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Some Factors Affecting Monetary and Credit Policy Remarks by Mr. Chas. N. Shepardson, Member of Board of Governors, Federal Reserve System, at Pacific Northwest Conference on Banking, April 11, 1957, at State College of Washington, Pullman, Washington, The Federal Reserve System has as its broad objectives the mainnc e of price stability and the fostering of sustainable economic growth. It oe eks to achieve these objectives through its influence on the cost and liability of crcdit in the market place. I propose to discuss with you ,Y s °Ne of the ways in which this credit policy is related to achievement goals of price stability and economic growth. Of e s e In an expanding economy geared to the needs of a groxd.ng population s Uch a s ours, there is a continuing need for more jobs to provide the earning f •tor this growing population and for more production of goods and ser- ies + meet their demands. Such growth calls for a continuing investment Production facilities, both for expansion and for modernization or replaceThis means that, at any given time with full utilization of existing Q 0n snd production resources, total output should equal demand for cur* nt c sumption plus that needed for expansion. Or to state it conversely, c0n ^Ption must be limited to that fraction of total production which will W v e th n e f a requisite amount of manpoirer and materials to provide for needed e ment and growth of plant and equipment. By the same token, income rom S° ,h Production u must be apportioned, part to current consumption expendV g a -nd p a r t -to savings to finance the necessary capital expenditures for Production facilities. - 2 - In a free economy there is no way to insure an automatic balance between the flow of spending and the flow of goods and services. to s Decisions Pend are made by millions of individual businessmen, farmers, and workers, al1 of whom are also consumers. Access to bank credit and to cash balances saved makes it possible for business and consumers to spend in SXces s of their incomes. Usually, while some units in the economy are spend- more than their incomes, others are spending less than their incomes -that is, saving. As long as the total of spending in excess of income equals th e "total of saving, the economy will remain on an even keel, avoiding both Elation and deflation. At times, however, the use of credit or the spending of cash balances tends to exceed saving. The result is that the demand for goods runs ahead to a^ e amount produced and prices are forced up. The opposite tendency leads shortage of spending relative to the potential of the economy, and the 4. . & !s falling prices and reduced output. In a strictly free economy, we would depend on the forces of the ^a nki sem t to equalize these supply and demand pressures through the price mech> including interest rates on money. However, since market adjustments Sub J e c t to violent and sometimes erratic fluctuations, we have assigned to f j seal and monetary authorities the task of moderating the gyrations of thg vv,o r i e y market through their power to influence the cost and availability Of ^ ne ° y and credit. Both of these forces act on the stream of spending and its size in relation to the stream of goods the economy is capable of - 3 - The government budget is itself a major component of the flow of ex Penditures and, in addition, influences private decisions to spend for con- slu ttption and investment. Government taxation affects the spendable income business and consumers. Debt management policies also have an important ln f-luence on credit markets and on the terms and availability of funds to p3?i vate borrowers. While fiscal policy thus plays a vital role in economic s-ta b i i i z a t i o n ^ government spending and tax programs are not adapted to quick a) J Nation in accordance with short-run variations in economic conditions, is the special province of monetary policy. In performing its task, monetary policy is usually concerned with or hastening rates of growth of money and credit rather than with acting the money supply. Monetary policy normally utilizes either the the accelerator; seldom does it find it necessary to put the gear shiftG . into reverse. Thus, despite the public discussion of "tight" money and credit a ^city j l n re b a n k c r e d i t expanded by more than $h billion or about 2-1/2 per 1956. That growth, however, \ms less than the growth in the demand dit. jn that relative sense, credit was scarce. In a period when resources were intensively utilized, further growth Cre of p h <iit would have resulted in greater increases in prices since in terms ysical resources there was little margin for growth of output over and ab 0 V e wh a t was achieved in 1956. During the past Uro-year period of upward pressure on prices and e dit restraint, we have heard much talk about "creeping