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Statement by
Frederick H. Schultz
Member, Board of Governors of the Federal Reserve System
before the
Subcommittee on Access to Equity Capital and Business Opportunities
House Committee on Small Business
April 2, 1980

I am pleased to appear before you once again to discuss the impact
on small business of the Federal Reserve's efforts to fight inflation.


welcome, in particular, the opportunity to discuss the program of credit
restraint announced on March 14.
When I last appeared before this committee in October, the Federal
Reserve had just undertaken a number of actions designed to slow the growth
in money and credit.

The October 6 policy changes were adopted in response

to continued rapid expansion of money and credit, and an apparent worsening
of inflation and inflationary expectations.

These conditions had made them­

selves felt most prominently in the markets for gold and for some other com­
modities, where speculative activity was reaching alarming proportions.
As I indicated at that time, it was essential that the Federal
Reserve take strong action to restrain money and credit growth in order to
prevent a further serious acceleration of inflation and make a start on wind­
ing it down.

Only in this way could we work toward a more stable financial

environment for economic activity over the long run.
years is quite clear:

The lesson of recent

namely, that the long-run consequences of allowing

inflationary pressures to get out of hand are likely to be far worse than
the short-run costs of actions to contain these pressures.
The policy procedures adopted in October, and the accompanying
rise in market interest rates, led to a marked slowing in the growth of
money and credit in the fourth quarter of last year.

Since the beginning

of this year, however, there has been a resurgence in credit demands, espe­
cially on the part of business firms.
expanded very rapidly.

Bank loans and commercial paper have

Moreover, it has become clear that the financial

markets, and the general public, remain concerned about the ability and com­
mitment of the government and the monetary authorities to contain inflation.




No doubt inflationary expectations have been reinforced by the
recent surge in the major price indexes--even though these increases were
in large part the predictable result of the spurt in OPEC prices in the
latter months of 1979 and of higher mortgage rates that are an unavoidable
consequence of anti-inflationary monetary policy.

Expectations also have

been heightened by the continuation of strength in economic
activity--in particular by the failure of the long-expected recession to
materialize--and by the possibility that an acceleration in our defense
expenditures would enlarge the Federal deficit.
The most dramatic manifestation of the reinforcement of expecta­
tions has been the unprecedented run-up in yields on long-term bonds--a move­
ment that has erased hundreds of billions of dollars of market values.
ing patterns also have been affected.


The household savings rate in the

fourth quarter reached its lowest point since the Korean war, and retail
sales were strong early this year suggesting that the 1 buy in advance1 psy­
chology was still in operation.
It was against this background that the monetary and credit pro­
gram was announced on March 14 as part of a government-wide effort to stem

The program is intended to strengthen the effectiveness of the

October measures and to reaffirm our commitment to bring inflation under con­

The thrust of the program, as it pertains to businesses,


several aspects. First we are seeking to slow the overall growth in credit.
A key element in this regard is the imposition of restraint on certain types
of consumer credit, including credit cards and check overdraft plans.


addition, several specific actions have been taken that apply directly to
bank credit growth.

These actions include a tightening of the marginal




reserve requirement on managed liabilities of large member banks that was
initiated on October 6 and a special deposit requirement on increases in
the managed liabilities of large nonmember banks, as well as the establish­
ment of a surcharge on repeated borrowings by large banks at the discount
The March 14 actions also initiated a Special Credit Restraint

Under this program, banks are expected to limit loan growth this

year to 6-9 percent, a range consistent with announced targets for growth
in money and credit reported to Congress on February 19.

Through the Special

Credit Restraint Program, guidelines have been set forth for borrowers and
lenders to assure that funds are available to meet certain priority needs.
These guidelines are designed to moderate the uneven impacts that reduced
credit availability may impose on particular sectors of the economy, such
as small businesses and agriculture.

The program also covers business bor­

rowing from finance companies and in the commercial paper market.
The increased marginal reserve requirements on managed liabilities
and the surcharge on discount borrowing further increase the cost of addi­
tional acquisitions of borrowed funds by the banks.

Banks thus will be

faced with the task of allocating a more costly and slower growing volume
of credit among alternative uses.

Businesses--both large and small--will

find that bank loans are more costly and less readily available.

Some bor­

rowers will determine they cannot afford to pay higher rates charged on
loans, and a greater portion of credit demands will not be met.
A reduction in the availability of bank loans is, of course, a
more serious matter for some borrowers than for others.

Limited access to

alternative sources of funds makes small enterprises very dependent on


commercial banks for credit.



This dependency may be even greater during a

period such as now, when cash flows may be weakening, and suppliers are pro­
bably less willing or able to expand trade credit.
Following the Federal Reserve's actions in October, Chairman Volcker
sent a letter to member banks urging them to give particular care to accommo­
dating the needs of small businesses and other borrowers that rely primarily
on banks for credit.

The Special Credit Restraint Program incorporates

explicitly our concerns in this area.

The program states that a primary

responsibility of banks during the coming adjustment period will be to "meet
the basic needs of established customers for normal operations, particularly
smaller businesses, farmers, thrift institution bank customers, and agricul­
turally-oriented correspondent banks and homebuyers with limited alternative
sources of funds."

Moreover, the Board expects that in setting interest rates

and other lending terms banks will, where possible, take account of the
special needs of these borrowers.

At the same time, institutions are asked

to avoid extensions of credit for speculative or nonproductive purposes, or
for purposes that may be financed from other sources.

Thus, within the over­

all range of the 6 to 9 percent loan growth target, banks are encouraged to
channel funds to groups likely to use them for productive purposes and to
those that have limited alternative sources.
The Fed has not attempted as part of this program to specify the
portion of credit that banks should allocate to specific borrowing groups
nor to establish numerical guidelines for the relative terms of lending.


feel that individual institutions are much better able to assess the needs
of particular customers and their own ability to service those needs.

I have

little doubt that most lending institutions will make a concerted effort to
meet, as best they can, the legitimate needs of their regular customers.




The Federal Reserve plans to follow closely developments in all
sectors of the credit market, seeking to spot distortions in credit flows
that may emerge.

As part of this monitoring, we are requiring monthly or

quarterly reports from selected banks that detail, among other things, the
nature of their lending programs and the volume of credit flows to particu­
lar groups, especially small businesses.

We are asking what steps have

been taken to implement the guidelines and for explanations when lending
patterns appear to violate them.
finance companies.

Similar information will be sought from

Large businesses are on notice that they should not turn

to the commercial paper market to replace other credit, as such a shift would
reduce the residual credit available for other borrowers.
Let me reiterate, however, that these measures can not prevent
small, and indeed all, businesses from encountering strains in coming months.
As I stated in October, the process of breaking the inflationary grip in our
economy will not be a painless one.

But only by obtaining some degree of

price stability can we create an environment in which small business can

Once the inflationary spiral is broken we may expect to see inter­

est rates move down, with particular benefit to small businesses.


the procedures adopted by the Fed in October promise a more prompt decline
in rates once demands for money and credit ease than in the past.


a reduction in inflationary expectations, however, we have no hope of lower­
ing interest rates over the longer-term.

Such a reduction can only occur

when businessmen and consumers become convinced that all branches of govern­
ment have truly recognized inflation as our 1 number one problem1 and have
taken the necessary--often painful— steps to deal with it.

I believe that,

with time, successful implementation of the March 14 program by the Fed,




along with fiscal restraint exercised by Congress and the Administration will
have this effect.

We will emerge on the other side of these troubles, a

stronger nation, with heightened dedication to the provision of a stable
economic environment in which all sectors of our economy have the opportunity
to flourish.