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For release on delivery (Approximately 12:30 p.m., Mountain Standard Time, Saturday, January 29, 1966) MONETARY POLICY IN A PROSPEROUS ECONOMY Remarks by Chas. N. Shepardson Member of the Board of Governors of the Federal Reserve System at the 73rd Annual Convention of the Mountain States Lumber Dealers Association Denver, Colorado January 29, 1966 MONuiARY POLICY IN A PROSPEROUS ECON*rtg It is always a pleasure to come home. And today I come home again to Colorado. But I must admit that pleasure is mixed with a little apprehension, apprehension in speaking to an industrial group like yours. If I'm an expert on anything, it's agriculture, not industry. And to compound my apprehension, today I'm not going to talk about either industry or agriculture. Rather I'm going to talk about the developing economic prosperity that we've been experiencing here in the United States for the last few years, and the problems it's be ginning to pose for us, particularly those of us in the Federal Reserve System who have the responsibility of administering monetary policy. A Glance Backward The Economic Scene. 1965 was a year in which we were bigger and better than ever according to most all of the broad indicators we use to measure our economy's performance* production grew 8 per cent. Industrial The dollar value of our total national product increased 7-1/2 per cent. And all this came after four pre vious years of steady and substantial economic growth. Employment in 1965 was the highest in years. We also made at least some progress toward solving our serious balance of payments problem. Business and consumer confidence remained high. Businesses spent 15 per cent more on new plants and equipment than they did in 1964, and they plan another If^SHncrease this year. As total in come rose, consumer expenditures for a,utos, other durable goods, - 2 - services, and even nondurable goods— for just about everything except houses— also rose sharply, even though they saved about the same share of income as in other recent years. So— with almost everybody working, making higher incomes than ever, saving and spending unprecedented amounts, and confident about the future— what in the world was there to worry about? One thing to worry about was that there were signs of im balance and threats of unsustainability in the expansion developing. In an economy as diverse as ours, pressures and imbalances can exist in critical areas long before they show up in the over-all statistics. In fact, by the time they do show up there, it may be too late to do very much about them. Ours is a very adaptable economy, but some times we are too sanguine about the insignificance of problems, so long as they remain selective and the over-all picture continues to look good. There was increasing evidence, as 1965 progressed, that at the high average rate at which human and national resources were being utilized, some critical resources were being badly strained. During the year we effected a further reduction in our unemployment rate, which had been too high for too long. We finally got close to the Administration's interim target of 4 per cent. But serious shortages of some kinds of skilled workers were developing even though among some groups of our people there continued to be alto gether too many who could not find jobs. By December, the over-all jobless rate was down to 4.1 per cent— the lowest since May 1957. In such Great Lakes industrial centers as Chicago, Detroit, Milwaukee, Cincinnati and Cleveland, - 3 - unemployment rates went below 2-1/2 per cent. There, with virtually the only workers idle those moving from one job to another, the supply of labor* was really tight. Around the country, factories were pressed for skilled workers such as tool and die makers, machinists, and sheet-metal workers, and overtime for factory workers was the highest in the 10 years that records have been kept. These scattered but critical labor shortages did not de velop over night. Manufacturers were operating at an average rate of 90 per cent of capacity throughout the year and the rate in some industries was well over 90 per cent. At such high levels of opera tions, labor shortages develop, overtime becomes necessary, older and less efficient plant is brought into operation, costs rise^and productivity declines. There are also consequences elsewhere from the kinds of strain that develop when labor and capacity are inadequate for the demands put on them. As operating costs rise, businesses feel justified in raising their prices and, as you know, some have done so. Moreover, as availability of certain skills becomes more crucial to meeting the demands of customers, labor feels justified in demanding more generous wage settlements and, after four years of wage increases that kept pace with rising productivity, some settlements last year exceeded the Administration's guideposts. Eventually, training of new workers and additional in vestment in plant and equipment will ease the strains on our physical resources, but they don't help much over the short-run. In fact, the step-up in business capital expenditures last year, - 4 - with all the demands it created for steel, machine tools, and the other labor and materials that go into new plants added signifi cantly to the pressure on existing resources* The kinds of pressures that developed last year had not been expected at the start of the year. In addition to the stepped- up pace of Government spending, private demands for goods and services turned out to be surprisingly large. There was a great flurry of activity early in the year which was expected to be temporary, since it reflected both the aftermath of the auto strikes in late 1964 and efforts of steel-using businesses to build up inventories in advance of an expected steel strike. But consumers continued to purchase autos and other consumer goods in record volume and, though busi nesses stopped spending quite so much for inventories, they began to spend more and more for new plants and machinery. Every time the Government asked them about their capital expenditure plans, the total planned for 1965 came out larger. It now appears that they spent $2 billion more for plant and equipment last year than they had been expected to at the start of the year— and the final figures aren't yet in. The Financial Scene. So far I have been talking about the squeeze on