inflation. " e n It argued by some that creeping inflation — by which is meant a steady ^ gradual upward movement of prices of 2 or 3 per cent per year - - i s prob- a 1 % inevitable if the United States is to continue to maintain economic Srowth with full use of resources. Those who tell us that creeping inflation is inevitable, and that we u ° Sht to relax and enjoy it, base their case on the proposition that the colloc U v e bargaining process is bound to raise the wage level more rapidly than the growth of labor productivity. They contend that, although the resulting ^ e a s e i n unit labor costs must eventually reflect itself in a rising level of ^ices, this rise can be kept within reasonable limits. It is not my purpose to attempt to predict the course of collective ^gaining over future years. 1" cannot refrain from observing, hoirever, that ' keeping inflation argument appears to attribute a certain amount of ^t-sightedness to labor leaders. We are asked to believe that these leadbe so blind to rising prices and a rising cost of living as to contheir demands for wage increases to amounts only slightly in excess of l s e in productivity. We may be sure that labor leaders are not as short-sighted as they 1Tlade to appear by this argument and that if prices were allowed to creep age demands would inevitably reflect the anticipated rise in the cost V l n. of Xi, S . In fact, the built-in cost of living and productivity increase a w s in many of the present x^age agreements provide concrete evidence of i• l n e of thinking already. Similarly, businessmen, farmers and consumers ^ g i n to take account of expected increases in prices and costs. ^ De bought and held for speculative purposes. Goods Prices would be estab- not on the basis of actual costs but on the basis of anticipated costs. - 5 - Th'j s n ary would not only distort the pattern of production and investment but would, g with other undesirable effects, provide a further impulse to inflationAssures. In consequence, wage demands would be further increased. In uiler to words, it is likely that inflation would stop creeping and would begin run. While no one wants a run-away inflation, there is an even greater ar of deflation. Although the entire history of our country is a record °°ntinuing growth and expansion with only temporary interruptions, we still See m +r> u nave an overwhelming fear of depression. It is this fear of getting c lose to the line of equilibrium that drives many people to accept the Idea n f> 1 e a little inflation even though inflationary excesses again and again brought on us the wreckage of depression. And the exhilaration of a e inflation inevitably leads to these excesses. In fact, our present day mania for speed seems to have infiltrated c °nomic thinking. Our pathway of economic progress is like the mountain w ith which you are all familiar. It is a series of hills and curves .. l i•united rn v.isability ahead. Certainly, it is bad business to go so slowly stall our motor on every hill, yet there are far more crashes and ^ i e s from rounding a curve or cresting a hill too fast than there are ^ a Stan ns. a ation m a j u s t so, the danger of a depression is far greater from excessive tion than it is from a careful deceleration even though such decelery bring an occasional stall. I would conclude, therefore, that creeping inflation is not a realis- e ^ rnative to price stability as an objective of economic policy. Further- ^ X Would reject the premise that creeping inflation is necessary if we - 6 are eco to enjoy economic growth. In fact, inflation might well discourage *omic expansion. Another of the principal reasons for rejecting the acceptability of Cree of Ping inflation lies in the relationship of price stability to savings and ba n n g S to economic growth. Within the institutional framework of our 9- large portion of savings is in the form of fixed dollar obligations, s Uch as Stead &Ve bonds, claims on pension funds, insurance policies, and deposits. y rise in prices came to be Would inevitably be weakened. If generally anticipated, the incentive to This in turn would lower the rate of capi- t a t i o n , with the result that economic growth in real terms would slow One of the consequences of our economic progress is that an increasing b Proportion of the population is accumulating pension and retirement benefits. The r a Pid growth of pension funds among financial institutions is evidence of ia ct. reci The result is that an increasing proportion of the population has a direct stake in stable prices. Creeping inflation would cause pen- nons anc fh u n i a ° * other such claims to lose their value, exacting severe costs in terms n misery. In this connection, an important part of the growth of pension funds b e e n stimulated by collective bargaining demands for pension rights as a erne ^ n in H>na in nt to Social Security benefits. a This is another