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FEDERAL RESERVE BANK O F ST. L O U IS JUNE 1971 CO N TEN TS How Fast is Money Growing?......................... 2 The Road to Accelerating Inflation is Paved with Good Intentions.................... 9 HS Vol. 53, No. 6 How Fast is Money Growing? by NORMAN N. BOWSHER Concern has been expressed about the progress this nation is making in the struggle against inflation. In recent months money has been rising at a very rapid pace. Experience has demonstrated that prolonged, rapid increases of money are follow ed by an excessive rise in spending and an intensification of inflation. R e c o v e r y FROM the slowdown of 1969-70 has continued. Total spending has risen at a 7 per cent annual rate since the second quarter of 1970, after a 4 per cent rate of increase in the three previous quarters. The growth rate in real output, adjusted for strikes and other irregular forces, has steadily in creased since the first quarter of 1970. In the second quarter of this year, it is estimated that total spending is increasing at about a 10 per cent rate and real out put is rising at about a 5 per cent rate.1 Retail sales have risen markedly since last Novem ber, following a two-year period of sluggishness, and housing starts have risen substantially since last fall. The composite of leading business indicators has risen at a 15 per cent annual rate since last September. Industrial production, after rebounding from the au tomobile strike, increased gradually in March and April. By contrast, industrial production declined about 3 per cent in the year preceding the strike. Indications of the course of inflation are mixed. Consumer prices have risen at a 4 per cent annual rate since June of last year, compared with 6 per cent from mid-1969 to mid-1970. However, there has been little, if any, improvement in the wholesale sector. Average hourly earnings in manufacturing, adjusted for interindustry shifts and changes in overtime, have risen at an 8 per cent rate since last August, compared with a 6.4 per cent increase in the previous year. Monetary restraint was applied in 1969 to reduce the inflationary pressures. During 1969, the money stock rose about 3 per cent, down from the 7.6 per cent rate of the previous two years. Growth in total spending slowed about six months later. After a still longer lag, the rate of advance in some price indica tors began receding gradually. 1See the “Quarterly Economic Trends” release of this Bank, May 26, 1971, p. 6. Digitized forPage FRASER 2 Since early 1970, monetary policies have been re laxed considerably. During 1970 money increased 5.4 per cent. Spending and production have been stimu lated, despite the auto strike and cutbacks in Govern ment defense spending. Early this year the growth rate in money again accelerated. Concern is develop ing over whether the rate of monetary expansion has become too rapid.2 This article discusses the recent rate of money growth and attempts to place it in some historical perspective. The accompanying note discusses some problems in measuring money growth. Recent Growth of Money In the four months from January to May, the money stock rose at a 14 per cent annual rate to a level of about $224 billion. The rapid rise did not depend on an unusual jump in any one month. On the contrary, month-to-month annual rates of increase were 15 per cent, 12 per cent, 10 per cent, and 18 per cent, respectively. Since last November, money has risen at a 10 per cent annual rate and since September, at an 8 per cent rate. For the entire fifteen-month period from Feb ruary last year, which began a marked and sustained increase in the rate of growth, to May this year, money grew at an average 7.6 per cent annual rate. Comparisons With Previous Rates The recent rates of money expansion are relatively rapid compared with other periods since the early 1950’s. The 10 per cent annual rate since November, and the 7.6 per cent rate since February 1970, com pare with a 3 per cent rate from January 1969 to February 1970, a previous period of a relatively 2See dissents in the “Record of Policy Actions of the Federal Open Market Committee,” contained in the Federal Reserve Bulletin for February 1971, pp. 118-19; for April 1971, p. 327; and for May 1971, p. 397. FEDERAL RESERVE BANK OF ST. LOUIS uniform growth rate in money. With the 3 per cent rate, total spending slowed to about a 5 per cent rate of growth, just slightly faster than the upward trend of productive capacity and perhaps near an optimum rate for the longer run. However, because of previous excesses, prices continued to rise rapidly at about the same rate as total spending, leaving total production nearly unchanged. JU N E 1971 Money grew at a 5.8 per cent average rate from May 1965 to January 1969. Total spending on goods and services rose at a rapid 8 per cent annual rate from 1965 to 1969. Since production was at near capacity levels, output was limited by growth in labor, capital, and technology, and prices were bid up at increasing rates. Overall prices, which had risen 1.5 per cent from 1963 to 1964, rose 1.9 per cent from Some Problems in Measuring Money Growth Monetary developments have significant effects on spending, production, employment, incomes, and prices. One measure of monetary influence is the growth rate in the nation’s money stock (private demand deposits and currency in the hands of the public). Measuring how fast money is currently rising, and judging the appro priateness of that rate, however, are not simple matters. The appropriateness of a given rate of money growth depends, in part, on the economic situation. Because the economy is now sluggish, some analysts believe that money growth, no matter what the rate, has been too slow. Others, focusing on inflation, believe that the growth rate of money has been much too fast. However, most analysts feel a moderate policy course is more appro priate than either of these extremes which focus on a single objective. Some recommend a policy of stimulation so long as gains in current production and employment outweigh the increases in current prices. However, value judg ments differ on the costs of inflation and idle resources, causing disagreements on the appropriate rate of mone tary expansion. Still others emphasize the effect of lags, and find that a rate of money growth acts with a longer lag on inflation than on employment. To them, the ap parent paradox of unemployment with inflation may merely be an unavoidable transition from a period of excessive monetary expansion. The money supply fluctuates each day by as much as a billion dollars and more. Short-run fluctuations may be caused by movements in total bank reserves, Treasury deposits, time deposits, and excess reserves, as well as by a number of other factors. Most of these daily move ments are offset within a brief period by opposite shortrun fluctuations. Daily fluctuations in money probably have no significant effect on aggregate spending, produc tion, and prices, and daily data are not published regularly. D ata on money are collected, tabulated, and published on a daily average basis, both seasonally adjusted and unadjusted, for weeks and for months. Compounded annual rates of change for various combinations of be ginning and ending periods are published by this Bank in order to facilitate comparisons.1 Selecting a proper period for analysis is an important step in interpreting money movements. One-week or onemonth changes are quite irregular and seldom have been found to have a measurable effect on spending, produc tion, or prices. The