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SEMI-ANNUAL REPORT ON MONETARY POLICY

Statement by

Go William Miller

Chairman, Board of Governors of the Federal Reserve System

before the

Committee on Banking, Housing and Urban Affairs

United States Senate

November 16, 1978

Mr. Chairman, members of this distinguished Committee,
events in recent months have presented a formidable challenge to
our nation.

While sustained economic expansion has led to higher

levels of output and employment, continuing domestic inflation and
a sharp decline in the value of the dollar on foreign exchange markets have posed growing threats to the vitality of the U.S. and
world economies.

Monetary policy is being directed forcefully toward

helping to resolve these urgent problems.
The objective of the Federal Reserve has, for some time
now, been to foster monetary and financial conditions that would lead
to a reduction of inflationary pressures, while encouraging continued
moderate economic growth.

Real gross national product rose at a 4 per

cent annual rate, on average, during the first three quarters of this
year, as compared with 5-1/2 per cent over the course of 1977.

This

slower pace in the expansion has been sufficient to achieve substantial
further gains in employment, but at the same time it has avoided a
significant overshoot of general levels of resource utilization that
would have intensified inflationary demand pressures in labor and product
markets.
Even so, there has been a marked pick-up in the rate of inflation.

For example, consumer prices have climbed at an annual rate of

9-1/2 per cent so far this year.
to this development.




A number of factors have contributed

Reduced supplies of some agricultural cdtamodities—

« 9 —

especially meats—have caused sharply higher food prices.

Legislated

increases in the Federal minimum wage and in employer contributions for
social security and unemployment compensation have boosted labor costs.
Wage gains have been somewhat larger this year than last, on average,
while our productivity performance has been lagging.

And the depre-

ciation of the dollar in' international exchange has raised the prices
of imports and weakened competitive restraints on the prices of domestically produced goods.
With a heavy calendar of collective bargaining in prospect
for 1979, and with wage demands likely to be intensified by recent
price advances, the threat of a further escalation of labor costs is
very real.

Furthermore, scheduled increases next year in the minimum

wage and social security taxes will again provide a significant inflationary impulse to costs.
President Carter has announced a major program to break the
self-destructive cycle of wages chasing prices and prices chasing wages.
The program includes quantitative guidelines that establish standards
for constructive behavior on the parts of labor and management.

In

addition, the President has indicated that he will seek to eliminate
needlessly costly and anti-competitive regulation.

He has also committed

his Administration to the containment of Federal spending and greater
fiscal restraint.
On November 1, the Administration's anti-inflation program
was fortified by the joint actions of the Federal Reserve and Treasury




o
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to strengthen the dollar in exchange markets.

The Federal Reserve

discount rate was raised by one percentage pointy and reserve requirements on large denomination time deposits were increased.

In addition,

$30 billion in key foreign currencies were mobilized for exchange
market intervention.

The speculative assault on the dollar in inter-

national currency markets had depressed its exchange value well below
what could be justified on the basis of fundamental economic considerations.

The psychological momentum of the markets, if not broken,

threatened to worsen our inflation problem and to undermine confidence
at home and abroad.

The clear willingness of the United States to

intervene actively in exchange markets and the monetary actions of the
Federal Reserve have led to a rebound in the exchange value of the
dollar and a more stable market environment.

This should be beneficial

for domestic price performance in the period ahead and bolster confidence
in the nation's economic policies.
If the cooperation of business and labor that is so essential
to the success of the Administration's anti-inflation program is to be
obtained and if we are to gain the fullest benefit of the recent dollarsupport initiatives, it is absolutely essential that monetary and fiscal
policies demonstrate prudent restraint.

If inflation is to be gradually

slowed, aggregate demand must not be permitted to expand to the point
where it presses excessively on available supplies of labor and industrial
resources.




This means that real GNP at this juncture probably should not

grow at an annualized rate much above 3 per cent, in line with' the

- 4prospective growth of potential output.

Nor, of course, do we

want to see a protracted shortfall from that pace that would bring
on recession and underutilization of labor and productive capacity.
Recent trends in the economy and in financial markets
suggest that expansion likely will be sustained, but at a more moderate
pace over the next year or so.

