
twice as great using long-term relative to short-term
money growth. This suggests that prices are more
responsive to the changes in M l that have occurred
during the preceding three-year period than to the
changes in the previous quarter. Thus, altering the
growth of M 1 in response to current changes in a price
index — changes that are actually the result of policy
actions during the past three years — aggravates the
volatility of prices over the long run.
For shorter time periods, the money-price link is
quite variable. Except for the RICP index and the PPI,
the correlation between long-term money growth and
inflation drops noticeably during the 1970-74 period.
This is due primarily to the non-monetary factors — for
example, the imposition and removal of wage and price
controls and the OPEC oil price increases — that
affected some prices relatively more than others dur
ing this era.
For a short-run price rule to work effectively, prices
must respond quickly and reliably to changes in the
money stock. The evidence in table 3 demonstrates
that this is not the case. The correlation between price
changes and short-run money growth is extremely
variable across different time periods: in some periods,
(June 1976), pp. 17-23; Keith M. Carlson, “The Lag from Money to
Prices,” this Review (October 1980), pp. 3-10; and John A. Tatom,
“Energy Prices and Short-Run Economic Performance,” this Re
view (January 1981), pp. 3-17. It is this type of evidence on which
the argument for reducing the long-term rate of inflation by reduc
ing the trend rate of money growth is based.
An alternative view is represented in George L. Perry, “Inflation
in Theory and Practice,” Brookings Papers on Economic Activity
(1: 1980), pp. 207-41.
!>
The analysis also was done using a 20-quarter moving average of
M l growth as the long-run measure. This change did not alter the
conclusions reached in the text.
FEBRUARY 1983
there is a positive relationship, while in others it is
negative. Indeed, this is true regardless of the index
used. More important, only 2 out of 16 subperiod
correlations reported in table 3 are statistically differ
ent from zero at the 95 percent level of confidence for
the short-run correlations. In contrast, 10 out of 16
subperiod correlations are significantly different from
zero for the long-run correlations.
Thus, the evidence indicates that the various price
indexes do not respond to changes in short-run M l
growth in a sufficiently reliable manner to make a price
rule practical for short-term policy horizons. The cor
relations do reveal, however, the existence of a reliable
long-run connection betw een price changes and
money growth.
A PR IC E-R U L E MONETARY POLICY
AND VARIABLE MONEY GROWTH
Variable money growth can affect real economic
activity in the short run. As noted previously, in the
long run, changes in money growth are reflected in
price changes. During the short run, however,
changes in money growth first affect spending and
production decisions. If money growth declines far
enough and long enough from its established trend, it
then leads to a downturn in real economic activity.
To illustrate this point, chart 3 plots the trend rate of
M l growth, measured as a 20-quarter moving average,
and its short-run growth, depicted by a 2-quarter mov
ing average. Recessions are designated by shaded
areas.
Chart 3 depicts the common relationship during the
past two decades between sharp reductions in shortrun M l growth relative to its trend and real economic
activity.10 Prior to each recession, substantial reduc
tions in short-run M l growth relative to trend oc
curred. For example, short-run M l growth fell from
10Clark Warburton was a pioneer in this type of analysis. See his
“Bank Reserves and Business Fluctuations, "Journal o f the Amer
ican Statistical Association (Decem ber 1948), pp. 547-58, re
printed in D epression , Inflation, and Monetary Policy: Selected
Papers 1945-1953 (The Johns Hopkins Press, 1966). Similar analy
ses are presented by Milton Friedman and Anna J. Schwartz,
“Money and Business Cycles, ” Review o f Economics and Statis
tics (February 1963), pp. 32-78; William Poole, “The Relationship
of Monetary Decelerations to Business Cycle Peaks: Another
Look at the Evidence,” Jou rn al o f Finance (June 1975), pp. 6 9 7 712; and Dallas S. Batten and R. W. Hafer, “Short-Run Money
Growth Fluctuations and Real Economic Activity: Some Implica
tions for Monetary Targeting, ” this Review (May 1982), pp. 15-20.
An analysis using a 12-quarter moving average of money growth
did not alter the findings reported in the text.
11
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
C hart 3
Rates of C h an ge of M o n e y Stock (Ml)
Percent
Percent
1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 1983
[]_ T w o -q u a rte r ra te o f c h a n g e .
|_2 T w e n ty -q u a rte r r a t e of c h a n g e ; d a t a p rio r to 1st q u a r te r 1 9 6 4 a r e M l on the old basis.
S h a d e d a r e a s re p re s e n t p e r io d s o f b u s in e s s re c e s s io n s .
12
FEDERAL RESERVE BANK OF ST. LOUIS
about 2 percentage points above its trend to about 5
percentage points below trend within several quarters
prior to the II/1980-III/1980 recession. A similar pat
tern of rapid deceleration in M l growth relative to
trend precedes the most recent recessionary episode
during 1981 and 1982.11
The implementation of monetary policy using a
short-run price rule necessitates varying the growth of
the money stock in response to changes in some price
index. Consequently, it is likely that the growth of the
money stock would be more variable under a price rule
than it would be under a monetary targeting rule. The
prospect of increased variability of money growth is an
additional factor that argues against the adoption of a
short-run price rule.
CONCLUSION
Advocates of a short-run price rule approach to
monetary policy argue that it is superior to current
policy actions. While the arguments supporting a
n Indeed, the dramatic slowing in short-run M l growth relative to
its trend and the increase in its volatility (i.e., short-run M l
growth that is far above and below trend) during the past two years
have been associated with substantial reductions in real economic
activity. From IV/1979 to IV/1982, real output decreased at a 0.4
percent rate. The standard deviation of money growth during this
period was 5.91 percent. In comparison, the standard deviation of
money growth from IV/1976 to III/1979 was 1.45 percent.
FEBRUARY 1983
short-run price rule might seem appealing at first
glance, the facts suggest that this approach is unlikely
to achieve its promised goal of price stability in either
the short- or the long-run.