minimum period for meaningful analysis is usually about three months. Yet, arbitrarily picking a three-month or one-year period may be quite misleading. Experience indicates that selecting “good” base and ending periods for comparison is essential. Ideally, these points should mark the terminal points of a relatively uniform trend, or at least be on such a trend. The points selected should be free of significant bulges or dips, and if the ending period is the most recent data available, as is frequently the case, then allowances should be made for possible revisions and for known influences that are likely to be temporary. This is especially true where the period to be studied is relatively short, since a given deviation affects rates of change more over a short pe riod than when spread over a longer time span. On the other hand, if the period reviewed is unduly long, mean ingful shorter run trends may be lost. Other considerations in selecting appropriate periods for measuring money growth may include policy inten tions, movements in related monetary aggregates, and movements in spending, production, and prices. Then, too, periods selected may differ, depending on the use to be made of the data. For example, if the object is to evaluate the effectiveness of the Federal Reserve System in controlling money, the period should be relatively short, say, about three months. If the object is to measure the im pact of a given change in a money trend on a change in the rate of real production, a longer period would probably be desirable for the new trend, say about five months to a year. If the object is to relate the growth of money to the upward trend of prices, the ap propriate period may be a trend over several years. xSee the statistical release H.6, “Money Stock Measures,” and the Federal Reserve Bulletin published by the Board of Governors of the Federal Reserve System. Also see the “U.S. Financial Data” and “Monetary Trends” releases of this Bank. Page 3 JU N E 1971 FEDERAL RESERVE BANK OF ST. LOUIS M o n e y Stock Percentages ore onnuoi rates o f change for periods indicated 1964 to 1965, and 2.7 per cent, 3.2 per cent, 4.0 per cent, 4.7 per cent, and 5.3 per cent, respectively, in successive years. The trend growth in money was 2.3 per cent per year from 1951 to 1965. This trend was sufficient to accommodate the growth in business and financial transactions caused by the expansion of real output. Comparisons With Other Recovery Periods The economy is now in the process of recovering from a mild recession. Some stimulation might be ap propriate during a recession, but the 10 per cent rate of growth of money since last November is more rapid than during other recovery periods. Recessions occurred in 1949, 1954, 1958, and 1960, and there was a marked slowing of activity in 1966-67. During the recession of 1949, money growth acceler ated, and from November 1949 to April 1953 money grew at a 4.3 per cent annual rate. From April 1954 to May 1955 and from January 1958 to June 1959, money again grew at the accelerated rate of 4.3 per cent. In each of these recessions, monetary actions were considered to be aggressively stimu lative at the time; in each case the acceleration of money growth was followed within a few months by an upturn in the growth rate of spending and produc tion. Also, inflation generally became stronger about a year later, and the rate of monetary expansion ap peared, in retrospect, to have been too rapid. http://fraser.stlouisfed.org/ Page 4 Federal Reserve Bank of St. Louis Money growth accelerated again during the reces sion of 1960. The rate of money growth, beginning in 1960, was more moderate than those during the three earlier recovery periods, and was continued longer. Money, after declining from mid-1959 to mid-1960, rose at a 3 per cent average rate for about 5 years, from June 1960 to May 1965. The economic recovery after 1960 was less pronounced than after the three previous recessions, but the expansion occurred with out great imbalances or an intensification of infla tionary pressures. By late 1964 and early 1965, pro duction was approaching the limits of capacity and expanding at near the maximum sustainable pace. The economy was then given an upward jolt by a sharp increase in Federal spending and the accom panying large monetary injections of 1965, 1967, and 1968. During the slowdown in spending and production of late 1966 and early 1967, money growth accelerated to a 7.6 per cent annual rate, and this rate was main tained through 1968. Total spending spurted after about a six-month lag, and inflationary pressures in tensified more quickly and to a greater extent than after any of the previous recessions. Percentile Comparisons Comparison of monetary increases in some recent periods —the last three months, the last six, the last nine, and the last twelve — with all earlier periods of similar length may provide additional insight into how rapid recent monetary growth has been. In the last three months, money has risen at a 13 per cent annual rate. This is in the 100th percentile of all con secutive three-month periods since January 1950. In fact, money rose faster in both the January-to-April and the February-to-May 1971 periods than in any of the other 255 three-month periods. In the last six months, money has risen at a 10 per cent annual rate. This also is in the 100th percentile of all consecutive six-month periods since January 1950. The 8 per cent rise in money over the last nine months places it in the 99th percentile of all nine-month periods. The 7 per cent growth of money in the last twelve months is in the 95th percentile. Sizable monetary injections might be appropriate under extremely depressed economic conditions for brief periods. At the present time, excess capacity in the nation is moderate, and price increases continue at near peak rates. Unemployment, which averaged 5.7 per cent in the last twelve months, was in the 79th percentile of all twelve-month periods since January JU N E 1971 FEDERAL RESERVE BANK OF ST. LOUIS 1950. Overall prices rose 5 per cent in the last four quarters, which is in the 90th percentile of all fourquarter changes. Quantity of Money Demanded The supply of money should be just sufficient to accommodate increasing public desires to hold money as an asset when spending rises at a rate consistent with potential output. If money rises more rapidly than the amount demanded (given current interest rates, incomes, wealth, and other pertinent condi tions ), the public will tend to increase current expen ditures in an attempt to reduce the excess cash balances. Conversely, if the money supply rises less rapidly than does the amount the public wishes to hold, they will decrease current expenditures in an attempt to build up cash balances. The aggregate amount of money demanded cannot be measured precisely. Relating past changes in the money stock with the accompanying and lagged changes in spending is, in effect, a method for esti mating the past growth in the demand for money to hold. Such studies indicate that the growth in money demanded in the United States has been relatively steady at about a 3 per cent annual rate since the late 1940’s. Whenever the money stock rose at a 2 per cent rate or slower for an extended period, economic acti vity tended to slow. On the other hand, whenever money rose at a 4 per cent rate or faster for an ex tended period, spending tended to rise more rapidly and, in time, price increases accelerated. It is possible that the amount of money demanded has changed recently, so that earlier relationships no