One noteworthy development has been

the less robust pattern of spending by households following exceptional strength earlier in the cyclical recovery.

Personal consump-

tion expenditures rose at an estimated annual rate of less than 3 per
cent in real terras during the first three quarters of this year, after
having advanced at an average rate of 5-1/2 per cent in the preceding
2-3/4 years.

Rising costs of foods and other necessities have put

substantial pressure on the budgets of many families, and the proportion of disposable income spent has been unusually high.

Record levels

of borrowing have played an important role in supporting consumer outlays, and the heavy repayment burdens households face are likely to be
an increasing constraint on spending in the forthcoming year.

As a

consequence, personal consumption expenditures probably will no more
than keep pace with increases in personal income.
In addition, financial factors should induce some tapering
off in homebuilding

in 1979.

To date housing starts have remained

on a high plateau, but the effects of recent increases in interest rates
will soon begin to show through.

The new 6-month certificates, intro-

duced in June, have enabled thrift institutions to avoid the disinter-




- 5 -

mediation that has curtailed mortgage credit availability in the past,
but they have not sheltered the housing market from the effects of
higher interest rates.

Builders already are experiencing steeper

rates on construction loans, for which charges tend to move in step
with the bank prime business loan rate, and the stock of loan commitments for permanent mortgage financing made earlier at lower rates is
being depleted.

The combined effects of higher mortgage rates and

inflated house prices on the cost of home ownership is likely to bring
about some decline in building—although nothing approaching the disastrous drops we've seen in the past seems in store.
Business investment meanwhile should remain supportive of
economic expansion.

Inventories by and large are quite lean in relation

to current sales levels, and even with a continuation of cautious inventory policies, businessmen likely will wish to expand their stocks in
line with rising sales.

As for spending on plant and equipment, a

recent private survey of investment intentions suggests only a modest
increase next year in real terms.

On the other hand, contracts and

orders for new plant and equipment have been running well ahead of
year-earlier levels—even after adjustment for inflation.

In general,

the willingness of businessmen to commit funds for major investment
projects will hinge in large part on the success of efforts to control
inflation, and thereby provide the basis for greater confidence in the
future health of the economy.




- 6 -

The foreign trade sector represents an element of strength
in the economic outlook.

The U.S., trade deficit should continue to

shrink as a result of the stronger growth in prospect for some of our
major trading partners and as a result of the effects of past exchange
rate changes on our competitive position.
In all, it is my expectation that real GNP will increase by
roughly 2-1/2 to 3 per cent in the year ending with the third quarter
of 1979.

With labor force growth unlikely to be so rapid as in the

past couple of years, this rise in activity should be enough to keep
the unemployment rate in the 5-3/4 to 6-1/4 per cent area.
In this projection I have assumed that inflation will slow
into the 6-3/4 to 7-1/2 per cent range.

There are as always many

uncertainties on the price front--the effects of weather on crop harvests
and the decisions of the OPEC cartel, for example, are factors beyond
the sphere of economic analysis.

What is clear is that the cost increases

already in train will be placing continued pressure on the price structure, so that it will be difficult to break the momentum of inflation.
However, if there is general compliance with the Administration's guidelines, the advance of prices next year could be held to around the low
end of the range I f ve projected.

This would represent a substantial

deceleration from the 8-1/4 per cent increase in the GNP deflator
expected for this year, and would be a good start in the difficult
process of restoring price stability.




- 7 -

The recent credit-restraining actions of the Federal Reserve
have aroused fears in some quarters that an overly restrictive monetary
policy might precipitate an economic downturn.

There is no doubt that

domestic credit markets are tauter than they were 6 months ago.

None-

theless, current financial conditions appear consistent with the moderate economic expansion that is desirable at this juncture.
The Federal Reserve has been moving its policies in a progressively less accommodative direction this year in an effort to prevent excessively rapid growth in money and credit.

In an environment

of inflation and heightened inflationary expectations, borrowers have
become willing to pay higher rates of interest in order to obtain credit
to finance acquisition of assets whose values they anticipate wj.ll be
rising more rapidly.

