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Economic Policy - The Path to Inflation, Depression or Growth

Talk by Darryl R. Francis, President,
Federal Reserve Bank of St. Louis, before the
Spring Credit Conference, Tennessee Bankers Association
Nashville, Tennessee, March 8-9, 1967

It is good to have this opportunity to return to Tennessee
and discuss with you some monetary and banking problems of
mutual interest to the Federal Reserve System and the commercial
banking community. 1 am particularly glad to receive an invitation
to outline some Federal Reserve policy actions in response to the
course of the nation's economy.
This is a most appropriate time for such a discussion in
view of the importance of 5 major developments during the past year.
(1) Nineteen sixty-six was a year of excessive demand for
goods and services. Production and spending had risen for five
consecutive years from the cyclical trough in I960.
(2) Output of goods and services had approached its
potential effective capacity early In the year. Unused plant capacity
in manufacturing industries had declined to 9 per cent of the total,
and unemployment was down to 3.9 per cent of the labor force.
(3) The excess demand for goods and services was
translated into higher prices. Prices of consumer goods rose
3.7 per cent from late 1965 to October 1966. Wholesale prices
rose about 3 per cent during this period.



-2(4) In response to these conditions, monetary policy
changed markedly.
(5) Interest rates, which had already increased in
response to rising demand, rose to the highest levels in over
30 years.
With these developments in 1966 as the central theme,
I propose in this discussion: (a) to consider the basic causes
of the 1966 developments, (b) to examine more recent Federal
Reserve and fiscal policies, and (c) to point out some widelyheld misconceptions of Federal Reserve actions.
It is generally believed by most students of economic
developments that monetary and fiscal policies are the two chief
public policy factors which influence spending and total demand
for goods and services. Some view fiscal policy as dominant,
while others view monetary policy as more effective. Advocates
of the fiscal policy view believe that a change of a dollar in
Government spending or taxing may lead to more than a dollar
change in total spending because of the impact of Government
spending on disposable incomes of consumers and business.
Changes in the incomes of these groups will in turn influence
their spending. Monetary actions, on the other hand, are
believed to influence spending through changes in such variables
as the stock of money, interest rates, credit availability and




-3liquidity. If the stock of money held by individuals increases or
decreases relative to their desire to hold money, spending likewise
increases or decreases.
With the aid of the fiscal and monetary tools of analysis,
I shall take a few minutes to review the policies that led to the
situation in 1966. First, I shall trace the course of fiscal actions.
The fiscal program of the Government became progressively more expansive starting in early 1961 and continuing until
about mid-1962. The high-employment budget surplus, which is
an estimate of the Federal surplus given current tax rates, and
assuming economic activity unchanged, declined from $14.2
billion in the fourth quarter of i960 to about $6.1 billion in the
second quarter of 1962 (Cha rt i). The smaller the surplus or
greater the deficit in this budget, the more stimulative the impact
of Federal fiscal activities. The stimulative character of the
Government's fiscal program during the 1960-62 period was caused
mainly by rapidly increasing expenditures, but new depreciation
guidelines and an investment tax credit provided additional
stimulus to private demand.
From mid-1962 through 1963 the Federal Government's
fiscal program became more restrictive in its impact on total
demand; the high-employment budget surplus rose from $6.1
billion to $13.7 billion in the fourth quarter of 1963. The growth
of Federal expenditures slowed, while high-employment receipts
rose rapidly.



.

-4-

In early 1964 the fiscal program of the Government again
assumed a more stimulative role in the economy, primarily as a
result of enactment of a tax reduction bill. The high-employment
budget surplus declined from $13.7 billion in the fourth quarter
of 1963 to $6.8 billion a year later. In the second half of 1964
and in early 1965, the high-employment surplus rose, and the
budget became somewhat less stimulative. But beginning about
mid-1965 and continuing through 1956, Federal budget policy
was by this measure more stimulative to total, demand than it had
been for more than a decade. On a high-employment budget
basis the Government operated at a surplus of only $0.2 billion
during this period. The consolidated cash budget deficit (cash
flow between the Government and other sectors of the economy)
rose from about $4.5 billion in 1965 to an estimated $7.5 billion
in 1966.
In summary, budget posture over this period moved from
a relatively restrictive stance in I960 and became progressively
more expansionary through tax cuts, additional welfare programs,
and expenditures on the war in Viet Nam. By 1966 it had become
more expansive than at any time during the previous ten years.
The course of monetary policy over the years since 1960
may be traced on the basis of changes in the stock of money. In
mid-1950, several months before the cyclical upturn, the money