longer hold. Economic studies indicate that the amount of money demanded as an asset depends on a number of factors, particularly interest rates, real in come and wealth, and prices, as well as the technology of minimizing cash balances. Interest rates are currently at relatively high levels historically. Since an increase in interest rates raises the opportunity cost of holding money, the amount of money demanded has probably declined. A reversal occurred last fall and winter with the decline of interest rates from their peak levels, but most rates have risen again since March. Real income has changed little since mid-1969. By comparison, the upward trend of real income was 4 per cent per year from 1957 to 1969. With the slower growth of income (and wealth), other things equal, it might be expected that the growth in the amount of money demanded also has slowed. Inflation has been strong in recent years, and infla tion and inflationary expectations have several effects on the amount of money demanded. Since inflation Prices Ratio S ca le 1 9 67= 100 130 R atio S ca le 1 9 67= 100 130 Interest Rates R atio S c a le o f Y ie ld s 11 R atio S c a le o f Y ie ld s M onthly A v e ra g e s of Dot ----,11 10 Consumer 9 8 7 Corporate Wholesale Industrial 1963 1964 1965 19 6 6 Latest d a ta plotted: M ay 1967 1968 19 6 9 19 7 0 1971 1 96 3 196 4 1965 19 6 6 19 6 7 1968 196 9 1970 1971 Source-. U .S. Department of Labor Percentages are a nnu al rates of change for perio ds indicated. L atest data plotted: C onsum er-April; W ho lesale-M ay Page 5 FEDERAL RESERVE BANK OF ST. LOUIS reduces the real value of money, the amount desired as a store of value declines. On the other hand, as prices for goods and services increase, the amount of money demanded by individuals and businesses for transactions probably rises. However, supplying money in response to an inflation-induced increase in the amount of money demanded tends to accommo date the inflation malady. The rate of inflation may have been gradually receding for about a year, slow ing the increase in the amount of money demanded for transactions because of rising prices. JU N E 1971 Grow th in Total Spending1 St. Louis M od el Simulation Assuming 9 Per Cent Grow th in M oney S to ck 1^ Per C ent 12 Per Cent 10 8 This review of recent developments in the forces thought to be most influential in determining the quantity of money demanded suggests that only litde change has occurred in the trend of money demanded in the last year. If this is true, past relationships be tween the quantity of money supplied and the sub sequent growth in spending can be expected to con tinue with little change. To the extent that there have been any changes in the past year, some acceleration in the growth in the amount of money demanded probably occurred in 1970 with the decline in market rates. More recentiy, most forces seem to be slowing the growth rate in the amount of money demanded, indicating that the growth rate of total spending will be faster in the near future relative to growth in the quantity of money supplied. 6 4 0 1968 1969 1970 1971 1972 [^ F ig u re s p lotted a re co m p o u n d e d a n n u a l rates of c h a n g e , a d ju s te d to rem ove irre g u la r flu ctu a tio n s in both a c t u a l a n d p rojecte d d a ta . B e g in n in g in 11/1971, p ro je c tio n s assu m e 9 p e r c e n t gro w th in m o n e y stock a n d high-em ploym ent F e d e r a l e x p e n d itu re s b a s e d on the fiscal 1972 b u d g e t through 11/1972; th e re a fte r, e x p e n d itu re s are assu m ed to g ro w a t a n 8 p e r cent rate. [2 S e e " A M o n e ta r is t M o d e l for E c o n o m ic S t a b iliz a t io n ," this R e v ie w (A p ril 1970), pp. 7-25. Model Projections Evaluation of whether a rate of money growth is too rapid depends on the likely economic impact. Assuming a 9 per cent annual rate of money growth, which is slightly less than that experienced since last November, a very rapid economic expansion is likely in the near future. At this rate of monetary injection, this Bank’s model indicates that growth in total spend ing for goods and services would accelerate from the recent 7 per cent annual rate to about a 10 or 11 per cent rate in the latter part of 1972.3 Deviations of spending from the model projections seem more likely to occur on the high side than on the'low. Typically, when money has risen very rapidly for an extended period, the growth in velocity of money also has risen after a two or three quarter lag .4 The model has not captured fully the increases of velocity in previous recovery periods. 3For details on the model, see “A Monetarist Model for Eco nomic Stabilization,” April 1970 Review of this Bank, pp. 7-25. For current projections of this model, see the “Quar terly Economic Trends” release of this Bank. 4See “Changes in the Velocity of Money,” Reprint No. 4 of this Bank. Page 6 Growth in real product with a 9 per cent rate of increase of money would accelerate from the recent 1 per cent annual rate of increase to about a 6 per cent rate late next year, according to this Bank’s model. This would be above a sustainable rate, given the trend growth of productive capacity, estimated to be about 4 per cent per year. By utilizing idle resources, a greater-than-sustainable rate of production growth could be accommo dated for a short period with the current rate of inflation changing little. The model indicates litde or no increase in the rate of price advance for the next year and a half, even with the 9 per cent money growth. However, the model indicates that inflation would intensify markedly after 1972 under such a stimulative policy. Resisting inflation at a later time, then, would lead to greater costs in reduced output growth than presentiy. Interest Rate Considerations Although money has expanded sharply, most inter est rates have risen in recent months. Interest rates on highest-grade corporate bonds rose from 7.1 per cent JU N E 1971 FEDERAL RESERVE BANK OF ST. LOUIS Yields on Selected Securities Interest rates perform a function in our economic system similar to that of prices of goods and services. They allocate scarce resources among competing users, but have little bearing on the level of total resource utilization. As such, high market interest rates should be viewed as having about the same implications for economic stabilization as higher market prices on commodities or services. Trends of Money Growth Source: Board ol Governors ot the Federol Reserve System ond Moody s Investor! Service 11 Weekly averoges ol doily figures |2 Thursday figures in February to 7.7 per cent in early June. Concern has been expressed that a rise in interest rates, par ticularly long-term rates, might choke off the economic recovery.5 Market interest rates are the prices at which the quantity of credit supplied and the quantity de manded are equated. Monetary actions affect both the demand for and supply of credit. An increase in the stock of money and bank credit adds directly to the supply of loanable funds, tending to cause interest rates in the short run to be lower than they otherwise would be. A rise in the money stock also has expansionary effects on the total demand for goods and services. When dollar balances and credit are increased rap idly, given existing assets, incomes, prices, and inter est rates, the public attempts to exchange some of the “excess money” for goods and services. This tends, in time, to cause an increase in total spending, produc tion, and prices. With expectations of greater sales and a higher rate of inflation, demands for credit may be expanded at a faster rate than the supply of credit created, and net upward pressure on interest rates results. The rise in rates in recent months is probably a reflection of a very rapid monetary stimulation of demands for credit rather than evidence of any mone tary restraint.6 5See Wall Street Journal, “Interest Rates Reverse Downward Trend; Stir Fears for the Economy,” May 25, 1971, p. 1; and Ben Weberman, “Fed Baffled as to How to Get Rates Down,” American Banker, May 24, 1971, p. 1. 