There are a variety of problems that beset the shortrun price rule for monetary policy: Which price index
should be chosen? What should be done about relative
price change effects on the observed index? What will
the policymaker’s response be if variations in the
money stock to achieve short-run price stability
threaten to impede economic activity?
The evidence presented in this article indicates that
these problems are critical in discussing the adoption
of a price rule for monetary policy. Perhaps the most
damaging of all the evidence is the finding that shortrun money growth has widely different effects on the
various price indexes investigated in this article. In
fact, there does not appear to be a simple stable rela
tionship between short-run movements in the money
stock and the different price indexes that is necessary
for the success of a price-rule monetary policy.
Finally, a price rule calls for varying the short-run
growth of money in an attempt to achieve and maintain
a zero rate of inflation. The evidence suggests that such
variation in monetary growth could well lead to lower
growth in real economic activity and could even pro
duce frequent recessions if the variations in M l growth
were sufficiently drastic and prolonged.
13
Outlook for Agriculture in 1983
M IC H A E L T . B E L O N G IA
.t iA R L Y forecasts for 1983 indicate that it will be the
fourth consecutive year of low income for farmers.
Speaking at the U.S. Department of Agriculture’s
(USDA) recent Outlook Conference, government and
industry analysts alike agreed that the combination of
large carryover stocks, declining exports and limited
reductions in output will not promote significant in
creases in depressed grain prices, which are important
determinants of net farm income. The relatively low
price and reduced farm income outlook for grains is
expected to be offset somewhat by modest increases in
livestock prices. The retail price of food, as measured
by the food component of the Consumer Price Index
(CPI), is expected to increase by 3 percent to 6 percent
in 1983.
released in January revealed that food prices increased
about 4 percent in 1982, the smallest rate of increase
since 1976. Generally smaller increases in marketing
costs — associated with the reduction in the rate of
inflation — and relatively large supplies of most major
commodities were cited as the factors behind this
dampening of food price increases. Poor weather,
larger-than-expected (export or domestic) demand or
an unexpected acceleration of general inflation, how
ever, could increase the growth rate of retail food
prices to the upper end of the 3 percent to 6 percent
forecast range. Historical and forecast data for food
prices are listed in table 1.
This article is divided into two parts. The first sec
tion reviews and summarizes the data presented at the
Outlook Conference, and discusses price and produc
tion figures for 1982 and forecasts for 1983 in primary
commodity groupings. The second section analyzes
the grain surplus problem that continues to keep prices
and farm income at relatively low levels. The discus
sion indicates that current policies designed to in
crease farm prices while limiting surplus accumulation
provide conflicting incentives that inhibit the accom
plishment of either objective. Finally, provisions of the
payment-in-kind (PIK) program are evaluated as a
means of resolving conflicts among existing policies.
Most financial indicators for the farm sector declined
in 1982 and are not expected to show significant im
provement in 1983. Although complete farm income
data and forecasts were not available at the Outlook
Conference, estimates released in January place 1982
net farm income at $20.4 billion with forecasts for 1983
in the $16 billion to $20 billion range. Direct govern
ment payments to farmers were about $3.5 billion. As
chart 1 shows, real net farm income is about one-third
of its 1972 level and is expected to decline again in
1983. Particularly important to farm income in 1983
will be the strength of export demand and the success
of programs aimed at achieving reductions in grain
stocks and production.2
OUTLOOK SUMMARY
The rate of increase in retail food prices, as mea
sured by the CPI, is expected to be toward the low end
of the 3 percent to 6 percent range in 1983.1 Data
Actual returns to farmers in 1982 would have been
even less had it not been for government price support
and subsidy payments. As chart 2 indicates, commodi
ty prices below the target prices of support programs
led to a three-fold increase in the level of Commodity
Credit Corporation (CCC) payments for price supports
'Paul C. Wescott, “The 1983 Outlook for Food Prices and Con
sumption,” Outlook '83, Proceedings of the Agricultural Outlook
Conference, Washington, D .C ., Decem ber 1, 1982 (United States
Department of Agriculture), pp. 639-50.
2Ronald L. Meekhof, “Agricultural Finance Outlook,” Outlook ’83,
Proceedings of the Agricultural Outlook Conference, Washington,
D C ., Decem ber 1, 1982 (United States Department of Agricul
ture), pp. 469-81.
Retail Food Prices
14
Financial Conditions
FEBRUARY 1983
FEDERAL RESERVE BANK OF ST. LOUIS
Table 1
Changes in Consumer Price Indexes (1980-83)
Food Category
1980
1981
1982
19831
8.6%
7.9%
2.5%
3 - 6%
Food away from home
9.9
9.0
4.9
4 -6
Food at home
8.0
7.3
1.5
2.9
5.7
- 3 .4
5.1
- 1 .8
9.8
9.2
7.3
22.9
11.9
6.6
10.6
10.8
3.6
0.9
0.8
4.1
8.3
7.1
8.3
12.0
7.9
10.0
10.7
4.2
10.3
5.6
0.7
15.9
-1 .5
-8 .7
1.5
0.9
-6 .3
2.7
2.9
0.9
3.0
3.0
All Food
Meats
Beef and veal
Pork
Poultry
Eggs
Dairy products
Fish and seafood
Fruits and vegetables
Sugar and sweets
Cereals and bakery products
Fats and oils
Nonalcoholic beverages
Other prepared foods
3-6
3
2
4
2
-3
2
2
1
3
2
2
3
3
-
6
5
7
5
0
5
5
4
6
5
5
6
6
’ Forecast.