resources of labor and productive capacity. Finan cial resources were also under increasing pressure last year. Both consumers and businesses increased their spending at a faster rate than their incomes were rising. They were able to do so only by relying heavily on borrowed funds. Debt expansion was substantial - 5 - in 1965, so substantial as to raise serious doubts as to whether it was either sound or sustainable. Consumer credit and business borrowing at banks accounted for the largest part of the increased credit flows, and did so right from the start of the year. Business loans at banks, for example, grew at an annual rate of 26 per cent in the first quarter of 1965. This extraordinary increase reflected not just the financing re quired to rebuild dealers' stocks of autos and the accumulation of steel inventories, but also the funds needed by exporters and im porters to hold inventories they could not move during the dock strike. It also included a very heavy volume of lending to foreign businesses, partly connected with earlier commitments. Things were expected to calm down once the auto and steel inventory buildups were completed, the dock strike was settled, and the President's February balance of payments program was under way. But they didn't calm down. Businesses continued to borrow rather large amounts from banks, though less than in the early part of the year and less to finance their foreign activities. in the security markets also increased sharply. Financing Credit flows to business corporations over last year as a whole were nearly 50 per cent larger than they were the year before. Internal funds avail able to them from undistributed profits and depreciation allowances, on the other hand, rose only 12 per cent. Rapid expansion of debt such as occurred last year tends to create two kinds of imbalances, both of considerable concern to us. It almost goes without saying, of course, that an expanding - 6 - economy requires and can handle increasing amounts of debt, and we could hardly have sound and sustainable economic growth without a steady flow of appropriate amounts of debt. But as debt con tinues to mount in the economy as a whole, and especially as it appears to be financing an exceptionally large proportion of total spending, one begins to suspect that some businesses and consumers are taking on more debt than they can handle, that the quality of credit is declining, and that debt burdens for some are becoming dangerously high. One begins to worry about what happens to spend ing when, after th(.s debt-financed binge, the debt must be repaid. Sustainable growth in our economy requires that we not try to do too much at once. Excessive borrowing to support spend ing on goods and services that are in short supply is most likely both to add dangerously to wage and price pressures at the time and to require a sharp cutback in spending while the debts are worked off— the boom and bust we all want to avoid. This is one kind of imbalance that threatens the health of the economy through its effect on the financial position of borrowers and their spending plans. A second imbalance— which is simply the other side of the same coin as excessive debt expansion— was the imbalance that arose in credit markets because demands for credit were running ahead of the supply of saving. several factors. The situation last year was compounded by The increased expansion in credit occurred at a time when there was virtually no increase in the total volume of funds flowing to savings institutions. Also, business corporations - 7 - were so pressed for liquidity that they found it difficult to provide funds to others by adding to their holdings of bank deposits, U.S. Government securities, finance company paper, and other short-term securities* The surge in demand for a limited supply of investment funds resulted both in sharp increases in market interest rates— that is, in those rates that were free to move up— and very heavy demands on commercial banks. Throughout the expansion period, the Federal Reserve has acted to supply banks with enough reserves to accommodate the needs of a growing domestic economy but hopefully not so much as to promote excessive and inflationary use of credit at home or to contribute to a worsening balance of payments situation internationally. For four years, this relatively easy monetary policy, together with expanding flows of savings, permitted substantial credit growth at interest rates that remained below their recent earlier high that occurred in 1960. But as 1965 progressed, provision of enough reserves to support a strong rise in the money supply was still not enough to prevent market rates of interest from rising considerably. It became increasingly clear that an excessively large volume of bank reserves would have been needed to have halted the upward pressure on interest rates and to have reversed the trends that had carried money market rates above the discount rate and pushed time deposit rates against their ceilings. There was also growing evidence that heavy demands for credit were likely to be with us for some time to come. This increased the inflationary risks of coping with the situation through a large additional in crease in bank reserves. - 8 - The problem as it related to bank credit expansion was that banks, faced with heavy demands for credit, were handicapped by the existing maximum ceilings payable on time deposits in their efforts to compete for such deposits. The most appropriate solution to this situation appeared to us to be threefold: (1) to continue to supply a reasonable amount of bank reserves through open market purchases of Government securities; (2) to increase the discount rate, both to bring it into line with money market rates and indirectly to moderate the expansion of bank credit and money through increasing the cost of borrowed bank reserves; and (3) to raise the permissible maximum rate on time deposits so that banks would be better able to compete for money market funds needed to enable them to meet their large loan demands. The threefold approach to reducing the distortion in credit markets recognizes the appropriateness of higher interest rates as a deterrent to excessive credit expansion in an economy that has absorbed most of its previous slack. The intent is not to cut off the expansion, but simply to keep it from accelerating to an unsustainable pace— to encourage both borrowers