6For additional analysis of the interaction of monetary actions, inflation, and interest rates, see “The Road to Accelerating Inflation is Paved with Good Intentions,” in this Review, pp. 9-15. Additional perspective on the recent rate of money growth can be obtained by comparing trends over longer periods, covering several monetary cycles. From early 1952 to mid-1964, the money stock grew at an average 1.9 per cent average annual rate. Within this twelve and a half year period, several cyclical upswings in money growth occurred, and spending, production, and employment increased rap idly. At other times, the money stock drifted down relative to the trend, and, with a brief lag, spending and production slowed and unemployment rose. Over all prices in this period rose at a relatively slow 1.8 per cent annual rate. Since mid-1964, money has risen at a faster 5.3 per cent average annual rate. Early in the period, as money accelerated to the new trend, and later, as money moved up relative to the trend, spending, production, and employment received a temporary stimulus. But as money moved down relative to the trend, sluggishness and slack reappeared. The rate of overall price increase has accelerated from the 1.8 per cent rate of the Fifties and early Sixties to a 5.3 per cent rate since mid-1969. Unemployment experience was about the same whether the trend growth of money was 1.9 per cent (1952-64) or 5.3 per cent (1964-71). Both trend pe riods contained some relatively high and some rela tively low unemployment rates. The trend growth of money apparently had its chief impact on the trend of spending growth and the rate of price advance. It has been the shorter-run movements around the trends which have apparently had the greatest im pact on cyclical changes in spending, production, and employment. Conclusions Recent growth rates of money have been very rapid, as measured in a number of ways. Experience has demonstrated that large, prolonged injections of money will be followed by an excessive rise in spend ing and an intensification of inflationary pressures. Largest increases of money have usually occurred Page 7 FEDERAL RESERVE BANK OF ST. LOUIS JU N E 1971 during periods of economic slack for the purpose of stimulating spending, but from 1960 to early 1965 a balanced recovery and expansion occurred while money rose moderately. Experience also indicates that when money growth accelerates for a prolonged period and then ceases to accelerate, as it must if the economic system is to survive, growth in production slows and unemployment increases at higher rates of inflation. Two lessons seem to emerge from the money ex perience of the past two decades. First, if the upward thrust of inflation is to be halted, the trend growth of money must be reduced to a moderate rate. The pre cise rate depends on the growth of money demanded under conditions of anticipated price stability (per haps about a 3 or 4 per cent annual rate). However, money has risen rapidly in the last six months, rais ing slightly the growth trend of money for the past several years and indicating likely intensification of inflation in the near future if continued much longer. Second, changes in the trend growth of money should be gradual, and short-run movements around the trend should be slight, because marked move ments away from a previous trend have usually been followed by destabilizing changes in spending. The sharp money growth in recent months has deviated significandy upward from the previous trend, indicat ing a faster-than-sustainable rate of increase in pro duction in the near future. Reprint Series 0 VER THE YEARS certain articles appearing in the R e v i e w have proved to he helpful to banks, educational institutions, business organizations, and others. To satisfy the demand for these articles, our reprint series has been made available on request. The following articles have been added to the series in the past year. Please indicate the title and number o f article in your request to: Research Department, Federal Reserve Rank o f St. Louis, P.O. Rox 442, St. Louis, Mo. 63166. NUM BER TITLE O F ARTICLE ISSU E 57. Federal O pen M arket Committee Decisions in 1969 — Y e a r of M o n etary Restraint Ju n e 58. M etropolitan A re a G row th: A Test of Export Base Concepts Ju ly 59. Selecting a M onetary In d ic a to r— Evidence from the United States and O ther D eveloped Countries Septem ber 1970 60. The “ C row ding O u t” of Private Expenditures by Fiscal Policy Actions O ctober 1970 61. A g g reg a te Price Changes and Price Expectations N ovem ber 1970 62. The Revised M o n ey Stock: Explanation and Illustrations Ja n u a ry 1971 63. Expectations, M o n ey and the Stock M arket Ja n u a ry 1971 64. Population, The Labor Force, and Potential Output: Implications for the St. Louis M odel February 1971 65. O bservations on Stabilization M anagem ent December 1970 66. The Im plem entation Problem of M o n etary Policy M arch 67. Controlling M on ey in an O pen Econom y: The Germ an Case A pril 68. The Y e a r 1970: A "M o d e s t" Beginning for M o n e ta ry A ggregates M ay Page 8 1970 1970 1971 1971 1971 The Road to Accelerating Inflation Is Paved with Good Intentions First Annual Monetary Policy Lecture, delivered by DARRYL R. FRANCIS, President, Federal Reserve Bank of St. Louis, to the School of Banking of the South, Louisiana State University, Baton Rouge, Louisiana, June 1, 1971 J t is good to be here this evening, and it is an exciting experience for me to deliver the “First Annual Monetary Policy Lecture” to the School of Banking of the South. I have felt for a long time that people engaged in banking should become more familiar with the influence of monetary policy actions on the econ omy. Increased public awareness of the ways policy decisions are made, and the ways stabilization actions work, may help to move us towards better policies in the future. I wish you a long and successful lecture series. As we approach the mid-point of 1971, I wish I could say to you that it is my belief that the battle against inflation is nearing successful completion and that we can now turn our primary attention to moving the economy quickly back towards its noninflationary, high-employment growth potential. Unfortunately, this is not the case. I must report diat I am just as con cerned now about the long-run inflationary trend of the U. S. economy as I was last year and the year before. Tonight I will trace the economic developments from the mid-1960’s to the present which, in my opinion, created the present inflationary environment and cause me great concern regarding the prospects for achieving price stability in the near future. It is important to make clear at the outset that I do not believe anyone desires a continuation of the inflationary trend in this country. However, I do be lieve that there is a danger of focusing too much attention on other immediate objectives, and that the consequences of resulting actions could lead to a re acceleration of the rate of inflation, contrary to our desires. I will elaborate more fully