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FEDERAL RESERVE BAN K
OF ST. LO UIS
SEPTEMBER 1974

Recent Economic Developments in Perspective
KEITH M. CARLSON

SUPERFICIAL reading of economic data sug
gests that the first half of 1974 was apparently one of
the worst periods of economic attainment in the postWorld War II period, with indexes of real growth and
the price level moving adversely at the same time.
The reported decline in real product for the two
quarters was exceeded only during the recessions of
1953-54 and 1957-58. At the same time the reported
inflation rate was the highest for all successive twoquarter periods since 1947.
The purpose of this article is to review economic
developments in the first half of 1974, with special
emphasis on the interpretation of the GNP data.
These data will be examined and compared with
other time series to determine if any inconsistent
signals are being emitted as to the course of the econ
omy.1 To place the recent experience in perspective,
the course of the latest economic expansion —from
late 1970 to present —will be compared with other
expansion periods in the United States over the last
twenty years. The two most recent quarters are in
cluded in this comparison to give the current position
of the U.S. economy some perspective, without at-

'For an exercise with similar objectives, see Geoffrey Moore,
“Recession?”, Econom ic Outlook USA, a quarterly publica
tion of the Survey Research Center at the University of
Michigan (Summer 1974), pp. 4-5.
Page 2

tempting to determine if the most recent experience
will be classified as a recession.

Recent Developments
Total spending rebounded somewhat in the second
quarter after slowing sharply in the first quarter. Con
sumer spending increased, with purchases of durable
goods rising sharply from the depressed rate of spend
ing last winter. Business investment also advanced
rapidly in the second quarter.
Real product in the second quarter was below the
first quarter, and since fourth quarter 1973 this meas
ure of real activity has declined at a 4 percent annual
rate. By comparison, real product had increased at a
2.1 percent annual rate in the previous three quarters
and at a 6.7 percent average annual rate from fourth
quarter 1970 —the trough of the previous recession —
to first quarter 1973.
Industrial production, on the other hand, is up
somewhat from the depressed levels of last winter.
Though advances have been sluggish and irregular
since February, industrial production was up at a 1.9
percent annual rate from February to July. Although
this gain is not particularly impressive, it should be
noted that industrial production growth has been
dampened by work stoppages in various industries.
For the first seven months of 1974, 29.5 million man-

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

days were lost because of work stop
pages, compared to 13.1 million mandays lost in the comparable period of
1973.
Despite irregular movements in in
dustrial production thus far in 1974,
employment conditions have been re
markably strong. Total employment,
after holding steady from October 1973
to April 1974, has since increased at a
2.5 percent annual rate. Unemployment
has changed little since January, aver
aging 5.2 percent of the labor force.

SEPTEMBER

Table I

P R O D U CTIO N A N D

EM PLOYMENT

I V / 7 3 to 11/74
Annual
Rate of
Change
Real Pr oduct ( c on s t an t d o l l a r G N P )

— 4.0%

I ndust r i al Pr oduct i on

— 2.7

Per cent i l e
Rank*
3

11/73
Annual
Rate of
Change
-1 .0 %

to 11/74

Percentil
Rank*
8

0.3

Total Empl oy ment

0.7

2. 2

Pay r ol l E m p l o y m e n t

1. 3

2. 3

♦Computed fo r all successive tw o- and fo u r-q u a rte r periods fro m 1/47 to 11/74 excep t
fo r to tal em ploym ent, w hich is com puted fo r th e period 1/48 to 11/74.

Prices have continued to increase very rapidly. The
general price level has risen at a 9 percent annual
rate since early 1973, compared to about a 4 percent
increase in the previous year. Consumer prices have
advanced at a 10 percent average rate since early
1973, and prices for wholesale industrial commodities
have increased at a 20 percent average rate.

Interpretation of GNP Data
A controversial aspect of the recent data is whether
or not the first half figures indicate recession. It is
well known that a shorthand method of determining
whether or not a recession has occurred is to examine
the movements of real product —in particular whether
or not real product declines for two consecutive
quarters. But the National Bureau of Economic Besearch (N B E B ) emphasizes that the label of recession
is not determined in such a simple manner.2 Bather,
the N BEB makes such a determination from a much
broader data base and uses the criteria of duration,
severity, and the degree of diffusion.
The question of whether or not a particular period
of economic experience should be defined as a reces
sion is of little consequence for economic policy. Such
labeling is helpful in later years since identification
of recession periods assists in the interpretation of
past economic events. What is important for the pol
icymaker is whether or not a slowdown is occurring,
and if so, is some kind of countercyclical action neces
sary in light of the objectives of policymakers.
To assess the meaning and significance of the most
recent GNP data, other relevent time series are
-See Geoffrey Moore, “Recession?”, and as a general reference,
Victor Zamowitz, ed., The Business Cycle Today, Fiftieth An
niversary Colloquium I (New York: National Bureau of
Economic Research, 1972).

1974

ranked according to rates of change for the period
from 1947 or 1948 to the present. In this way, what
appear to be extremes for prices and real GNP can be
checked against other series measuring prices and real
economic activity to determine to what extent the
GNP data are providing consistent signals. Industrial
production and employment are considered as comple
mentary indicators of real activity. For prices, alter
natives to the GNP deflator are consumer prices and
wholesale prices. Each of the alternative measures is
designed for its own purpose, and none is meant to
substitute for the GNP measures. Yet, in past periods
of several months duration, alternative time series re
lating to, say, real activity have tended to move in
concert with one another.
Tables I and II provide percentile rankings for
various measures of real economic activity and prices.
A percentile ranking is a shorthand method of sum
marizing the movement of a particular time series in
a specified time period relative to the historical move
ment of that series. A ranking of a specified rate of
change in the 50th percentile, for example, indicates
there were as many observations above as below that
rate of change. High percentile rankings ( greater than
50 but not more than 100) indicate rates of change
that are high relative to past experience. Low per
centile rankings (less than 50 but not less than zero)
indicate rates of change that are low relative to past
experience.
Table I shows percentile rankings for alternative
measures of real economic activity. It should be noted
that real GNP is the only series in this table which is
computed by deflating nominal magnitudes. The other
series involve more direct measures of physical pro
duction and employment. The 4 percent annual rate
of decline for real GNP from fourth quarter last year
to second quarter 1974 ranked in the 3rd percentile.
In other words, the last two quarter’s decline in real
GNP ranked very poorly relative to economic experiPage 3

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

SEPTEMBER

T a b l e II

PRICES
IV/73
Annual
Rat e of
Change
GNP

Def l at or

to 11/74

11/73

Percenti l e
Rank*

10.5%

100

to 11/74

Annual
Rate of
Change

Percenti l e
Rank*

9.5%

100

C o n s u m e r Prices

11.8

10.7

W h o l e s a l e Prices

19.4

1 5. 9

33.0

100

20.0

100

-4 .6

7.0

W h o l e s a l e I ndust r i al s
W h o l e s a l e Far m & Foods
C o r p o r a t e A a a B o n d Yi el d

19 . 5

14.5

4-6

35.6

40.0

M o n t h C o mme r c i a l P a p e r Rate

♦Com puted fo r all successive tw o- and fo u r-q u arte r periods from 1/47 to

ence since 1947, exceeding only 3 percent of all other
successive two-quarter periods.
The question being asked here is whether or not
the severity of the real GNP decline is borne out by
other measures of real activity. Industrial production
growth for the last two quarters was in the 19th per
centile. Total employment was in the 30th percentile,
while payroll employment growth was greater than 32
percent of all other two-quarter periods since 1947.
Examination of the record for the past four quarters
shows a similar pattern.
Substantially higher percentile rankings for indus
trial production and employment than
for real GNP indicate that real GNP may T a b l e III
be providing misleading signals as to
how severe the recent downturn really
was. Though the source of the discrep A f tQeura rTtreorusg h
ancy cannot be readily identified, it
0
should be pointed out that with severe
1
inflation and/or substantial changes in
2
relative prices, any figures denominated
3
in dollars, or making use of calculations
4
5
involving dollars, are suspect because of
6
index number problems inherent in the
7
measurement of price change.3
Though the chief question of interest
is whether real activity declined as much
as the GNP data indicate, there is a sub
sidiary question — is the rapid change in
the GNP deflator confirmed by other
price series? For purposes of compari
son, consumer prices, wholesale prices,
and the price of short- and long-term
3This point >has also been made in Moore,
“Recession?”. For a recent discussion of price
indexes, see Denis S. Karnosky, “A Primer on
the Consumer Price Index,” this Review (luly
1 9 7 4 ), pp. 2-7.

Page 4

100

1974

credit are ranked in Table II. The GNP
deflator was in the 100th percentile; that
is, the rate of change of the GNP de
flator over the last two quarters was
the highest for all successive two quar
ters since 1947. This extreme is con
firmed by both consumer prices and
wholesale prices, and to a lesser extent
by short- and long-term interest rates.