-5stock began rising moderately. From mid-1950 to mid-1964 the
stock of money rose at a 2.7 per cent annual rate compared with
an average 2 per cent rate in the previous decade (Chart 11).
From the summer of 1964 to the spring of 1965, money rose at
an expansionary 4 per cent rate, and from the spring of 1965 to
the spring of 1966 it went up at a very stimulative 6 per cent rate.
Then from April through January of this year the stock of money
declined on balance. In recent weeks the quantity of money may
have again turned upward.
As a result of favorable monetary and fiscal policies,
demand for goods and services began to expand in 1961 (Chart 111).
During the 1961-64 period, the economy moved steadily closer to
its potential output. On the whole, the expansion was orderly,
creating no undue problems of resource allocation or inflationary
pressures. Consumer prices rose about I per cent per year,
while wholesale prices remained stable. During 1965, however,
with the relatively rapid expansion in money stock and the more
expansive Federal budget, especially in the last half of the year,
demand grew more rapidly. Again, most of the demand growth
was matched by an increase in output until the closing months
of the year. During most of 1966, however, the rapid increase
in total demand significantly outpaced the ability of the economy
to produce, and with the economy at virtual capacity, much of
the increase in demand was translated into higher prices
(Chart IV).



-6ln response to this situation, monetary policy was
reversed in the spring. The money stock (demand deposits and
currency) decreased at an annual rate of 1.5 per cent from
last spring to January of this year, after increasing 6 per cent
in the preceding year and at a 4 per cent rate from mid-1964 to
April 1965. Typically, changes in the stock of money have had
their greatest impact on economic activity after some time lag.
During the last half of 1966 monetary policy tended to restrain
economic activity, while fiscal policy continued expansive.
The net effect of these opposite forces was a reduction
in growth of total demand to levels approaching the rate of
increase of our productive capacity. Gross National Product
in real terms is expected to show little increase from the fourth
quarter last year to the first quarter this year. The industrial
production index was down in January and is expected to decline
further in February. Also, the utilization rate for manufacturing
capacity was about 87 per cent in February, down from 91 per
cent in mid-1966. Upward pressures on prices appear to have
moderated, reflecting less rapid growth in total demand. Consumer
prices increased at a 1.9 per cent annual rate from August to
January, compared with a 3.7 per cent rate from October 1965 to
August of 1966. Wholesale prices have declined since August
compared with a 4.3 per cent rate of increase from October 1965




-7to August. The recent decline in these prices is a reflection of
price decreases in farm products and processed foods accompanied
by only slight rises in industrial prices. With this moderation
in demand, monetary policy in recent weeks has undertaken a more
expansive role.
Now I shall discuss some general misconceptions by the
public of the part played by monetary policy in the economy during
the cyclical upswing and including 1966.
(1) First, there is a general view that monetary policy
became more restrictive with the rising interest rates in late
1964 and 1965. You will recall that three-month Treasury bills
rose about 3/4 of a percentage pointin late 1964, remained
fairly stable in early 1965, and rose another percentage point
in late 1965 (Chart V). ! contend that during this period monetary
policy was relatively easy. For example, from June 1964 until
December 1965, the stock of money rose at an annual rate of
5 per cent, and total bank credit rose at a 1 per cent rate
0
(Chart Vi). !n comparison, during the ten years 1954-1964, the
stock of money rose only 2 per cent per year, while total bank
credit rose only 6 per cent per year.
The rapid increases in interest rates during late 1964
and i965thus reflect greatly increased demands for loanable
funds as the nation's businessmen went to the credit market
to get more loans in an attempt to satisfy the growing demand