on this view after looking back to the events which led to our present situation. Approach to Analysis Throughout my remarks I will be drawing heavily on research of the Federal Reserve Bank of St. Louis. In recent years our economists have been exploring new approaches to empirical measurement of the re sponse of total spending, real product, prices, the unemployment rate, and market interest rates to vari ous monetary and fiscal actions. This research has shown that changes in the nation’s money stock — that is, demand deposits at commercial banks and cur rency in the hands of the public —provide a reliable indicator of the influence of monetary policy actions on total spending in the economy. Furthermore, evidence has been provided and be come widely accepted that the levels of, or changes in, market interest rates do not give a reliable indica tion of the “tightness” or “ease” of stabilization policy actions. On the contrary, it has been shown that mar ket interest rates are significantly influenced by the Page 9 FEDERAL RESERVE BANK OF ST. LOUIS past rate of inflation and people’s expectations with regard to the future rate of inflation. Finally, the ongoing work by our research staff is attempting to quantify the immediate and delayed responses of real product and prices to a pronounced change in the rate of increase of total spending. We have been able to make fairly reliable predictions of the rate at which total spending will accelerate or decelerate in response to substantial accelerations or decelerations in the growth of the money stock. There is less certainty, however, about the breakdown of the changes in total spending into the real product and price component parts. The range of estimates on this breakdown is especially large at a time when there appears to be substantial slack in the economy, in the form of unused plant and equipment capacity and relatively high unemployment, while there continues to be a fairly high rate of inflation as a result of previous excesses. I believe that a careful study of events from the mid-1960 s to the present sheds con siderable light on the risks that would be incurred by underestimating the speed at which substantial inflationary pressures would be rekindled if prolonged monetary stimulus resulted from efforts to achieve other short-term objectives. Background to the Current Situation I turn now to consideration of past developments which seem to provide clues to assessing our future course.1 In this review I will emphasize the fact that avoidance of increased inflationary pressures was at all times a fundamental desire of stabilization au thorities. For the most part, however, the actions actually taken were with a view to achieving other near-term objectives. It is my opinion that this suc cession of actions taken to deal with goals other than achieving price stability has added up to an uninten tional long-run acceleration in the rate of inflation. The review begins with 1964, the last year of a sixyear period of relative price stability. Growth of both total spending and real product strengthened through out that year as a result of the continuing monetary ■Federal Open Market Committee policy actions for each year have been discussed in detail in the following articles published in this Review: “Implementation of Federal Reserve Open Market Policy in 1964,” (June 1965); “Federal Reserve Open Market Operations in 1965: Objectives, Actions, and Accom plishments,” (June 1966); “1966 — A Year of Challenge for Monetary Management,” (April 1967); “1 9 6 7 — A Year of Constraints on Monetary Management,” (May 1968); “Fed eral Open Market Committee Decisions in 1968 — A Year of Watchful Waiting,” (May 1969); “Federal Open Market Committee Decisions in 1969 — Year of Monetary Restraint,” (June 1970); and “The Year 1970; A ‘Modest’ Beginning for Monetary Aggregates,” (May 1971). JU N E 1971 stimulus initiated in 1963 and the tax-cut of March 1964. The published record of Federal Reserve policy actions2 shows that for the first eight months of 1964, policy was conducted with a view to maintaining prevailing conditions in the money markets. In the final four months, System actions were directed to move towards slightly firmer conditions in the money markets. However, the rate of growth in total spend ing was increasing, and the public was demanding a growing amount of credit to finance increased spend ing. Consequently, System holdings of Government securities rose fairly rapidly, as the tendency for mar ket interest rates to rise was resisted by open market purchases of securities. The result was progressively more rapid rates of growth in the nation’s money stock. On balance for 1964, money rose 4.5 per cent, over twice as fast as the average growth rate during the previous decade. As a direct consequence of the growing monetary stimulus in 1964, 1965 became the first of many years of mounting inflationary pressures. Reflecting back on 1965, I find it to be a year of great paradox. At each of the sixteen meetings of the Federal Open Market Committee in that year, the ultimate policy objective was to avoid emergence of inflationary pressures, yet monetary actions were more stimulative than at any time since the Korean War. Throughout the year the operating instructions for policy were to maintain the same or slightly firmer conditions in the money mar kets. In view of the increasing demands for credit, this meant, in effect, that open market operations were to be conducted so as to keep interest rates from rising significantly. Yet interest rates did rise a significant amount in 1965, in spite of record pur chases of securities in the open market by the Federal Reserve. This is where the paradox comes in. Restrictive policy was desired in order to combat inflation, and many observers contended that the rising interest rates were an indication that restraint was achieved. But I think a closer look indicates that the rising interest rates were not at all restrictive, while the actions to resist the upward trend of interest rates were very stimulative. During ten of the sixteen policy periods in 1965, open market transactions were directed to take ac count of the U. S. Treasury financing activity. As I see it, the problem was that the public demand for 2AU quotes and references to policy instructions in this speech are from the Annual Report of the Board of Governors of the Federal Reserve System unless specified otherwise. FEDERAL RESERVE BANK OF ST. LOUIS credit to finance an accelerating rate of total expendi tures was growing very rapidly, and at the same time the Government was incurring very large deficits as expenditures rose rapidly to finance the Vietnam War buildup along with mounting nondefense outlays. Since Federal Reserve policy actions were conducted with an immediate objective of maintaining stable or only slightly rising interest rates, System actions pro vided increased bank reserves at a very rapid rate. This, in turn, resulted in “a record expansion of bank credit and deposits” to finance the faster rate of spend ing of the public and government. Early in 1966 policy objectives shifted to “moderat ing the growth in the reserve base, bank credit, and the money supply” in order to resist inflationary pres sures. However, through April of 1966 policy actions were constrained by continued Treasury financing. As a result, the money stock rose at a very rapid 6 per cent rate from May 1965 to April 1966. Here I must emphasize that the 6 per cent rate of money growth in 1965 and early 1966 was sufficiently rapid to stimulate substantial