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Statement by
Frederick H. Schultz
Vice Chairman

Board of Governors of the Federal Reserve System
before the
House Committee on Small Business
April 7, 1981

I a m p l e a s e d to h a v e the o p p o r t u n i t y this a f t e r n o o n to p a r t i c i p a t e
in t hese h e a r i n g s on the e f f e c t s of m o n e t a r y p o l i c y on sm a l l b usiness.
At the outset,

I x^ant to e m p h a s i z e that the f i n a n c i n g p r o b l e m s of small

b u s i n e s s are a su b j e c t v e r y m u c h on our m i n d s at the F e d e r a l Reserve.

We

r e c o g n i z e that in m a n y k e y r e s p e c t s small b u s i n e s s e s for m the b a c k b o n e of
the A m e r i c a n e c o n o m i c system, p r o v i d i n g m u c h of the e m p l o y m e n t ,

investment,

t e c h n o l o g i c a l i n n o v a t i o n , and c o m p e t i t i v e v i g o r that are so i m p o r t a n t to
the c o n t i n u e d v i t a l i t y of o ur economy.

At the same time, w e are a w a r e of

the p r o b l e m s s mall b u s i n e s s e s are e n c o u n t e r i n g in the c u r r e n t f i n a n c i a l and
economic environment.

T h e s e are the p r o b l e m s that y o u r C o m m i t t e e g r a p p l e d

w i t h last year, and in m y t e s t i m o n y I w i l l be c o m m e n t i n g on the is s u e s
r a i s e d in the re p o r t y o u p u b l i s h e d last fall on the s u b j e c t "F e d e r a l
M o n e t a r y P o l i c y and Its E f f e c t on Small B u s i n e s s . "
A l t h o u g h I a m glad to p a r t i c i p a t e in y o u r d e l i b e r a t i o n s on these
issues, n o n e of us c an be p l e a s e d that c o n d i t i o n s h a v e m a d e it n e c e s s a r y to
h o l d h e a r i n g s a g a i n on the same s u b j e c t that w a s of suc h c o n c e r n o v e r a y e a r
ago.

The r e a s o n w e are b a c k is, I b e l i e v e , the re s u l t of the c o n t i n u a t i o n

an d v i r u l e n c e of i n f l a t i o n o v e r the i n t e r v e n i n g period.

Small b u s i n e s s e s

t h e m s e l v e s m o s t f r e q u e n t l y list i n f l a t i o n as t h e i r n u m b e r one prob l e m , even
a h e a d of h i g h i n t e r e s t rates, g o v e r n m e n t r e g u l a t i o n and taxation.
It is eas y to see w h y this is so.

Businesses— whose survival de ­

pe n d s on th e i r a b i l i t y to e a r n a r e a s o n a b l e rate of r e t u r n on the i r i n v e s t ­
m e n t s — m u s t be a b l e to a n t i c i p a t e c h a n g e s in p r o d u c t sales and f u ture i n c o m e
flows.

Th e p e r s i s t e n c e of g e n e r a l l y r i s i n g p r i c e s g r e a t l y a l t e r s e s t a b l i s h e d

p a t t e r n s of s p e n d i n g and saving, a nd cr e a t e s an e n v i r o n m e n t in w h i c h it is
p a r t i c u l a r l y d i f f i c u l t to d i s c e r n u n d e r l y i n g d e m a n d and s u p p l y r e l a t i o n s h i p s .
In p a r t i c u l a r , p r i c e a d j u s t m e n t s that are f r e q u e n t and v a r i a b l e u n d e r m i n e the




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a b i l i t y of b u s i n e s s m a n a g e r s to plan; p r o f i t flows are m u c h less p r e d i c t a b l e ;
and the risks of u n d e r t a k i n g n e w i n v e s t m e n t s are g r e a t l y increased.