SOURCE: Historical data from Department of Labor; forecasts by U.S. Department of Agriculture,
Economic Research Service.
and other income transfers (e.g., storage subsidies).3
In fiscal year 1982, the cost of government programs
rose to almost $12 billion with about $2 billion for the
dairy program and $10 billion in loans and subsidies for
grains, cotton and some 20 other supported commod
ities. Unless target prices are frozen at 1982 levels or
output reductions increase market prices, budget of
ficials have estimated that the cost of price support
programs could exceed $15 billion in fiscal year 1983.4
Contributing positively to the income outlook of
farmers in 1983 are projections of continued reductions
in interest rates and the prices of primary inputs rela
tive to output prices. Although interest rates fell in
1982, the declines probably occurred too late in the
year — after contracts for seed and fertilizer were
written — to have reduced costs significantly. The
world oil glut and lower input prices, however, did
reduce costs in 1982 and are expected to reduce them
further in 1983. If declining interest rates and farm
input costs materialize in 1983, net farm income could
be improved even in the absence of output price in
creases. According to the US DA, however, any major
3“Target prices” are established by law. I f market prices for a
supported commodity fall below the target price, farmers meeting
eligibility requirements receive a “deficiency payment” based on
the difference between the target level and market price.
See Seth S. King, “Farm Price Props Expected to Rise Above ’82
Record,” New York Times (January 23, 1983).
improvements in net farm income will have to come
from higher prices for farm products resulting from
large increases in aggregate demand — especially ex
port demand.
Corn and Wheat
The dilemma facing grain producers in 1983 is, at
least in part, the result of policy actions taken in 1982.5
After the record harvests of 1981, wheat and corn
producers were encouraged to participate in the re
duced acreage program (RAP). In return for idling a
portion of their base acreage, farmers were eligible to
participate in the Farmer-Owned Reserve (FOR) and
to receive both price support loans and deficiency
payments. The objective of these programs was to
increase grain prices by reducing grain output.6
5Other contributing factors to the current situation of low prices and
large surpluses were the 1980 Soviet export embargo, record
yields, the appreciation of the dollar and export subsidies for
French and Canadian wheat.
6An important change in the 1981 farm bill is the shift from “setaside” programs to the RAP. Under a set-aside, farmers were asked
to idle a certain percentage of their acreage without stipulations
concerning what was grown on remaining land. Thus, if the reason
for a set-aside was to increase wheat prices, the program may have
been totally ineffective if the 10 percent of acreage idled was
formerly planted in oats and wheat plantings were unchanged. The
RAP attempts to overcome this problem by using crop-specific
acreage reductions; that is, a wheat RAP now calls for a reduction in
the acreage historically planted in wheat.
15
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
C h a rt 2
C h a rt 1
Farm Price Supports -
Agricultural Income
B illio n s of d o lla r s
B i ll io n s o f d o l l a r s
B illio is o f d o lla rs
36
B i ll io n s of d o lla r s
14
14
36
1970
1972
73
74x
75
76
77
78
79
80
81
82
1983
The programs, however, did not achieve the desired
level of output reductions. Provisions of the wheat
program were announced after much of the winter
wheat crop had been planted. As such, the 48 percent
overall participation rate in the wheat program was an
unbalanced mix of low participation by producers of
winter wheat and high participation by producers of
spring wheat. The corn program was even less success
ful with about a 24 percent participation rate.
Output reductions achieved by the programs were
more than offset, however, by ideal growing weather
and record yields. The 2 percent reduction in corn
acreage was countered by a 4 percent increase in yields
to an average of 114 bushels per acre. The picture for
wheat was somewhat different. The 48 percent par
ticipation rate in the acreage reduction program
achieved a 1 percent decline in the total wheat crop
from the level of 1981’s record harvest.
The volume of wheat and corn production in the
1982 crop year had some important consequences. As
the data in table 2 indicate, the United States now
holds about 76 percent of world corn stocks and 39
percent of world wheat stocks; these figures are ex
pected to increase to 85 percent and 44 percent, re
spectively, in 1983. These data also indicate that the
United States is expected to produce almost one-half of
all corn and one-sixth of all wheat grown in the world
during this crop year. Although the volume of corn
exports is expected to increase about 9 percent to
almost 55 million metric tons, the price of corn, cur
16
71
72
73
74
75
76
77
78
79
80
81
1982
S o u rce : U.S. D e p a r tm e n t o f A g r ic u ltu r e
Q, F ig u re s f o r e a c h f is c a l y e a r in c lu d e b u d g e t o u tla y s f o r lo a n s , p u r c h a s e o f s u r p lu s d a i r y
p r o d u c t s , s u b s id ie s , s to r a g e a n d tr a n s p o r t a t i o n c o s ts .
rently at a 10 year low, may actually decrease the value
of corn exports. The volume of wheat exports is ex
pected to decline about 8 percent to 45 million metric
tons.'
Although both the wheat and corn programs have
added a paid diversion as an extra incentive to program
participation in 1983, the predominant view among
analysts appears to be that acreage reduction alone will
not increase prices significantly.8 One estimate con
cluded that if the corn program achieved 70 percent
compliance among eligible producers (almost triple
the 24 percent compliance rate of 1982), the price in
the Eastern corn belt will reach only $2.80 per bushel,
about equal to the target price. The same analysts,
however, cautioned that a compliance rate this high is
unlikely; little new storage space is being built and
many producers likely will withdraw from the pro
grams if market prices begin to strengthen. None of
these analyses, however, considered the effects of the
PIK program that officially was announced after the
7One metric ton is equivalent to about 37 bushels of wheat or 39
bushels of corn.
8Under a paid diversion — unlike a voluntary set-aside — producers
are given a payment for not producing on a portion of their land.
For example, under 1983 corn program rules, producers will be
paid $1.50 per bushel on the 10 percent of their base acreage and
yield that constitutes the diversion. This is in contrast to the 10
percent of their land which constitutes the voluntary acreage re
duction and receives no direct payments. A possible reason for low
compliance with the 1982 program is that no direct payments were
made to producers for laying idle a portion of their land.
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
Table 2
World and U.S. Summaries for Corn and Wheat (millions of
metric tons)
Crop Years
1980-61
1981-82!