In summary, there is reason to doubt
whether the decline in real product was
85
as severe as indicated by constant dollar
82
GNP. Measures of industrial production
11/74.
and employment do not show a corre
sponding degree of severity. The price
situation, on the other hand, appears without doubt
to be one of the worst in the postwar period. Com
parisons of this type do not yield definite conclusions,
but it does appear that past patterns of consistency
among alternative measures of real product can be
altered when relative prices change suddenly or
substantially.
79

Recent Economic Expansion in Perspective
To provide additional perspective, the economic
events of 1974 are examined in a business cycle con
text. The current expansion —from late 1970 to the

IN D U S TR IA L P R O D U C T I O N
Trough Qua rt er —
111/54

11/58

100

1/61

1/67

IV/70

100.0

102.8

105.2

104.0

100.0

102.0

108.4

109.9

107.2

101. 1

103.2

1 13. 1

1 1 4. 8

1 1 1. 0

102.9

102.6

114.8

120.3

1 1 2. 8

104.8

103.5

1 17.6

1 15.5

1 13.8

106.5

106. 1

117.9

11 6 . 0

115. 1

107.5

109.6

117.5

123.0

1 16.0

108.6

1 1 2.1

1 1 6. 8

120.3*

1 1 7. 8

1 1 0. 8

1 15.8

121.2

1 18.3

120.9

1 1 1.8

1 18.6

122.2

1 15.5

121.8

1 13.0

120.3

120.7*

1 13.7

123.9

112.0*

122.0

121 . 1

1 1 8. 3

125.6

109.4

122.4

1 16.0

121.9

128.7

109 . 1

120.4

109.5

126.2

130.7

108.5

120.8

Aver age annual
r at e of c h a n g e f r om
t r o u g h t o:
Peak

7.1%

9.7%

8.3%

4.2%

1 4 quar t er s af t er
t r ough

2.6

6.9

8.0

2.4

5.6%

♦R ep resen ts business cycle p eak. P e a k fo r period b e g in n in g in 1/61 is 23 q u a rte rs a fte r
troug h (n o t shown in ta b 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

SEPTEMBER

T a b l e IV

PAYROLL E M P L O Y M E N T
Quarters
Af t e r T r o u g h

____________________ T r o u g h Q u a rter —
111/54

11/58

10 0
1/67

1/61

IV/70

100.0

100.7

100.6

100.4

100.3

101.7

101.8

101.3

101.0

100.6

103.5

102 . 1

101.9

100.8

104.6

1 05 . 1

102.8

102.6

101.4

105.7

105. 1

103.8

103.5

102.4

106.8

105.4

104.3

104.4

103.4

107.5

106.9

104.6

105.4

104 . 1

107.2

107.1*

104.8

106.4

105.3
106.5

108.3

106.6

105.7

107.3

108.7

105.9

106.3

108.0

107.5

108.8*

105.2

107.0

108.5*

108.0

108.6

105.7

107.6

108.7

109.2

107.7

106.6

108.5

108.4

109.4

105.8

107.4

109.5

108.0

109.9

A v er age annual
r at e of c h a n g e f r om
t r o u g h t o:
Peak

3.1%

3.5%

3.4%

3.0%

14 q uar t er s aft er
t r ou g h

1. 6

2.1

2.6

2. 2

♦ R ep resen ts business cycle peak. Peak fo r period b eg in n in g in 1/61 is 23
trough (n o t shown in ta b le ).

present —is compared with other periods of expan
sion. Even though there is still some question as to
whether or not the first half of 1974 will be classi
fied as a recession, it is useful to compare the position
of the economy relative to the recession
trough with similar periods in the past. T a b le V
This most recent expansion of three and
Quarters
one-half years is compared with previous
expansions from 1967 to 1969, 1961 to Af t e r T r o u g h
0
1966, 1958 to 1960, and 1954 to 1957.4
Measures of R eal Activity —An ex
amination of the movement of industrial
production (Table III, p. 4) in postwar
economic expansions indicates that the
most recent expansion has not been sub
stantially different from other postwar
cyclical expansions. Of course, each ex
pansion is unique, and the most recent
expansion is characterized by a slow
start which picked up steam after about
4The NBER expansion of 1961-1969 has been
divided into two subperiods of expansion —
from 1/1961 to IV/1966 and from 1/1967 to
IV/1969. This division does not dispute the
judgment ,of the NBER, but helps to provide
additional perspective on the relationship
between money and measures of economic
activity. For general discussion of NBER
procedures and methods, see Zamowitz, The
Business Cycle Today.

1974

four quarters. Though the decline from
fourth quarter 1973 to second quarter
1974 places industrial production well
below the comparable position in the
long 1961-66 expansion, the current level
of industrial production (second quarter
1974) is about average for comparable
periods measured from trough reference
points.
The table for payroll employment
(Table IV ) shows greater similarity dur
ing expansions than for industrial pro
duction. Though, initially, payroll em
ployment in the most recent expansion
lagged other expansions, it has since
caught up. In fact, looking at all periods
14 quarters after the trough, the current
expansion shows the best performance
for payroll employment in the post-war
period.

The position of the economy in 1974
is about average when viewed relative
q u a rters a fte r
to progress in other postwar periods
of economic expansion. The current
expansion was characterized by a slow start, but
once the momentum started, it carried through 1973;
and 1974 continues strong relative to its trough
reference point.
2.7%

CONSUMER

PRICES

____________________ T r o u g h Q u a r t e r —
111/54

100

11/58

1/61

1/67

100.0

100.0
100.9

IV/70

99.6

100.0

100.6

99.8

100.0

100.4

101.6

101.9

99.7

100.2

100.5

102.5

102.8

99.7

100.4

100.9

103.7

103.5

100.0

100.9

101.3

104.7

104.4

100. 1

101.5

101.6

105.9

105. 1

100.7

101.6

101.8

107.3

106.0
107. 1

101.7

102.2*

1 02. 1

108.6

102.6

102.3

1 10.4

108.7

103.5

103.0

102.9

11 1. 9

110.9

104.4*

103.2

113.5*

113.3

105.3

103. 1

103.6

1 1 5. 4

116.0

105.8

103.5

103.8

117.0

119.4

107. 1

103.7

104.0

118.3

122.7

Aver age annual
r at e of c h a n g e fr om
t r o u g h t o:
Peak

1.6%

1.1%

1.7%

4.7%

—

2.0

1. 0

1.1

4.9

6.0%

1 4 q uar t er s aft er
trough

•Repr esent s busi ness cycl e peak. P e a k fo r period b eg in n in g in 1/61 is 23 qu a rters a fte r
t r o u g h ( n o t s h o wn i n t ab l e ) .

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

SEPTEMBER

T a b l e VI

FEDERAL EXPENDITURES
Quarters
After Tr oug h

Trough
111/54

Quar ter —

11/58

100
1/67

1/61

I V/ 70

100.0

98.5

102.3

101.2

101.7

99.0

105.2

103.6

105.6

97.8

103.9

105.0

106.0

106.4

99.6

102.4

109.2

109.5

108.8

1974

In fact, the advance of Government
spending in the latest expansion has kept
pace with the 1967-69 period — a period
when Viet Nam hostilities were still in
effect. Even though the composition of
expenditures has shifted away from war
time production, the increase of total
Federal spending in the current expan
sion is just as rapid as from 1967 to 1969.

The other chief policy indicator sum
marized here is the money stock (Table
102.4
117.2
114.2
1 04.7
113.2
7
V II). The advance of money since late
105.4
104.2*
115.2
1 1 6. 8
125.2
8
1970 has been rapid and has paralleled
1 1 2.9
117.8
124.7
9
108.0
106.7
1 19.2
almost exactly the early stages of the
108.4
125.8
1 1 3. 8
1 14.6
10
1 16. 2*
1 15.9
1 21.3*
126.3
1 12.5
11
1967 - 69 expansion. It is also of in
1 1 6. 2
1 15.1
1 18.6
122.7
129.7
12
terest to note that the other paths of
1 29.8
1 17.9
1 1 6. 5
1 19.3
134.7
13
money
expansion (with the possible ex
1 18. 1
14
122.6
1 1 8. 9
128.8
139.8
ception of the 1957-59 expansion) show
A v er age annual
a downturn just prior to the peak of
r at e of c h a n g e f r om
t r o u g h to:
economic activity; that is, the end of all
2.1%
7.6%
7.3%
Peak
5.6%
economic expansions in the past has been
1 4 q ua r t er s aft er
preceded by a marked slowing in money
7. 5
10 . 0 %
4.9
5.1
t rough
6.0
growth. No such marked slowing is evi
♦Repr esent s busi ness cycl e peak. Peak f o r per i od b e g i n n i n g i n 1/61 is 23 q uar t er s aft er
dent for the path of money in the current
t r o u g h ( n o t s h o wn i n t a b l e ) .
expansion, although latest data indicate
Prices —Examination of prices relative to other pe
signs of slight slowing in the rate of monetary expan
riods of cyclical expansion indicates that the price
sion beginning in third quarter 1973 (11th quarter
experience for the most recent expansion stands
after the IV/1970 trough).
out quite dramatically, along with the
experience of the previous expansion T a b l e VI I
— 1967-69 (Table V, p. 5). The advance
M O N E Y STOCK
of prices in the current expansion started
Trough Quar ter —
100
Quorters
out almost identical to the 1967-69 ex A f t e r T r o u g h
IV/70
111/54
11/58
1/61
1/67
pansion. Prices then slowed, but acceler
100.0
100.0
100.0
100.0
100.0
0
ated again more recently. This pattern of
100.8
101.5
101.6
101.0
1
101.0
price movement, a slow rise followed by
102.2
101.4
103.7
104.3
102.2
2
106.0
103.6
102.4
105.3
a sharp acceleration, was influenced in
102.8
3
103.2
104.5
106.6
106.5
4
103.0
considerable measure by price and wage
108.0
103.4
105.0
103.5
108.6
5
controls. Nevertheless, of the five post
104.4
110.2
103.8
103.2
1 10.9
6
war expansions, the last two stand out
103.9
1 1 2. 5
1 04. 1
103.9
1 13.1
7
relative to the others in terms of price
115.2
1 14.8
8
1 04. 1
103.7*
104.8
116.8
105.9
1 1 6. 5
performance.
9
104.6
104.6
5

