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FEDERAL RESERVE BANK O F ST. L O U IS MARCH 1971 Capital Markets and Interest Rates in 1970 2 The 1971 National Economic Plan ............. 11 The Implementation Problem of Monetary P olicy.......................................... 20 Vol. 5 3 , No. 3 Capital Markets and Interest Rates in 1970 JL H E M OST SP E C T A C U L A R fluctuations in m ar ketable securities prices in the era since W orld W a r II have been encountered since early 1970. The markets for both common stocks and bonds staged large rallies between June 1970 and February 1971, after declin ing in the spring of last year. At their zenith in June, high-grade bond yields reached levels never before recorded in U. S. financial annals. Stock prices slumped to six-year lows in May. Capital market pes simism reached great extremes; some ( though not a ll) observers foresaw a dearth of funds available for in vestment extending far into the decade. Low er inter est rates and higher stock prices have doubtless caused revision of such views, although the pace of the market changes makes reappraisal of long-run financing prospects difficult. Beyond that, the 1970 experience raises questions about the causes of such gyrations and their effects on the economy. Cyclical Variations in Interest Rates and Stock Prices Among the unusual features of financial markets in 1970 was the delayed response of long-term interest rates to the business downturn. W hereas in previous postwar business slowdowns, peaks in bond yields o c curred promptly after business peaks or even pre ceded them, three quarters elapsed after the business downturn in 1969 before long-term Treasury and cor porate bond yields reached their peaks. Since then, the reductions in yields have been the greatest in amount of any comparable period since W orld W ar II. Seasoned corporate Aaa bonds, for example, de clined from a peak of 8.6 per cent in the week ending June 26, 1970 to 7.1 per cent in the week ending M arch 5, 1971. Long-term U. S. government securities fell from a yield of 6.8 per cent to 5.9 per cent in the same span of time. In a recent reversal, yields, esPage 2 Yields on Seasoned A a a Corporate Bonds Per C ent Per C ent 1 9 6 9 -7 2 . 19 59 -6 2 P -------------------- — " _______________ P _________ 1 9 5 6 -5 9 P"— — 19 53 -5 6 1 9 4 8 -5 1 4 T H Q TR. 49 3RD Q TR/54 ow n r t p 1ST Q T R '61 4T H Q T R . 7 0 _______ I--------___________________________________________ 1_______________ i_______________ 1 •6 -5 -4 -3 -2 -1 0 1 2 3 Q U A R T ER S TO A N D FRO M T R O U G H 4 5 6 S o u rc e -. M o o d y 's In v e s to r S e r v ic e P d e n o t e s th e p e a k q u a r t e r of th e b u s in e s s c y c le . L a t e s t d a t a p lo t t e d : 1st q u a r t e r 1971 e s tim a te d pecially on corporate new issues, have risen and other long-term interest rates have stopped declining. Short-term interest rates displayed more typical cyclical behavior, reaching highs at the beginning of 1970, a quarter after the downturn in business activity, then falling rapidly with only one tem porary reversal throughout the year. The four- to six-month com m er cial paper rate, which was 9.08 per cent in the second week of January 1970, plumm eted to 4.25 per cent by early M arch 1971. Three-m onth U. S. Treasury bill yields fell from 7.91 per cent to 3.35 per cent in the same period. F E D E R A L R E S E R V E B A N K O F ST. L O U I S MARCH In terest R a te s on Four- to S ix -M o n th C o m m e rcia l P a p e r -6 -5 -4 -3 -2 -1 0 1 2 3 Q U A R T E R S TO A N D FRO M T R O U G H 4 5 6 P d e n o te s the p e a k q u a r t e r o f th e b u s in e s s c y c le . Late st d a ta p lo tte d : 1st q u a rte r 1971 estim ated 1971 months, both their average level and the term struc ture of interest rates are affected. It is typical for short-term rates to fall much more rapidly than long term yields. F o r example, rates on U. S. Government obligations maturing in less than one year, which entered 1970 one percentage point above twenty-year U. S. bonds, were m ore than two percentage points below long-term bond yields by February 19, 1971. This is consistent with the assumption that the long term bond yield is an average of a sequence of ex pected short-term yields. A decline in current short term market rates would generally have only a small immediate effect in changing this long-term average. As mentioned previously, short-term rates peaked several months before long-term rates. If the bond market had anticipated the general decline in inter est rates, the decline should have been reflected ini tially (although mildly) in medium-term or longerterm interest rates. A related development was the whiplash action of the yield curve between January 2, 1970 and May 28, 1970 when yields fell in the shortest maturity ranges, while rising in the mediumand long-maturity segments. Usually, all segments of the yield curve move in the same direction simultane ously, with the short-term end moving more than the long-term end. This pattern did indeed quickly reas sert itself by July 1970. Stock prices underwent a broad retreat throughout 1969 and early 1970. In Spring 1970, retreat threat ened to turn into rout for a brief interval, as stock prices fell by 23 per cent between April 1 and M ay 26. By the end of May, however, the market began to regain composure, and since then, stock prices have rebounded. The Standard and Poor’s Index of 500 Stocks (1941-43 = 1 0 ), which reached a low of 69.29 on May 26, 1970, climbed to 97.56 by early M arch 1971. Term Structure of Interest Rates The accompanying chart depicts three “yield curves” (relationships between maturities of fixed in terest-bearing obligations and their market yields) for U. S. obligations with maturities running from less than one year out to thirty years. The curves were observed at three different dates: January 2, 1970, M ay 28, 1970, and February 19, 1971. They are based on actual yields on these dates, but each curve has been smoothed to fill in gaps in maturity where no actual obligations are available. In general, when interest rates undergo a rapid downward readjustment, as in the past fourteen Page 3 FEDERAL RESERVE B A N K O F ST. L O U I S Inflation Expectations and Interest Rates The expectations interpretation of the yield curve helps explain how some of the recent change in in terest rates was transmitted through the maturity spectrum. Other considerations would explain how the general level of interest rates is determined. A factor which may have contributed greatly to the high levels of interest rates up to the 1970 peaks is anticipated inflation. Interest rates on new loans were adjusted upward to reflect the expected depreciation of the purchasing power of the dollar during the period of each loan. Since borrowers expect to repay loans in depreciated dollars, they were willing to offer higher interest rates. Lenders, on the other hand, were will ing to accept such terms only because high interest rates include an inflation premium that compensates for the exp ected reduction in the value of the dollar. In other words, what borrowers and lenders agree upon is a nominal or market interest rate ( R n ) which, when the premium for the expected percentage rate of inflation (A P e) is subtracted, leaves a net interest rate (R r ) that represents both an acceptable rate of return to the lender and cost to the borrower. This net return, after allowing for anticipated inflation, is what some economists have labelled the “real” rate of interest.1 That is, the real rate, Rr, equals Rn — A Pe. This interpretation of interest rate movements has been incorporated in the interest rate equations of the St. Louis model.2 It has also been employed in a related study of stock price determination.3 These studies find that other factors influence real rates of interest, notably growth in the money stock (currency plus demand deposits) which exercises a short-lived negative effect (positive on stock p rices), and growth in real output, which affects the real rate of interest positively with a lag over a longer time span (n e g a tive effect on stock p rices). Corporate after-tax profits also have a positive impact, with a lag, on stock prices. Anticipated inflation, in the sense already described, has a powerful influence in these equations, tending to drive average stock prices down and interest rates up.4 ^‘Interest Rates and Price Level Changes, 1952-69,” this Review (December 1969), pp. 18-38. 2“A Monetarist Model for Economic Stabilization,” this Review (April 1970), pp. 7-25. •^“Expectations, Money and the Stock Market,” this Review (January 1971), pp. 16-31. 4The effect of anticipated inflation on stock prices runs counter to some interpretations of stocks as “hedges” against inflation. The findings suggest that expected corporate earn ings do not fully adjust to anticipated price advances. In vestors apparently regard common stocks typically as mixtures Page 4 MARCH 1971 Most of the rise in bond yields from 1965 until early 1970 can be attributed to the escalation in the inflation premium. It appears, however, that inflation anticipations ( based on past price experience) cannot fully account for the high levels of interest rates ( and low levels of stock prices) in the second and third quarters of 1970. Correspondingly, in the first quarter of 1971, the interest rate equations forecast only a mild decline in rates, by comparison with the declines which have already occurred. Stock price forecasts are below the current market average, although the direction of change is being correcdy predicted. Either inflation fears are now subsiding more rapidly than these equations recognize, or some other factors are at work pulling interest rates down. Other Possible Explanations for Recent Interest Rate and Stock Price Movements Apart from anticipated inflation, other factors might have exercised an influence on nominal interest rates by altering die real rate of interest. Such factors in clude special disturbances affecting either the supply of money relative to the demand for money, or the flow of intended saving relative to intended invest ment. In addition, there might have been sudden or unusual shifts among sectors in their borrowing or lending patterns, causing tem porary adjustment prob lems that could have been reflected in interest rates. Recent developments will be surveyed from each of these points of view. Factors Affecting Demand for and Supply of Money and Near Monies Rapid growth in monetary aggregates relative to growth in demand for them should exert downward pressure on interest rates — in the short run. The op posite short-run effect on rates occurs when the sup ply of monetary aggregates is growing less rapidly than their demand. Monetary rates of change, both including and ex cluding net time deposits, reached lows in the latter half of 1969, and thereafter reversed the downtrends that began in 1968.5 Business activity began to recede in the third or fourth quarter of 1969. This represents of fixed nominal income streams, like bonds, and earnings streams that escalate with inflation. For this reason, the average price of all common stocks cannot be viewed simply as the market valuation of real capital. "'Net time deposits are total time deposits less large denomina tion CD’s. A similar statement could be made describing the rate of growth in money plus total time deposits, or even broader liquidity aggregates including savings and loan shares and mutual savings bank deposits. F E D E R A L R E S E R V E B A N K O F ST. L O U I S MARCH 1971 a prominent feature of growth in monetary aggre gates. Negotiable C D ’s grew from $13.2 billion in June 1970 to $27 billion in February 1971. Money supply plus all comm ercial bank time deposits in creased at a 17.4 per cent annual rate in the same period. Upward interest adjustments on C D ’s (follow ing suspension in June of Regulation Q interest ceil ings on large C D ’s of less than 90 days m aturity), combined with a declining trend of interest rates on competitive assets such as commercial paper, E u ro dollars, and Treasury bills, made C D ’s more attractive for businesses to hold. There has also been a very substantial increase in net time deposits at commercial banks and savings institutions. Between June 1970 and February 1971, these liquid assets grew by $43.1 billion. Over the same time span, money supply, defined as currency plus demand deposits, rose at a 5.7 per cent annual rate. In comparison with the turnarounds in previous periods of monetary expansion, the increased growth in the money stock relative to its low point in 1969 has been m oderate, but the recovery in growth of money stock plus net time deposits has been rapid. Some of this growth can be ascribed to “reinterm e diation” which occurs when interest rates decline on competing liquid assets. In addition, the decline in these interest rates, especially in recent months, has received a significant stimulus from expansionary monetary policy. F o r example, reserves of member banks have increased at an annual rate of 14.3 per cent since last June. The recent high rates of growth in the broader aggregate of money plus net time de posits reflect both the rapid expansion in bank re serves and the sharp decline in interest rates on marketable securities. a relatively early turnaround in comparison with monetary rates of change near previous postwar busi ness cycle peaks.11 Frequently the lowest rates of monetary growth have come several months after the business peak. Hence, the continued high level of interest rates in early 1970 cannot be attributed to sluggish increases in the monetary aggregates in the face of the business slowdown. During the last half of 1970, when interest rates fell sharply, the large increase in negotiable C D ’s was •’Centered rates of change of moving averages give somewhat different results than “step” rates of change. Both are shown in chart above. The “step” method is generally used in this Bank’s reports. Changes in “steps” tend to be preceded by peaks and troughs in centered moving average rates of change. A useful, though crude, measure of the demand for money balances in relation to income is the “income velocity of money” — the ratio of income to money balances. This ratio is an indicator of the turnover rate of money balances in exchange for goods and services. The following chart shows the ratio of GNP to money plus “net time deposits” (com mercial bank time deposits excluding large denomi nation C D ’s) in postwar business recessions. The amount of money balances demanded increases either more or less than proportionately with income or GNP. D uring much of the postwar period, the chart shows velocity to have risen with each successive business cycle, indicating a tendency for holders of money and net time deposits to increase their spending on goods and services faster than the growth in their liquid Page 5 F E D E R A L R E S E R V E B A N K O F ST. L O U I S MARCH V elo city of M o n ey Stock Plus Time Deposits* 2.6 2.6 19 59-62 1 9 5 6 -5 9 _______ 1 9 5 3 -5 6 / / / / / ^ ------- 1948-51 / 4TH T R .4 9 3RD Q T R .5 4 1ST QTR. 61 4TH QTR. 70 ~ ------ 1 ------- 1------- j------- 1 ------- 1 ------- 1-------1---------------1 ------- i-------------4 -3 -2 - 1 0 1 2 3 4 5 6 Q U A R T E R S TO A N D FR O M T R O U G H Source-. U .S. D e p artm en t o f Com m erce g ro ss n a tio n a l p ro d