inflationary pressure, even though real product was growing very rapidly as prior unused capacity declined. The rate of price advance as measured by the GNP deflator moved up from about 1% per cent in early 1965 to over 3% per cent by mid-1966. The acceleration of consumer price increases was even greater. The last nine months of 1966 marked a period of effective restrictive action to combat inflation. The growth of the money stock dropped to zero, as interest rates were allowed to rise in response to market de mand. Policy instructions explicitly called for a reduc tion in bank reserves, as fighting inflation finally be came a more important objective than maintaining relatively low interest rates, or stable money markets, or accommodating Treasury financing. You may recall that the economy survived a “credit crunch” in the early fall of 1966, as the continued strong demands for credit in the face of restrictive monetary actions resulted in a temporary upward spurt in market interest rates. In comparison with recent interest rates, those of the 1966 credit crunch period look rather low. The yields on neither shortnor long-term market securities rose above six per cent at their peak levels. There is an especially important lesson here. Dur ing 1964 and 1965, policy actions were directed to wards maintaining relatively low interest rates, but the efforts were in vain, since the resulting rapid growth in money generated inflation and rising inter JU N E 1971 est rates. On the other hand, following the nine-month period in 1966, when the immediate attention of pol icy actions was turned to controlling the growth of monetary aggregates in order to combat inflation, lower interest rates accompanied the slower growth of total spending and easing demands for credit. The restrictive monetary actions of 1966 were fol lowed by a sharply slower rate of growth of total spending and real product in late 1966 and the first half of 1967. This was the period of the so-called mini-recession. As the growth of total spending in the economy slowed, the immediate objective of policy turned to other near-term goals such as stimulating renewed real economic growth, maintaining the lower interest rates that had resulted from previous restric tions, and facilitating continued large Treasury financ ing activities. During most of the first half of 1967, there was a definite desire to move policy in the direction of ease. Since the growth of total demand continued to slow in delayed response to the restraint of 1966, demands for credit continued to be moderate and market interest rates continued to fall. Even with falling interest rates making money market conditions easier, System open market purchases of securities increased, resulting in a rapid resumption in the growth of the money stock. The very clear intention of policymakers was to be only as expansionary as necessary to promote growth of real production, but not so stimulative as to refuel the inflationary forces. During the spring, however, policy ceased seeking still easier conditions in the money market, and sought only to maintain the easier conditions that had developed. Although concern was being expressed about the possibility of re-emergence of inflationary pressures, other immedi ate considerations received more weight. By June the economy was strengthening rapidly, and a definite tendency developed for all market in terest rates to rise. Once again, as in 1964 and 1965, open market policy actions turned towards a direct attempt to prevent market interest rates from rising further in response to growing public demands for credit and extremely heavy Treasury financing requirements. The published public policy record shows that through the summer and well into the fall of 1967, a dominant reason for attempting to slow the uptrend in interest rates was the view that higher interest rates might reduce the flow of funds into mortgages and slow the recovery of residential construction activ ity. Also, some argued that higher interest rates might Page 11 FEDERAL RESERVE BANK OF ST LOUIS have adverse effects on the flow of funds into financial intermediaries such as savings and loan associations. Inasmuch as the U. S. Treasury borrowed over $23 billion in the fiscal year beginning in July 1967, money and capital markets were under great pressure. Consequendy, many contended that open market opera tions by the Federal Reserve should hold interest rates down in order to avoid these many undesired effects. In response, the System expanded bank re serves and the money stock at very rapid rates in this period. Furthermore, in the fall of 1967, some felt that pol icy actions should be constrained from becoming re strictive, because of the possible adverse effects such actions might have on the position of the British pound sterling in the foreign exchange markets. The prevailing view was that if System actions became less expansionary through reduced purchases of securi ties in the open market, and market interest rates rose as a consequence, relatively more international capital might flow out of Britain and into the United States. Such events might, in turn, force the British to devalue the pound. Thus, the international situation was a more immediate concern of policymakers than was the avoidance of renewed inflationary pressures. As you may recall, the British devalued the pound in late November 1967 in spite of the good intentions of United States policy. By the end of 1967, it finally became clear that inflationary pressures were building up rapidly and some restraint would have to be exercised in order to avoid greatly overheating the economy. However, policy actions were constrained to allowing only slightly firmer conditions to develop in the money market, because of the continuing concern about the possible adverse effects of higher interest rates on financial intermediaries. This is a puzzling period to assess. The experience of 1964 and 1965 had shown that direct policy actions attempting to maintain low interest rates would be frustrated, since the rapid growth of the money stock which resulted from the low interest rate policy caused acceleration of inflation and sharply rising interest rates. The more recent experience of 1966 had shown that an anti-inflationary policy of holding down the growth of the money stock would produce lower in terest rates once the upward thrust of inflationary expectations was broken. Yet, policy actions in 1967 returned to direct attempts to maintain low interest rates. Once again the result was accelerating inflation. If policy decisions were misdirected in 1967, it was even more true in 1968. In the first half of 1968 there Page 12 JU N E 1971 was a clear consensus that a restrictive anti-inflation ary policy was appropriate. Yet, short horizons and other immediate considerations forestalled restrictive actions. There was the almost ever-present Treasury financing to consider, and in March the crisis in the London gold market militated against restrictive actions. The public policy record for early April 1968 delin eates the considerations which dominated this period. Although the desirability of fighting inflation was com monly agreed upon, some argued that any firming actions should proceed with caution for several rea sons. First, restrictive monetary policy was believed to be inappropriate in view of the prospects for fiscal restraint. Second, some thought the sharply rising in terest rates indicated “a considerable degree of mone tary restraint had already been achieved”, and also there was the persistent concern that