factor to be consid- connection with arguments for creeping inflation. lso have a stake in price stability. n It means that labor It also means that, should creep- N a t i o n come to be accepted as permanent, demands for upward adjustments Sl °ns would also be frequent. This would add further fuel to the fires - 7 - of s Piraling prices and make it even more difficult to prevent creeping infladegenerating into a gallop. Price stability by itself cannot insure economic growth. GVer If, how- j we are able to preserve financial stability the prospects for sustained ec °norriic growth in this country appear, from all indications, to be very promts. For one thing, prospective population trends foretell strong consumer eiT1 ands, Rising population does not automatically bring with it a growing ^idard of living, as experience in many countries demonstrates. om In our o\m ic system, however, rising population tends to call forth both higher aGnds a ^ d increased productive capacity. Apart from the upsurge of population, technological factors also ntl? ibute to the favorable outlook for economic growth. The terms atomic and automation immediately invoke a picture of vast technological elo Pment. Here in the West one might speak of the technological frontier 'that u s replaced the land frontier. The land frontier, inviting economic na e L - °pment, was an important factor in economic growth in the United States a vv wnole, in many respects the new fields of technology that modern science has 0 DPened to us constitute an even broader frontier inviting economic devel14 °Prnent The incentives to push back and exploit this ers > farmers, and businessmen. frontier are felt by In the case of consumers, there is the °f greater leisure and of attractive products that increase comfort, ei 0< Producers find it possible to introduce iucts, reduce costs, improve quality J e fort, and provide pleasure. e r - Ve and, in the process, to increase capacity. As in the case of the land frontier, the technological d encourages the growth of demands for goods and services and also of P*° ^ctive facilities to satisfy these demands. - 8 - One might press the analogy further and say that many of the qualties re ^ a t we associate with the pioneers who pushed the frontier westward also involved in the technological upsurge we are now experiencing. The Agination, ingenuity, and willingness to accept change that characterized the front!er are also playing an important role in the rapid economic progress the United States has enjoyed in the twentieth century. In this connection, it i s . . significant that, in their effort to stimulate more rapid economic S^ovth q 3 some of the countries of Western Europe are attempting through pro^Ucti hav programs to instill some of these qualities into industries that vl+ ® bep come ossified and fearful of change and competition. The upsurge of population and the prospects for technological advance, Providing the basis for optimism regarding the strength of demands for ari 4 services, also have implications for the amount of capital goods °nomy will require if these demands are to be satisfied. With rapid p0 Pui a t ,j-on growth we must expect, in due time, a corresponding increase in ^ e lab °r force. To provide jobs and homes for a rapidly growing labor .force, ec need i •^rge amounts of capital and this, in turn, requires saving. If this needed capital is not provided through voluntary savings and nds for goods and services continue strong, it would doubtless be proVi cied th* if aema r °ugh inflationary credit expansion were it not for the restraining monetary and credit policy. u r x 1 Ve But, in addition to the many other opposing this method of providing savings, there is the over- gument that it is a self-defeating method. Persistently rising prices in tnemselves discourage savings, at any given income Isvel, and will thus ri s to still further increases in prices. - 9 - Hence, preservation of price stability is extremely important if tVi e ' American people are to have the incentive to save the amounts that will ne c eded to provide the capital for economic growth. Unless people have n ° fidence that the future value of the dollar will be stable, they will have kittle incentive to save. In addition, it is necessary of course that savers Vfc a^ deceive reasonable return. In thinking about economic growth^ it is useful to remember that the es re tward movement of the land frontier was not a steady process. Rather, it OCCUPY, d J in surges as do most processes of development. Similarly, it is not 111 uri action that economic growth will be a steady upward movement without inter• either in direction or in rate of expansion. Growth of our economy as a whole is the resultant of what happens in Altitude of different industries. all We should not expect the output of B and services to grow together and at a constant rate. n It is in the ^ture of