u c t m o n e y s to c k + n e t tim e d e p o s its * N e t time d ep o sits e q u a ls a ll tim e d e p o s its le s s c e rtific a te s of d e p o s it in d e n o m in a tio n s e x c e e d in g $1 00,00 0. P d e n o te s the p e a k q u a rt e r of the b u s in e s s c y c le . L a te s t d a ta p lo tte d : 4th q u a rte r 1970 balances.7 However, during business slowdowns, velo city falls — monetary assets increase relative to GNP. This happened in each of the recessions of 1949, 1954, 1958, and 1961, and in 1970. The decline in velocity during business slowdowns is typically associated with reductions in interest rates.8 After the business trough is reached, interest rates rise and velocity tends to recover. If the contracyclical rise in long-term interest rates in early 1970 had been the result of a sudden rise in the demand for money plus net time deposits, we should be able to detect it in an abnormally sharp drop in velocity.9 Similarly, the rapid decline in interest rates would be associated with an abnormally sharp rise in velocity — signifying a reduction in the demand for money plus net time deposits. The decrease in velocity dur7The rise in velocity of money stock as conventionally defined has been greater than the rise in the velocity of money plus “net time deposits,” especially in the last decade. sThe rise in velocity between successive post World War II business cycles is associated with (and may, in part, be due to) successive higher levels of interest rates. ^Assuming that unintended variations in velocity are of negli gible importance. Page 6 1971 ing the 1970 business contraction was not unusual by comparison with postwar recessions. Nor has there been any evidence of an unusually sharp rise in veloc ity in recent months. E xcep t for possibly the fourth quarter, one may rule out sudden changes in the demand for money plus net time deposits as a con tributing factor to the abnormal behavior of interest rates since Januar) 1970.10 The velocity of money plus net time deposits is perhaps too broad a measure, especially since it tends to consist very largely of liquid assets held by house holds, which exhibited none of the symptoms of a liquidity crisis in 1970. Some observers found such symptoms among business firms reacting to unfavor able financial developments in 1970. The failure of Penn Central Company sent liabilities of business fail ures upward in midyear. Corporate profits sagged for four quarters in a row beginning with third quarter 1969. Liquidity positions of nonfinancial corporations, by a variety of yardsticks, were stretched thinner in m id-1970 than in any previous postwar year. There is little evidence, however, that in 1970 a significant number of otherwise financially viable firms were forced to close for liquidity reasons alone. Velocity of nonfinancial corporate cash balances tends to decline during business contractions. The 1970 decline was delayed until three quarters after the fourth quarter 1969 turning point in business ac tivity, but it is not clear whether this was a cause or a result of high interest rates. To be a cause of high interest rates, one must assume the rise in corporate velocity after the business peak was unintended, so that corporations were attempting to improve their liquidity positions. Much of what appears to be a decline during 1969 and early 1970 in corporate liq uidity (rise in velocity) merely represents switching from negotiable C D ’s to comm ercial paper and gov ernment securities. Such shifts were a result of high interest rates ( and regulatory interest ceilings on C D ’s ) , not a cause of high interest rates. 10The General Motors strike of September-November, 1970 may have temporarily depressed the amount 'of money de manded in the fourth quarter of 1970 by reducing output and income below what it would have otherwise been. This response would not be fully reflected in velocity, if both income and demand for money declined and money stock were also reduced or permitted to grow less rapidly. Interest rates, therefore, could have been forced downward in the fourth quarter because of the effect of the strike. In the three months since the strike was settled, output growth has recovered from its strike-induced low, but interest rates have continued to fall. Other factors are evidently at work in reducing interest rates currently. FEDERAL RESERVE B A N K O F ST. L O U I S MARCH Personal saving, measured in the national income accounts as disposable income minus consumption expenditures, excludes accumulation of consumer dur ables. It represents mainly liquid asset accumulation, net of additions to consumer debt. During the cur rent business slump, this category of saving grew as a percentage of personal disposable income from 5.3 per cent in the second quarter of 1969 to a peak of 7.6 per cent in the third quarter of 1970, and declined slightly to 7.3 per cent in the fourth quarter. Taken by itself, the rise in personal saving has exerted a downward influence on interest rates since 1969. Velocity of Corporate Cash Balances* 11 10 9 8 7 6 5 4 3 0 - 6 - 5 - 4 - 3 - 2 - 1 0 1 2 3 Q U A R T E R S TO A N D FRO M T R O U G H 4 1971 5 6 S o u rc e s -. S e c u r it ie s a n d E x c h a n g e C o m m is s io n a n d U .S . D e p a rtm e n t of C o m m e rc e * R a tio fo r n o n fin a n c ia l co rp o ra tio n s of g ross c o rp o ra te p ro d u c t to c a sh on h a n d a n d in b a n k s. In previous postwar recessions, the personal saving rate has shown no clear cyclical pattern; it has some times risen, sometimes declined. The cyclical varia tion in measured personal income around its expected growth path does not seem to exercise a substantial influence on the saving rate. Part of its behavior may reflect monetary growth itself, since high rates of liquid saving relative to income are likely to take the form of rapid accumulation of cash balances. A rise in price levels will reduce the purchasing power of liquid assets and might induce households to attempt to restore that purchasing power by increased liquid P d e n o t e s th e p e a k q u a r t e r o f th e b u s in e s s c y c le . L a t e s t d a t a p lo t t e d : 3 r d q u a r t e r 1 9 7 0 More recently, the velocity of corporate cash bal ances has declined, partly because of the reversal of previous movements out of C D ’s. Even so, corporate liquidity is not at present exceptionally high, nor has it improved rapidly by comparison with experience in previous business slowdowns. Hence, current down ward pressures on interest rates do not appear to have their origin in greater liquidity of corporations. Saving and Investment in a Business Slowdown An excess of intended saving over intended invest ment tends to reduce interest rates, and conversely. There are practical difficulties, of course, in distin guishing intended from actual saving and investment. One technique for attempting this involves a decom position of saving by sector and investment by cate gory of expenditure, within the national income accounting framework. Saving is composed of three volatile components — personal saving, corporate undistributed profits (adjusted to remove inventory revaluation), and the net surplus of Federal and state and local governments. Investment consists of residential construction plus business expenditures on durable equipment, and structures, and inventory a c cumulation, shown in the accompanying chart. Page 7 F E D E R A L R E S E R V E B A N K O F ST. L O U I S saving. Sustained inflation, on the other hand, builds up anticipation of future price advances, which tends to discourage liquid saving. Higher interest rates on liquid assets, however, could compensate for antici pated inflation, and may have done so to some extent in recent years. The rise in the personal saving rate that began in the third quarter of 1969 appears to coincide with more rapid monetary growth. Looking ahead, a sub stantial decline in personal saving rates could occur as a result of lower interest rates, slower monetary growth or reduced inflation, especially if anticipated inflation remains high. Investment in dwellings is generally regarded as highly responsive to interest rate movements, rather than as a factor operating to exert strong pressure on interest rates, especially pressure of a procyclical na ture. High and rising mortgage interest costs in 1969 and early 1970 were reflected in declining residential construction expenditures. Federal government sup port of housing programs may have moderated the decline. Since the second quarter, homebuilding ex penditures have rebounded to an annual rate of $32 billion, less than $2 billion below their 1969 peak. Prospects for a continuation of this resurgence have been bolstered by the recent declines in long-term interest rates. These have enabled the Federal gov ernment to reduce FH A and VA ceiling mortgage loan rates to 7 per cent from the 8V2 per cent level of D ecem ber 1969. Capital expenditure plans in the business sector were exceedingly bullish in the early stages of the economic slowdown. Initial anticipations called for plant and equipment outlays in 1970 to increase by more than 10 per cent over the previous year. Actual 1970 business capital spending was only 6.6 per cent greater than in 1969. As the chart (p. 7 ) shows, busi ness spending on equipment and nonresidential struc tures turned down after the third quarter of 1970. Nevertheless, the early plant and equipment surveys for 1970 mirrored the upward thrust of fixed invest m ent intentions at the outset of the 1969-70 slowdown. Coupled with declining profits, which reduced the ability of corporations to finance capital spending through retained earnings, the net pressure on inter est rates of the corporate sector’s intended saving and fixed investment was undoubtedly upward in early 1970.11 Capital spending plans were revised n A $9.7 billion decline in inventory accumulation from the third quarter of 1969 to the first quarter of 1970 helped offset this pressure. In the second quarter, inventory change reversed direction, and by the fourth quarter was increas ing at a $3.6 billion annual rate. Digitized for Page FRASER 8 MARCH 1971 downward later in the year and corporate profits im proved, so that this pressure on interest rates was eased.1- In the latest survey conducted by the D e partm ent of Com m erce and SEC in January and February, business planned to increase its 1971 spend ing on plant and equipment by 4.3 per cent over the 1970 level. An important sector affecting capital markets through flows of expenditures relative to receipts is the Federal Government. The Federal budget, on a national income accounts (N IA ) basis, moved from a surplus at a $13.4 billion annual rate in the second quarter of 1969 to a $14.2 billion rate of deficit in the second quarter of 1970. An increase in the Federal net deficit usually occurs during business slowdowns due to reduced growth in tax revenues relative to expenditures. Expiration of the surtax, retroactive Federal pay increases, and increased social security benefits also contributed to the decrease in the net surplus in early 1970. The strong swing by the Federal Government from a net “saver” to a net “dissaver” position, primarily between the fourth quarter of 1969 and the second quarter of 1970, coincides with the abnormally long lag in response of bond yields to a downturn in business activity. A continuing large government defi cit may not elevate interest rates, but a rapid increase in the deficit, or decrease in the surplus, may exert tem porary upward pressure on interest rates. The de cline in long-term interest rates since midyear may therefore represent a return to their typical cyclical response as the Federal deficit passed its period of most rapid increase.13 The Federal deficit (national income accounts basis) increased somewhat in the fourth quarter of ,2It is conceivable that some or even most of the strength in early capital expenditure plans for 1970 reflected inflation anticipations. Expected productivity of additional plant and equipment might even have declined throughout 1970. Low and falling levels of capacity utilization suggest that the marginal productivity of new facilities may be decreasing; so also does the deceleration of growth in total real output in the economy, which began in early 1968. It can be argued that the rate of growth in total output is an approxi mation to the expected return on physical investment. 13The immediate impact of a sharp rise in the government deficit need not be concentrated in the maturity ranges in which new government debt is being issued. The effects might register most heavily in another sector, if simultane ously with heavy government borrowing in one maturity region, the private sector is retiring debt in that range and increasing its borrowing in some other maturity region. As discussed below, in 1970 corporations were retiring their short-term debt while increasing their long-term debt. At the same time the Federal government was borrowing heavily in the short-term end of the maturity range. F E D E R A L R E S E R V E B A N K O F ST. L O U I S 1970 to an estimated $15.3 billion annual rate. From this point, the NIA deficit is likely to decrease gradu ally as the economic recovery picks up momentum. The Administration projects a $15 billion NIA deficit in fiscal 1971, which would imply deficits averaging more than a $13 billion annual rate in the first two quarters in 1971. In fiscal 1972, which begins July 1, 1971, the NIA deficit is projected to decline to a $4.2 billion annual rate. Taking the national income a c counts budget as an indicator, and assuming the a c curacy of the Administration’s projections, the Federal sectors’ upward pressure on interest rates would seem to be easing.14 Disturbances in the Capital Markets Sudden changes in asset and liability positions in various sectors, especially when they are related to alterations in the maturity structure of outstanding credit obligations, sometimes provide clues about the net direction of pressures on interest rates. It is not always easy to distinguish between autonomous and accom m odating financial transactions, but when the changes are of extremely large magnitude, as some w ere in 1970, there may be less difficulty in discern ing the sources of disturbances in credit markets. Tw o features of 1970 capital markets are deserving of special mention. The first is the exceptionally sharp increase in long-term borrowing by nonfinancial cor porations. Much of this reflected refinancing of shortrun debt (bank loans primarily) carried over from 1969 and earlier, and did not represent a marked change in the rate of growth in total corporate debt. Lengthening of the maturity of corporate debt in 1970 may have eased the pressure of net government borrowing in short-term credit markets, while adding to weakness in long-term credit markets early in the year. The dollar volume of new corporate securities is sued (gross proceeds) continued at an unslackened rate throughout 1970, totaling more than $38 billion, only $8.6 billion of which were new stock issues. New issues in the first two months of 1971 were in excess of the corresponding months of 1970, and there are as yet no definite signs of a letup in long-term financ ing demands. The calendar of new corporate issues for M arch is extremely heavy. Since corporations have been reducing their short-term borrowing, particularly