Small

b u s i n e s s e s are e s p e c i a l l y v u l n e r a b l e to the p r o b l e m s a s s o c i a t e d w i t h infla t i o n .
U n e x p e c t e d shif t s in p r o d u c t d e m a n d are l i k e l y to be m u c h m o r e d e v a s t a t i n g to
a sm a l l f i r m w h o s e a c t i v i t i e s t y p i c a l l y are c o n c e n t r a t e d in a n a r r o w r a n g e
of p r o d u c t lines or in a small g e o g r a p h i c area.

In a d d i t i o n , the s l u g g i s h

p a c e of e c o n o m i c a c t i v i t y that h as a c c o m p a n i e d recent i n f l a t i o n has m a d e it
m o r e d i f f i c u l t to pass t h r o u g h cost i n c r e a s e s to their c u stomers.
O n l y by r e t u r n i n g to a p a t h of p r i c e s t a b i l i t y and l ower i n f l a t i o n a r y
e x p e c t a t i o n s can this c o u n t r y h o p e to o b t a i n so u n d e c o n o m i c g r o w t h and the
k i n d of e c o n o m i c e n v i r o n m e n t in w h i c h b u s i n e s s e s ,

small and large, can thrive.

A n e s s e n t i a l e l e m e n t in the effort to r e s t o r e pr i c e s t a b i l i t y is the F e d e r a l
R e s e r v e ’ c o m m i t m e n t to a r e s p o n s i b l e and d i s c i p l i n e d m o n e t a r y policy.
s

Expe­

r i e n c e ove r lon g p e r i o d s and in m a n y d i f f e r e n t c o u n t r i e s h a s s h o w n that i n f l a ­
tion c a nn o t p e r s i s t in the a b s e n c e of ra p i d m o n e t a r y g r o w t h to s u p p o r t it:
it seems onl y s ensible,

theref o r e , that the F e d e r a l R e s e r v e w o r k to b r i n g d o w n

the p a c e of m o n e y e x p a n s i o n ove r the long run to n o n i n f l a t i o n a r y levels.

This

is the a p p r o a c h that has g o v e r n e d m o n e t a r y p o l i c y for w e l l over two y e a r s now.
Last year, as the F e d e r a l R e s e r v e r e f u s e d to a c c o m m o d a t e i n f l a t i o n fed d e m a n d s for m o n e y and credit,

interest r ates ro s e s u b s t a n t i a l l y .

Th e s e

r a t e a d v a n c e s a l s o w e r e g i v e n i m p e t u s by c o n c e r n s about i n f lation, the u n ­
e x p e c t e d r e s i l i e n c e of the economy, a nd the g r o w i n g F e d e r a l d e f icit,
whose importance cannot be overemphasized.

factors

U n d e r c i r c u m s t a n c e s like t h o s e p r e ­

v a i l i n g last year, the F e d e r a l R e s e r v e could not h a v e a t t e m p t e d to hol d down
i n t e r e s t rates w i t h o u t a b d i c a t i n g its c o m m i t m e n t to a c h i e v i n g t a r g e t e d g r o w t h




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3-

rates in the m o n e t a r y a g g r e g a t e s and thus its c o m m i t m e n t to a p o l i c y that w o u l d
u l t i m a t e l y r e s u l t in b r e a k i n g the i n f l a t i o n spiral.
Unfortunately,

e x p e r i e n c e lias s h o w n that w h e n m o n e t a r y p o l i c y

c a r r i e s a d i s p r o p o r t i o n a t e r e s p o n s i b i l i t y for r e s t r a i n i n g i n f l a t i o n a r y p r e s ­
sures,

the g r e a t e s t b u r d e n falls on t h o s e s e c t o r s of the e c o n o m y that are

h e a v i l y d e p e n d e n t on financial, i n t e r m e d i a r i e s for c r e d i t — i n c l u d i n g h o u s i n g ,
f a r m e r s , and s m a l l b u s i n e s s e s .

T h e r a is no q u e s t i o n that sm a l l b u s i n e s s e s

h a v e b e e n p a r t i c u l a r l y h a r d hit by the h i g h l e v e l of i n t e r e s t rates.