1982-83
404.4
412.7
49.1
11.9
78.2
436.0
406.5
78.7
19.4
71.5
443.4
418.8
103.2
24.6
68.8
168.8
123.8
59.8
26.3
53.6
208.3
124.5
50.0
60.1
76.4
211.6
129.5
54.6
87.6
84.9
439.3
444.8
74.6
16.8
96.5
445.8
438.2
82.3
18.8
105.8
461.6
453.5
90.4
19.9
103.0
64.6
21.1
41.9
26.9
36.1
76.0
23.1
49.1
31.7
38.5
76.5
23.5
45.0
39.8
44.0
CORN
World
Production
Utilization
Ending Stocks
Stocks/Utilization (%)
Trade
United States
Production
Utilization
Exports (October/September)
Ending Stocks
U.S. Stocks/World Stocks (%)
WHEAT
World
Production
Utilization
Ending Stocks
Stocks/Utilization (%)
Trade
United States
Production
Utilization
Exports (July/June)
Ending Stocks
U.S. Stocks/World Stocks (%)
SOURCE: Historical data and forecasts by U.S. Department of Agriculture, Economic Research Ser
vice.
Outlook Conference. The probable impact of the PIK
program is discussed later in this article.
Livestock, Poultry and Dairy
R ed Meats — Despite low feed grain prices, finan
cial considerations likely will result in a second con
secutive year of lower red meat production.9 Cash flow
problems have forced producers to reduce their debt
and to generate internal capital. To accomplish this,
producers have liquidated herds and retained a smaller
than average number of animals for breeding pur
poses. The reduced breeding herds imply a decline in
red meat production in 1983.
9Ronald A. Gustafson and Leland W. Southard, “Red Meats Out
look,” Outlook S3, Proceedings of the Agricultural Outlook Con
ference, Washington, D .C ., November 30, 1982 (United States
Department of Agriculture), pp. 319-28.
Some price increases for beef and pork are likely to
result from the reduction in aggregate red meat sup
plies. Analysts are expecting a 1 percent decline in
commercial beef production, which is expected to in
crease cattle prices by 3 percent in 1983. Prices for
choice Omaha steers are expected to reach $66.25 per
hundred weight (cwt.), up from $64.25 per cwt. in
1982. Commercial production is expected to be 22.3
billion pounds in 1983, down from about 22.4 last year.
Average prices for barrows and gilts are expected to
rise 5 percent to $58.50 per cwt. in 1983 based on an
expected 6 percent drop in production.
B eef and pork producers’ incomes likely will be
strengthened further by reductions in production
costs, most notably in feed costs and interest rates. For
instance, feed costs for hogs declined $5-$7 per 100
17
FEDERAL RESERVE BANK OF ST. LOUIS
pounds of weight gain in 1982 while feed costs for cattle
declined by about $10 per 100 pounds of gain. With the
likelihood of continued low grain prices and further
reductions in interest rates in 1983, producers again
should face a favorable cost picture.
Poultry an d Eggs — Broiler production is expected
to increase slightly in 1983. This, together with slow
growth in demand, is expected to moderate price in
creases. Growth in aggregate demand will continue at
low rates as a result of the slow economic recovery and
a substantial reduction in the level of exports, down 30
percent in 1982 from the previous year’s levels. In
addition, demand has failed to increase in response to
relatively high red meat prices.10
After poor returns in 1980 and 1981, lower feed costs
increased the incomes of egg producers in 1982. Pro
duction figures for 1983 are expected to approximate
1982 levels. Some cutbacks in the number of replace
ment pullets will tend to limit production gains. Even
with egg production at 1982 levels, however, prices in
1983 should remain near their 1982 average level of
about 70 cents per dozen; a substantial drop in foreign
demand is expected to offset the effects of stable pro
duction figures.
Dairy — Milk production is expected to be 135.8
billion pounds in 1982, 2 percent above year-earlier
levels. Although producer reaction to the 50-eent de
ductions imposed by the Secretary of Agriculture is
still uncertain, production is expected to increase
another 1.9 percent in 1983. These increases in pro
duction will occur despite reductions in average prices
from 1981 levels. Prices declined an average of 1.8
percent in 1982 due to a “roll-back” in the level of price
support to $13.10 per ewt. and continued surplus
production.11 The effects of output price declines on
producers’ incomes, however, were offset somewhat
by reductions in feed costs paid by producers.
The dairy outlook necessarily reflects the assump
tions about specific policy provisions that will be in
10Allen Baker, “Poultry and Egg Outlook,” Outlook ’83, Proceed
ings of the Agricultural Outlook Conference, Washington, D .C .,
November 30, 1982 (United States Department of Agriculture),
pp. 329-33.
HThe support had been raised to $13.49 per cwt. — 75 percent of
parity — on October 1, 1981. Special legislation enacted on Octo
ber 20, 1981, “rolled back” the support level to $13.10. When the
1981 Food and Agriculture Act was adopted in D ecem ber 1981,
the $13.10 figure was maintained for the remainder of the 1981-82
marketing year. The Farm Bill also scheduled an increase to
$13.25 per cwt. for the 1982-83 marketing year. However, with
production surpluses continuing, special legislation enacted in
September 1982 held the support price at $13.10 until October 1,
1984. The new support then will be set at the level of parity $13.10
represented on October 1, 1983.
Digitized for18
FRASER
FEBRUARY 1983
effect during 1983. If the support price remains at
$13.10 per cwt. and the Secretary of Agriculture im
poses both of the authorized 50-cent deductions, the
following results are likely this year.12 Production will
increase by 1.9 percent and USD A purchases of sur
plus products will increase by 8.8 percent (milk
equivalent).13 The average price received for all milk
will decline by 1.8 percent, but cash receipts (includ
ing direct payments) will increase by 9.7 percent. The
number of cows used in production will increase by 1.0
percent.
PRO BLEM AREAS FO R 1983
The 1982 price and production estimates presented
at the US DA Outlook Conference indicate that low
relative prices and large grain surpluses continue to be
the primary sources of conflict in agricultural policy.