restrictive actions “might have large adverse effects on flows of funds to financial intermediaries”, and such would be undesir able. Finally, there was uncertainty about the eco nomic effects of the Vietnam War. The second half of 1968 was a regrettable period for United States stabilization policy. In June, Con gress passed the Revenue and Expenditure Control Act which raised corporate and personal income taxes and slowed the growth of Government spending. A view became very widely held in the summer and fall that this fiscal package was too restrictive and would cause too sharp a slowdown in the economy. As a result, there was an overt move towards easier monetary policy to counter this presumably very re strictive fiscal impact. By December 1968, however, it became widely rec ognized that the fiscal package had little, if any, restrictive impact, and that the monetary ease had further fanned the flames of inflation. Monetary ac tions moved strongly towards restraint, as the growth of the money stock was curtailed in spite of continuing strong demands for credit and rising interest rates. This marked the end, for the time being, of a twoyear period of the most stimulative monetary actions since the Korean War. The direct efforts to thwart the tendency for interest rates to rise had been a total failure, since the expanding inflationary pressures had resulted in sharply higher short- and long-term inter est rates. To recapitulate so far, the rapid 6 per cent rate of growth of the money stock in 1965 and early 1966 resulted in an overall inflation rate of about 3% per cent, and interest rates of 5% to 6 per cent before the FEDERAL RESERVE BANK OF ST. LOUIS restrictive actions of 1966 took effect. The still more rapid 7% per cent growth in money throughout 1967 and 1968 ultimately resulted in the overall rate of inflation accelerating to over 5% per cent and most interest rates peaking between 8 and 9 per cent. Finally in 1969, policy actions brought about significandy slower growth rates of money. In turn, after a lag, the slower growth of money brought the growth in total demand down to more sustainable long-run rates. As in the credit crunch of 1966, restriction of the growth of money in 1969 temporarily resulted in sharply higher interest rates, as the inflation-fed growth in demands for credit continued very strong for a while after the supply of new funds to the market was curtailed. But, as before, once the upward thrust of expectations concerning continued inflation was broken, growth in the demand for credit slowed and interest rates began to move quickly downward. After two major episodes of stop-and-go actions, policymakers in 1970 were in a position to benefit significantly from their recent past experience. Last year monetary policy actions moved to a moderately expansionary stance, and I have no disagreement with the growth of the money stock that resulted on bal ance in 1970. By year’s end the quantity of money outstanding was somewhat over 5 per cent greater than a year earlier, and I think that was about right in view of the lack of real output growth and the rising unemployment we were experiencing. However, I believe that over a longer period of time and especially under conditions of a stronger pace of real economic growth and a higher level of employ ment, a 5 to 6 per cent rate of growth of the money stock would prove excessive in terms of the average rate of inflation. It is my view that the longer-run noninflationary growth rate of money most likely would be on the order of 3 to 4 per cent. As the economy strengthens, I believe that the rate of growth of money should be lowered to this more sustainable range. I would like to elaborate on this view within the con text of the overall experience during the post-Korean War period. Trend Velocity of Money During the decade ending in late 1962, money grew at about a 1% per cent average annual rate. Both the velocity of money and the economy’s productive po tential increased at about a 3% per cent average rate during this period. As a result, the overall rate of price increase was a relatively slow 1% per cent aver age annual rate. Then, from 1962 to the end of 1966, which includes the period of restrictive monetary ac JU N E 1971 tions in 1966, the growth of money was at an acceler ated 3% per cent average annual rate. With velocity continuing to rise at its earlier pace, and potential real output growing somewhat faster, this rate of mon etary expansion resulted in a quarterly rate of inflation of 4 per cent in the latter part of that period. Following the credit crunch of 1966, the growth of money accelerated to very rapid rates, as emphasized previously. By looking across the second period of monetary restraint in 1969, the resumption of mod erately rapid growth of money in 1970, and the period of very rapid monetary growth thus far in 1971, I see that the growth of the money stock has risen at about a 6V2 per cent average annual trend rate since January 1967. In this period there was a marked fall in the rate of increase of velocity, and the rate of potential output growth rose slightly. Consequently, the very rapid growth of money since early 1967 has resulted in about a 4% per cent average annual rate of infla tion as measured by the implicit price deflator, and a peak rate of inflation of over 7 per cent as measured by the consumer price index. Even if the trend growth of velocity should continue in the future to be at the recent slower rate, which, in my estimation, would be a highly optimistic out look, a continuation of the 6% per cent trend growth of money since early 1967 would imply a sustained 4 per cent rate of inflation. If, on the other hand, the trend growth of velocity in the future were some where between the low IV2 per cent rate of the past four years, and the 3 V2 per cent rate of the previous fifteen years, then the recent trend of monetary growth could imply as much as a sustained 6 per cent trend rate of inflation. If I get somewhat ahead of myself by noting that the money stock has risen at a 9V2 per cent rate in the past six months, I am sure that you can see why my reading of the events of the past seven or eight years gives me cause for concern. The trend growth of money from 1962 to 1966 was over twice the average rate of the previous decade. I am fairly certain that after the credit crunch of 1966, there were few who would have viewed another doubling of the growth of money to be desirable. But that is what happened in 1967 and 1968. After the high interest rate, highly inflationary developments of 1969, and the liquidity crisis of 1970, I suggest that further acceleration of the longer-term trend growth of money should be avoided at all cost. Thus, the excessively rapid growth of money in recent months gives me a feeling of “butterflies” where butterflies ought not to be. Page 13 FEDERAL RESERVE BANK OF ST. LOUIS Recent Monetary Growth Additional insight into how rapid monetary growth has been recently can be obtained by comparing the increases in some recent periods with all earlier pe riods of similar length. In the last three months money rose at a 12 V2 per cent annual rate, which is faster than all other three-month periods since World War II. In the last six months, money rose at about a 9V2 per cent annual rate, which is also faster than all other consecutive six-month periods in the last twentyfive years. Similarly, in the fifteen months since Feb ruary 1970, the approximate time when more rapid monetary growth was resumed following the restraint initiated in early 1969, money has risen at about