Be c a u s e

they t y p i c a l l y h a v e f ewer a l t e r n a t i v e sour c e s of f u n d s 9 sm a l l firms re l y
h e a v i l y on c o m m e r c i a l b a n k s for cred i t , and t h e r e f o r e m u c h of t h e i r b o r r o w i n g
is s h o r t - or i n t e r m e d i a t e - t e r m .

As i n t e r e s t r a t e s rise, sm a l l firms, w h i c h

in g e n e r a l a l r e a d y b o r r o w at r ates a b o v e those e x t e n d e d to l a r g e r c o m p a n i e s ,
e x p e r i e n c e s u b s t a n t i a l i n c r e a s e s in f i n a n c i n g c o s t s that are not r e a d i l y
p a s s e d on.

Infl a t i o n , m o r e o v e r , h as g r e a t l y e n l a r g e d t h e i r f i n a n c i n g ne e d s ,

thu s i n c r e a s i n g the i r e x p o s u r e to c h a n g e s in c r edit m a r k e t c o n d i t i o n s and p e r ­
h a p s i n c r e a s i n g the r i s k p r e m i u m s they m u s t pay for b o r r o w e d funds.
On b a l a n c e ,

1980 w a s no t a good year for the e c o n o m y in g e n e r a l and

for s m a l l b u s i n e s s in p a r t i c u l a r .

Not o n l y did i n t e r e s t r ates m o v e to u n p r e c ­

e d e n t e d le v e l s last year, b ut they als o b e h a v e d in an e x t r a o r d i n a r i l y i r r e g u l a r
a n d v o l a t i l e fashion.

Suc h a b r u p t s w i n g s in the le v e l of a c t i v i t y a n d f i n a n c i a l

c o n d i t i o n s o b v i o u s l y c r e a t e s e r i o u s p l a n n i n g and a d j u s t m e n t p r o b l e m s for
businesses:

s mall b u s i n e s s e s p r o b a b l y find it p a r t i c u l a r l y d i f f i c u l t in the

s h o r t r u n to a l t e r o p e r a t i n g or f i n a n c i n g p r a c t i c e s in r e s p o n s e to s u c h r a p i d
c h a n g e s in the e n v i r o n m e n t .

A n u m b e r of factors c o n t r i b u t e d to the u n u s u a l l y

s h a r p f l u c t u a t i o n s in r ates last year, not the least of w h i c h w as the i m p o s i t i o n
of c r e d i t c o n t r o l s last M a r c h , w h i c h had a p r o f o u n d impa c t on d e v e l o p m e n t s in




-

the s p r i n g and summer.

4-

And, d e m a n d s for m o n e y a nd credit f l u c t u a t e d w i d e l y

in r e s p o n s e to e x c e p t i o n a l m o v e m e n t s in real a c t i v i t y — i n c l u d i n g one of the
s h a r p e s t d e c l i n e s in o u t p u t on r e c o r d in the s e c o n d q u a r t e r f o l l o w e d by a s u r ­
p r i s i n g l y s t r o n g r e b o u n d in the third.
A l t h o u g h 1981 s h o u l d h a v e less v i o l e n t ups and down«, I c e r t a i n l y
:annot a s s u r e y o u that the m o n t h s just a h e a d w i l l o f f e r a s u b s t a n t i a l i m p r o v e ­
m e n t in o v e r a l l e c o n o m i c c o n d i t i o n s .

W e at the F e d e r a l R e s e r v e b e l i e v e we

h a v e e m b a r k e d on a c o u r s e that w i l l e v e n t u a l l y r e d u c e i n f l a t i o n a nd i n t e r e s t
rates.

But this w i l l take time an d w e r e c o g n i z e that, in the i n t erim, t h e r e

c o u l d be c o n s i d e r a b l e d i s c o m f o r t for m a n y as w e m o v e to a n o n i n f l a t i o n a r y
environment.