100.6

102.9

111.0

113.6

1 13.0

101.0

103. 1

111.0

1 15.4

116.8

Policy V ariables —It is of analytical
interest to examine the movement of
policy variables in the current expansion.
Comparison of Federal expenditures in
the current expansion with other postwar
expansions indicates that the most recent
advance has paralleled that of the 196769 expansion (Table V I). All other post
war expansions showed less Federal ac
tivity, as measured by Federal expendi
tures, than does the current expansion.

Page 6

104.8

106.9

1 17.2

1 19.0

104.8*

105.2

108.0

117.8*

120.6

104.8

1 06. 1

108.6

1 19. 1

122.0

104.3

106.7

109.7

1 21. 1

123.8

104.2

107.8

111.5

122.9

1 26. 1

Aver age annual
rat e of c h a n g e fr om
t r ou g h t o:
Peak

1.7%

1.8%

3.4%

6.1%

1.2

2. 2

3.1

6.1

1 4 quar t er s aft er
t r ou g h

6.8%

‘ Repr esent s busi ness cycl e peak. Peak f or per i od b e g i n n i n g i n 1/61 is 23 q uar t er s aft er
t r o u g h ( n o t s h o wn i n t a b l e ) .

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

Another aspect of the tables that is of interest is that
when viewed together, the latest expansion is differ
ent in two respects —in terms of the policy variables
and in terms of prices; the two latest expansions are
characterized by extremes. The real variables do not
demonstrate the same pattern. During periods of eco
nomic expansion, industrial production and payroll
employment do not seem to be systematically related
to the movements of the policy variables. For the last
seven years — covering the two most recent expan
sions —monetary and fiscal policy have been much
more stimulative than in previous expansions, with the
chief effect being that prices have increased more
rapidly than otherwise with little noticeable effect on
production and employment.

Summary
The first half of 1974 for the U.S. economy was a
failure from the standpoint of the degree of achieve
ment of goals relating to economic growth and price
stability. Yet, upon closer examination of the data,

SEPTEMBER

1974

whether or not the economy experienced recession is
still an open question. Only the time series of real GNP
definitely supports the notion that a recession did
occur; other measures of real economic activity —
though they have slowed —have not demonstrated
such weakness when viewed in perspective. It seems
that rapid inflation and/or substantial changes in rel
ative prices cause considerable difficulty in the meas
urement of overall price levels which, in turn, creates
problems in the conversion of nominal magnitudes to
“real” magnitudes.
Examination of the current expansion from a longerterm perspective indicates that the advance of pro
duction and employment is quite similar to previous
expansions. Where the current expansion stands out
relative to most other expansions is in the movement
of the price level and in the policy variables. During
the expansion period from late 1970 to the present,
substantial monetary and fiscal stimulus has caused
a rapid rise in the price level without commensurate
gains in production and employment.

Page 7

Economic Forces Facing the Bank Holding
Company Movement
An Address by DARRYL R. FRANCIS, President, Federal Reserve
Bank of St. Louis, at the BAI Conference on
Bank Holding Company Administration, Chicago, Illinois, August 16, 1974

I t IS good to have this opportunity to discuss with
you some thoughts on the economic forces facing
bank holding companies. The bank holding company
movement is of increasing interest to both the eco
nomic and the political sectors of our society. Bank
holding companies own about one-fourth of the na
tion’s banks which, in turn, hold about two-thirds of
the banking assets. In addition, they have made sub
stantial inroads in a number of bank-related activities.
Most of the bank holding company growth occurred
during the past decade. From 1963 to 1973, the num
ber of multiple bank holding companies rose five-fold,
and the number of one-bank holding companies dou
bled from 1968 to 1973.
The rapid increase in bank holding companies can
be traced to the restrictions on commercial banking.
In a competitive market, the type of firm or structure
which evolves is that which tends to maximize both
profits and consumer well-being. The incentive for
profit provides the motivation for banks to fill any
voids in their markets. When they observe opportuni
ties to increase services and profits by a change in
structure, they will attempt to make such a change.

the public expanded. In recent years branching restric
tions have become increasingly onerous to banks lo
cated in declining central cities of unit banking states.
Regulation Q has also been more burdensome to banks
in the more competitive banking markets with the
rising interest rates. Bank holding companies permit
banks to expand their operations into new geographic
markets through the organization of new firms or
through the purchase of existing firms where branches
of the parent firm are prohibited. As evidence that
holding companies are used to bypass restrictions on
individual banks, the multi-bank holding company
movement is much more pronounced in unit banking
states. For example, in 1972 there was less than 2
multi-bank holding companies per state in the 18
state-wide branching states which permitted multi
bank holding companies. In contrast, there was 12 per
state in the 8 unit banking states which permitted
multi-bank holding companies.

Banks

THE EVOLUTION OF REGULATION

Regulation of banks has proceeded without a clear
recognition of what was to be regulated. Most of the
restrictions have come about since the early 1930s as
a result of confusion as to the cause of economic
instability.

The formation of a bank holding company can be
looked upon as a way whereby many restrictions on
commercial banks can be overcome and services to

In the early years of the nation, commercial bank
regulation was largely concerned with the chartering
provisions for state banks, their bank note (paper

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money) issuing function, and the impact of such is
sues on the economy. There was little interest in the
maintenance of sound banks as long as they could
redeem their paper money with specie.
That sage of American politics, Thomas Jefferson,
and a number of political leaders who followed, rec
ognized that the restrictions on banking should be
directed at the quantity and quality of money rather
than other functions of financial firms. Albert Gallatin,
Jefferson’s Secretary of the Treasury, contended that
the creation of bank money should be restrained; but
with that single exception, banks should be left free
as any other firm. President Jackson in his farewell
address in 1837 said that corporations which create
paper money cannot be relied on to maintain a uni
form amount.
The National Banking Act (1863) focused largely
on the quantity and quality of money. A maximum
was placed on national bank note issues, and the
stock of money (deposits plus notes) was restricted
by legal reserve requirements.
While its general focus was on the protection and
control of money, the Act contained some provisions
for protecting banking firms. It prohibited some bank
ing practices which were considered risky, such as
real estate lending. It also provided for a surplus in
capital accounts and the examination of all national
banks.
The chief objective of examination following the
Act was to make sure that the condition of banks
would enable them to redeem their notes. In the late
1800s, however, the Comptroller of the Currency
adopted the view that the correction of basic man
agerial difficulties was also a function of bank
supervision.
The original Federal Reserve Act (1913), while not
specifically requiring that individual banks be main
tained in a sound and viable condition, indicated that
this was an important supervisory objective. For ex
ample, in acting upon membership applications, the
Act required that the financial condition and the gen
eral character of the applying bank’s management be
considered.
Following the great depression and the rash of bank
failures in the early 1930s the Government began to
take greater responsibility for the maintenance of
strong, viable banks. Bank failure was associated with
economic instability and the view developed that
banks cannot be allowed to fail for so-called public
interest reasons. This view led to the onerous bank

1974

regulations in the banking acts of 1933 and 1935
which sustain modem bank supervision. Thereafter,
banking activities, rather than the quantity and quality
of money, consistently received the major focus of
bank regulation.
The control of bank assets and the maintenance of
sound banks has become a paramount supervisory
objective. For example, before admitting banks to the
Federal Deposit Insurance Corporation (F D IC ), their
future earnings prospects, adequacy of capital, and
character of management, as well as the convenience
and needs of the community, must be considered. The
Comptroller considers the same factors before grant
ing charters, thus, in effect, giving the Federal
Government power to limit the number of banking
firms.
The Acts require that each Federal Reserve Bank
ascertain whether bank credit is being used for pur
poses inconsistent with “sound credit conditions”. If
such unacceptable use is made of bank credit, the
Federal Reserve Board may suspend a member bank
from the use of the credit facilities of the System.
These Acts placed increased restrictions on the es
tablishment and operation of branches. The payment
of interest on demand deposits was prohibited and
maximum rates were set on time and savings deposits
by the supervisory agencies. The Acts set limits to the
bank’s investments in its premises, divorced banking
from security dealing, and set restrictions on loans to
banking affiliates, dividends payable, and bank capi
tal. The Federal Reserve Board and the Comptroller
of the Currency were authorized to remove bank of
ficials for illegal or unsound bank practices. This leg
islation, in effect, limited the bank managerial func
tion to those actions consistent with the regulators’
view that banks should always remain in condition
to withstand another great depression. Furthermore,
bank legislation and regulation by individual states
during this period was often more restrictive than
at the Federal level.