a 7V2 per cent annual rate. This is faster than all but one per cent of similar length periods. This is telling evidence that recent monetary growth has indeed been very rapid, whether viewed in terms of absolute rates of growth or relative to historical experience. Implications for the Future In closing, I would like to review with you some factors which may have an important influence on the growth rate of money in the near future. For obvious reasons, I cannot divulge recent policy deci sions, and I could not disclose the growth rate of money that is likely to result from policy actions, even if I knew. However, I can discuss some factors which might be considered in the formulation and especially in the implementation of policy, as these have been made public elsewhere. I will indicate my judgment as to the direction of influence of some factors which seem likely to lead to excessive monetary growth if we do not profit from the experiences of the past. These factors are: Treas ury financing requirements in fiscal 1972; concern over the general level and trend of market interest rates; and desires to rapidly expand growth of real product and to achieve a lower rate of unemployment as soon as possible. Obviously there is some overlap among these factors. First, I think the direction of influence of Treasury financing requirements in the past is clear; that is, periods of large Government deficits have tended to be accompanied by rapid monetary growth. President Nixon’s budget message in January this year indicated a deficit of $11% billion in the fiscal year beginning July 1, 1971. However, as widely discussed at the time, the deficit will be larger than otherwise to the extent that national income falls short of the assump tions made by the President’s advisers. Also, the deficit will be larger if there is any tendency for Congress to Digitized for Page FRASER 14 JU N E 1971 spend more than the President requested. According to assessments reported in the press earlier this year, the planned deficit is probably the minimum that will occur. The experiences of two previous periods, 1965 through early 1966 and 1967 through early 1968, in dicate that monetary actions may result in a more rapid growth of the money stock than otherwise under conditions of substantial Treasury financing. The second factor which must be guarded against in order to avoid continued excessively rapid growth of money, and this ties in with the Treasury financing constraint, is concern for the level and trend of inter est rates. As the growth of real output in the economy accelerates during the balance of this year and in 1972, or as anticipation of inflation increases, the de mand for credit to finance production, consumption, and investment will increase. Such increases in de mand for credit put upward pressure on market inter est rates. There are at least two ways such a tendency for market interest rates to rise would indicate conditions which might induce excessively rapid growth of money, unless we carefully guard against them. First, interest rates have traditionally played an important role in the implementation of policy decisions, as I have illustrated previously. High or rising interest rates have frequently been identified with more re strictive monetary policy, and I doubt there is a pre dominant desire of policymakers to achieve a very restrictive policy stance at this time. Decisions to maintain relatively easy conditions in the money and short-term credit markets might lead to substantial purchases of securities on the open market. Such ac tions could very well foster too rapid growth of bank reserves and deposits, and thereby too rapid a rate of money creation, if we are not careful to avoid such a development. The other way that a tendency for interest rates to rise might suggest rapid growth of money is the view that low interest rates, especially on longer-term se curities, are essential for a recovery of real economic growth. This view holds that the market level of long term interest rates is an important factor in business investment plans. It is argued that a rise in interest rates might “choke-off” recovery in business capital expenditures before the economy has returned to a balanced level of high-employment real growth. I am suggesting that one approach to stabilization analysis views low interest rates as being necessary for real recovery, and that stabilization actions should be di rected towards achieving and maintaining low inter est rates. Again, policymakers cannot accept this line JU N E 1971 FEDERAL RESERVE BANK OF ST. LOUIS of reasoning without running the risk of excessive growth in money. The third factor which, if given considerable weight, would tend to indicate continued rapid monetary growth is the desire for rapid reattainment of high growth in real output and a low rate of unemploy ment. Aside from the influence of interest rates, there are some who argue that rapid growth of money is necessary and desirable in order to reduce quickly the rate of unemployment by two or more percentage points, and to avoid the lasses in output inherent in continuing to produce below capacity. While I agree that these are very desirable objec tives, I feel that achieving continued reduction in the rate of inflation is also a worthy cause. It seems that some balance between the actions necessary to achieve a quick end to the inflation and those necessary to achieve a quick return to full employment is best. Especially at the present time, those who argue for very stimulative policies should make a realistic assess ment of the implications for future inflation, and indicate their willingness to accept such consequences. Given the very long lags we have observed in the past between the initiation of restrictive actions and progress towards smaller price rises, it is not sufficient to say we can fight that battle when the time comes. Present actions must be made with full recognition of their eventual consequences. In the period we have reviewed tonight, policy actions were frequently di rected towards the attainment of short- or intermedi ate-term objectives, such as holding interest rates down to help the housing industry or to encourage business investment. Recently, actions also have been directed towards achieving an early reduction in the average rate of unemployment, and a prompt return to growth of real output at long-run potential. However, a careful analysis of the events of this period show that actions taken to deal with an immediate concern can later have adverse effects on longer-run aspects of eco nomic activity. Thus, it frequently appears that pres ent actions are simply dealing with problems created by past actions. While I do not view the situation as hopeless, it is obvious that there is ample room for improvement. In conclusion, my remarks tonight may not appear to be very optimistic. Possibly our future policy ac tions will be better than in the past. We have ample experience from which we can learn. If we do, then an adage regarding our ability to learn from past experience would not be valid, at least with regard to the conduct of stabilization policy. The adage is: W hat men learn from history, is that men do not learn from history. Page 15 SUBSCRIPTIONS to this bank’s R e v ie w are available to the public without charge, including bulk mailings to banks, business organizations, educational institutions, and others. For information write: Research Department, Federal Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166.
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