from banks, while adding to their short-term assets, 14For an evaluation of the Administration’s fiscal 1972 budget and 1971 economic plan, see “The 1971 National Economic Plan” in this Review, pp. 11-19. MARCH 1971 especially C D ’s, it is evident that many corporations are striving to strengthen their liquidity positions. The second notable feature was the extremely large rise in commercial banks’ net lending, particularly in the third quarter. A major portion of this, of course, arose out of the retirement of commercial paper by banks’ parent holding companies and its replacement by C D ’s. Bank credit expansion was $25.8 billion greater (annual rate) in the Summer quarter than in the Spring, after allowing for this. Almost $15.2 billion of this increase in bank credit was accounted for by loans to security dealers and brokers to finance a c quisition of U. S. Government and other securities. An increase in the rate of acquisition by banks of U. S. Government securities accounted for another $8.2 billion (annual ra te ) of the bank credit increase. Commercial bank lending to business slowed in the third quarter and declined in the fourth. In the fourth quarter, banks becam e heavy net purchasers of muni cipal and Federal agency securities. Long-term bond yields, which had generally de clined in January, February, and M arch 1970, con forming to their cyclical pattern, rose again in April, May, and June. It appears that the sharp declines in the Spring, and the subsequent Summer rallies in bond and stock markets, gained strength from a mas sive shift in investment policy among securities deal ers and brokers, from net liquidation of their positions in the second quarter to aggressive rebuilding in the third quarter. The reasons for this behavior may be traceable to special circumstances — the Cambodian incursion, the campus riots, and a series of failures, forced mergers and recapitalizations among broker age firms. These events took their toll on the stock and bond markets in the Spring. Then the failure of Penn Central sent tremors through the bond and commercial paper markets in June. After the severe buffeting subsided, securities dealers regained confi dence. The much discussed liquidity crisis of the Spring and early Summer of 1970 centered very largely in the fortunes of brokerage firms. It may account for a large part of the unusual cyclical re sponse of bond yields. The effect on interest rates and stock prices, while possibly significant at that time, was short-lived. Summary and Conclusions Interest rates, particularly bond yields, remained near peak levels for an abnormally lengthy period in 1970 after the downturn in business activity. Sev eral factors could have contributed to this long lag in response. These include ( 1 ) the persistence of infla Page 9 FEDERAL RESERVE B A N K O F ST. L O U I S tionary anticipations; (2 ) the sharp rise in the Federal deficit during fiscal 1970; (3 ) heavy long-term borrow ing by corporations, coupled with exuberant capital expenditure programs early in the year; (4 ) the very gradual decline in real output growth, compared with previous postwar recessions; (5 ) the financial prob lems of securities dealers, which were reflected in net liquidation of their securities inventory positions in the Spring; and (6 ) special circumstances, such as the Cambodian incursion and campus rioting. The Penn Central crisis temporarily lifted interest rates in June. After the mid-year turnaround in bond yields, all interest rates except yields on lower grade bonds went into a decline, which accelerated in the fourth quar ter. In part, the fall in rates represented a return to their typical behavior during cyclical downswings in economic activity. The drop in long-term and short term rates continued, however, in the first two months of 1971, following the low point of the business slow down that was reached in the fourth quarter of 1969. In February, three-month Treasury bills yielded less Digitized forPage FRASER 10 MARCH 1971 than 4 per cent for the first time since 1967, and Aaa corporate bonds yielded less than 7 per cent for the first time since 1968. Inasmuch as the high interest rates of the last few years may well have been largely a reflection of infla tion anticipations, it is possible that we are now wit nessing a dram atic de-escalation of these anticipations. A broader interpretation accepts such de-escalation as part of the story. It would, however, emphasize other forces exerting downward pressure on interest rates and upward pressure on common stock priccs in re cent months. These include ( 1 ) an improved financial outlook among securities firms; (2 ) the automobile strike in the fourth quarter; and (3 ) reduced business optimism regarding rates of return on physical invest ment (reflected in conservative 1971 plant and equip ment spending plans and sluggish short-term business borrow ing). An expansive monetary policy, especially as displayed in the broader m onetary aggregates, also may have played a major role in the recent bond and stock market rallies. The 1971 National Economic Plan by K E IT H M. CARLSON X H E F E D E R A L B U D G E T , the E conom ic Report of the President, and the Annual R eport of the C o u n cil of Econom ic Advisers were presented recently to Congress and the public.1 These three documents represent the Administration’s national econom ic plan for the eighteen-month period ending June 30, 1972. Targets for total spending (G N P ), output, prices, and unemployment are presented along with a proposed Federal budget program presumably consistent with these goals. Underlying the statement of targets and the Fed eral budget plan is an assumption regarding the course of monetary actions by the Federal R e serve System. Specific targets for the U. S. economy are set forth by the Council of Econom ic Advisers (C E A ) in their A nnual Report.2 These goals, stated with reference to second quarter 1972, consist of a reduction in the unemployment rate to near 4.5 per cent of the labor force and a reduction of the inflation rate, as measured by the GNP deflator, to near a 3 per cent annual rate. An 11 to 12 per cent annual rate of increase of total spending (nominal G N P) from fourth quarter 1970 to second quarter 1972 is proposed as a means of achieving these targets. To realize this advance of total spending, the C E A recommends an 8 per cent annual rate of increase in Federal expenditures and a continuation of the 5 to 6 per cent rate of monetary expansion which prevailed in 1970. This article evaluates the Administration’s national economic plan with the aid of a methodology de veloped at this Bank. The 1970 economic plan is compared with actual developments for purposes of obtaining some perspective on stabilization plans and realizations. Then, the 1971 economic plan is ex amined in terms of feasibility and internal consistency. The St. Louis model is used to evaluate the Admin istration’s plan, thus any conclusions necessarily reflect the particular characteristics of that methodology. 1T he B udget o f the United States Government, Fiscal Year Ending June 30, 1972 (Government Printing Office, 1971), and Econom ic Report o f the President, together with The Annual Report o f the Council o f Econom ic Advisers (Gov ernment Printing Office, 1971). 21971 CEA Report, p. 78. Stabilization Actions and Economic Developments in 1970 The recent E conom ic R eport of the President described 1970 as a year of transition, when the U. S. economy paid for the excesses of 1966 through 1968. The general level of prices rose 5.3 per cent from fourth quarter 1969 to fourth quarter 1970, G ene ral Price Index* Ratio Scale 1958=100 150 1964 Ratio Scale 1958=100 150 1965 1966 1967 1968 1969 1970 1971 1972 *As used in N otional Income Accounts Source: U.S . Department of Commerce P e rce n tag e s a re o nn u al rates of change fo r periods in dicated. Latest data plotted: 4th quarter 1970; dashed line in dicates h a lf-y e a r estim ates by this Bank based on the fis c a l 1972 Fe d e ral Budget and the 1971 A nnual Report o f the C ou ncil of Economic Advisers. com pared with a 5 per cent advance in the previous year, and unemployment rose from 3.6 per cent of the labor force in fourth quarter 1969 to 5.9 per cent a year later. Total spending increased at a m oderate 4 per cent rate in the first half of the year, then stepped up to a 7 per cent rate in the second half (after allowance for the depressing influence of the auto strike in the fourth q u arter).3 The faster advance of total spending in the second half of the year was fostered by more rapid monetary expansion and increased growth of Federal spending beginning in early 1970. 3The CEA estimated the impact of the fourth quarter strike to be approximately $14 billion, or that total spending (GNP) would have risen at about a 7 per cent annual rate from third to fourth quarter in the absence of the auto strike. See the 1971 CEA Report, pp. 34-36. Page 11 MARCH F E D E R A L R E S E R V E B A N K O F ST. L O U I S Fiscal Actions Federal budget actions w ere moderately stimula tive in 1970, as Federal expenditures rose somewhat faster than during the previous year. Accelerated growth of Federal expenditures, along with expiration of the 10 per cent tax surcharge, resulted in a slight net fiscal stimulus during 1970. E xpend itures — Federal spending in 1970 was dom inated by developments in the second quarter. Effec tive in April, but retroactive to January 1, social security benefits w ere increased at a $4.3 billion an nual rate, and Federal employee compensation was raised at a $2.5 billion annual rate. The 7.1 per cent increase in Federal spending during the year ending fourth quarter 1970 compared with a 4.6 per cent rise during the previous year and a 13.4 per cent average annual rate of increase from 1965 to 1968. The advance of Federal spending from late 1969 to late 1970 reflected a 5.3 per cent decline in defense spending and a 16 per cent rise in non defense spending. Defense spending had changed litde in 1969, after increasing at a 15 per cent average annual rate from 1965 to 1968. Nondefense spending Page 12 1971 had advanced 8.4 per cent in 1969 following a 12.4 per cent average rate of increase from 1965 to 1968. R eceipts — The major actions affecting budget rev enues were the two-step elimination of the 10 per cent tax surcharge originally imposed July 1, 1968, and some net tax relief as a result of the T ax Reform Act of 1969. Expiration of the surcharge decreased Federal receipts by an estimated $8.3 billion. This action, along with sluggish growth in econom ic activ ity, resulted in a $9 billion dollar decline in Federal receipts from fourth quarter 1969 to fourth quarter 1970. S urp lu s/deficit position — The combination of a c celerated Federal spending, lower effective tax rates for personal and corporate income, and a reduced rate of advance of total spending in the economy, resulted in a shift of the national income accounts (N IA ) budget from a $7.2 billion annual rate of surplus in the second half of 1969 to a $14 billion rate of deficit in the second half of 1970. The $21 billion shift of budget position, as measured by the NIA budget, tends to overstate the extent of stimulus provided by the Federal budget. A substan tial portion of the 1969 to 1970 shift from surplus to a deficit reflects the slowdown of the economy and is thereby misleading as a measure of discretionary fiscal action. Standardizing the estimates of expenditures and receipts on a high-employment basis provides a method of more accurately measuring the extent to which discretionary Federal budget actions were taken. On a high-employment basis, as estimated by this Bank, the NIA budget moved from a $10 billion annual rate of surplus in the second half of 1969 to a $7 billion rate in the second half of 1970.4 By com parison, this measure of the Federal budget averaged a $7.2 billion rate of deficit from 1966 to 1968. Monetary Actions M onetary actions in 1970 were quite expansive com pared with the previous year, but according to most measures were less stimulative than in 1967 and 1968. The money stock increased 5.1 per cent during the year ending fourth quarter 1970, com pared with 3.8 per cent in the previous year and a 7 per cent average rate of increase in 1967 and 1968. 4Estimates of the high-employment budget are prepared by this Bank and are published in our quarterly release, “Fed eral Budget Trends.” These estimates differ slightly from those published in the 1971 CEA Report, pp. 24 and 73. For further discussion of the high-employment budget concept, see the 1971 CEA Report, pp. 70-74. F E D E R A L R E S E R V E B A N K O F ST. L O U I S MARCH Table I M o n e y Stock Ratio Sc a le Q u a rte rly A v e ra g e s of M onthly Fig ures 1971 Ratio Sc a le Projected a n d A c t u a l C h a n g e s in T o ta l S p e n d in g ( G N P ) a n d C o m p o n e n t s — 1 9 6 9 to 1 9 7 0 (B illio n s of D ollars) CEA Projection Personal consumption Business fixed investment $ 4 0 .0 Actual Error $ 3 9 .2 $0 .8 4 .6 4.1 7.9 3 .3 Business inventories - 0 .9 - 5 .0 Residential construction - 2 .2 - 2 .3 0.1 Federal purchases - 4 .5 — 1.6 - 2 .9 11.5 0 .9 10.1 1.4 1.7 - 0 .8 State and local purchases Net exports Total spending (G N P ) 5 2 .7 45.1 ( 4 8 .6 ) * 7.6 ( 4 .1 ) * * Excluding effect of auto strike, CEA estimate. was underestimation of the growth of Federal pur chases of goods and services. Evaluation of Last Years National Economic Plan The C E A R eport of a year ago projected a 5.7 per cent increase in total spending (G N P ) for calendar 1970 over 1969.5 The subsequent actual increase was 4.8 per cent, or, after adjusting for the effects of the auto strike in the fourth quarter, 5.2 per cent. The C E A anticipated a slow advance of total spending in the first half followed by a quickened pace in the second half. Apparently this pattern was realized, though an accurate assessment is clouded by the strike developments late in the year. The C E A error of $7.6 billion in projecting the growth of GNP from 1969 to 1970 was not large, considering that about $3.5 billion was attributable to the auto strike. A comparison of the actual changes in the components of GNP with the C E A projections (Table I) indicates the primary source of error was overestimation of business fixed investment and of in ventory accumulation. This type of forecasting error is common when the pace of econom ic activity is slow ing; business investment plans typically are scaled back at such times. The other source of error, which partly offset the error in the investment projection, •’1970 CEA Report, Chapter 2. Added relevance for stabilization policy is provided by the C E A projections of real product, prices and unemployment. Table II shows that the C E A pro jected an increase in real product from 1969 to 1970 of 1.2 per cent, a 4.4 per cent rise in the price level, and a rise in the unemployment rate of .8 per cent. Despite considerable success in projecting the growth in total spending, the C E A failed to anticipate the continued strength of inflation and the extent of sluggish growth in real product and employment. Table II Proje cted a n d A c t u a l C h a n g e s in S p e n d in g , O u t p u t , Prices a n d U n e m p l o y m e n t — 1 9 6 9 to 1 9 7 0 (P er Cent) CEA Projection Actual Real product 5 .7 % 1.2 4 .8 % - 0 .4 Prices 4.4 5.3 — 0 .9 Unemployment rate 0.8 1.4 - 0 .6 Total spending (G N P ) Error 0 .9 % 1.6 Stabilization plans vs. realizations — To evaluate the 1970 C E A projections and determine underlying sources of error, it is useful to compare monetary and fiscal plans with realizations. Table III gives planned and actual changes in the NIA budget from 1969 to 1970 on both an actual and a high-employment basis. From the standpoint of fiscal plans, the high-employ ment budget is more relevant. On this basis, expendi tures increased $4.5 billion more in 1970 than planned. Combined with a quite accurate projection of highemployment receipts, the change in net position Page 13 MARCH F E D E R A L R E S E R V E B A N K O F ST. L O U I S Table III P la n n e d a n d A c t u a l C h a n g e s in F ed e ra l Budgets — 1 9 6 9 to 1 9 7 0 (B illio n s of D ollars) Budget Plan N IA receipts N IA expenditures N IA surplus or deficit High-employment receipts High-employment expenditures High-employment surplus or deficit Error Actual $ 4.8 $ - 0 .6 $ — 5.4 9 .6 15.0 — 5.4 - 1 0 .2 — 20.4 10.2 1 1.0 10.4 0 .6 8 .7 13.2 - 4 .5 2.3 - 2 .8 5.1 N ote: Federal budget plans for 1970 were tfiven in the quarterly release. “ Federal Budget Trends,” prepared by this Bank,- Feb ruary 20, 1970. turned out to be a slight stimulus compared with plans for slight restraint. This error in fiscal planning is not large, however, compared with some in the past. The C E A assumption about monetary actions in 1970 was not specific in terms of a growth rate of the money stock, though a rate about mid-way between the 1967-68 rate and the rate in the second half of 1969, or about 4.5 per cent, was implied.