Bank Holding Companies
Until recently bank holding companies were sub
ject to relatively few restrictions. State banking of
ficials have generally found it difficult to gain much
control over such companies.
The first Federal regulation of bank holding com
panies occurred with the Banking Act of 1933. This
Act provided the Federal Reserve Board with some
control over the voting of member bank stock owned
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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

by corporations. It required such corporations to
establish certain reserves, to publish financial state
ments, and to withdraw from the securities business.
Following the rapid growth of bank holding com
panies after World War II, Congress enacted the Bank
Holding Company Act of 1956. This law restricted
multiple bank holding company activities to banking
and closely related services, and, with minor excep
tions, forced them to divest themselves of ownership
or control of any other kind of business. It limited
most acquisitions of bank stock by such companies to
the state in which their operations were principally
conducted, thereby effectively curbing new interstate
bank acquisitions. The Act was amended in 1966 so
as to require prior approval of the Federal Reserve
Board for future acquisitions by bank holding
companies.
One-bank holding companies, however, were sub
ject to less Federal control, and their number almost
doubled from 1968 to 1970. As a consequence of this
rapid growth, some bankers, the regulators, and others
who were fearful of these new competitors - called for
their regulation. The Bank Holding Company Amend
ments of 1970 were passed, ending the exemption of
one-bank holding companies from Federal control.
The Amendments did, however, liberalize the activi
ties in which bank holding companies could partici
pate. They were permitted to acquire nonbank firms
across state lines.

REGULATION AND COMPETITION
As a consequence of the onerous restrictions on
banking and bank holding companies, the quality and
efficiency of financial services have declined, and the
competitiveness of the banking system has been re
duced. As pointed out by the Hunt Commission, the
interest rate regulations during the period of “tight”
money in 1970 made it increasingly difficult for bank
supervisors to accomplish their objectives of maintain
ing strong, viable firms, and at the same time de
creased the role and effectiveness of the institutions
they aimed to preserve. The regulations which pro
hibited banks from paying a market rate of interest
to savers actually weakened the banks as savings
were withdrawn and placed in higher-yielding invest
ments. More importantly, however, savers, borrowers,
and consumers were bearing unnecessary risks and
costs.
In contrast to the controls on banks and bank hold
ing companies, nonbanking firms enjoy rights of entry
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1974

and flexibility in the introduction of new financial
products and services not enjoyed by either banks or
bank holding companies. Furthermore, as pointed out
in a recent study by the First National City Bank,
New York, some of these nonbank firms are relatively
large credit suppliers. Three nonbank installment lend
ers have receivables outstanding equal to 11 percent
of the total held by all commercial banks, and one
has more receivables than the combined total for all
commercial banks in New York and Chicago. It is not
my intention to criticize these firms, but only to sug
gest that they saw business opportunities and entered
the financial services market to the advantage of both
the firm and the consumer.
In my view the public is entitled to the best and
lowest cost financial service that the market can pro
vide. Competition in providing such service is the
best means of achieving this objective, but not all
bankers are eager to participate in a freely competi
tive market. Some, probably reflecting their overly
protected status, have not always been awake to their
opportunities and challenges. They are not unanimous
in their support of the Administration’s efforts to re
move some of the regulatory shackles to vigorous
competitive operations. They are often blind to a
competitor when it is called by some name other than
a bank. But the very fact that nonbank competitors,
such as the Farm Credit Banks, sales finance com
panies, savings and loan associations, and the credit
departments of retail stores, have entered the finance
business and achieved vigorous growth indicates that
commercial banks have left voids in the financial
services market. The assets of these nonbank financial
firms increased more than ten-fold from 1946 to 1972,
and their share of the total financial services market
rose from 43 to 62 percent.
The Hunt Commission recognized the excessive reg
ulation of banks, and proposed changes that would
free them from many controls. Its proposals included:
the relaxation of interest rate restrictions, the removal
of most usury ceilings on loans, the removal of limita
tions on branch banking, and the relaxation of char
tering and investment restrictions. The Commission
recognized that the public would be better served
by the increased competition resulting from the im
plementation of the proposals. I am not here to pro
mote any specific plan for restructuring the financial
system, but rather to point out the economic forces
facing the bank holding company movement. With
this background, I believe those forces are now
obvious.

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

REGULATION AND THE ALLOCATION
OF CREDIT
The demand for financial services is growing, and
bank holding companies have the organization and
the technical know-how to supply them. Competitive
challenges abound which they are inhibited from
meeting. However, if history is a reliable teacher they
will have to fight for the opportunity to participate
in such markets as an equal. Their opponents in the
struggle for an equal opportunity to participate can
be classified into two groups. First are those politically
powerful sectors of the economy that demand pre
ferred treatment in the credit allocation process. Sec
ond are the regulators of financial firms and their
supporters, who include those current participants in
the markets who fear competition. And third is a
large segment of the population which believes that
strong, viable financial firms can be maintained only
by restricting their natural incentive to compete.
Much of the impetus for preferential treatment in
the allocation of credit has occurred during periods
of economic depressions or high nominal interest
rates. When market rates exceed limits established by
usury laws and Regulation Q, credit flows are diverted
from normal patterns. These market barriers have
tended to starve some sectors.
Numerous Government credit subsidy programs
have been established to “correct” these assumed de
fects in the credit market and the number of such
programs continues to grow. A staff study by the
Joint Economic Committee of the Congress in 1972
listed 42 major Federal credit subsidy programs (those
with outstanding credit of more than $10 million).
These programs, designed to finance agriculture, edu
cation, housing, commerce, economic development,
natural resources, and medical care, cost the taxpayers
of the nation $4.2 billion in 1970. At the close of 1972
direct government loans outstanding through these
programs were estimated to be $56 billion and the
guaranteed loans $167 billion. In addition to these 42
major programs, there are numerous subsidized credit
programs with less than $10 million credit outstanding.
These programs provide preferred treatment for
some activities at the expense of others since the total
volume of credit available is not increased much, if
any. They divert credit flows from more produc
tive uses to those uses selected through the political
process. They neither add to national well-being nor
the well-being of most of those sectors that they pur
port to help. To the extent that they are successful
in increasing credit flows into one sector, they cause

SEPTEMBER

1974

excesses of resources in that sector relative to other
sectors. If welfare of the individual is their objective,
such welfare can be purchased at a much lower cost
through cash grants. Furthermore, such programs are
extremely biased against those individuals who have
already obtained their credit or other resources at
market prices.
Of greater concern to bankers, however, should be
the encroachment of such activities in the financial
markets. These programs are based on the false prem
ise that our financial system is doing a poor job of
allocating credit. Yet, instead of pointing out the ef
ficiency of the free market system, and demanding
equal opportunities to markets, bankers have often
stood idly by or even assisted in the proliferation of
credit markets by these privileged agencies. Indeed,
the American Bankers Association actually joined other
groups this summer in urging Congress to enact leg
islation for a new program of guaranteed loans to
livestock producers. By acceding to requests for sub
sidized credit, or assisting in furthering such activities,
bankers may have contributed to the public view that
something is wrong with our private credit allocation
system.

SUMMARY AND CONCLUSIONS
In summation bankers should not remain silent on
such important subjects as political credit allocation
and bank regulation. Most bankers know that the al
leged problems are usually not credit problems at all,
but only the voice of a social idealist. The alleged
credit problem in the cattle feeding industry which
led to the recent government credit program was
actually a profit problem that the market system will
solve. Once price relationships move to profitable lev
els, sufficient credit will be available to finance the
feeders. The problem is simply made worse if addi
tional credit is made available to inefficient producers
during periods of unfavorable price relationships.
Bankers should speak out and resist useless govern
ment encroachment in this, as well as in other areas,
including the various alleged consumer protection
plans. Bankers have sat silent too long and let other
less qualified people run their business, reduce their
markets, and subsidize competitors with their profits.
In the regulatory area confusion still prevails as to
which banking functions should be controlled. Hence,
the urge to protect your firms from so-called “cut
throat” competiton is great. It arises from both cur
rent participants in- the markets who fear your com
petition, from the desire of regulators to regulate,
and from a large sector of the population which be
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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

lieves that strong, “viable” financial firms necessary for
economic stability can only be maintained by re
stricting their natural incentive to compete. They as
sociate failure of banks with economic depression. In
my view it is the money-creating function of banks
that has led to economic instability. We can protect
the money holders through deposit insurance and if
we provide for a stable rate of monetary growth, the
economy will function satisfactorily.
I do not view an occasional bank failure as being
disastrous. An occasional failure eliminates the ineffi

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1974

cient and is a signal to other firms to exercise caution.
Relatively free entry and exit are indicators that an
industry is competitive. Regulation that is sufficient
to prevent new firms from entering and prevent
failure is sufficient to inhibit growth and vitality in a
competitive economy. The proposals for limiting the
rates payable on bank holding company credit instru
ments are examples of a regulation that will inhibit
your growth. Your success in avoiding such controls
will thus likely determine your long-run growth and
profitability.