The following discussion argues that conflicting incen
tives in U.S. agricultural programs, on balance, have
promoted expansions in grain production that in
creased surpluses and lowered relative prices and farm
income. Though many programs are similar in design,
only corn and wheat are discussed in detail.
To understand the current structure of grain policies
and the results they have fostered, it is necessary to
know something about the price and production his
tory of the major commodities, corn and wheat. Until
the mid-1970s, it commonly was agreed that ongoing
technological improvements and a slow transition of
excess labor from agriculture created an environment
in which “chronic surpluses,” low or declining relative
prices and lower farm incomes were the norm. Since
the 1930s, when price support programs were estab
lished, government’s response to this situation has
been to legislate “fair” prices for farm products and to
purchase surplus production at these prices.
In the mid-1970s, however, there was a perceptible
change in expectations. For a variety of reasons — the
beginning of the first Russian grain sales in 1972, price
support programs that idled one-fifth of U. S. cropland,
and large increases in total export demand — real farm
income reached a record high in 1973 and remained
above historical levels in 1974 and 1975. Many analysts
and farmers believed that these events signalled an
end to the era of low prices and commodity surpluses;
'^Clifford M. Carman, “United States Outlook for Dairy,” Outlook
'S3, Proceedings o f the Agricultural Outlook C onference,
Washington, D .C ., November 30, 1982 (United States Depart
ment of Agriculture), pp. 436-41.
13U.S. Department of Agriculture purchases surplus products in
several forms: butter, American cheese, nonfat dry milk and
evaporated milk.
FEDERAL RESERVE BANK OF ST. LOUIS
the prevailing opinion was that a combination of many
factors finally had solved the agricultural “problem”:
“ The secular incom e problem in agriculture is now
largely behind us. T he em erging equilibrium in the
labor m arket is o f m ajor significance in this respect.
W hen this equilibrium is com bined with the decline in
the rate o f p roductivity growth, the release o f most o f
the idled land back to production, and the shift to the
right in the dem and for agricultural products as a result
o f devaluation, the result is an almost total disappear
ance o f the excess capacity that existed at prevailing
price ratios for such a long tim e .” 14
This view has led some analysts recently to argue that
unabated increases in world food demand and limita
tions on U. S. productive capacity likely are to make the
1980s a decade of commodity shortages and rising food
prices.15 Within this view, a major development in
agricultural policy during the 1980s will be “[t]he de
clining role of price and income supports and produc
tion adjustment programs.”16
Although this brief history gives short shrift to the
political and economic complexities that have shaped
agricultural policies, it does provide a flavor for the
attitudes that have led to the current policy mix. On
the one hand, legislators have persisted in their belief
that minimum levels of some commodity prices should
be established by law to provide a “fair” return to
producers of those products. On the other hand, the
crop shortages and volatile prices of the early 1970s
have spawned new grain storage programs that simul
taneously attempt to stabilize prices and provide an
adequate reserve stock in the event of further short
ages. This policy mix, general macroeconomic activity
and random events in nature have produced the cur
rent production and price situation in agriculture.
As 1983 begins, three sets of major grain programs
are in place: the reduced acreage program (RAP), price
14See G. Edward Schuh, “The New Macroeconomics of Agricul
ture,” American Jou rnal o f Agricultural Economics (Decem ber
1976), pp. 802-11.
L See, for example, Ann Crittenden, “Can the World Feed Itself?
’
an interview with Howard Hjort, New York Times, February 14,
1982; J. B. Penn, “Economic Developments in U.S. Agriculture
During the 1970s” and John A. Schnittker, “A Framework for
Food and Agricultural Policy for the 1980s,” both included in
Food and Agricultural Policy f o r the 1980s, D. Gale Johnson, ed.,
American Enterprise Institute, Washington, D .C ., 1981. An
opposing view is presented by Don Paarlberg, “The Scarcity
Syndrome,” American Jou rn al o f Agricultural Economics (Febru
ary 1982), pp. 110-14, and Michael V. Martin and Bay F. Brokken,
“The Scarcity Syndrome: Com ment,” American Journal o f Agri
cultural Economics (February 1983), pp. 158-59.
16Schnittker “A Framework for Food, ” p. 210.
FEBRUARY 1983
support programs and the Farmer-Owned Reserve
(FOR). Each program attempts to manage the supply
of grains to achieve either stable prices above some
minimum level or adequate reserve stocks in the event
of new commodity shortages.17 Because these goals are
not always compatible, however, existing policies
often work against each other; the results are thus often
contrary to stated objectives.
MAJOR GRAIN PROGRAMS18
Acreage Reduction Programs
Farmers are encouraged to reduce production
through two types of programs. One is the reduced
acreage program (RAP) in which a farmer “voluntarily”
agrees to idle a portion of his acreage; the actual
amount is based on the acreage planted in the past
(called the historical base acreage). A farmer has an
economic incentive to comply, however, only if the
benefits of compliance exceed their costs. Typically,
these benefits include eligibility for price support
loans, income support payments and participation in
the FOR; the cost of not complying is the income
foregone by not producing on the idled land. A paid
diversion, which represents a portion of the RAP, pro
vides a cash payment for farmers who idle the required
percentage of their base acreage.19
Price Supports
Grain prices are supported primarily by loan rates
while income is supported by target prices. Under
provisions of the price support loan-rate program, pro
ducers who comply with grain program requirements
(for instance, reduced acreage) are eligible for a nonre
course loan. Producers then have two options: they can
hold their grain and market it at their discretion or they
can obtain a loan. The value of a loan is determined by
the loan rate multiplied by the number of bushels
17These programs focus on supply strategies because previous
attempts to increase private demand for food have had limited
impact on food prices. See, for example, M. Belongia, “Domestic
Food Programs and Their Belated Impact on Food Prices, ” Amer
ican Journal o f Agricultural Economics (May 1979), pp. 358-62.