a progressing economy that newer industries will be advancing ^ y while some older industries may even be declining, For example, the television sets amounted to only a few thousand in 19)46 but rose to 1c 7-1/5 million . in the next four years. gr ^ t This represents an enormous rate owth and one which, needless to say, could not be maintained. In con- +u wie production of anthracite coal was declining over the same period 5 e r fuels replaced it. Apart from the growth and decline of industries in response to tech- Ho Sical „ developments, we have no reason to expect that consumer, business, g0v ernment demands will each expand at a steady rate without swings and * Automobiles may attract a greater proportion of the consumer's dollar yea r and clothing or houses another year. In response to such changes in - 10 - ^ttand, there are bound to be changes in the rate of growth of different types of u ° tput, and this may in turn lead to variations in the rate of aggregate output. It would be ideal, of course, if the type of rolling adjustment we have experienced in the past two years could be relied upon to prevent varians in output in individual sectors of the economy from being reflected in l e g a t e incomes and economic activity. nci au In 1955 consumer outlays for homes tomobiles provided the principal expansive force in the economy. ou 5 u While tlays declined in 1956, business plant and equipment expenditures ahead and overall economic activity continued to expand. What is the role of monetary policy in this process of economic One important function is the preservation of an environment of ^ability and general financial stability. p6 opl e a In such an environment re more willing to save and to undertake the types of long-term .invest- ^ftt oc °ttmitments that are necessary if the technological frontier is to be d o i t e d wisely. Economic growth requires capital investment and this in turn spends 1 u Pon willingness to save, A second general function of monetary policy in the process of econ- ^owth is to attempt to smooth out the growth process. ^ This does not tl la t it is the function of monetary policy to attempt to regulate the of growth of each segment of the economy. As noted earlier, it is in the of UI anc a dynamic economy that there are fluctuations, some of a short-run * some of a longer-run character, in the output of individual indus- - 11 - At times when growth appears more rapid than can be sustained, a d e r a t i o n of the rate of growth by means of a restrictive monetary policy tencis to spread out over time the rising demands for goods and services and to av °id a later downturn. In other words, rolling adjustments are more likely to occur, along the upward path of economic growth, if some demands Postponed when total demands are already strong. If such postponed demai °n markets at a later time, encouraged by easier credit conditions as J -°r demands slacken, overall growth will continue. It is with these objectives in mind that Federal Reserve policy has directed toward retarding the rate of credit expansion in the face of inflationary pressures of the past two years. There is some evidence in Cu ^ rrent picture that demand pressure is lessening in certain areas. Ttfh Cl? n If aggregate pressures ease, we may reasonably expect some easing of 0 edit conditions. On the other hand, a return to the excessive ebullience of , year ago might necessitate further credit restraint if we are even to a Ppr 0 3 H ^itfiate the price stability which is so essential to our continuing economicC „ growth. And now just a word about farm credit. th Agriculture as a whole in *s °Untry is an excellent example of the effect of over-expansion of pro4uctiv e facilities. Unlike the situation in the farm depression of the thirds une 6 e r im present depressed condition of agriculture is not due to lack of buying power. 0Ve It is primarily due to surplus production and can only d as we retire some of our less productive lands from cultivation "^g production more nearly into balance with consumption. - 12 - At the same time, agriculture is going through a technological revolution that is resulting in a tremendous growth in credit requirements for ^vestment and operating capital. No longer can credit extension be based Sole tn l y on character and collateral. Both borrower and lender must be able ttake realistic projections of the earning potential of an operation and to ad Just the amount and terms of credit extended to that earning capacity on long-time averages of production, Some of the distress in the u ° ght areas at the present time is due more to the extension of too much rec ° *it than it is to any lack of c redit. This means that bankers and other Meiers must find ways to adapt their lending practices to these changing as if they are to continue to serve the farmers of their community.
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