The Current Inflation:
The United States Experience
ALBERT E. BURGER

The following paper was presented at the “International C onference on The ‘New Infla
tion and Monetary Policy” held June 24-26, 1974 in Milan, Italy. The C onference was spon
sored jointly by Banca Com m erciale Italiana and the D epartm ent o f Econom ics, Universita Bocconi. Professors Gaetano Stammati and Innocenzo Gasparini w ere joint chairm en of the C onfer
ence. Papers on inflation and the problem s it im plies for monetary analysis were presented by
Professors John Hicks, Karl Brunner, Franco Modigliani, and R obert A. Mundell. Papers discuss
ing the inflationary experience in specific countries were presented for Brazil, the European
Econom ic Community, France, the F ederal R epu blic of Germany, Italy, Japan, the United
Kingdom, and the United States.
The authors o f individual country papers w ere asked to direct their comments to specific
questions about the inflationary experience in their countries. The organization and headings of
the folloiving paper reflect this procedure. The organizers of the C onference are arranging to
have the com plete proceedings published in the near future.

L e t ME begin by setting forth a position on the
features of the “new inflation.” First, the current wide
spread inflation across industrial countries is a “new”
inflation only in the sense that it is a phenomenon of
the last ten years. The current inflation has not been
largely determined by the supply behavior of non
industrial countries. The basic cause of the current
inflation is the same as the cause of all previous infla
tions —too much money chasing too few goods.
The most disturbing aspect of the current inflation
is not that there has been a movement from one rate
of price increase to a new maintained higher level of
price increase, but that there has been a periodic
upward movement in the rate of inflation. There is
no reason that this process has to continue. Policy
makers have the power to prevent a permanently
accelerating rate of price increase. It is true that more
attention is being devoted to “how to live with infla
tion” rather than “how to fight inflation,” but this is
a very dangerous approach. A little inflation leads to a
Note: The views expressed in this article are the responsi
bility of the author and do not necessarily reflect the views
of the Federal Reserve System.

little more inflation which leads to a little more infla
tion until inflation has become a major disruptive
force in the economic as well as the social fabric of
a country.

IS INFLATION LARGELY
DETERMINED RY SUPPLY FACTORS?
An exogenous decrease in the supply of one good
will tend to (1 ) raise the price of that good, (2 ) raise
the demand for and price of substitute goods, (3)
lower the demand for complementary goods and hence
put downward pressures on the prices of these goods.1
The way a market economy adjusts to a change in
supply conditions is through changes in relative prices
and re-allocation of resources from one type of pro
duction to another. Assuming no Government controls
1Economists refer to two goods as substitutes if both goods
have many properties that satisfy the same preferences of
consumers; for example, gas heat and electric heat, public
transportation and automobiles, a vacation in Europe and a
vacation in the United States. Goods that are used together
are called complementary goods; for example, gasoline and
automobiles, tires and automobiles, European vacations and
airline travel.

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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

19S0

1951

1952

1953

1954

1955

1956

1957

1958

1959

SEPTEMBER

I9 6 0

1961

1962

1963

1964

1965

1966

1967

1961

1969

1970

1971

1972

1973

1974

1975

Shaded oreas represent periods of business recessions as defined by the National Bureau of Economic Research.
Percentages are annual rates of change for periods indicated,
latest data plotted: July

on prices, resources will be bid away from those in
dustries producing complementary goods and will
move into industries producing substitute goods. In
itially, the average price level will rise, assuming
prices of complementary goods are not immediately
flexible downward, and unemployment will tempo
rarily rise since resources do not immediately move
fully from producing complementary goods to pro
ducing substitute goods.
For a decrease in the supply of one good to cause
a permanent increase in inflation, holding growth of
total expenditures constant, would appear to require
that the item was so vital to production that no sub
stitute existed or could be developed. In that case,
reducing the supply of that good means that the
potential growth of real output is reduced. This seems
a highly unlikely case, except in the short-run. Man
seems capable of finding a substitute good for almost
any item. However, even if this were the case, the
increase in inflation is not ultimately due to the reduc
tion in supply, but results from the fact that growth
of total expenditures is not reduced along with the
reduced growth of real output. If the growth of total
expenditures is maintained, but the growth of real
output is reduced, then prices will rise more rapidly.
The monetary authorities cannot affect the supply
situation, but they can follow policies that reduce the
growth of total expenditures.

Page 14

Inflation began to develop in the United States long
before any so-called supply-induced effects developed.
For example, over the 1963-69 period real output rose
at an average annual rate of 4.7 percent, compared to
an average rate of about 3 percent over the previous
ten years. However, from 1963 to 1969 the rate of
inflation increased to a 3 percent annual rate, about
double the rate of the previous ten years.2
We must look somewhere other than at supply fac
tors for the underlying cause of inflation. The basic
underlying cause of the inflation currently being ex
perienced in the United States is simply that the trend
growth of money has been accelerating over the last
ten years, approaching a 7 percent rate on average
over the last three years. This has resulted in a
growth of demand for goods and services that is much
greater than the long-term average growth of real
output.

INTENT OF MONETARY POLICY
The current intent of monetary policy in the United
States is to reduce inflation and avoid causing a sub
stantial medium-term rise in unemployment. In fact
this is the same “intent” that has characterized mone- Unless otherwise noted, all growth rates are computed on an
average-of-year basis.

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

SEPTEMBER

1974

vious ten years. With progressive accelerations in the
rate of growth of money leading to a markedly faster
growth of total expenditures, and with real output
growing at only a slightly more rapid rate, prices
rose at accelerated rates.

tary policy since the middle 1960s. No member of the
Federal Open Market Committee desired to have the
rate of inflation, as measured by the consumer price
index, rise from an average annual rate of about 1.5
percent over the period 1952-64 to an average annual
rate of about 4 percent from 1964 through 1972, or to
see price increases accelerate to an average annual
rate of over 6 percent during 1973, as shown in Chart

Again, I do not believe that any member of the
Federal Open Market Committee desired the pro
gressive upward movements in the growth of money.
From 1964 to 1973 the Federal Open Market Com
mittee ( F O M C ) met 141 times and voted for a policy
of restraint at seventy percent of these meetings. Only
in 1967 and 1970 did the FOMC adopt a policy of
ease at virtually every meeting.

The basic force underlying the accelerating infla
tion in the United States has been the accelerating
average annual growth of the money stock. As shown
in Chart II, the growth of the money stock acceler
ated from about a 2 percent average annual rate over
the period 1952-62 to about a 5 percent annual rate
over the period from 1962 through 1970. Over the
period 1962-70 the growth of the money stock fol
lowed a pattern of sharp accelerations followed by
periods of sharp reductions in the growth rate (for
example, in 1966 and from early 1969 to early 1970).
Since 1970 the growth of money has reaccelerated
to about a 7 percent annual rate. At the same time,
real output has grown at an average rate of about 4
percent since 1962, somewhat faster than its average
annual rate of about 3 percent recorded over the pre

Given diat the intent of policy has not changed,
why has there been a progressive rise in the average
growth of the money stock and, hence, a progressive
rise in inflation? Three related factors appear to ac
count for this situation. First, in the United States
since the mid-1960s, there has been a sharp rise in
the growth of Government spending. Since 1965, Fed
eral Government expenditures have risen at an aver
age annual rate of 10 percent, compared to about a
6 percent rate over the previous ten years. In 1966
and 1967 the major rise was due to defense spending

Chart II

M o n e y Stock

Shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.
Percentages are annual rates of change for periods indicated.
Latest data plotted: August

Page 15

F E D E R A L R E S E R V E B A N K O F ST. LOUI S

which rose 20 percent per year. However, since 1967
the growth of defense spending has been much slower,
and actually declined from 1969 through 1973. The
rise in Federal Government expenditures since 1965
has primarily reflected the public’s growing demands
that the Government sector do more in the way of
social welfare programs. Since 1965, Federal nonde
fense expenditures have risen at a 12.6 percent annual
rate, compared to a 9.5 rate over the previous ten
years.
Essentially, the public has demanded that the Gov
ernment sector provide a larger flow of goods and
services. However, while Government spending was
rising, taxes were not raised enough to finance the in
creased expenditures. This brings us to the second
factor. As a result of a rising spread between tax
revenues and Government expenditures, the growth
of the outstanding stock of Government securities ac
celerated as the Government was forced to borrow
to finance its expenditures. Over the period of fiscal
year 1966 through fiscal 1973, Federal Government
expenditures exceeded tax receipts by almost $98 bil
lion. The net result of deficit financing was upward
pressures on market interest rates.
This brings us to the third factor. The Federal Re
serve System traditionally has been concerned with
the stability of interest rates and with the “viability”
of financial markets. Consequently, the Federal Re
serve has tended to resist demand-determined move
ments in interest rates and has always stood ready to
offer substantial aid to the financial markets in times
of stress. The substantial rise in Government financing
requirements was bound to put upward pressures on
market interest rates and put stress on financial mar
kets. Essentially, the Government was attempting to
acquire more funds than before through the credit
markets, and, assuming no change in the growth of
total credit, other demanders of credit would have
had to be rationed out of the market.
Among the other demanders of credit was the hous
ing industry. As market yields on Government debt
rose, funds were drawn out of savings and loan as
sociations, the supply of funds to finance housing fell,
and mortgage interest rates rose. Questions arose
about the solvency of the major financers of mortgage
credit. These results, along with pressures on the fi
nancing of state and local governments, developed
quite early in the inflationary process, and in 1966
culminated in what has come to be called “the credit
crunch of 1966.”
The Federal Reserve came under considerable criti
cism for permitting the development of the “crunch”
Page 16