1SA more detailed discussion of these programs and their impacts on
economic activity can be found in Bruce L. Gardner, The Gov
erning o f Agriculture, The Begents Press of Kansas, Lawrence,
Kansas, 1981.
19The 1983 corn and wheat BAP both require a 20 percent reduction
in base acreage. The com program includes a 10 percent paid
diversion; 5 percent of the wheat program is a paid diversion.
19
FEDERAL RESERVE BANK OF ST. LOUIS
placed in storage. The loan rate is a legislatively deter
mined price per bushel that serves, essentially, as a
price floor.
The loan is in effect for less than one year. If market
prices do not rise to levels substantially above the loan
rate over the period of the loan, farmers can forfeit
their grain to the CCC as full payment for the loan.
Forfeiture of grain in this manner contributes to CCC
grain stocks — government stocks separate from those
in the FOR. In contrast, if market prices should rise
above loan rates, farmers may elect to repay the loan,
remove their grain from storage and sell it.
Producer income is supported directly by target
prices and deficiency payments. If market prices are
below the target price established by law, farmers
receive a transfer payment from the government for
the size of the price differential. An advantage to this
program is that deficiency payments effectively raise
farmers’ incomes without generating higher prices to
consumers or the purchase of large surplus stocks by
the government. A disadvantage is that deficiency pay
ments can become very expensive to the government
— and taxpayers — if large quantities of grain are
eligible for the maximum payment.
To illustrate how the program works, consider the
1982 wheat crop when the June-Oetober average
wheat price was $3.34 per bushel, the target price was
$4.05 per bushel and the loan rate was $3.55 per
bushel. The deficiency payment is calculated as the
difference between the target price and the higher of
the loan rate or average market price for the first five
months of the marketing year (June-October). Because
market prices were below the loan rate — the effective
price floor — deficiency payments last year were based
instead on the difference between the target price and
loan rate ($4.05 — $3.55 = $.50). The 48 percent of
wheat producers who complied with acreage reduction
provisions then were eligible for a 50-cent per bushel
income support or deficiency payment. These produc
ers received $475 million in deficiency payments for
the 1982 wheat crop.
The Farmer-Owned Reserve (FOR)
The FOR was established in 1977 to promote grain
price stability. In principle, the FO R stabilizes prices
by releasing stored grain to the market when prices are
high and removing grain when prices are low. In one
sense, it is an additional element of the CCC loan
program described earlier.
Digitized for 20
FRASER
FEBRUARY 1983
The initial CCC loan has a typical duration of nine
months at which time the participant must either repay
the loan or forfeit his grain to the CCC. Under the FOR
a farmer has a third option. He can receive a prepaid
subsidy (26.5 cents per bushel annual payment) to
store his grain for a longer period and extend the length
of his loan at below-market interest rates; the interest
rate for the last two years of the loan is zero. Loan
extensions typically have covered three years; thus, a
participant must keep his grain off the market for a
three-year period unless market prices increase to a
predetermined level; by repaying the loan, farmers
then can remove grain from the FOR and sell it. A
farmer must repay storage costs and other penalties if
the loan is redeemed under conditions that do not
satisfy the requirements established by program for
mulae.
GRAIN PROGRAMS AND ECONOMIC
ACTIVITY
The major grain programs have had a substantial
effect on economic behavior. On a purely descriptive
level, the data show that grain prices have persisted at
relatively low levels and real farm income has fallen to
historic lows; at the same time, the costs of government
support programs have reached record highs. On a
more analytic level, however, it is interesting to in
vestigate the economic incentives that have produced
these results. Thus, rather than attribute the low
prices and income to unusually good weather or other
random events, as many analysts have done, one
should examine the program’s incentives to see if they
reveal conflicts that could account for the observed
results, especially those that seem contrary to the
stated objectives of the programs.
Programs That Increase Production
Farmers will increase their grain production if they
expect grain prices to increase, if they expect their
costs to decline or both. Although grain programs do
reduce costs of farmers through free crop insurance
and the interest subsidies mentioned earlier, their
most important influence is on the distribution of ex
pected output prices.20 By increasing the average
“ Government programs affect farmers’ costs in a variety of ways. In
the longer run, USDA research produces technological innovations
(e.g., disease resistant crops) and information (e.g., outlook reports,
budgeting and business methods) that help lower costs. Converse
ly, price support programs tend to increase costs because increases
in expected output prices will tend to cause increases in the prices of
inputs, especially land. The net effect of government programs on
farmers’ costs would be difficult to determine.
FEDERAL RESERVE BANK OF ST. LOUIS
FEBRUARY 1983
F igure 1
Effects of Support Program on Expected Crop Price and Price V ariability
(mean) price expected by producers and reducing the
variability of expected market prices, programs that
establish a price floor tend to encourage farmers to
increase production.21
Figure 1 shows how. For simplicity, grain prices are
assumed to be distributed normally around some aver
age value, E(P), with a given variance, a 2, in the
absence of government programs. The mean price rep
resents the “best guess” of what actual prices will be at
harvest; it is the price upon which production decisions
will be based. In practice, E(P) could be the cash price
at the time of planting or the futures price dated for
end-of-season delivery minus the cost of storage.
2IThe same general argument applies to target prices and direct
income transfers made via deficiency payments. That is, eligible
producers are guaranteed at planting a minimum harvest price
equal to the market price plus a direct payment equal to the
minimum of the difference between the target price and either the
loan rate or market price.
The effects of a price support program also are shown
in figure l . 22 First, an effective support must be set at a
level greater than P„ to affect economic activity. If no
one believes that prices will be less than P„, a support
22Without a price support program, the expected price would be
calculated as:
00
E(P) = J P '{'(P)dP.
0
After a price support program is imposed, however, the left-hand
tail of the distribution is reallocated over the area to the right of Ps.
The most basic representation of this change is to “stack” the
shaded area at Ps; the expected price would then be calculated as:
Ps
x
E(P*) = Ps / ^(P)dP + /P ^(P)dP.