This phenomenon is most clearly seen in the real

estate market, but the behavior is common in other sectors as well.

To

hold down nominal rates of interest in such a circumstance is to invite
a credit-financed surge in aggregate demand that would add further to
inflationary pressures.

Consequently, the Federal Reserve has pursued

policies that have permitted market rates to rise appreciably this year.
Yields on Federal funds and other short-term instruments have increased
more than 3 percentage points since the beginning of 1978, while interest
rates on long-term bonds and mortgages have risen about one percentage
point.
These are sizable movements, to be sure, but the fact is that,
even at current levels, real rates of interest—that is, actual rates




adjusted for inflationary expectations—are not very high and credit
remains in adequate supply to finance a volume of spending that is
appropriate in light of the availability of real resources in the
economy.

Usury ceilings, which are unrealistic in relation to present

market interest rates in many states, are cutting into credit availability in some local markets, and it would be desirable if these
obstacles to the efficient operation of our financial system were
eliminated.

But there has been nothing like a general "credit crunch,11

and we do not foresee one.
It is the intention of the Federal Reserve to work toward a
gradual deceleration of monetary and credit expansion to a pace consistent with price stability.

The speed with which we can move in that

direction without severely disrupting economic activity is limited by
the degree to which inflation has become embedded in our economy.
some progress has been made in the past year.

But

While M-l growth over

the past four quarters—at 8 per cent—was about the same as in the
previous year, growth in M-2 and M-3 decelerated to rates of 8-1/4 and
9-1/4 per cent, respectively.

Growth in these broader aggregates was

3 to 3-1/2 percentage points slower than in the previous year.

The

actual growth in M-l over the past four quarters was well above the
4 to 6-1/2 per cent range set for this aggregate, but growth in the
broader aggregates was within their ranges.

To have achieved sig-

nificantly lower growth rates for the monetary aggregates than actually
developed would have required substantially higher market rates of




- 9 -

interest and a sharper curtailment in credit supply, which in our
judgment would have run an unacceptably high risk of wrenching
financial markets so severely as to lead to an economic recession.
Growth in the monetary aggregates has to be evaluated in
relation to basic economic and financial forces affecting the public's
preferences for money in its various forms.

During the past four

quarters growth in nominal GNP remained very rapid as moderate expansion in real output was accompanied by an accelerated rate of price
increase, generating a substantial demand for money—particularly
M - l — t o finance transactions.

Federal Reserve policy did not

fully accommodate these strong demands, and, in fact, the rate*of
growth in real money balances actually slowed.
The pattern of growth in the broader aggregates has been
strongly influenced by the introduction at banks and thrift institutions in June of this year of the 6-month money market certificate
whose ceiling varies weekly with changes in the auction yield on 6-month
Treasury bills.

Growth in savings and small-denomination time deposits

subject to Federally regulated interest-rate ceilings had slowed markedly in the fall of 1977 and in the first half of this year as higher
yields on market securities increasingly attracted funds that would
otherwise have been held in accounts at banks or thrift institutions.
In order to enable these institutions to compete more effectively for




- 10 -

lendable funds, the Federal Reserve and other regulatory agencies
created two new deposit categories—an 8 per cent, 8 year certificate
and the money market certificate.
The money market certificates have proven especially successful.
They have been widely offered, most frequently at the ceiling rates,
and have resulted in a marked pick-up in consumer-type deposit growth.
Growth in deposits at savings and loan associations and mutual savings
banks, which averaged 6-3/4 per cent at an annual rate in the first
5 months of 1978, has averaged 13 per cent since the introduction of
the new accounts.

This growth has permitted thrift institutions to

increase their commitments for mortgage loans while reducing their
dependence on borrowed funds and stemming the decline in their liquidity
positions.

At commercial banks, which are at a quarter percentage point

rate disadvantage relative to the thrift institutions, there has been a
less marked, but still noticeable gain in growth of the combined total
of savings and small time deposits — from 3-3/4 per cent through May, to
6-1/2 per cent in the past 5 months.