and lenders to examine proposed debt-financed expenditures a little more care fully and to screen and postpone some marginal projects. In the eight weeks since these actions were taken, new information that has become available has confirmed our judgment of the underlying situation. I am thinking here of the large up ward revision in business plant and equipment expenditures in the - 9 - last half of last year and in planned spending in the first half of 1966. There has also been a significant upward revision in the esti mates of gross national product for the first three quarters of 1965 and a consequent raising of sights for the fourth quarter and the year ahead. In December, industrial production, personal incomes, wholesale prices, housing starts, new orders for durable goods, bank credit, and the money supply all showed sharp increases. And on top of all this came the need for greater military expenditures to finance the fighting in Viet Nam. A Look Ahead All these pieces of additional information suggest that the pressures on resources— human, material, and financial— that were developing last year could be even more intense this year. Price pressures and labor shortages are likely to increase with further expansion in activity and increased transfer of manpower to the needs of our military effort. Business demands for credit, which accounted for much of the increased credit expansion in 1965, are likely to remain very large. In addition to the big planned increase in plant and equipment expenditures, spending for inven tories is likely to rise now that liquidation of steel inventories is about completed, and corporate profits, which benefited from a tax cut last year, may not rise much further this year. Our balance of payments problem is still not solved. Though we have made some welcome progress toward equilibrium, we have a way to go yet. The last billion and a half of the deficit may be the hardest to eliminate. There is no easy way to improve - 10 - the situation further, given our commitments to spend heavily for defense abroad, except to request financial institutions and nonfinaneial corporations to continue to curtail, for the time being, their foreign lending and investing. Military expenditures which were already accelerating last year are, as we all know, going to be even larger over the remainder of this fiscal year and are currently expected to be even larger in fiscal 1967. In the happy event that peace breaks out in Viet Nam and such heavy military expenditures prove to be unnecessary, an intensification of the war on poverty and increased outlays for other needed domestic programs can be expected. It is quite impossible to say what changes in monetary policy may be required from here on. Such changes will depend on many things— particularly on the full effects, which are as yet unknown, of the actions we have already taken, and on the Federal Government's fiscal and debt management policies. In the area of fiscal policy, the President's recent messages indicate that, al though a large increase in spending is planned, a large increase in revenues is also expected— partly because of the continued rise in incomes and partly because of plans for an acceleration in the timing of receipts, which it is hoped will moderate not only Federal borrowing but also private spending. Thus, it remains to be seen in what degree, and even in what direction, monetary policy may need to move in order best to promote the sustained and healthy growth of our economy. Monetary policy is a flexible instrument, and I can assure you we will be - 11 using it to the best of our ability to help bring about a continuation of a sound and sustainable economic expansion. Conclusion Now, in conclusion, what does all this mean to your busi ness? What does it mean for construction and real estate finance? You will note that it was the discount rate and maximum rates payable by commercial banks on time deposits that were raised in December. The ceiling rate on passbook savings was not raised. In the first place, such savings are in practice available on demand and, therefore, do not warrant as high an interest rate as time de posits with fixed maturities. Also, we did not want to disrupt the usual flow of individual saving to the variety of financial insti tutions and savings instruments. Our actions raising time deposit ceiling rates are but another step in a series we have been taking in recent years to im prove the functioning of financial markets. For a long time com mercial banks were at a disadvantage relative to other financial institutions in competing for savings and money market funds. That disadvantage is being reduced, not by curbing other institutions but by eliminating unnecessary limitations on the banks. Hopefully, the end result will be freer and fuller functioning money and capital markets. Evidence we have received to date suggests that banks have been using their new found freedom in competing for funds wisely. There has been no great rush to raise rates or to compete too aggressively for funds. - 12 Moreover, there has been no great shifting of savings among various institutions. Commercial bank time and savings de posits, in fact, have risen less sharply since the change in Regulation Q ceilings than they did before. And flows of funds to other savings institutions have not been greatly affected. Having said all this, although we expect a continued ample flow of funds into mortgages and residential construction this year, that flow will no doubt be dampened by our recent actions. But this, it seems to me, is warranted by the likely over-all economic situation and, indeed, by the construction industry itself. I have been struck by the fact that we have been ex periencing inflation in your industry for some years. Land values, construction wages, and construction costs in general have risen steadily and substantially. With the general economy likely to be under increased wage and price pressures this year, it is appro priate for some moderate additional restraint to be put on construc tion activity if disrupting price and wage pressures are to be pre vented. The longer-run needs of the economy for houses and con struction of all kinds are very large. We want to do all in our power— both you in the industry and we in Government— to keep activity growing, but on a sound and sustainable basis.
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