0
Ps
A more mathematical analysis of this example and simulation
results can be found in Michael Boehlje and Steven Griffin,
“Financial Impacts of Government Support Price Programs,”
American Journal o f Agricultural Economics (May 1979), pp.
285-96.
21
FEDERAL RESERVE BANK OF ST. LOUIS
at P0 or below would be viewed as irrelevant. But, an
effective price support, at say, Ps, increases the ex
pected price from E(P) to E(P*). The shaded area of the
price distribution to the left of Ps represents the por
tion of the old price distribution that is now eliminated;
the probabilities attached to this range of prices are
now “reassigned” to Ps. This shift in the expected price
distribution must increase E(P) which, ceteris paribus,
will tend to increase production.23
This reshaping of the expected price distribution by
a price support may have an even greater impact on
production through its impact on the variability of
expected prices.24 If the new price distribution facing
farmers has a lower variance, farmers face less price
risk than they did before.25 Farmers’ output decisions
will be based on a higher expected price and lower risk
of price fluctuations. If farmers are generally riskaverse, the reduced price risk also will generate
greater production.
Programs That Decrease Production
As the foregoing suggests, programs designed to
increase commodity prices also tend to increase pro
duction. The unfortunate side effect of this reponse is
that increased production tends to decrease prices. In
recognition of this, price support programs often re
quire compliance with a reduction of the number of
acres planted under programs of the form described
earlier.
But, will the reduction in the number of acres
planted necessarily support prices at levels desired by
the legislation? It is unlikely unless more acreage is
idled than is typically the case, for the following
reasons. First, because farmers can select the land they
idle, they will designate the poorest quality land for
participation in the RAP. Thus, the reduction in
quantity produced will be proportionately smaller than
that suggested by the number of acres idled. Second,
depending upon individual circumstances, farmers
also may attempt to raise yields on the remaining land
by using fertilizer and pesticides more intensively.
“3This example represents a partial analysis. The distribution itself
will shift to the left if the support program increased production.
Higher expected output would lower the probabilities of obtain
ing relatively high prices and offset some of the increase in the
expected price.
24This argument has been made for a number of years, dating back at
least to Holbrook Working, “Price Supports and the Effectiveness
of Hedging, ” Journal o f Farm Economics (Decem ber 1953), pp.
811-18.
25Under reasonable assumptions, truncating the lower tail of the
distribution at Ps also will reduce its variance.
22
FEBRUARY 1983
Existing evidence suggests that these practices can
offset about one-half of the impact of an acreage
reduction.26
Most important, however, is the recognition that
grain is an internationally traded good and, hence,
grain prices are determined in the w orld market.27
Therefore, in the absence of tariffs or quotas, attempts
to reduce U.S. production will have to increase the
w orld price of grain in order to raise grain prices for
U.S. farmers. Because w orld grain supplies affect grain
prices in the United States and abroad, far more
acreage must be idled in the United States than would
be necessary if U.S. grain supplies alone affected the
U.S. grain price. For example, if the U.S. elasticity of
demand for grain were —0.2 but the elasticity of total
(U.S. domestic plus export) demand were —1.5, the
influence of a world market would require the idling of
over 600 percent more land to achieve a 10 percent
increase in grain prices.28 Without cooperative agree
ments for output reductions by other countries, U.S.
attempts to increase grain prices by idling acreage are
likely to be unsuccessful.29
Storage Programs
Because price supports encourage increased pro
duction and current acreage reduction programs are
insufficient to offset this effect, “surplus” stocks are
likely to accumulate in government storage. Histor
ically, the CCC loan program has acquired this surplus
“ Federal Reserve Bank of Chicago, Agricultural Letter, No. 1595
(January 21, 1983).
2'In many years, U .S. policy has ignored this fact and set loan rates
above world prices. Because the loan rate isafloorfor U .S. prices,
minimum U .S. prices were maintained above the world price.
Such a policy, however, effectively removed the United States
from international trade unless other producing nations could not
fully satisfy world demand, thereby making the United States the
“supplier of the last resort.” That is, U .S. grain was not traded
internationally because U .S. producers could receive returns
higher than the world price by selling grain domestically or plac
ing it under CCC loan. Conversely, importers would buy U.S.
grain only if all other trading partners could not supply it at the
lower world price.
28This example and a more detailed analysis can be found in Gard
ner, Governing o f Agriculture, p. 38-9. His example shows that a
10 percent increase in price can be achieved by a 2 percent output
reduction if the elasticity of demand is —0.2. If it is —1.5, howev
er, the same 10 percent increase in price requires a 15 percent
reduction in output. The approximate difference between these
output reductions is 600 percent.
29In fact, the lack of such an agreement has allowed other producing
nations to be “free-riders” with respect to U .S. grain programs.
That is, other countries benefit from U .S. price support and
storage programs without paying any direct costs. This is partially
why the U .S. will hold 85 percent of the world’s corn stocks and 44
percent of its wheat stocks in 1983.
FEBRUARY 1983
FEDERAL RESERVE BANK OF ST. LOUIS
production. More recently, however, the FOR has
been introduced to build even greater reserve stocks.
The stated intention of the program is to promote
greater price stability by increasing and manipulating
the mean level of reserve stocks. To be successful,
then, the FOR must accomplish two objectives: First,
it must increase the level of reserve stocks. Second,
this increase in stock levels and the handling of the
reserve itself must dampen the variability of grain
prices. The evidence to date, however, suggests that
neither objective has been achieved.