(i Money actually grew 5.1 per cent from fourth quarter 1969 to fourth quarter 1970. Consequently the C EA pro jection of monetary growth was quite accurate. 1971 but this was not the primary source of error, according to St. Louis methodology. In fact, the projections based on policv assumptions w ere closer to the actual than w ere the projections based on perfect knowledge about the course of these policy actions. Realized monetary and fiscal actions implied that the projections should have been low rather than high. As a result, based on the St. Louis methodology, the C E A error in project ing total spending reflected factors other than errors in projecting the course of monetary and fiscal actions. Though the C E A error in projecting total spending was not large, there were larger errors in projecting the division of total spending growth betw een prices and real product. Table IV shows prices, real product, and unemployment as projected and realized. Real product growth from calendar 1969 to 1970 was over estimated by the C E A , a projection of a 1.2 per cent increase, com pared with no change in actual output (excluding the effect of the fourth quarter strike). Unemployment was forecast to rise to a 4.3 per cent average for the year, but turned out to be 4.9 per cent. The rate of inflation, on the other hand, was underestimated. The C E A in early 1970 expected a substantial improvement in price inflation over 1969, projecting a 4.4 per cent increase. Prices actually rose 5.3 per cent from calendar 1969 to 1970. Table IV shows that the projections for prices, Analysis based on St. Louis m odel — To better un output, and unemployment based on St. Louis m e derstand the significance of the difference between thodology were more accurate than the C E A ’s projecprojected and actual changes in key econom ic varia bles from 1969 to 1970, some alterna Table IV tive simulations with the St. Louis Projected C h a n g e s in S p e n d in g , O u t p u t , Prices methodology are examined.7 Fou r cases a n d U n e m p l o y m e n t — 1 9 6 9 to 1 9 7 0 are considered: estimates based on (1 ) changes in money and expenditures as Unem ploy Real ment Rate Total Spending Product Prices assumed by the C EA in February 1970; Billions of (2 ) perfect anticipation of changes in Per Cent Per Cent Per Cent Per Cent Dollars Federal expenditures, but not money; 1. 2 % 4 .4 % 0.8% CEA Projection ( 2 / 2 / 7 0 ) $ 5 2 .7 5 .7 % (3 ) perfect anticipation of changes in 1 .4* 5 .2 * 4 8 .6 * 5 .2 * 0.0 * Actual * St. Louis Model Projections money, but not Federal expenditures; 1 ) with changes in money and (4 ) perfect anticipation of both and Governm ent spend money and expenditures. ing based on CEA Examination of Table IV suggests that the C E A was quite accurate in their total spending projection, mainly because they assumed an acceleration in the rate of monetary expansion in 1970. Federal expenditures advanced somewhat more rapidly than planned, «1970 CEA Report, p. 60. 7“A Monetarist Model for Economic Stabili zation,” this Review (April 1970), pp. 7-25. Page 14 assumptions 52 .5 5.6 0.6 5 .0 1.3 2) with changes in Government spending perfectly perceived but not changes in money 5 6 .0 6.0 1.0 5 .0 1.2 3) with changes in money perfectly perceived but not changes in G o v ernment spending 53.1 5 .7 0 .7 5 .0 1.3 4) with both changes in money and Government spending perfectly perceived 5 6 .6 6.1 1.0 5 .0 1.2 * Excluding effect of auto strike, CEA estimate. FEDERAL RESERVE B A N K O F ST. L O U I S tions. Again, the St. Louis projections were more accurate when based on policy plans than when calculated with policy realizations. Nevertheless, de spite the error in projecting total spending, the St. Louis methodology forecast prices to rise 5 per cent from 1969 to 1970, or only slightly less than realized. Due to the slow short-run response of prices to mone tary and fiscal actions in the St. Louis model, these price projections were relatively insensitive to the dif ference between policy plans and realizations. MARCH Federal Budget Program for Calendar 1971 The budget plan for calendar 1971 calls for a sur plus in the high-employment (N IA ) budget of $6.5 billion, as estimated by this Bank.8 A surplus of this magnitude would be about the same as in 1970. W hen compared with calendar 1969, the budget plan ap pears slightly more expansionary, but compared with the 1966 to 1968 period, when the high-employment budget was substantially in deficit, the budget for calendar 1971 appears much less expansionary. St. Louis model projections of real product growth were in error by about the same amount as the CEA . By past projection experience, neither of the projec tions for real product, by the C EA or by the St. Louis methodology, were in substantial error. The differ ences between the projections by the C E A and St. Louis of real product translated into larger discrepan cies in the projection of unemployment. The C EA correctly foresaw the rise in unemployment but under estimated its magnitude. The St. Louis model forecast the rise with considerable accuracy, even with a pro jection of real product growth similar to that by the C EA . Sum mary — The C E A projected quite closely the growth of total spending, even though they under estimated the rise in Federal purchases from 1969 to 1970 by $3 billion. Their errors were significant, how ever, with respect to projections of inflation and unemployment. The magnitude of these errors was typical of most forecasts, including those of large econom etric models. As indicated in the 1971 C EA A nnual Report, the inflation proved to be much more stubborn than anticipated. As a result, all of the ad vance in total spending manifested itself in price in creases, and output did not grow at all, resulting in a much sharper rise in unemployment than anticipated. The St. Louis model, which has built into it a very slow price response, also underestimated the rate of inflation. F o r this one year, however, it cam e closer than the C E A in its projection of inflation and un employment, despite the fact that the St. Louis model did not do as well in projecting the change in total spending. Economic Goals and Policy Plans for 1971 The Administration has set targets of 4.5 per cent unemployment and a 3 per cent rate of inflation by second quarter 1972. To achieve these goals, a 9 per cent advance of total spending from calendar 1970 to 1971 has been projected. This section summarizes the Federal Budget program for calendar 1971, and then evaluates the Administration’s plan with the aid of the St. Louis methodology. 1971 H ig h - E m p lo y m e n t B u dg e t Surplus or Deficit as a Per Cent of H ig h - E m p lo y m e n t G N P * jA---- ( V 1964 1965 1966 1967 1968 1969 1970 . /A 1971 , 1972 So u rce s: U .S . D epartm ent o f C om m erce, C ou ncil of Econom ic A d vise rs , a nd Fe d e ra l R eserve Bank of St. Louis *H ig h .E m p lo y m e n t G N P is P o te n tia l G N P in c u rre n t d o lla rs . la te s t d a ta p lo tted : 4th q u a rte r 1970; d o sh e d lin e in d ic a te s h a lf- y e a r e stim ates b y this Bank ba se d on the fis c a l 1972 F e d e r a l B udget and the 1971 A n n u a l R e p o rt o f the C o u n c il of Econom ic A d vise rs. E xpend itures — The budget plan projects an 8.4 per cent increase in Federal expenditures from calendar 1970 to calendar 1971. This increase would be up slightly from the 6.6 per cent rise in 1969 and 1970, but much less than the 14 per cent average rate of advance in Federal spending from 1965 to 1968. The 1971 increase in Federal expenditures translates into about a 1 per cent advance in real terms, compared with a 1.3 per cent decrease in real terms in 1970. Defense spending is projected to decline about 5 per cent in calendar 1971, compared with a 3 per cent decline in 1970 and a 1 per cent increase in 1969. The average annual rate of advance from 1965 to 1968 was a very rapid 16 per cent. Estim ates for 1971 apparently reflect declines in Vietnam spending, 8The Administration’s budget program is discussed as it relates to calendar 1971 rather than fiscal 1972, with estimates for calendar 1971 prepared by this Bank. Furthermore, to be consistent with the GNP accounts, which represent the frame work in which the CEA projections are made, the Federal sector of the national income accounts (NIA budget), rather than the unified budget, is used to summarize Federal budget plans. For a summary of the budget program on a fiscal year basis, along with rate-of-change triangles, see the quarterly release of this Bank, “Federal Budget Trends,” February 1971. Page 15 FEDERAL R E S E R V E B A N K O F ST. L O U I S MARCH though no figures are given in the budget as to their magnitude. Federal spending on civilian programs, that is, non defense spending, is planned to rise 16.5 per cent from calendar 1970 to 1971. This increase would follow increases of 15 per cent in 1970 and 9 per cent in 1969. From 1965 to 1968, nondefense spending rose at a 12 per cent average annual rate. 1971 expendi tures for nondefense purposes reflect proposed in creases in social security benefits and a pay raise for Federal employees, both effective January 1, and an increase in grants-in-aid to state and local govern ments (general revenue-sharing), effective O ctober 1. R eceipts — Federal receipts on a national income accounts basis are projected to rise $18 billion from calendar 1970 to 1971, or by 9 per cent. This projec tion is closely associated with the assumption about the growth of total spending (G N P). 1971 Fiscal M e a s u r e s (+) S u rp lu s ; (-} D e fic it Q u a rte rly To ta ls a t A n n u a I R a te s B illio n s of D o lla rs B illio n s o f D o lla rs 20 20 1964 1965 1966 1967 1968 1969 1970 1971 1972 Sources: U .S. Department of Com m erce, Council of Econom ic A d vise rs, a n d Fe d e ral Reserve Bank of St. Louis L ate st d a ta p lo tted : 4th q u a rte r 1970; d a sh e d lines indicate ha lf-ye a r estim ates by this Bank ba se d on the fisca l 1972 Federal B udget and the 1971 A n n u a l Report of the Council of Econom ic A d v is e rs . Table V P la n n e d C h a n g e s in F e d e ra l Receipts— 1 9 7 0 to 1971 N a t i o n a l Inco m e Accounts B u dg e t (B illio n s of D ollars) Change in total receipts .............................................................. -.................. $ 1 7 .8 Change due to growth ................................................. ....................... 19.6 Change due to tax rate changes .... -..................................... — 1.8 Personal tax and nontax receipts ........... ....................... — 5 .3 Corporate profits tax accruals ................. .......................... — 2.6 Indirect business tax and nontax accruals ............ 0 .2 Contributions of social insurance ................. ................ 5 .9 Table V shows the sources of increased receipts for 1971. Changes in tax policy include (1 ) the sched uled increase in social security taxes, which was effec tive January 1, (2 ) a proposed expansion of the base for social security taxes, from $7,800 to $9,000, (3 ) continuing the effects of the T ax Reform A ct of 1969, and (4 ) the effect of liberalized depreciation allow ances, tending to reduce receipts. The combined effect of these tax changes is expected to decrease receipts by $1.8 billion in 1971. All of the expected increase in receipts reflects the rapid expansion of economic activity projected by the Administration. Surp lu s/deficit position — The NIA budget is pro jected to be in deficit by $10.6 billion in calendar 1971, com pared with a deficit of $11.1 billion in 1970. Since the NIA budget is influenced to a considerable extent by the p ace of econom ic activity, it is useful to estimate receipts and expenditures on a high-employment basis. By eliminating the effects of deviations in real economic activity from high-employment, budget plans can be assessed more accurately in terms of their econom ic impact. Digitized for Page FRASER 16 On a high-employment basis, the planned NIA budget indicates a $6.5 billion surplus for calendar 1971. This estimate is about the same as for 1970, indicating no change in the degree of fiscal stimulus from 1970 to 1971. The Federal budget program for calendar 1971 ap pears to contain about the same amount of stimulus as did the program in 1970. W hether the im pact of such a program will turn out to be essentially un changed from 1970 depends largely upon Congres sional action as well as the lag structure of economic reaction. Developments in Southeast Asia and domes tic demands for Government: programs are of vital importance in determining the actual course of F e d eral spending. Evaluation of 1971 National Economic Plan Using the St. Louis methodology, two questions are considered in the evaluation of the 1971 economic plan of the Administration: ( 1 ) whether the price and unemployment goals are consistent with the pro jected increase in total spending; and (2 ) w hether the projected increase in total spending is consistent with proposed stabilization policies. Feasibility of total spending goal — Table VI shows the results for the St. Louis model for four different combinations of policies: (1 ) an increase of Federal spending as proposed in the budget and an expansion of the money stock at a 6 per cent annual rate; FEDERAL RESERVE MARCH B A N K O F ST. L O U I S Table VI Projected C h a n g e s in T o ta l S p e n d in g ( G N P ) — 1970 to 1971 Billions of Per Cent Dollars Increase CEA Projection (2 / 2 / 7 1 ) $ 8 8 .2 1 9 7 0 to 1 9 7 2 1971 to 1972 Billions of Per Cent Dollars Increase 9 .0 % $ 1 2 0 .9 11.4% St. Louis Model Projections 1 ) with 6 per cent money growth and Government spending based on fiscal 1972 budget (C EA policy assum ptions) 6 7 .6 6 .9 2) with 8 per cent money growth and Government spending based on fiscal 1972 budget 7 4 .4 7 .6 3) with 6 per cent money growth and accelerated Governm ent spending 7 1 .4 7 .3 4) with 8 per cent money growth and accelerated Government spending 7 8 .2 8 .0 (2 ) an increase of Federal spending as proposed and a faster 8 per cent rate of expansion of the money stock; (3 ) a faster increase of Federal spending than pro posed and a 6 per cent rate of expansion of the money stock; and (4 ) both a faster increase of Federal spending than proposed and an 8 per cent rate of expansion of the money stock. According to the St. Louis methodology (T able V I), the planned policies would not yield a growth in total spending of 9 per cent in 1971. Since the model is subject to error, the question arises whether this dis crepancy is within the range of possible error. F o r this purpose, the model was used to forecast one year ahead, quarter by quarter from 1966 through 1970. The largest error in prediction of total spending was $8 billion, or substantially less than the $20 billion discrepancy between the C E A projection and the St. Louis model projection based on their policy assump tions.” The possibility of error in the St. Louis model cannot be ruled out, but it seems most likely that continuation of monetary and fiscal stimulus in 1971 of roughly the same magnitude as we had in 1970 will not foster a sharp acceleration in growth of total spending in 1971. Because the monetary and fiscal restraint of 1968 and 1969 is fading into the past, total spending is projected to advance more rapidly in 1971 than in 1970, but not markedly so. !lThese forecasts were based on estimation of the total spend ing equation for a sample period through 1966, then 1967, etc., and using actual money and expenditures to generate the forecasts outside of the sample period. Perhaps more relevant for the current situation is the performance of the model around business cycle turning points. Within the sam ple period of 1953 to 1970, the average error for the fourquarter period following business cycle troughs was $5.3 billion, or 1 per cent of GNP in the four-quarter period ending with the trough quarter. 