I n f l a t i o n h a s b e c o m e d e e p l y e m b e d d e d in o ur e c o n o m i c system,

an d there is no p a i n l e s s w a y out of our p r e d i c a m e n t .

In t h e s e c i r c u m s t a n c e s ,

as we p o n d e r s p e c i f i c e f f o r t s that m i g h t s m o o t h the t r a n s i t i o n ,

it is u n f o r ­

t u n a t e l y e a s i e r to st a t e w h a t w e ought not to do than it is to s u g g e s t w h a t
s h o u l d be done.
T he q u e s t i o n of i n t e r e s t rate v o l a t i l i t y ,

for exam p l e ,

is v e r y

t r o u b l e s o m e , but the small a m o u n t of a d d i t i o n a l s h o r t - r u n i n t e r e s t v o l a t i l i t y
t hat m a y be r e s u l t i n g f r o m the F e d e r a l R e s e r v e ' s m o n e t a r y c o n t r o l t e c h n i q u e s
m u s t b e w e i g h e d a g a i n s t the a d v a n t a g e s of b e t t e r c o n t r o l o v e r the m o n e t a r y
aggregates.

To s e e k to s t a b i l i z e in t e r e s t r a t e s by a c c o m m o d a t i n g s h i f t s in

m o n e y and cr e d i t d e m a n d s can p r o d u c e d a n g e r o u s d e v i a t i o n s fro m t a r g e t e d g r o w t h
r ates of the m o n e y s u p p l y and m a k e it m o r e d i f f i c u l t to a c h i e v e n o n i n f l a t i o n a r y
g r o w t h of m o n e y and c r e d i t o v e r time.

A n d in the p r o c e s s it can i n c r e a s e the

c y c l i c a l m o v e m e n t s in r a tes that are far m o r e s i g n i f i c a n t in the i r e f f e c t s on
the economy.




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5
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Similarly, many have called for the monetary authorities to lower
interest rates, but we see this as a transitory short-run response that in
the long run would be detrimental to our financial well-being.

Although the

Federal Reserve might be successful in temporarily lowering short-term rates
by pouring reserves into the system and by increasing growth of the money
stock, such a policy would only serve to exacerbate inflationary pressures
and produce even higher interest rates down the road.
It also would be extremely unwise for the Federal Reserve to get
into the business of setting guidelines or reserve allocation schemes designed
to channel credit flows to specific sectors.

Our experience with the credit

restraint program last year reinforces our reluctance in this regard.

I can

assure you that administering these controls proved to be a task filled with
intractable problems.

The program was designed to rely as much as possible

on market forces, given the basic objectives of the Administration's anti­
inflation effort, yet it demonstrated all too plainly how difficult it is to
implement desired credit allocation policies.
distorted in unanticipated and unintended ways.

Business decision-making is
Inequities multiply and re­

quire an unending chain of exemptions and qualifications.

In the short-run,

the confusion and uncertainty are damaging to the economy; in the long-run,
the market devises ways of circumventing the controls; and in the meanwhile,
attention may be diverted from the fundamental policies needed to achieve
economic stability.
Nor should the Federal Reserve get involved in setting terms on
credit, such as requiring banks to maintain dual prime lending rates.

We

believe that the lending institutions are best able to determine the require-




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ments of their customers and their own abilities to service those needs.
The lending rate appropriate for any particular loan will vary depending,
among other things, on the bankfs costs of funds, the borrower’ credit­
s
worthiness, and the purpose and terms of the loan: these factors can only
be evaluated by the individual institution, and the loan terms negotiated
between bank and borrower.
Many banks, of course, tie rates on their loans to small businesses
to the prime lending rate.

The meaning of this practice has been called

into question recently by the phenomenon referred to as Mbelow-prime lending."
As you .are aware, some of the large commercial banks have made a sizable
share of their loans at interest rates that fall below prime.

Indeed, our

most recent data indicate that about 70 percent of loans extended in the
first week of February at a selected sample of the nation’ largest banks
s
were at rates below prime.