Nonetheless, with bank credit

demands remaining strong, banks continued to liquidate Treasury securities and to increase short-term borrowings through such instruments as
large CD ! s and Federal funds in financing these demands.
At its October meeting, the FOMC updated its longer-term
ranges for the monetary aggregates.

Its task was complicated by new

uncertainties associated with the introduction on November 1 of automatic transfer services (ATS) which permit consumers to authorize their




- 11 -

banks to shift funds from savings to demand deposit accounts as needed
to cover checks written.

The major impact of this innovation should

be on M-l, as consumers take advantage of the opportunity to reduce
their holdings of non-earning demand deposits, but the size of this
effect cannot be projected with any real precision.

M-2 and M-3

will be less affected because shifts of funds from thrift institutions
to banks, and also from market instruments to deposits, are likely to
be comparatively modest.
Against that background, the continuity in the FOMC's objectives with respect to the monetary aggregates for the one-year period
from QIII:1978 to QIII:1979 is more clearly indicated by the broader
aggregates M-2 and M-3,

The Committee re-established the ranges for

these two aggregates at 6-1/2 to 9 per cent and 7-1/2 to 10 per cent,
respectively.

It is expected that growth in these aggregates will be

well within these ranges as monetary policy pursues a course of responsible restraint to complement the Administration's program to combat
inflation through fiscal discipline, wage and price moderation, and
regulatory reform.

The Committee anticipates growth in bank credit

at an 8-1/2 to 11-1/2 per cent rate to be associated with the ranges
adopted for the monetary aggregates.

With regard to M-l, the FOMC

expects growth within a range of 2 to 6 per cent over the QIII:1978
to QIII:1979 period.

The existing 4 to 6-1/2 per cent range has been

lowered because the public can be expected to shift funds to take




- 12 -

advantage of the ATS service, and the range has been widened because
of uncertainties about the speed and extent to which the public may
undertake such shifts.
Because of uncertainties about the relationship between M-l
and the transactions demand for money during the transition to the new
ATS service, and in view of the widening role in financing transactions
played by savings accounts, the Committee also indicated a growth range
for Mrl-f-

(M-l plus savings accounts at commercial banks, NOW accounts,

demand deposits at mutual savings banks, and credit union share drafts)
that it expected to be generally consistent with ranges of growth in
the other aggregates.

This range

has been set at 5 to 7-1/2 per cent

over the one year period ending in QIII:1979.
The structure of the domestic payments system has been
changing considerably over the past several years as a result of
regulatory changes and financial innovations.

Deposits in thrift insti-

tutions have been increasingly used for third-party payments.

At banks,

liquidity reserves of the public, as well as funds held against expected
transactions needs, have come to be held more and more outside of demand
accounts.

On the other hand, banks and particularly thrift institutions

have also lengthened the maturity of consumer-type time deposit liabilities, so that some deposits have become less money-like.

And, in general,

distinctions among depository institutions with respect to their deposits
have become increasingly blurred.




Existing measures of the monetary

- 13 aggregates are, as a result, becoming outdated.

The Federal Reserve

is studying possible adjustments to these measures to reflect the
changing institutional environment.

The measure of M-1+ represents

an interim step in this process, while a more comprehensive revision
is underway.

It should be noted that one consequence of these ongoing

changes is a need for more timely and broader reporting of deposit
data—not only from nonmember commercial banks, but also from thrift
institutions.
While monetary aggregates are useful indicators of financial
conditions, the continuing change in the institutional environment and
in public preferences for different deposits indicates that any single
monetary measure, or even a set of several measures, can by no means
be the sole focus of policy.

Thus, a broad range of financial indi-

cators—including nominal and real interest rates, credit flows, and
liquidity conditions--necessarily must be considered in assessing the
stance of monetary policy.
Looking beyond these relatively technical questions about how
best to characterize monetary policy, it is clear that in the present
environment we cannot rely solely on monetary management to contain
inflationary pressures.

It is essential to obtain public cooperation

in the Administration's anti-inflationary program and to exercise
restraint in fiscal policy, if the nation is to achieve a gradual,
orderly reduction in the rate of inflation.

You can be assured that

monetary policy will do its part in achieving that objective.