With respect to stock levels, the most current esti
mate is that each additional bushel of grain in the FOR
represents only a 0.2 to 0.4 bushel addition to total,
privately owned stocks.30 The closer this estimate is to
zero, the more strongly it suggests that farmers have
viewed the publicly-controlled FOR as a subsidized
alternative to private storage. That is, rather than
paying to keep grain in private storage, eligible farmers
can place grain in the FOR, receive a 26.5 cent per
bushel prepaid storage subsidy and pay no interest on
the last two years of a three-year loan. The substitution
estimate of 0.2 to 0.4 might be closer to zero if par
ticipation in the FO R did not require a three-year
contract during which the grain cannot be sold unless
market prices rise to a specified multiple of the loan
rate. As one analyst has remarked, however, “It is not
clear that the FO R program has added significantly
more to either corn or wheat stocks than would have
been achieved by the CCC loan program without it. ”31
Evidence to date also suggests that the FO R’s effects
on price stability have been contrary to the program’s
presumed objectives. Frequent changes in program
rules — especially changes in trigger prices and other
factors that affect the release of FOR grain to the
market — have increased the uncertainty associated
with participation in the FOR. This uncertainty, it is
argued, also tends to increase the variability of market
prices. 32 In a study of daily wheat and corn prices
before and after the establishment of the FOR, Gard
ner found that the program, in fact, was associated with
increased variability of grain prices. Another study
using monthly data yields results consistent with
Gardner’s.33 This evidence suggests that the FOR has
been more successful in transferring income to farmers
through storage subsidies than it has in increasing
stocks or stabilizing grain prices.
The Payment-in-Kind Program (PIK)
In an effort to reconcile the results produced under
conflicting incentives, the US DA has implemented the
PIK program for 1983. Under its provisions, producers
who have reduced acreage by the 20 percent of base
stipulated by the RAP may idle up to an additional 30
percent of base acreage under PIK; in some cases,
farmers may bid to idle their entire acreage. Participat
ing corn producers will be given corn from CCC or
FOR reserves in an amount equal to 80 percent of the
normal yield on the number of acres idled.34
Because wheat producers already have planted their
winter crop, they will be given 95 percent of normal
yield if they plow it under to participate. Participating
farmers are then free to sell the grain they receive or
feed it to livestock. While participants will avoid the
costs of planting and harvesting acreage declared to
PIK, they probably will have to plant some cover on
this land to prevent erosion.
The motivation behind PIK is twofold. On one hand,
it attempts to remove more land from production than
has been possible under existing programs. On the
other hand, the distribution of reserve grain to farmers
will reduce surplus stocks. It is hoped this payment-inkind will reduce the costs of support programs — now
at record highs — and reduce the depressing effects
that large surplus stocks exert on market prices.
W ILL PIK WORK?
Preliminary estimates by the US DA indicated that
PIK would idle about 23 million acres of land over and
above land already taken from production by other
programs. Other estimates ranged as high as 50 million
acres.30 The actual figures exceeded both estimates,
however, showing that over 69 million acres had been
committed to the program; this acreage is in addition to
the 13.2 million acres idled by the RAP alone.
A range of estimates is presented in Jerry A. Sharpies, An Evalua
tion o f U S. Grain Reserve Policy, 1977-80. U .S. Department of
30
Agriculture, Agriculture Economic Report No. 481, March 1982.
31Bruce L. Gardner, “Consequences of Farm Policies During the
1970s,” in Food and Agricultural Policy f o r the 1980s, D. Gale
Johnson, ed., American Enterprise Institute, Washington, D .C .,
1981.
3ZSee Sharpies “An Evaluation of U .S. Grain Reserve Policy, and
Gardner, “Consequences of Farm Policies.
“ Michael T. Belongia, “Factors Affecting Placements of Corn and
Wheat in The Farmer-Owned Reserve,” processed, February
1983.
■^Farmers currently without grain in CCC or FO R stocks must put
their current crop under CCC loan to participate in PIK.
35William Robbins, "Farm Officials Stump for Plan to Reduce Plant
ing of Crops,” New York Times (January 22, 1983).
23
■
Although the 82.3 million acres to be idled this year
are spread across seven crops, corn and wheat are
expected to show the largest reductions.36 In fact,
about 87 percent of all acreage idled has a base in corn
or wheat. But, because some uncertainty still exists
about the overall quality of land planted and growing
season weather, yields may reinforce or offset the
effects of a reduction in acres planted. Based on reason
able assumptions about increases in yields, however, it
appears as if 1983 programs will cause output reduc
tions on the order of 20 percent for wheat and 30
percent for corn.
The effects of 1983 crop programs on commodity
prices can be estimated by using cash prices at the time
PIK was announced and the total elasticity of demand
cited in an earlier example. That is, in January, when
PIK was announced as a new program option, cash
prices for corn and wheat were $2.58 and $4.08 per
bushel, respectively. The estimated total elasticity of
demand of —1.5 also suggests that a 1 percent decline
in production will raise prices by 0.67 percent. There
fore, for these estimates, a 30 percent reduction in corn
production implies a 20 percent increase in price.
Based on a January price of $2.58, this simple analysis
suggests corn prices, at time of harvest, will be near
$3.12 per bushel. A similar analysis for wheat shows
uT h e PIK program covers com , wheat, sorghum, cotton and rice.
Barley and oats arc not included in PIK.
Digitized for24
FRASER
prices reaching $4.60 per bushel. These prices com
pare to 1983 target prices of $2.86 for corn and $4.30 for
wheat.
SUMMARY AND CONCLUSIONS
Programs to manage farm production and prices
have been in existence since the 1930s. An analysis of
current programs intended to limit surplus accumula
tion and raise farm prices indicates, however, that they
have failed to achieve either objective. Specifically,
supply reductions resulting from some programs
targeted at output reductions have been offset by in
centives to increase production contained in other
programs. The result has been a continuation of the
“farm problem”: chronic surpluses and relatively low
prices.
The PIK program, the latest effort to reconcile these
conflicts, could increase corn and wheat prices mar
ginally above their support levels only if the most
optimistic estimates of farmer participation are real
ized. Estimates based on USDA projections, however,
indicate that surplus removal under PIK will not in
crease com or wheat prices substantially above their
target prices. With surplus conditions prevailing for at
least two more years, the 1980s are unlikely to become
the decade of increasing commodity shortages and ris
ing relative prices that many analysts forecast just a few
years ago.
@FedFRASER