-8for goods and services. This rising demand for credit simply
outpaced the quantity of funds flowing into the loanable funds
market through savings and new increments to the money
supply. Higher interest rates during the period thus resulted
from a very rapid increase in demand for credit and not from
any reduced rate of additional supplies. Monetary policy was
quite expansive throughout the period.
(2) Second, many assume that the increase in the
Federal Reserve discount rate in late 1965 was a major force
tending to push up interest rates generally. Most of you will
recall the increase in the discount rate from 4 to 4 1/2 per cent
in December 1955. This action of the System was probably more
widely discussed than any single System action since 1951. This
discount rate change, however, was an insignificant factor in
monetary policy, or in the determination of interest rates. It
had little or no impact.on either the over-all supply or demand
for loanable funds, the forces that determine interest rates
generally.
Monetary policy has certain targets or objectives in
view which are determined independently of the volume or cost
of borrowings from the Federal Reserve Banks. These objectives
may be stated or they may simply be assumed. They may relate
to money supply, bank reserves, bank credit, employment, spending, the balance of international payments, or other economic
factors. Almost all however, involve the impact of monetary
actions on the economy through changes in the volume of bank




-9reserves or reserve ratios. Changes in the volume of reserves
can come about through member bank borrowings from the Federal
Reserve Bank and repayments of such loans, or through purchases
and sales of securities by the Federal Open Market Committee.
Reserves created in either case flow throughout the banking system
and have a general impact on the economy. Thus, extended borrowings at Reserve Banks which add to reserves in sufficient quantity
to have an excessive impact on economic activity, must be offset by open
market operations. Since the target level of total reserves would
have been provided without borrowing from the Federal Reserve
Bank, we cannot say that such borrowings or the discount rate
were factors in determining the total level of reserves, the stock
of money, the volume of loanable funds, or any other monetary
variable.
Instead of the discount rate change setting off the
general interest rate spiral in late 1965, I suggest that the
increase in the discount rate was a response to rising interest
rates that had already reflected the rising demand for loanable
funds. When short-term rates rise above the discount rate,
it becomes profitable for. banks to borrow from the Federal Reserve
Bank for investment purposes. This type of borrowing, if it
were to occur without offsetting actions, could nullify all other
monetary controls. Thus, borrowing by individual banks for




-10temporary reserve shortages must remain a relatively minor
source of bank reserves which can be offset by other central bank
actions.
Average daily borrowings from the Federri Reserve Banks
were less than $0.5 billion in 1965. This is equivalent to about
one-sixth of one per cent of the volume of all bank credit outstanding.
(3) The third misconception is that the decline of interest
rates from the September 1966 peak until December reflected an
easing of monetary policy. After rising sharply in the last half
of 1965 and the first three quarters of 1966, interest rates declined
moderately from September to early December and somewhat
more sharply after early December.
I view the moderate decline in interest rates from
September to early December as reflecting a decline in the price
of loanable funds that resulted from a decline in demand for
credit, rather than an easing of monetary policy. An expansive
monetary policy would have involved higher growth rates of
important monetary variables. Instead of the higher growth
rates, however, the following movements of monetary variables
occurred:
(a) The stock of money, which had been declining since
the second quarter of 1955, continued down from September to




-IIDecember. Only in recent weeks has the stock of money
possibly again turned upward.
(b) Total reserves of member banks, which had turned
down about mid-1965 continued down at an annual rate of 3.5
per cent from September to December 1966. In contrast, reserves
rose at an annual rate of 2.9 per cent during the ten years 1956
to 1966. Since December bank reserves have increased at a
whopping annual rate of 1 per cent, which might indicate an
9
expansive monetary policy, but which, I believe, up to now
reflects in the main a provision of reserves to accommodate
a reversal of money market flows which has resulted in a reflovv
of funds to banks in the form of certificates of deposit and other
time deposits. Within the past week the ratio of required reserves
on time and savings deposits has been reduced.
(c) Total bank credit declined at a very slight annual
rate from September to December, in contrast, total bank
credit expanded at an annua! rate of 7 per cent during the ten
years prior to 1966.
From these data I believe you will conclude that monetary
policy, which had become restrictive in the second quarter of
1966, continued to be relatively restrictive from September to
December, measured in terms of money supply, bank reserves,
or total bank credit. With relatively low or negative increments




- 1 2
to the money supply, assuming a fairly stable level of savings
relative to income, the rate of increase in loanable funds was
well below that of the decade prior to early 1965. With the lower
rate of increase in loanable funds coincident with a lovver rate of
return on such funds, it is apparent that the rate of increase in
demand for such funds declined concurrently with the reduced
supply. Since December, however, monetary policy has attempted
to become more expansive. The stock of money may have turned
up; bank reserves have begun to rise at a relatively high rate, and
bank credit has expanded rapidly.