SEPTEMBER

1974

in 1966. However, although certain Federal Reserve
policies probably added to the strain on financial mar
kets at tliat time, the situation in 1966 reflected
the attempt of financial markets to adjust to the added
financing pressures from the Federal Government. The
1966 Federal Reserve policy of resisting a substantial
expansion in money and credit was an attempt to
force the adjustment through financial markets. If the
Government was going to get a larger share of real
output, then some other sector had to receive a smaller
share.
The Federal Reserve tried to halt the upward march
of inflation again in 1969. From February 1969 to
February 1970 monetary policy actions slowed the
growth of the money stock to about a 3 percent rate.
This led to the slowdown in economic activity in 1970,
and from about mid-1970 there was evidence of a
slowing in inflation. By the end of 1970, the market
yield on Treasury bills had fallen below 5 percent,
compared to about 8 percent at the end of 1969. In
the first quarter of 1971, yields on long-term corporate
bonds had eased to about 7.25 percent, compared to
about 8 percent in late 1969.
However, after early 1970, Federal Reserve actions
resulted in a reacceleration in the growth of the money
stock. From 1970 through 1973, Federal Reserve
credit grew at an average annual rate of 9.5 per
cent and the monetary base grew at a 7.7 percent rate.
On balance, since early 1970, money has grown at
about a 7 percent rate. Although inflation continued
at a slower rate through late 1972, how much of this
was due to the lagged effect of the previous slowing
of money on prices extending into late 1972 is open
to question. In August 1971 a fairly comprehensive
set of price and wage controls was instituted in the
United States. The lag in the response of prices to
the reacceleration of money probably reflected the
effect of these price controls. Sooner or later the up
ward pressure on prices had to surface, and price
controls appear to have only delayed the upward
thrust of prices. The main result of the various phases
of price controls was the distortion in supply condi
tions that the United States is still experiencing.

EFFECT OF INFLATION ON
CURRENT POLICY
Inflation affects current monetary policy because in
flation affects interest rates and financial markets. Also,
accelerating inflation, when joined with price controls,
tends to raise questions about the predictive perform
ance of econometric models that are used to forecast

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

SEPTEMBER

1974

Chart III

M o n e t a r y Base*

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

Shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.
*Uses of the monetary base are member bank reserves and currency held by the public and nonmember banks. Adjustments are made for reserve requirement changes and shifts in deposits among closses of
banks. Data are computed by this bank.
Percentages are annuol rates of change for periods indicated
Latest data plotted: August

the response of the economy to policy actions. A fur
ther effect has been the suggestion by some observers
that “real” instead of nominal quantities should be
used as indicators of the effects of policy actions.
Recently the United States has been experiencing
levels of interest rates that are “high” by historical
standards. However, it would be hard to ascribe these
high interest rates to “tight” monetary policy. As
shown in Chart III, over the last three years the mon
etary base has grown at a 7.7 percent rate, compared
to about a 5 percent rate from 1962 through 1970
and less than a 2 percent rate over the 1952-62 period.
Bank credit has grown at about a 13 percent rate
since 1970, compared to a 7.6 percent rate over the
previous five years, and about a 6 percent rate from
1955-65. These growth rates indicate that Federal
Reserve actions have resulted in a large enough growth
of the monetary base to support a substantially more
rapid expansion of bank credit than in previous
periods.
The increase in the monetary base predominantly
reflected the fact that the Federal Reserve System
purchased a large volume of Government securities
and the Treasury monetized the proceeds of the May
1972 and October 1973 changes in the official price

at which the U.S. gold stock is valued. The monetary
base averaged $20 billion higher in 1973 than in 1970,
the Federal Reserve’s holdings of Government securi
ties averaged $17.8 billion more in 1973 than in 1970,
and the Treasury’s actions subsequent to the two of
ficial revaluations of the U.S. gold stock added $2
billion to the monetary base.
A central bank policy of buying Government debt
and providing the monetary base for a rapid expan
sion of credit has the initial effect of holding interest
rates below what they would be in the absence of
such a policy. However, the growth of the monetary
base determines the growth of the money stock. The
close relationship between accelerations and decelera
tions in the growth of base and money can be seen
by comparing Charts II and III. Therefore, a policy
of attempting to resist movements in market interest
rates also leads to a rapid expansion of the amount
of money balances which individuals must absorb into
their wealth portfolios. From 1970 to 1973, the money
stock grew on the average at about a 7 percent annual
rate. This is more than three times as fast as over the
1952-62 period of slowly rising prices. As discussed
earlier, the rapid growth of money led to a progres
sive upward movement in the rate of change of prices
and this led to a growth in the demand for credit.
Page 17

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

SEPTEMBER

Today’s high levels of interest rates largely reflect
the accelerating rate of inflation in the United States.
When the current rate of inflation is taken into con
sideration, interest rates are not unusually “high.” As
shown in Chart IV, relative to the rate of inflation,
adjusted yields on Corporate AAA bonds are currently
lower than any time within the last eight years, with
the exception of early 1971. Although long-term mar
ket interest rates have been rising sharply since early
1973, the adjusted yield has been falling since about
mid-1973.
Chart IV

Yields on H ig h e s t- G r a d e Seasoned Corpor ate Bonds

1966

1967

1968

1969

1970

1971

1972

1973

faster than what they think is the Federal Reserve’s
intent, then they expect that the Federal Reserve
will have to tighten policy, and hence expect higher
interest rates, at least in the immediate future.
To restrict the growth of the money stock in periods
of rising demands for credit, the Federal Reserve must
raise its target range for the Federal funds rate
ahead o f the market determined level. If increases
in the target range for the Federal funds rate lag the
market-determined rate, then the money stock will
accelerate, even though the Federal funds rate moves
upward quite rapidly.
Central bankers must be extremely wary of state
ments that, because interest rates are high, money is
tight or monetary policy actions are restrictive. Such
statements exhibit a fundamental confusion between
money and credit that can be fatal for attempts to
slow inflation. Interest rates are the price of credit,
not the price of money. The reason the price of
credit is high is not because money is tight, but be
cause it has been too easy. The previous rapid growth
of money has generated an expected rise in demand
and rising prices and, hence, growing demands for
credit. Comparing Chart V and Chart II, it can be
seen that, empirically, it is the case that low interest
rates, not high interest rates, follow a period of tight
money.

1974

'Market Yield less overage annual rate of change in consumer prices over three previous years.
Latest data plotted: August estimated

Through the middle of 1974 the Federal funds
rate, the key interest rate used in short-run operating
strategy, has risen sharply. However, there is some
question as to whether the Federal funds rate has
risen because the Federal Reserve pushed the rate
up, or in spite of Federal Reserve actions. In times of
rapid increases in the demand for credit, it becomes
almost impossible for the Federal Reserve to hold in
terest rates constant. The more vigorously the Federal
Reserve tries to hold interest rates down, the more
rapidly the monetary base grows and, consequently,
the more rapid the growth in the money stock.
An increased rate of growth of the money stock ap
pears to have two effects on expectations of financial
market participants. First, they have learned by ex
perience over the last 8-10 years that a maintained
faster growth of money means a higher rate of infla
tion, and that means higher interest rates. Also, finan
cial market observers have some idea about the Fed
eral Reserve’s desired growth path for the money
stock. When they observe the money stock growing

Page 18

1974

Effect of Inflation on Financial Markets
An important part of the financial sector of the
United States is composed of financial intermediaries
which borrow short-term and lend long-term. These
institutions are primarily engaged in financing mort
gage credit demands, and consist of institutions such
as savings and loan associations, mutual savings banks,
life insurance companies, and real estate investment
trusts. For these financial intermediaries it is not the
level of the term structure of interest rates that is of
primary importance, but variations in the level.
In an accelerating inflation, market interest rates on
assets competitive with savings deposits are rising, and
savings institutions must raise the interest rates they
pay to borrow short-term or face an outflow of deposits.
Under such circumstances, the savings institutions
come under considerable pressure. The cost of bor
rowing short-term rises rapidly, but the bulk of their
portfolio of assets is locked into nonliquid long-term
mortgages that have a fixed interest rate.
The smooth operation of financial markets is also
adversely affected in other ways by inflation. For