7 7 .9 7.5 1971 To determine if some other combina tion of policies might not yield the targeted growth of total spending, the im pact of alternative policy assump tions was examined with the St. Louis methodology. Table VI suggests that the combination of more expansionary monetary and fiscal actions yields a total spending projection closer to the C E A ’s, but it still falls short by a sub stantial amount. Implications of C E A total spending goal — The 1970 economic plan was in error primarily with respect to its dis 8 1 .9 7.8 tribution of total spending change be tween prices and real product. To 10 3 .5 9.8 assess the implications of the St. Louis methodology for real product, prices, and unemploy ment, the C E A projections of total spending were assumed for the St. Louis model. W ithout concern for how the total spending is going to be achieved, Table V II shows the implied paths for real product, prices, and unemployment.10 9 9 .5 9.5 According to these estimates based on the St. Louis model, real product would rise about 4 per cent from calendar 1970 to calendar 1971, com pared with the C E A projection of 4.6 per cent. As a result, the St. Louis model suggests unemployment would average 5.5 per cent in calendar 1971, or slightly above the C E A projection of 5.3 per cent. Furthermore, the St. Louis model indicates that the C E A projection of total spending would lead to a 4.9 per cent advance of prices in 1971, com pared with the C E A estimate of 4.2 per cent. The difference between the C E A projections and those based on the St. Louis methodology becomes more evident when examined with reference to 1972. The C E A projections imply that real product would continue its strong advance in 1972, rising 7.7 per cent above 1971, and push the unemployment rate down to a 4.4 per cent average for the year. The St. Louis model also indicates a rapid increase of real product, but at a slower 6 p er cent rate of advance. Unemploy m ent would be reduced for 1972 to 5.1 per cent of the labor force. In sharp contrast with the C E A projection of a 3.4 per cent increase in prices in 1972, the St. Louis model shows a 5.2 per cent increase. 10Given the proposed Federal budget program, the St. Louis model indicates that a 12 per cent rate of increase in money beginning in first quarter 1971 would be required to achieve the CEA projection of a 9 per cent increase in GNP in calendar 1971. Page 17 Table VII Projected C h a n g e s i a Spe nding , O u t p u t , Prices a n d U n e m p l o y m e n t — 1 9 7 0 to 1 9 7 2 (Per C e n t*) 1971 1 1972 II III IV Year 1 ii III IV Year 1 3 .0 % 9 .4 3.2 5 .7 1 1.5% 6.8 4 .4 5 .5 1 1.8°/! 7 .7 3.8 5 .2 11.3% 7.3 3 .7 4.9 9 .0 % 4 .6 4.2 5.3 11 .7 % 8 .0 3.4 4 .7 11.2% 7.8 3.1 4.5 1 1.0% 7.7 3.1 4.2 10.5% 7.5 2.8 4 .0 1 1.4% 7 .7 3 .4 4.4 with CEA total spending assumption Total Spending Real Product Prices Unemployment Rate 13.0 8.5 4.1 5 .6 1 1.5 6.1 5.1 5 .6 11.8 6.3 5.2 5.5 11.3 5.9 5 .2 5 .4 9 .0 3 .9 4.9 5.5 1 1.7 6.2 5.2 5.3 11.2 5 .9 5.1 5.1 1 1.0 5.8 5.0 5 .0 10.5 5 .5 4 .9 4 .9 1 1.4 6 .0 5.2 5.1 with 6 per cent money growth and Government spending based on fiscal 1972 budget (C E A policy assum ptions) Total Spending Real Product Prices Unemployment Rate 11.1 7.6 3.2 5 .6 6.4 2.0 4.3 5.8 9.1 4 .7 4.2 5.9 7.2 3.0 4.1 5 .9 6.9 2.5 4.3 5.8 6 .9 2.9 3 .9 6 .0 8.1 4 .4 3 .7 6.1 7.3 3 .7 3.4 6.1 7.0 3 .7 3.2 6.1 7.5 3.5 3.8 6.1 CEA Projection (2 / 2 / 7 1 ) * * Total Spending Real Product Prices Unemployment Rate St. Louis Model Projections 1) 2) *P e r cent changes for total spending, output and prices are at compounded annual rates : unemployment rates are levels. ♦♦Quarterly pattern estimated by this Bank based on the 1971 Annual R ep o rt o f the Council o f Econom ic A dvisers and amplifying statements by the CEA. Summary A c t u a l a n d Potential Real Product Ratio S c a le B illio n s of D o lla rs 900 Ratio S c a le B illio n s o f D o lla rs 900 Q u a r te r ly T o ta ls a t A n n u a l R ates S e a s o n a lly A d ju s te d The Administration has forecast that the U. S. eco nomy in 1971 will attain reductions of unemployment and inflation simultaneously. To achieve these goals, a rapid expansion of total spending has been proposed. According to methodology developed at this Bank, the projected increase in total spending is not consist ent with the policy actions proposed by die Admin istration. A much slower increase is more likely. Furtherm ore, when the targeted increase of total spending is accepted (which is only possible in the St. Louis model with a very rapid acceleration of monetary an d /o r fiscal stimidus), the goals for un employment and prices also appear too optimistic. Our model suggests that such a policy of rapid spend ing growth would lower unemployment, but inflation would continue unabated. 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 S o u rc e s : U .S . D e p a rtm e n t of C o m m e rc e , C o u n c il o f Econom ic A d v is e r s , a n d F e d e r a l R e se rv e B a n k of Sf. Louis [^ P o ten tia l G N P in 1958 d o lla r s , o s o r ig in a lly fo rm u la te d b y the C ou n cil of Eco n om ic A d v is e r s . B a s e p e rio d is m id-1955. R ate of gro w th from IV /1 9 5 3 to IV /196 2 is 3 .5 % , IV /1 962 to IV / J 9 6 5 IV /1 9 7 0 to IV /1971 (2 A c tu a l G N P in 1958 Latest d a ta p lo tte d : is 3 .7 5 % , iV /1 9 6 5 to IV /19 6 9 is 4 % , IV /1 9 6 9 to IV /1 9 7 0 is 4 .3 % , is 4 .4 % . d o lla rs . P o te n tia l G N P p r o je c te d th ro u g h 4th q u a rte r 1971 A c tu a l G N P , 4th q u a rte r 1970; d a s h e d lin e in d ic a te s h a lf- y e a r e stim a te s b y this B a n k b a s e d on the fis c a l 1972 F e d e r a l B u d g e t a n d the 1971 A n n u a l R e p o rt o f the C o u n c il o f Eco n om ic A d v is e rs . In summary, introducing the C E A projection of total spending into the St. Louis model leads to the conclusion that such a policy of rapid spending growth would provide slight gains in reducing unemploy ment. However, such gains would be at the cost of no gains in the battle against inflation. Digitized forPage FRASER 18 The nation is faced with a serious dilemma, but a search for quick and easy solutions may be selfdefeating. The current inflation developed persistently over a substantial period of time. F o r this reason the current problem defies a fast and smooth adjustment to high employment with price stability. M onetary actions consisting of a 5 to 6 per cent annual rate of growth in money, and fiscal actions consisting of an 8 per cent annual rate of advance in Federal expendi tures, appear to be consistent with an orderly, but slow, return to a viable high-employment path. The post W orld W ar II economic experience does not indi cate that the present unemployment-inflation dilemma can be solved as quickly as the C E A has suggested. An A ppendix to this article is on the next page. A P P E N D IX ALTERNATIVE BUDGET CONCEPTS All references to the Federal budget in the preceding article are in terms of the national income accounts budget. This appendix discusses three budget concepts to provide the reader with an understanding of their interrelations. Unified Budget The unified budget was adopted as the Government’s basic planning document in January 1968, replacing both the administrative and consolidated cash budgets. E x penditures and receipts are recorded on a cash basis (when the checks are issued or the payment received). This budget will be presented on an accrual basis after ac counting procedures are revised. N et transactions of trust funds are included in this budget. All lending ac tivities of the Government as well as certain Governmentsponsored agencies are described in the unified budget, but only certain direct loans are included in the figures for total outlays (expenditures plus net lending). (F o r a com plete discussion of Federal lending activities see “Special Analysis E ” in S p ecia l A n alyses: B u d g et o f th e U. S. G overn m en t, F isca l Y ear 1972). The unified budget is presented to Congress for ap proval by the President in January or February of every year, for the fiscal year ending June 30, eighteen months hence. Also included are revised figures for the current fiscal year ending approximately six months later. The Office of Management and Budget normally revises the budget figures for the coming fiscal years in the spring and fall of every year. T he current data are published by the Treasury D epartm ent on a monthly basis. National Income Accounts Budget The national income accounts (N IA ) budget presents the receipts and expenditures of the Federal Govern ment as an integrated part of the economy, as represented by the national income and product accounts. The major differences betw een the NIA budget and the unified budget are: ( 1 ) the NIA budget excludes all lending transactions; ( 2 ) tax receipts in the NIA budget are, in general, recorded on an accrual basis (corporate income taxes are accrued when the income is earned rather than when the Government receives payment, and personal income taxes, most of which are withheld from earnings or paid on a quarterly basis, are recorded when the taxpayer makes paym ent); (3 ) on the expenditure side, defense purchases are recorded when the items are re ceived by the Government rather than when they are produced or paid for. The NIA budget is developed in conjunction with the rest of the national income accounts by the D epartment of Commerce. It is published on a quarterly basis, sea sonally adjusted at annual rates. ( “Special Analysis A” in the fiscal 1972 budget contains a more detailed descrip tion of the reconciliation of the unified budget with the NIA budget.) High-Employment Budget The high-employment budget is based on the NIA budget; however, it is adjusted to remove the effects of the level of econom ic activity on the NIA budget. For example, during a recession NIA receipts will tend to fall in response to lower levels of income, and NIA ex penditures for unemployment benefits will rise. T he re sulting move toward deficit in the NIA budget, however, implies expansionary policies when, in fact, the opposite might be occurring. T h e high-employment budget reflects primarily dis cretionary changes in fiscal policy, such as a change in the tax rate structure or a change in the pattern of ex penditures. The high-employment budget estimates pub lished by this Bank are based on potential gross national product as defined by the Council of Econom ic Advisers. In their 1970 A nnual R ep ort, the C E A defined potential GNP as the output of the economy at a 3.8 per cent unemployment rate. Incom e shares and tax rates, esti mated at high-employment levels, are applied to poten tial GN P in current dollars to arrive at the high-employment budget data. Such data are not published regularly by any Government agency. Estim ates prepared by this Bank are published in the quarterly release, “Federal Budget Trends.” Page 19 The Implementation Problem of Monetary Policy by A L B E R T E . B U R G E R D u ring the last two decades, there has b e en considerable controversy regarding the appro priate m ethod of im plem enting monetary policy. O ne approach em phasizes market interest rates; the other, monetary aggregates. This article sets forth the basic issues underlying this controversy. It demonstrates the m anner in w hich the m arket interest rate approach can lead to perverse monetary actions; w hereas the monetary aggrega te approach redu ces the likelihood of such a result. D e C ID IN G UPON an ultimate objective for mon etary policy, such as a more rapid increase in employ ment or a reduction in inflation, is only one part of monetary policy. The policymakers must also imple ment such a policy decision. A considerable amount of study has been devoted to this problem, resulting in numerous technical papers, several conferences, and some rather sharp differences of opinion among economists about the best way to implement policy decisions. This article explains this problem in a simplified form and highlights some of the areas of disagreement. First, the implementation problem is outlined. The use of indicators and operational targets as an aid in implementing policy is then discussed. Next, two hypotheses about the way in which the Federal R e serve’s policy actions are transmitted through the econom ic system are presented. Finally, this frame work is used to illustrate how alternative policy pre scriptions can develop. The Implementation Problem The monetary policy process consists of two broad phases. The policymakers must first decide upon the movements they desire to achieve in their ultimate policy objectives such as prices, output, and employ Page 20 ment. Second, they must decide how to manipulate policy instruments such as open market operations, reserve requirements, and the discount rate to achieve these desired effects on their ultimate objectives. This is the implementation phase of policy. To analyze the implementation problem w e shall use the physical analogy of heating a room with a steam furnace. First, let us set up the heating system, as shown in Exhibit 1. Our policymaker is Mr. Home owner. His policy problem is to maintain the tem