CHART I

FederoS Budgets
Billions of Dollars
15

Billions of Dollars
15

Annual Data

y\Hi

gh-EmpIo ymenf
10

10

L\
\Defkit

H

Deficit

\

0

Cash
-5
-5.7

-10

10

1960

19^1

1962

1963

1964

1965

1966

Sources: U.S. D e p a r t m e n t of C o m m e r c e , U.S. T r e a s u r y D e p a r t m e n t ,
C o u n c i l of Economic A d v i s e r s , a n d F e d e r a l Reserve Bank
of St. Louis
Latest data p l o t t e d : 1966 p r e l i m i n a r y
Prepared by Federal Reserve Bank of St. Louis




CHART I I

Money Stock
Ratio Sca!e
Billions of Dollars

Monthly Averages of Daily Figures
Seasonally Adjusted

Ratio Scale
Billions of Dollars

+4.iJ7o
"1170.8
V

j
I

+6.2%+*/
-1.7%
U.20/

+2.7%

U^C^N.
•3.0
o

1

A __

1959

June'64

June'60

July'59

!

L_

1960

1961

1962

1963

Apr.'65

Apr.'66

2

l-Q
O

i
L J L _ LJL_JL LL_J
1964 1965 1966 1967

Percentages are annual rates of change betv/een months indicated.
Latest data plotted: February estimated
Prepared by Federal Reserve Bank of St. Louis




CHART I I I

J

-I

Demand and Production

Ratio Scale
Billions of Dollars
800

QuarterlyTotals at Annual Rates
Seasonally Adjusted

Ratio Scale
Billions of Dollars
+2.7%-

750

o

J

i

Hin

I ^

<

450

1959

1960

1961

1962

1963

1964

1965

1966

1967

ULGNP in current d o l l a r s .
Source: U.S. D e p a r t m e n t of C o m m e r c e
[2GNPinl958do!lars.
Percentages a r e a n n u a l rates of c h a n g e b e t w e e n q u a r t e r s i n d i c a t e d .
Latest d a t a p l o t t e d : 4th q u a r t e r 1966
1st quarter 1967 estimated
Prepared by Federal Reserve Dank of St. Louis




CHART IV

Ratio Scale
1957-59=100
120

1959

1960

Ratio Scale
1957-59=100
120

Prices

1961

1962

1963

1964

1965

1966

1967

Percentages a r e a n n u a l rates of change b e t w e e n months i n d i c a t e d .
Latest d a t a p l o t t e d : J a n u a r y p r e l i m i n a r y
Source: U.S. Department of Labor




Prepared-byFederalReserveBankofSiLouis

CHART V

Y i e l d s on Selected Securities
Per C e n t
t6.5

Per C e n t
6.5i

Long-Teriii Government lands LL

Stele and Local Aae Bonds \l

0

I

"'""VTVX

^fc^
^VTv-N

3-Month Irsasury Bills ' n
/—v-Tv—N

^—vqp.x-s

/"VTv'N

'-NZ-TV-'N

"-s^D^^^s

0
1959

1960

1961

1962

1963

1964

1965

1966 1

Ll M o n t h l y averages of d a i l y f i g u r e s .
[2 M o n t h l y averages of Thursday figures.
Sources: Board of Governors of the Federal Reserve System a n d M o o d y ' s Investors Service
Latest d a t a p l o t t e d : F e b r u a r y




Prepared by Federal Reserve Bank of S i Louis

CHART VI

Book Credit

Ratio Scale
Billions of Dollars
400

1959

1960

Ratio Scale
Billions of Dollars
400

A l l C o m m e r c i a l Banks
Seasonally A d j u s t e d

1961

1962

1963

1964

1965

1966

1

Percentages a r e a n n u a l rates of change between months i n d i c a t e d .
Latest d a t a p l o t t e d : F e b r u a r y




Prepared by Federal Raseirve Bank of St. Louis