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

SEPTEMBER

1974

Chart V

Interest Rates

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

Shaded areas represent periods of business recessions as defined by National Bureau of Economic Research.
Latest data plotted: August

example, bond dealers are reluctant to take positions
in long-term securities, because with rapidly rising in
terest rates, there is an increasing risk of capital loss.
A potentially serious situation can develop if a few
large financial institutions misread the future path of
interest rates. Suppose a lender expects that interest
rates will fall in the next six months. In late 1973 and
early 1974 several respected financial advisory serv
ices were forecasting falling interest rates. The lender
will then try to borrow short-term in order to extend
his long-term assets. For example, a bank would try
to increase its borrowings in the Federal funds market
and sell short-term large certificates of deposit, while
extending longer-term business loans and purchasing
longer-term Government securities. If, however, short
term rates rise very rapidly, instead of falling as pre
dicted, then our hypothetical bank will incur losses.
From early December 1973 through late February
1974 short-term interest rates in the United States fell
while longer-term interest rates continued to rise. From
late November to late February, large commercial
banks increased their term business loans by about
$1.3 billion and their holdings of Government securi
ties with over 5 years to maturity by about $600 mil
lion. Over the same period, the volume of large certi

ficates of deposit outstanding increased by about $2
billion and the average net purchase of Federal funds
rose by $2.6 billion. In early March, short-term inter
est rates began to increase and over the following
months rose very sharply. The market rate on 90 day
certificates of deposit rose over 300 basis points from
late February to mid-May, and the rate on Federal
funds rose over 250 basis points. Therefore, the cost
to an individual bank of obtaining short-term funds
to finance term loans made during late 1973 and early
1974 and to carry securities purchased during that
time rose substantially in the following three months.
This discussion is not an attempt to picture the
financial system as “inherently unstable.” It is intended
to show that attempts by the monetary authorities to
resist demand-determined upward pressures on inter
est rates, except in the very short run, do not result
in easing financial market pressures. As the monetary
authorities expand the monetary base, money expands
and ultimately there are greater upward pressures on
interest rates as the demand for credit increases. Ulti
mately, such a policy results in greater, not less,
strain in the financial markets, and makes the prob
lems encountered by the central bank when it at
tempts to slow inflation that much greater. This is
Page 19

F E D E R A L R E S E R V E B A N K O F ST. LOUI S

especially true because some financial operators still
appear to believe that the monetary authorities can
hold market interest rates below the level determined
by fundamental market factors. The only way to even
tually achieve lower interest rates is to slow the growth
of money and credit. However, this implies additional
temporary upward pressures on interest rates, and
further raises the spector of another “credit crunch”.
These factors further illustrate that, the longer infla
tion is permitted to develop, the more difficult it is
to stop.

Effect of Price Controls on the Predictive
Performance of Econometric Models
It is very difficult to judge the effect of inflation
on the predictive performance of the Federal Reserve
Bank of St. Louis model, as well as any other model.
During most of the period since August 1971 the U.S.
economy has been subject to various types of price
controls. These controls probably distorted the be
havior of prices relative to what they would have
been without controls. Under these conditions, econo
metric models are only a guide to the upward pres
sures that are building on prices.
For example, the St. Louis model overestimated
the reported rise in prices during the period of price
controls, but since the lifting of most price controls,
it has underestimated the increases in prices. On bal
ance, the model has fairly accurately projected the
long-run behavior of prices. As shown in Table I, fit
ting the model through the second quarter of 1971,
the last full quarter before price controls, and project
ing through 1973 shows that the model estimated
about a 5 percent growth of the price deflator from
11/71 through IV/73. Actual reported prices rose at
a much slower rate during the price control period,
then accelerated as price controls were lifted.

Real vs. Nominal Quantities
The use of real instead of nominal quantities as
guides to monetary policy can be extremely danger
ous.3 First, all that policymakers, as well as other
economic agents, observe is nominal interest rates and
money balances. They never observe real interest
rates or real money balances, and economists cannot
agree on how to accurately measure these real quan
tities. This is not to say that the rate of inflation does
not enter into the public’s decision to borrow, nor
3This section drft\ys heavily on the article by Denis S.
Kamosky “Real Money Balances: A Misleading Indicator of
Monetary Actions,” this Review (February 1974) pp. 2-10.

Page 20

SEPTEMBER

Table

1974

Ante Projections of the G N P Price Deflator
Using the St. Louis Model*

Rates of
c h a n g e f r om
11/71 to:

Ac t ual

Ex A n t e

111/71

2.6%

5.0%

IV/71

2. 2

5.0

1 /72

3.3

5.0

11/72

3.0

4.9

111/72

3.0

4. 8

IV/72

3. 2

4.8

1 /73

3. 5

4.7

11/73

4.0

4.6

111/73

4.5

4.6

IV/73

4.9

4.5

* E q u ation fitted through 11/ 71 .

their decision as to the amount of money balances
they desire to hold. However, the crucial distinction
for central bankers is that, while individuals adjust
their money holdings to prices, for the economy as a
whole, prices adjust to the amount of money. Sec
ondly, the ratio of money to some price index is a
faulty indicator of tightness or ease of monetary policy
because this ratio is determined by the public and
is ultimately beyond the control of the monetary au
thorities. Monetary actions have only a temporary
effect on real money balances.
There are five periods from 1955 to 1973 when the
ratio of money to commodity prices declined for
two quarters or more: 1955-57, 1959-60, 1966, 1969,
and 1973. Prior to 1973, each period in which “real
balances” declined for two quarters or more was fol
lowed by a significant slowdown in economic activity,
ranging from the 1966-67 mini-recession to full-scale
recessions in the other periods.
In 1955-57, 1959-60, 1966, and 1969 a large portion
of the decline in real balances reflected a sharp drop
in the rate of growth of the money stock below its
trend. The deceleration in money growth in 1973 was
not as abrupt. Instead, the indicated decline in “real
balances” in 1973 reflected, in large part, the reported
acceleration of inflation.
Since the adjustment of prices to a change in the
bend rate of money growth is estimated to take from
four to six years to complete, it is probable that the
economy is still adjusting to the accelerated rate of
money growth over the last three and one-half years.
Supporting evidence for this contention can be found
in the movement of interest rates in 1973.

SEPTEMBER

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

The inflation of last year, instead of threatening to
restrict aggregate demand by eroding real money bal
ances below desired levels, reflects instead the efforts
of the public to dispose of excess money balances. On
the basis of past experience, if the money stock con
tinued to grow at an average rate of close to 6.5 per
cent, such as since early 1970, this adjustment would
continue at least through 1974.
The arguments which contend that monetary policy
is restrictive, on the basis of the recent decline in
“real money balances,” imply to some analysts a rec
ommendation to policymakers to increase the rate of
money growth above the rate of inflation in order to
restore the growth of real balances. Both theoretical
analysis and the experience of other countries indicate
that there are few more dangerous courses of action
that any monetary authority could undertake.
A further increase in the rate of money growth,
above its current trend rate of about 6.5 percent
would only generate pressure for further inflation. It
is not possible to avoid the adjustment of real money
balances to the level desired by the public by increas
ing the rate of money growth.
One extreme example of the futility of a policy of
trying to make money grow fast enough to prevent
desired real balances from falling is given by the Ger
man experience in the early 1920s. By late 1923 tax re
ceipts of the German government were covering less
than one percent of its expenditures. To finance its
expenditures, the government borrowed from the
Reichsbank, which simply turned on the printing
presses. The majority of trained economists in Ger
many refused to believe in a chain of causation run
ning from the growth of the money stock to the growth
of prices. Rudolf Havenstein, President of the Reichs
bank, tended to believe that the rise in prices created
a need for money on the part of businessmen and
the government which was the Reichsbank’s duty to
meet, and which would have almost no harmful ef
fects on the economy. When complaints of “short
ages” of money arose, despite the issue of denomina
tions as large as 100 trillion marks, Havenstein seri
ously expressed hope that new high-speed currency
printing presses soon to be installed would overcome
the shortage.4
'The material in this section draws upon Leland B. Yeager,
International Monetary Relations (New York: Harper and
Row Publishers, 1966), pp. 269-72), and quotes from the
League of Nations Study, T he Course and Control o f Infla
tion. See also, Frank D. Graham, Exchange, Prices and
Production in H yper-Inflation: Germany 1920-23 (New York:
Russell and Russell, 1930).

1974

PROPOSALS TO OFFSET INFLATION
Recently, proposals for tying future payments in
contracts to some price index (so-called indexing)
and explicit payment of interest on demand deposits
have been suggested as ways of removing some of
the losses associated with unexpected future price
movements.