pera ture in his house at a comfortable level. H e uses his room thermometer to give him a m easurement of whether the room tem perature is moving in the direc tion he desires (th e room is getting hotter or cold er). The means by which he implements a decision to change the room tem perature is to adjust the fuel control lever. If, for example, he wants the room tem perature to rise, he adjusts the fuel control level to increase the flow of fuel to the furnace. He then judges w hether he has correctly adjusted the fuel lever by watching the room thermometer. H e knows there is a lag between the time he adjusts the fuel control lever and when the room temperature begins to rise. Taking this lag into account, if the reading on the room thermometer does not rise suf ficiently, he would again adjust the fuel control lever. E x h ib it I F E D E R A L R E S E R V E B A N K O F ST. L O U I S It is worth emphasizing that the goal of Mr. H om e owner is a comfortable room temperature, not some reading on the thermometer. The thermometer is only a device that helps him to monitor the heating process. However, let us assume that Mr. Homeowner has an old furnace, and he is not confident that it works exactly the way the manufacturer claims it should. He installs two intermediate gauges to help him in his control process; a fuel flow gauge to monitor the flow of fuel between the fuel supply and the furnace, and a steam pressure gauge on the furnace to monitor the operation of the furnace. For example, the fuel flow gauge helps the homeowner check for leaks in the fuel line. If this gauge registers a leak, then the homeowner knows that the fuel flow must be increased to maintain the same heat from the furnace. Monetary Policy Now let us convert this discussion into an analogy with the implementation problem of monetary policy. The fuel control lever becomes the policy instru ments of the Federal Reserve; open market opera tions, reserve requirements, and the discount rate. The furnace becomes the financial system, and the room becomes the real sector of the economy. Mr. Homeowner becomes the Federal Open Market Com mittee, and the policy objective becomes something such as employment, prices, and real output, instead of room temperature. The room thermometer becomes a measuring instrument such as the unemployment rate, consumer price index, and GNP in constant prices. M onetary policy implementation would be much easier if there were complete information about the way in which policy instruments, financial variables, and real variables are interrelated. It would only involve manipulating the policy instruments in a way that would have a known and desired effect on the levels and rates of change of the ultimate objectives of monetary policy. Just as our homeowner, with complete information about how his furnace operates, would know where to set the fuel control lever to get the desired room temperature, the policymakers would know how close, by manipulating the policy instruments, they could come to achieving their de sired ultimate policy objectives. There would be no possibility of a “slip twixt cup and lip.” The policy instruments could simply be set at definite values, and the desired goals of policy would be achieved subject to any constraints. MARCH 1971 Indicators and Operational Targets The indicator-opcrational target approach is a pragm atic method of improving the implementation of monetary policy. It starts with the fact that no one has perfect information about the way policy actions filter through the economy, are modified by other factors, and ultimately influence real output, prices, and employment. Econom ic research, however, has provided some theoretical and empirical informa tion about these linkages. The indicator-operational target approach attempts to employ this information to guide the process by which policy is implemented. Policymakers are concerned with two major ques tions when implementing policy. First, what effects are monetary influences exerting on the ultimate pol icy objectives? Are monetary influences exerting a more, a less, or an unchanged expansionary influence on the future rates of change of prices and employ ment? An indicator provides information about this question. Second, policymakers want to know how they should manipulate their policy instruments to insure that monetary influences are modified to con tinue exerting the effect desired by the policymakers. An operational target provides a method for answer ing this second question. Indicators A monetary policy indicator is an econom ic variable that provides information about the current thrust of the financial sector, including Federal Reserve a c tions, on future movements in the ultimate policy objectives. Em pirical evidence confirms that the ef fect of monetary policy actions on the ultimate policy objectives is distributed over time. Hence, the F e d eral Reserve cannot accurately judge the degree of “ease” or “restraint” its current policy actions are exerting on the ultimate objectives of policy by look ing directly at measuring instruments such as the consumer price index and the unemployment rate. Current changes in the ultimate objectives primarily reflect the effects of policy actions taken in previous periods. A further point must be clarified. Policymakers do not need an indicator to tell them their current intent of policy. They know w hat they intend to accomplish with their policy actions.1 Policymakers 'Since the intent of current policy is not made public until about 90 days after the FOMC Meeting in the “Record of Policy Actions of the FOMC” appearing in the Federal Re serve Bulletin, a measure of policy intent may be of interest to market participants. However, this is a different problem from the one with which this article is concerned. Page 21 F E D E R A L R E S E R V E B A N K O F ST. L O U I S want information about the influence their past policy actions are exerting on the future course of the economy. The choice of an indicator involves choosing some financial variable that consistently provides reliable information about the current influence of the finan cial sector, including Federal Reserve actions, on future economic activity. In general terms, this re quires that the following relationship holds between the indicator and the ultimate policy objectives: A change in the magnitude of the indicator is fol lowed by a predictable change in the magnitude of the ultimate objectives of monetary policy. An economic variable that meets the above crite rion can serve as a “scale” that permits policy advisers to make meaningful statements about the relative effects of different policy actions on the ultimate policy objectives. It provides a means of relative comparision of different sets of policy actions; not necessarily an absolute means of comparison. The usefulness of an indicator hinges on whether or not it consistently supplies reliable information to the policymakers. If at times the ultimate policy objectives move in a direction opposite to the direc tion predicted using a given indicator, then in such instances the indicator provides false information to the policymakers about the thrust of their policy actions on the ultimate objectives of monetary policy. Operational Targets An operational target for monetary policy is an economic variable the Federal Reserve attempts to control directly in its day-to-day money market oper ations. Following each Federal Open Market Com mittee (F O M C ) meeting, the Committee issues a directive to the New York Federal Reserve Bank. The day-to-dav implementation of open market opera tions is carried out by the Trading Desk at the New York Bank. In general, these directives have tradi tionally been worded in broad terms such as: . . . maintain the prevailing firm conditions in the money and short-term credit markets. Although the directive may appear to be worded in somewhat ambiguous terms, the Trading Desk does not randomly buy and sell securities. It chooses some financial variable or variables to control and aims its day-to-day operations in the money market at controlling this operational target. The operational Page 22 MARCH 1971 target, to be of greatest usefulness, should satisfy three basic criteria as follows: (1 ) T he Federal Reserve should be able to accur ately measure the magnitude of the operational target over very short periods of time. (2 ) T he Federal Reserve should be able to control the operational target by manipulating policy instruments. In a very short period of time, the Federal Reserve should be able to offset any other factors acting to change the magnitude of the operational target. (3 ) Changes in the magnitude of the operational target over an intermediate period of time should dominate changes in tire magnitude of the economic variable chosen as an indicator. The question may arise as to why the concept of an operational target has to be introduced once an indicator is chosen. W hy cannot the Federal Reserve aim day-to-day operations directly at the indicator? The necessity for the introduction of operational targets, like indicators, arises basically from the lack of perfect information. At a minimum, the Trading Desk must have some means of evaluating whether its day-to-day operations in the money market are in accord with the intent expressed by the Federal Open Market Committee. To maximize the effectiveness of its daily operations in the money market, the Federal Reserve needs accurate information regarding the in fluence of these actions. In the short-run many other factors usually influence the movement of intermedi ate variables such as the money stock and interest rates. If these intermediate variables are used as operational targets, then the short-run influence of other factors frequently causes these variables to transmit misleading information to the policymakers about the effect their day-to-day policy actions are exerting on the intermediate-term movements of the indicator variables. In our furnace analogy, the operational target be comes the fuel supply. An indicator is a gauge set in the process by which monetary policy actions are transmitted to the real sector of the economy. Usually the indicator is “attached” to the financial sector. It gives the Federal Reserve a reading on how m uch of the fuel they are supplying (through open market operations, reserve requirements and the discount rate) is being converted into energy to drive the economy. Two Hypotheses The lack of complete information about the way policy actions are transmitted to ultimate objectives FEDERAL RESERVE B A N K O F ST. L O U I S MARCH requires the formulation of proposed explanations (hypotheses) about the process. A person’s choice of an indicator and an operational target usually de pends upon his hypothesis about the way policy actions are transmitted through the financial sector into the real sector. D isagreem ent among economists as to the appropriate choice of an indicator and op erational target is basically a disagreement as to the correct representation of the m onetary policy trans mission mechanism.2 Two frequently used hypotheses about the trans mission process of monetary policy, the Market In terest Rate Hypothesis and the Money Supply H y pothesis, are compared in Exhibit II. The policy in struments and ultimate objectives available to policy makers are the same regardless of whedier they use one of these hypotheses or any other hypothesis about the transmission process. There may be differences between advocates of the two hypotheses, however, concerning the relative importance of different policy instruments and ultimate objectives.3 In the Market Interest Rate Hypothesis, the in dicator is market interest rates. An econom ic variable such as free reserves (referred to as net borrowed reserves when borrowings exceed excess reserves) is generally chosen as the operational target. In a broader context, free reserves can be viewed as a substitute for a number of short-term money market factors, such as the Federal funds rate, “tone and feel of the market,” and the Treasury bill rate. In the Money Supply Hypothesis, the indicator is the growth rate of the money stock ( currency plus demand deposits of the nonbank public). The operational target is the net source base, total source base, or monetary base, as computed by the St. Louis Federal Reserve Bank.4 1971 Exh ibit POLICY INST RUMENTS O pe n M ark e t O p e ra tio n s R e s e rv e R e q u ire m e n t s i * D iscou nt Rate R e g u l a ti o n Q Free Base R e s erv es M oney * p g E lB E ffS T E k 2In some cases, individuals may accept an economic variable, such as money, as an indicator based solely on empirical evi dence, and still not accept a hypothesis in which money plays a key role in determining economic activity. 3For example, many supporters of the Money Supply Hy pothesis have traditionally placed more reliance on open mar ket operations and advocated very limited use of the other policy instruments, particularly Regulation Q. increases in Federal Reserve credit (holdings of securities, discounts and advances, and float), the gold stock, and Treasury currency outstanding increase the stock of source base. Increases in Treasury deposits at the Federal Reserve, Treasury cash holdings, and other deposits and other Federal Reserve accounts decrease the stock of source base. The net source base is total source base net of member bank borrowings. The monetary base is total source base ad justed for reserve requirement changes. See Leonall C. Andersen and Jerry L. Jordan, “The Monetary Base — Ex planations and Analytical Use,” this Review (August 1968), pp. 7-14. Exhibit III illustrates the analogy between the heat ing system and the monetary policy mechanism. The Federal Reserve looks at a wide range of data, including the unemployment rate, consumer and wholesale price indexes, and real GNP to evaluate w hat is happening to employment, prices, and real output. The Federal Reserve then adjusts open m arket operations, reserve requirements, or the discount rate to achieve its objectives with respect to employment, Page 23 MARCH F E D E R A L R E S E R V E B A N K O F ST. L O U I S 1971 E x h i b i t III (Room Thermometer) (Steam Pressure G a u g e ) ) U nem ploym ent I n d ic a to r M e a s u r e d in units Rate of I (2) Price Ind exes ---- - 1 % (Fuel C o n tro l Lever) (F u rn a c e ) (Fuel S up ply) — O pe ra tio na l Target (Room) — F in a nc ia l System -► R e a l Sector (1) O p e n M a r k e t O p e ra tio n s (2) Reserve Require m ents (Fuel Flow G a u g e ) (1) M o n e y M u l t i p l i e r (2) T r e a s u r y Bill Rate (3) D is c o u n t Rate (Room Tem perature) (1) E m p l o y m e n t (2) P r ic e s (3) R e a l O u t p u t prices, and real output. By altering the policy instru ments, the Federal Reserve changes the flow of fuel to the economy. The fuel supply is measured in units of base money or units of free reserves. To analyze the future effect of these actions on the real economy, the Federal Reserve then would look at its gauge on the financial sector, either the growth of the money stock or the level of m arket interest rates. To further monitor the process, the Federal Reserve may use another gauge, equivalent to the fuel flow gauge, such as the Treasury bill rate for the M arket Interest Rate Hypothesis or the money multiplier for the Money Supply Hypothesis.5 This type of gauge signals leak ages in the