Thus, the prime rate no longer seems to be the

lowest rate offered to prime or best business customers— as it was in the
past.
In a study of below-prime lending by the Fed staff, however, it
was clearly demonstrated that loans at these discounted rates are of a
different nature than ordinary business loans.

They tend to be very large

loans that are extended for very short time periods, with rates that are
tied to money market rates.

In essence, they are loans designed to compete

with commercial paper issuance as a source of short-term financing for very
large corporations.

This suggests that the prime rate may still be a relevant

concept for the traditional type of business loan, and that discounting below
prime need not be construed as an attempt by the banks to mislead their other
business customers.




Nevertheless, by grouping these different types of

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7
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business credit under one heading, considerable confusion has arisen.

I

personally believe the banks would do their customers a great service by
choosing different terminology to distinguish these lending rates.
Before concluding, let me suggest some ways in which the Federal
Reserve is attempting to better understand and deal with the financial pro­
blems of small businesses directly.

First, as a matter of continuing policy,

the Board encourages commercial banks to take account of the special needs
of' their small customers.

The vast majority of the banks in this country are

themselves small, local and regional institutions, whose economic well-being
is inalterably tied to the health and vitality of their local business commu­
nities.

Most of these institutions, I am sure, give top priority to the needs

of their small business customers.

Some large banks also have developed active

small business lending programs, and it is likely that such programs would be
initiated on a larger scale if bank managements were better informed of demand
and potential returns . Our staff and those of the Federal Reserve Banks
are working in a variety of ways to learn more about the particular pro­
blems of small businesses, and about the types of programs that have been
instituted.
We are also seeking ways to increase the availability of data on
small business financing.

As noted in this Committee’ report, the lack of
s

a substantial data base for small businesses makes it impossible to quantify
the impact of changing financial and economic conditions on this sector of
the economy.

In part the lack of data reflects the difficulty of establish­

ing uniform and useful definitions of "small business"; in addition, the cost
of collecting statistically reliable data for this heterogeneous population
has appeared prohibitive.




There are several projects currently underway,

-8however, that should give us a better indication of what data are needed and
the cost of obtaining them.

One of these projects— under the guidance of

an interagency task force on small business finance— is specifically focusing
on the financing needs of small businesses.

An important part of the project

is an interview survey of small business lending practices at a small sample
o^ banks and other creditors.

The results of this survey will be available

early next year and should provide some insight into the types of data that
might feasibly be collected from such lenders.
In summary, let me assure you that the Federal Reserve has very
much in mind the plight of small business firms in the current inflationary
environment.

We believe, however, that the best course is to pursue with

diligence those policies that will return us to a world of price stability.
Any sign that the Fed is turning away from its commitment to monetary restraint
would seriously undermine the credibility of our fight against inflation, set
back the progress that has been made, and make it much more difficult to
break the embedded inflationary psychology.
At the same time, it is essential that the burden of restraining
inflation not rest solely on monetary policy.

The Congress, along with the

Administration, have at hand one of the most important means for reducing
the strains on private financial markets— that means is the implementation
of prudent and disciplined budgetary policies.

A large volume of government

borrowing associated with huge federal deficits such as we have had in recent
years both raises the cost and reduces the availability of funds to private
borrowers— the impact of this is most pronounced on housing and small
business finance.

I strongly sup

the growth of budget outlays and




istration's efforts to reduce
e deficit, and ask that the Con-

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9-

gress give these proposals serious consideration.

I would be gravely con­

cerned, however, if the benefits achieved in budget cuts were dissipated in
excessive tax reductions so that the financing needs of the government remained
large.

Such a course would worsen rather than ease the financial pressures

facing private businesses and all borrowers.

While the process of reducing

the grip of inflation will require painful adjustments by all sectors of the
economy for some time to come, I feel confident that adherence to our mone­
tary goals, accompanied by responsible fiscal policy, will lead us to the
kind of stable financial and economic environment in which businesses can
operate efficiently and productively.