Indexing
The use of indexing has increased in the U.S. econ
omy as inflation has accelerated. Recently, the U.S.
Congress decided to tie social security payments to
the consumer price index, and more wage contracts
are being written with cost of living escalator clauses,
not only for wages, but also for pensions.5 However,
these actions represent only partial indexing. At pres
ent, it does not appear that the U.S. is likely to adopt
a full economy-wide pattern of indexing. Especially
difficult problems would arise when indexing such
items as interest rates. For example, attempts to de
velop variable interest rate mortgages have met with
less than enthusiastic support.
Partial indexing probably creates more problems
than it solves. Groups whose flow of payments are
linked to some price index will be far less willing to
support efforts to halt inflation. This is especially
true because policies taken to slow inflation also in
volve some short-run rise in unemployment. It is one
thing to explain the reason for tighter fiscal and mone
tary policy to an individual by pointing out that in
creased Government spending financed by money cre
ation results in a fall in his real income; it is much
more difficult, however, to convince him of the merits
of tighter fiscal and monetary policy when his income
is tied to a price index.
The actual implementation of generalized index
ing presents considerable practical difficulties. What
price index will be chosen? Who will decide the way
to index prices? What about outstanding contracts?
How do you index profits? For example, there has
been considerable furor raised over recent attempts
to broaden the coverage of the consumer price index.
Also, some aspects of indexing would require sub
stantial changes in tax laws, for example, tying the
personal exemption to inflation and taking the effect
of inflation into account in computing depreciation
5For about 5 million workers, changes in their incomes are
tied to changes in the consumer price index. Receipts of an
additional 3 million food stamp recipients and all social
security recipients are also affected by changes in the CPI.
Page 21

F E D E R A L R E S E R V E B A N K O F ST. LO U I S

and capital gains. Also, all state usury laws would
have to be abolished and regulations on payment of
interest on time and savings deposits would have to
be removed or modified. The effect of many in
dexing proposals would be to hold the Government’s
tax revenues constant as inflation increased. In infla
tion the cost of existing Government operations would
rise, and if there was no cut in Government opera
tions, deficit financing would increase. These decisions
move us from the field of economic theory into the
area of politics and bureaucracy. Having observed
the fiasco of wage and price controls, the author is
none too confident that the Government can resist
the temptation to selectively intervene in the develop
ment of an indexing system, and hence is doubtful
that a viable system of indexing can be developed.

Interest Payments on Demand Deposits
Generally, the arguments that have been advanced
for prohibition of interest payments on demand de
posits in the United States are not supported by
empirical evidence. Currently, commercial banks pay
an implicit rate of interest on demand deposits: the
cost of servicing demand deposits is greater than serv
ice charges by banks. This probably leads to some
inefficiency in allocation of resources that could be
avoided if banks paid a market-determined interest
rate on demand deposits and charged depositors the
full cost of bank services.
However, as a practical matter, a widespread move
ment in support of payment of interest on demand
deposits does not appear likely in the near future.
Changes in legislation would be required to permit
commercial banks to make explicit interest payments
on demand deposits, and there does not appear to
be wide enough support for these changes from any
well-organized political group.

CONCLUSIONS
The way to reduce inflationary pressures in the
United States economy is to slow the growth of the
money stock. On an average-of-year to average-ofyear basis, the money stock grew at about a 7 percent
rate from 1970 to 1973. It seems to be a generally
accepted proposition in economics that the growth of
prices adjusts to the growth of money over an ex
tended period of time. Therefore, if the 7 percent
rate of money growth experienced over the last three
years in the United States is maintained, this implies
our economy will adjust toward a long-run 6-7 percent
rate of inflation. The recent surge in prices reflects
partly an adjustment to the removal of price controls,
Page 22

SEPTEMBER

1974

and partly the continued upward adjustment to the
average growth of the money stock.
The only way to halt the upward movement of
interest rates is to slow money growth. If our economy
is being forced to adjust to a 6-7 percent annual rate
of inflation, then nominal interest rates on long-term
bonds will not remain at around 8 percent but prob
able will rise to 9-10 percent.
In the United States the central bank can halt the
growth of the money stock. The Federal Reserve,
through its open market operations, can control the
growth of the monetary base, and hence control the
growth of the money stock. The Federal Reserve is
on record as having the intent to slow the growth of
the money stock. The intent of policy is not to cause
a dramatic halt to money growth, because of the
short-run effects on employment, but to gradually
reduce the trend growth of money.
Whether or not this “intent” is realized will crucially
depend upon (1 ) the Government’s willingness to
exercise restraint in its spending, and (2 ) a willing
ness on the part of the Federal Reserve to allow
market interest rates to rise temporarily to high levels.
As discussed earlier, nominal interest rates that seem
extremely high by historical standards are not high
when the current rate of inflation is taken into account.
It is useful to refer again to the German experience
of 1920-23 to see how excessive government spending
and central bank creation of money become bound
together, and how difficult it is for any central bank
to pursue a monetary policy that runs counter to the
government’s fiscal policy.
This fundamental cause, insofar as it does not rest
on the balance of payments, is . . . the boundless
growth of the floating debt and its transformation
into the means of payment . . . through the discount
ing of the R eich Treasury bills and the Reichsbank.
Here too the Reichsbank is alleged to be guilty,
because it has not opposed the R eich government
and fiscal administration by refusing to continue the
discounting of Treasury bills. This reproach is also
unjustified and com pletely misjudges the actual situ
ation. T h e Reichsbank has done all it could do with
any chance of success. For years . . . it has continu
ally called attention to these conditions and demanded
a remedy in the most serious and urgent way, but
it was not in a position to stop the discounting of
Treasury bills as long as the R eich had no other
available means to cover its deficit, and as long as
all groups in the legislature were not fully con
vinced that such means absolutely have to be found.
F or the R eich must live, and real renunciation of
discounting in the face of the tasks set by the budget
. . . would have led to chaos. T he threat of a general
refusal to discount Treasury bills would have been

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

nothing but a futile gesture. Only very recently, un
der pressure of dire necessity, have all groups in the
legislature been convinced . . . that fiscal policy ab
solutely must be based upon adequate sources of
income.6
wRudolf Havenstein, “Defending the Policy of the Reichsbank”
( Address to the Executive Committee of the Reichsbank,
August 25, 1923) in Fritz K. Ringer, T h e G erm an In flation
o f 1923 (N ew York, Oxford University Press, 19 6 9 ), pp.
93-96.

SEPTEMBER

1974

Somehow the public must be convinced that once
inflation has gained a firm foothold there is no pain
less way to halt it. Also, the public must realize that
goods provided by the government are not free goods,
ff the government sector absorbs and redistributes a
larger segment of real output, then the private sector
must be satisfied with a smaller share. Unless these
fundamental facts are understood, then the good
“intent” of policy will probably not be realized.

Author’s Note
Since this paper was prepared in May 1974, there
has been a revision of money stock data for the first
half of 1974. The revised data suggest that monetary
actions in the United States have been directed at
reducing inflation ivith a minimum im pact on em
ployment. For exam ple, on a quarterly-average basis,
from second quarter 1973 to second quarter 1974, the
money stock grew about 6 percent. This represents
a m oderate reduction in the average growth of 7
percent recorded from first quarter 1970 to second
quarter 1973. It also represents a move away from
the pattern of accelerating m oney growth experienced
over the p eriod since early 1970.1
Since May, however, inflation has continued to ac
celerate at an alarming rate, and interest rates have
continued to rise. For exam ple, from D ecem ber 1973
to July 1974, consumer prices rose at about a 12 per
cent rate, and most forecasters see little reduction in
the rate of inflation through the rem ainder of 1974.
Yields on corporate bonds are up about 70 basis points
over their May levels, mortgage rates have risen, the
prime com m ercial bank loan rate is up 50 basis points
from the end of May, and com m ercial paper rates and
Treasury bill rates are up over 100 basis points.
W hile prices and interest rates have continued up
ward, real output has declined. Over the first two
quarters of 1974, GNP in constant dollars decreased
at a 4 percent annual rate. This continues the slowing
in real output growth that began in early 1973. For
exam ple, from the first to the fourth quarter of 1973,
iFrom 1/70 to 1/72 money grew at a 6.3 percent rate, then
from 1/72 to 11/73 money grew at an 8.1 percent rate.

real output grew at about a 2 percent rate, com pared
to a growth rate of 6.7 percent from fourth quarter
1970 to first quarter 1973.
In the authors opinion the recent sharp accelera
tion in inflation and the slower groivth of real out
put must be view ed in the long-run context of the
whole period since late 1970 w hen the most recent
expansion began. On balance, since the fourth quarter
of 1970, the general price index has risen at a 5.7 per
cent annual rate, about in line with what w ould be
expected from a 6.5-7.0 percent average growth rate
o f money. R eal output has risen at about a 4 percent
average rate, about in line with the longer-run groivth
o f the productive capacity of the econom y. By looking
only at the perform ance of the econom y in the last
one and one-half years, one gets a distorted view of
the perform ance of prices and output. Over the period
prior to early 1973, real output grew at a rate far in
excess of its long-run potential growth, and prices
were artificially held down by wage and price con
trols. The recent sharp surge in prices reflects the
adjustment to the trend growth of money, following
relaxation of wage and price controls, and special
situations in som e dom estic and foreign markets.
These adjustments may well continue through 1974.
The recent perform ance of the econom y has led
som e p eop le to suggest that fiscal and monetary p ol
icy be directed at stimulating econom ic activity. Such
a policy response might w ell frustrate the intent of
slowing inflation without substantially affecting the
rate of groivth of em ploym ent. The criterion of p a
tience must be ad d ed to the other criteria for success
ful achievem ent of an intent to slow inflation.

Page 23