flow of fuel to the financial system. Examining Exhibit II and Exhibit III, we can see .where some differences of opinion might arise about the influence of Federal Reserve actions. F o r one thing, the two hypotheses in Exhibit II measure the fuel supply by different means. One viewpoint meas ures the flow of fuel in terms of base, the other in terms of free reserves. Under the Money Supply Hypothesis, the Federal Reserve is supplying more 3The money multiplier summarizes the influence on the money supply process of all those factors other than changes in the base. By monitoring the movements of the components of the multiplier, the Federal Reserve could determine the effects of any given growth of base on the growth of the money stock. For example, an increase in the public’s desired hold ings of currency relative to demand deposits would decrease the growth of money associated with any given growth of base. This would be a “leakage” between the fuel supply and the furnace. By increasing the flow of base, the Federal Reserve could offset this influence on the money supply process. Page 24 fuel if the growth rate of the base increases. The Market Interest Rate Hypothesis takes an increase in the level of free reserves as a measure of an acceleration in the flow of fuel. A second area of disagreement can develop about the manner in which the flow of fuel from the F e d eral Reserve is converted into a flow of total spending. Supporters of the Money Supply Hypothesis contend that an increased flow of base money into the finan cial sector is converted into an increased growth of the money stock, which results in an increased flow of total spending, influencing employment, prices, and real output. The alternative view is that an increased level of free reserves is converted in the financial sector into lower market interest rates, which result in an increased flow of total spending and hence real variables are influenced. In our analogy, this question may be phrased, “how is fuel converted into energy that drives the econom y?” Supporters of the two hypotheses are monitoring the progress of policy by different gauges, where the gauges are attached to the same part of the process. Since the growth of the money stock and market interest rates frequently move in the same directions, substantial divergences of opinion often arise regarding the correct policy action to take to achieve the same ultimate objective. F o r example, suppose that the supporters of the Market Interest Rate Hypothesis look at their in dicator (th e gauge on the financial system) and F E D E R A L R E S E R V E B A N K O F ST. L O U I S observe that market rates are rising. If they desire no change in the influence of policy, they may conclude that the flow of fuel to the financial sector will not be converted into enough energy (low market rates) to maintain the rate of growth of real output and employment they desire. Hence, they would advise that policy instruments be used to raise the level of free reserves (pum p in more fuel). However, let us assume that the supporters of the Money Supply Hypothesis look at their indicator and observe that the growth rate of money is accelerating. They conclude that the fuel being supplied by F e d eral Reserve actions would be converted into a prog ressively more rapid flow of total spending, and they advise that the policy instruments should be used to slow the growth of the base (pum p in fuel at a slower ra te ). At this point a substantial divergence of opinion about the reason for the change in market interest rates arises between the supporters of the two hy potheses. This difference of analysis has important implications for the conduct of monetary policy. The supporters of the Market Interest Rate Hypothesis contend that Federal Reserve policy actions are dom inating the movements in interest rates and that the rise in market rates will result in a slowdown in the real economic activity. The supporters of the Money Supply Hypothesis, however, contend that changes in the public’s demand for credit are domin ating movements in market interest rates and that Federal Reserve actions through their influence on total spending are influencing the public’s demand for credit. In terms of our analogy, the Money Supply Hypothesis asserts that the market interest rate in dicator is not insulated from developments in the real sector. As the real sector heats up (employment, real output, and prices rise), this influences the read ings 011 the market interest rate indicator. To analyze the importance of this difference of analysis, we shall first discuss the interdependence of free reserves and the base. Then the implications for monetary policy of this interdependence are ex amined. I n t h e fo l lo w in g p r e s e n t a t io n , t h e n e t s o u r c e base is u s e d , a n d h e r e a f t e r m o n e y ” o r “b a s e ” a r e w h en th e u sed , th ey te r m s “h a s e w ill r e f e r to n e t s o u r c e b a s e . The same results may be derived by using the monetary base or source base. MARCH One of the components of the source base on the u se s side of the balance sheet is member bank excess reserves. The net source base is obtained by sub tracting member bank borrowings from the source base. Therefore, the components of the net source base may be combined so that free reserves is one of the uses of the net source base." If the Federal Reserve alters the level of free reserves, and if cur rency held by the public and vault cash in nonmember banks are held constant, the net source base is changed in the same direction. Free reserves and the net source base are not independent of each other. Actions taken by the Federal Reserve to alter or maintain the existing value of one of these opera tional targets exert an influence on the other. To analyze the importance of this interdependence, the bank credit market is introduced. Supply and demand conditions in this market are specified as follows: aB z= S = commercial banks’ supply schedule for bank credit D = public’s demand schedule for bank credit The equilibrium condition for the bank credit market is given as: S = D ( Amount of credit banks are willing to supply = amount of bank credit demanded by the public). In the above expression, ( a ) denotes the bank credit multiplier, which is the connecting link be tween the amount of net source base ( B ) and the amount of credit banks are willing to extend.7 ''In this article, the net source base is denoted by B. Gener ally this concept is denoted as B". The superscript has been removed to avoid any confusion that might arise when the hank’s credit supply curve is specified later. The net source base is defined in the following manner: B = R"> - A + V + Ci' where: Rm = member hank reserves = R1 + R1' V' = vault cash holdings of nonmember banks A = member bank borrowings from the Federal Reserve Banks O' = currency held by the nonhank public R° = excess reserves of member banks Rr = required reserves of member banks Free reserves (K f ) are defined as follows: Rf = Rc - A The relationship between the net source base and free reserves can be expressed as follows: B = (R e - A) + R'' Interdependence Free reserves are calculated by subtracting member bank borrowings from member bank excess reserves. 1971 Q> + V = Rf + R' + C» + V 7The money multiplier and bank credit multiplier summarize all those factors, other than changes in the net source base, that affect the money supply process. When the monetary base is used, the influence of reserve requirement changes and member bank borrowings are included in movements in Page 25 FEDERAL R E S E R V E B A N K O F ST. L O U I S Both the hank credit multiplier, and h en ce the amount of credit hanks are willing to extend, and the p ublic’s dem and for bank credit are d ep en d en t upon the bank credit market interest rate. MARCH 1971 F ig u re I B A N K C R E D IT M A R K E T i The public’s demand for bank credit and the bank’s credit supply also depend upon a number of other factors. F o r example, the public’s demand for credit depends upon the expected rate of return on real capital and upon price expectations. The banks’ supply of credit depends upon the amount and rate of growth of the net source base. In our following illustrations, these factors would appear as shifts in the supply and demand schedules. A rise in market interest rates could result from either a shift in the credit supply curve, or a shift in the credit demand curve, or some combination of the two. The effect of a shift in the credit supply curve is shown in Figure I. The credit supply curve shifts from Si to So and, in the resulting adjustment process, the interest rate rises to i2 and bank credit outstanding falls to E 2. F i g u r e II B A N K C RE DIT M A R K E T i Now let us look at an alternative explanation for the rise in market rates. Suppose that the rise in rates was due to a shift in the public’s demand for credit. This appears as a shift to the right of the pub lic’s demand curve from D , to D_>, as shown in Figure II. At the market interest rate ( i i ), the quantity of bank credit demanded by the public ( E 4 ) exceeds the amount of credit the banks are willing to supply ( E x ) , given the stock of base and the value of the bank credit multiplier. If the Federal Reserve System does not increase the growth rate of the net source base in response to the rise in interest rates, but permits market interest rates to adjust to clear the credit market, the interest rate rises toward i2. As the yields on loans and securities rise, the amount of the base, instead of in the multiplier. The money multiplier associated with the net source base is: m1 = ________ I + k_________ (r — b) (l + t + d j + k k and d, respectively, are the ratios of currency held by the public and U.S. Government deposits at commercial banks to the demand deposit component of the money stock, r, b, and t, respectively, are the ratios of bank reserves, member bank borrowings, and time deposits to commercial bank deposit liabilities (excluding interbank deposits). The reserve ratio, (through the dependence of banks’ de rived excess reserves), the borrowing ratio and the time de posit ratio are all dependent upon credit market interest rates. For an illustration of the derivation of a money multiplier, see Jerry L. Jordan, “Elements of Money Stock Determina tion,” this Review (October 1969) pp. 10-19. Page 26 credit banks are willing to supply rises; banks reduce their excess reserves, increase borrowings from F e d eral Reserve Banks, and raise the yields they offer to attract time deposits.8 The new equilibrium quan tity of bank credit demanded and supplied is E s. The policymakers do not observe these supply and demand curves shifting up and down: all they observe is the increase in the reading on the market interest rate indicator. If the policymakers believe sWhether bank credit increases or decreases depends upon the relationship between Regulation Q ceiling rates and the yields banks ofFer on time deposits. If banks are already at Regulation Q ceilings, then an increase in the public’s de mand for credit resulting in a rise in market interest rates may lead to disintermediation and a decrease in bank credit. FEDERAL RESERVE BANK OF ST LOUIS the rise in market rates to represents a leftward shift (decrease) in the credit supply curve, as in Figure I, and they desire no change in the influence of policy, they may now increase their purchases of securities to raise the level of free reserves. This pol icy action, according to the Market Interest Rate Hypothesis, would shift the credit supply curve to the right, from SL. back toward Si, and market yields would decline from i2 back toward ip If, however, the rise in rates resulted from a right ward shift of the public’s demand for credit ( as shown in Figure II ) , then to prevent market interest rates rising to iL>, the Federal Reserve must expand the net source base enough to shift the banks’ credit supply curve to S;!, as shown in Figure III. At a market inter MARCH 1971 Reserve would again have to increase the net source base to maintain the market yield at i,. Under these conditions, changes in the base are determined by shifts in the public’s demand for bank credit via the reaction of the monetary authorities. This implies that the Federal Reserve would give up its control over the money supply process. Total spending would rise at a progressively more rapid rate and interest rates would increase. Implementing Policy Under Different Economic Conditions This section illustrates how alternative policy pre scriptions can arise in response to changing economic conditions. Two different sets of conditions are speci fied, and the monetary policymakers are assumed to make a policy decision based upon this information. Condition 1 State of the economy: T he economy is operating at full employment. An increasing proportion of total spending is reflected in rising prices. Com mercial banks have raised their offering rates on time deposits to Regulation Q ceiling rates. Policy decision: Policymakers shift the focus of their attention from real output and employment to achieving stable prices.'1 est rate of i i, banks are now willing to supply a larger amount ( E 4 ) of credit. Under these conditions, the operational policy of raising free reserves, which accelerates the growth of the base, results in a more rapid expansion of bank credit and monev than would result in the situations illustrated by Figures I and II. Supporters of the Money Supply Hypothesis assert that Federal Reserve actions shifting the credit supply curve would be self-defeating, if the rise in market rates reflected a shift in the public’s demand curve. In a situation such as that illustrated by Figure III, the money stock expands very rapidly. The Money Supply Hypothesis predicts that market rates would only temporarily remain at i , . As the feedback effect of the rise in the money stock on total spending is reflected in the public’s demand for credit (shifting the demand curve further to the righ t), the Federal Using the Market Interest Rate Hypothesis, policy makers reason that interest rates must be pushed higher to slow total spending and bring aggregate demand in line with the productive capacity of the economy. Consequently, they adopt an operating strategy designed to raise market rates. This involves using policy instruments to reduce the level of free reserves. The Trading Desk is instructed to “pursue open market operations with a view to obtaining tighter money market conditions.” The result of these open market actions is to decrease the growth rate of the base, which results in a slowing in the rate of expansion of the money stock. As market interest rates continue to rise, banks can no longer compete for time deposits and disinter mediation begins. Consequently, the amount of earn ing assets banks can hold declines. In restructuring their portfolios, banks attem pt first to reduce their holdings of lowest-yielding assets. The time sequence of this process would probably be declines in their holdings of short-term Government securities first, '•'This shift in focus of attention does not mean the policy makers now ignore the growth rate of real output and em ployment. The ability of the policymakers to achieve a price objective is conditioned by the influence of their policy ac tions on real output and employment. Page 27 F E D E R A L . R E S E R V E B A N K O F ST. L O U I S followed by declines in holdings of municipal securi ties. As long as possible, banks try to reduce holdings of securities in order to continue to acquire business loans.10 The impact in the credit market is a sharp decline in the prices of municipal bonds and Government securities. Cries of a liquidity crisis, or “credit crunch” may arise in the financial community. Other financial intermediaries such as savings and loan associations are also affected by the rapidly rising interest rates. Added to the outcry from the securities markets may be the asserted danger of some possible failures of savings and loan associations. The economists who use market interest rates and other financial market conditions as their indicators might warn, in terms of our furnace analogy, that “there is too much pres sure and the furnace is going to blow up!” The scenario outlined in this stage corresponds, in rough form, to monetary policy in 1966. In late 1965 and early 1966, monetary policymakers moved to a more restrictive monetary policy aimed at reducing the “emergence of inflationary pressures.” During the summer of 1966 the Federal Reserve pursued a prog ressively more restrictive policy. As market interest rates rose above Regulation Q ceiling rates, the Board of Governors did not raise Regulation Q ceiling rates. As funds flowed out of banks and nonbank savings institutions, these institutions faced a new and costly period of portfolio adjustment. The result of these policies culminated in August 1966 in a relatively short-lived liquidity crisis, called the "Credit Crunch of 1966.”” Under such conditions, the Federal Reserve policy makers face a very difficult decision. Using interest rates as indicators, the information transmitted to them is that they are following very restrictive poli cies. Slower growth of bank credit, and other informa tion transmitted to them directly from financial m ar kets and the financial intermediaries, reinforce this view. The correct operating strategy now appears to be to reverse quickly open market operations, and “ease the pressures in the financial markets. l0The rise in the share of loans in bank assets during periods when banks must reduce the total volume or growth rate of bank credit also reflects the long-run profitability of bankcustomer relations. See Edward J. Kane and Burton G. Malkiel, “Bank Portfolio Allocation, Deposit Variability, and the Availability Doctrine,” Quarterly Journal of Economics (February 1965), pp. 113-34. "S e e Albert E. Burger, “A Historical Analysis of the Credit Crunch of 1966,” this Review ( September 1969), pp. 13-30. 1-It should also be noted that the Federal Reserve does not make policy decisions in a vacuum. At such times the Fed eral Reserve may be under considerable public or govern ment pressure to ease its policy. Page 28 MARCH 1971 If the money stock is being used as an indicator, the reduced growth rate of money resulting from the slowing in the rate of increase of the base also signals that the policymakers have begun to exert a less expansionary influence on the ultimate policy objec tives. However, the supporters of the Money Supply Hypothesis would argue that the sharp rise in credit market interest rates and the “above average liquidity pressures in the financial market” do not necessarily signal the desirability of a significant reversal of operating strategy. The key elements of a less expan sionary monetary policy are a reduced expansion of demand deposits and bank credit. This is the neces sary preliminary to the desired policy objectives of reduced aggregate demand and hence a reduced rate of increase of prices. An analysis based on the Money Supply Hypothesis agrees that a continued operational policy of restrict ing the growth rate of the base would, in the short-run, lead to higher levels of market interest rates. Over the intermediate-term, however, the resulting slower growth of the money stock would exert a dampening influence on total spending. The slowdown in total spending would exercise a dampening influence on the upward pressures on prices and also lead to a reduction in the demand for credit. H ence, pursuing such an operational target would, according to this hypothesis, lead to lower market interest rates and the desired ultimate policy objective of lower prices. Condition 2 L et us now assume that the policymakers have en gaged in a set of policy actions that resulted in a slowing of economic activity. This permits an analysis of the implications of different methods of implement ing policy in a cyclical downturn. State of the economy: T he growth rate of real out put has been reduced well below its long-run potential. T he level of unemployment has risen above 5 per cent. Policy decision: Pursue a monetary policy that re sults in an increased growth rate of real output and hence a decreased level of unemployment. In an economic downturn, if the Federal Reserve uses market interest rates as its indicator, it might conclude that the falling market rates signal monetary policy has become “easier” than previously. This in terpretation depends upon the condition that the de crease in interest rates is resulting from a shift in the credit supply curve. If the decrease in interest rates reflects a decrease in the dem and for credit, FEDERAL RESERVE BANK OF ST LOUIS then Federal Reserve policy may be “tighter” than previously. The fall in interest rates raises the banks’ desired excess reserve ratio which operates to reduce the money multiplier. Also, if the downturn has been preceded by a “crunch” in the financial markets, this may also operate to raise banks’ desired excess re serve ratio. If during the “crunch” the Federal Re serve exercised relatively strict administration of die discount window, this factor would lower the banks’ desired ratio of borrowings to deposits. Therefore, the decline in the growth rate of money, resulting from a slower growth of the base, is reinforced by the fall in market interest rates.1'1 Hence, the monetary ag gregates transmit the opposite information, that policy actions are having more of a restrictive effect 011 the future movements of real output, employment and prices. A rise in the member banks’ desired holdings of excess reserves, and a decrease in their borrowings from Federal Reserve banks, result in a rise in the level of free reserves. Under these conditions, to re duce the operational target of free reserves below its previous level, the Federal Reserve must engage in an even more aggressive policy of open market sales. The result is an even more rapid decrease in the net source base, and hence a further downward impetus on the money supply process. This stage might be labeled the “L et us turn it around” stage. As our previous discussion implies, the choice of an indicator and an operational target have important implications for the ability of the Federal Reserve to turn the economy around to a renewed period of expansion in the time period desired by the policymakers. To briefly outline the problems that might arise, let us assume that the policymakers decide that to achieve their ultimate objectives the money stock should increase at a more rapid rate. However, although policymakers accept the growth rate of the money stock as their indicator, let us assume that policy is still implemented using the operational target of the Market Interest Rate H y pothesis. W hen judging the im pact of day-to-day open market operations on the growth rate of money, the Trading Desk uses free reserves or, with equivalent results, the Federal funds rate. The growth rate of money is used to gauge the extent to which Federal Reserve actions are being converted into energy that will drive the economy upward. However, the flow of fuel is measured in free reserve units instead of in units of base. 1:1The reader may refer to footnote 7, page 25, to see how these factors would lower the money multiplier. MARCH 1971 Under the economic conditions set forth for this stage, the equilibrium level of free reserves would be expected to rise and the Federal funds rate would fall. If the m onetary authorities are guided in their open market operations by either of these operational targets, they may be reluctant to pursue an ag gressive policy of open market purchases. Therefore, the growth of the base may be slower than what is required to achieve the desired growth rate of the money stock. The policymaker’s failure to achieve some publicly announced growth rate of money does not mean that the Federal Reserve cannot control money. The fail ure to reach the desired monetary growth path may result from using an inappropriate operational target. As shown earlier, if the Federal Reserve tries to re sist market-determined movements of interest rates, without taking adequate account of the influence of of these actions on the growth rate of the base, policymakers may not be able to achieve the growth of money they desire. The Federal Reserve can continue to use- open market operations to smooth short-run pressures in the financial markets arising from situations such as Treasury financings or a Cam bodian Crisis. However, to control the growth rate of the money stock, it must consider the effect of these actions on the growth of the base, which dominates the intermediate-term growth rate of the money stock.14 Empirical evidence has been presented that, by combining information about the past move ments of money multiplier with a base operational target, the Federal Reserve can exercise reasonably close control over the intermediate-term growth rate of the money stock.1 r‘ Summary This paper has presented a simplified explanation of the implementation problem of monetary policy. The actual implementation process is somewhat more complicated. F or example, we assumed that the F e d eral Reserve had only one ultimate objective. In an actual situation its ability to achieve stable prices will be constrained by the effect that its policy actions have 011 employment. In our furnace analogy, this would be a case where the homeowner is con cerned not only with the room temperature, but also with the relative humidity in the room. The speed with which the homeowner can increase the room ' •For a further discussion of this point, see Allan Meltzer, “Controlling Money,” this Review (May 1969) pp. 16-24. '•"’Lionel Kalish, “A Study of Money Stock Control,” Journal o f Finance (September 1970), pp. 761-776. Page 29 FEDERAL RESERVE BANK OF ST tem perature to a comfortable level and still maintain a tolerable level of humidity is dependent upon a number of conditions under which the process is carried out (initial conditions), such as the outside tem perature. Likewise, the ability of the Federal Reserve to influence prices while maintaining a "tol erable” level of employment will depend upon initial conditions, such as price expectations, the price and employment response of producers to a decrease in total spending, and the structure of the labor market. M onetary policy at present and in the foreseeable future must be implemented under conditions of less than perfect information about the structural relation ships linking the economy together. The indicatoroperational target method uses existing knowledge to achieve efficient implementation of policy. This article has shown that the correct choice of an indicator, and an operating strategy for controlling that indica tor, are important problems. If the Federal Reserve follows an indicator that is providing false informa tion, then this can have severe consequences for prices and employment. Movements of market interest rates and the growth rate of the money stock frequently give conflicting information about the thrust of monetary policy. The possibility of conflict between proponents of these two indicators is greatest at times when it is most impor tant that the Federal Reserve accurately assess the thrust 6f monetary policy actions. The operational strategy used to influence the level of market inter est rates affects the relative expansionary or con trac tionary influences the Federal Reserve is exerting on the money supply process. If the Federal Reserve a tte m p ts to offset changes in levels of market interest rates that result from shifts in the public’s demand for credit, then the growth rate of the base becomes endogenously determined. Under these conditions, the growth of the money stock reinforces expansions or contractions in total spending and hence movements in prices and employment. T h is a r t ic le is a v a il a b le a s R e p r in t N o . 66. Page 30 MARCH LOUIS 1971 Bibliography This bibliography is not intended to be a comprehen sive listing of the literature 011 the implementation of monetary policy. In addition to the articles cited in the footnotes of this article, these references were chosen to provide the reader with a variety of opinions among economists concerning this subject. E. An E x p lan ation o f th e M on ey S upply P rocess. Belmont, Calif.: Wadsworth, Forthcoming, Septem ber 1971. Federal Reserve Bank of Boston. C on trollin g M onetary Aggregate's. Septem ber 1969. F a n d , D a v id I. “Some Issues in Monetary Econom ics.” Federal Reserve Bank of St. Louis R ev iew . (January 1 9 7 0 ), pp. 10-2.3, F r a z e r , W i l l i a m J. and Y o h e , W i l l i a m P. T h e A n aly tics a n d Institutions o f M on ey a n d B an kin g. New York: D. Van Nostrand and Co., 1966, Chapters 24-26. B urg er, A l be r t H a m b u r g e r , M ic h a e l J . H o l b r o o k , R o b e r t . S c h a p ir o , Papers Presented at the Session 011 “Money W ithin the General Econom ic Framework of the Econom ic System .” A m erican E c o n om ic R ev iew . (M ay 1 9 7 0 ), pp. 32-58. H a n s e n , B e n t . T h e T h eo ry o f E co n o m ic P olicy an d P lanning: L ectu res in E co n o m ic T h eo ry : Part T w o. Lund, Sweden: Student Litteratur, 1967. K e r a n , M i c h a e l W . “Selecting a Monetary Indicator — Evidence from the United States and O ther D evel oped Countries.” Federal Reserve Bank of St. Louis R ev iew . (Septem ber 1 9 7 0 ), pp. 8-19. H a r o l d . Z e g h e r , R ic h a r d . M e ltz e r , A lla n H . H o rw ic h , G eo rg e. H e n d e rs h o tt, “T he Appropriate Indicators of Monetary Policy.” Savings a n d R esid en tia l F in an cin g 1969 C o n fe r e n c e an d P roceed in g s. Chicago: Sponsored by the United States Savings and Loan League, 1969, P a tr ic H. pp. 11-67. W i l l i a m . “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro M odel,” Q u arterly Jou rn a l o f E co n o m ics. (M ay 1 9 7 0 ), pp. 197-216.' S a v i n g , T h o m a s R. “Monetary Policy Targets and Indi cators.” Jou rn a l o f P olitical E co n o m y . (August 1 9 6 7 ), pp. 446-456. T arg ets a n d In d icators o f M on etary P olicy. E d . K a r l B r u n n e r . San Francisco: Chandler, 1969. T i n b e r g e n , J a n . E co n o m ic P olicy: P rin ciples an d D esign. Amsterdam: North-Holland, 1966. W i l l m s , M a n f r e d . “An Evaluation of Monetary Indica tors in Germany.” P ro ceed in g s o f th e F irst E u ro p ea n C o n fer en c e o f M on etary P olicy at K on stan z. Edited by Karl Brunner. Goettinger, W est Germany: Vandenhoeck and Rupreeht, Forthcom ing 1971. P o o le , F E D E R A L R E S E R V E B A N K O F ST. L O U I S MARCH 1971 Publications of This Bank Include: W eekly U. S. 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