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For Release on Delivery

Statement by
G . William Miller

Chairman, Board of Governors of the Federal Reserve System

before the
Committee on the Budget
House of Representatives

July 13, 1978

M r . Chai rman and members of the Committee, I appreciate this
opportunity to meet with you to convey the views of the Federal Reserve
Board on the state of the economy as well as on economic policy issues
facing the nation.
The economy is now in its fourth year of expansion and unemployment has been substantially reduced. However, the nation is beset
by an unacceptably high and recently accelerating inflation, and budget
deficits continue large for this stage of the expansion.

It is essen-

tial that longer-term policies be structured to confront these problems,
while supporting continued growth.
. .

PACE OF GROWTH MAINTAINED RECENTLY
Economic growth, though uneven so far this year, has been on

the whole satisfactory.

As you know, the severe weather and the coal

strike temporarily halted over-all expansion during the winter.

How-

ever, with the subsequent surge in activity—illustrated in the first
chart—growth of real CNP in the first half appears to have averaged
about a 4-1/2 per cent annual rate, close to the average pace over
the first three years of the present expansion.
The vigor of employment growth is one important measure of
the underlying momentum of the economy, and indicates that business has
confidence in the sustainability of the expansion.

The addition of

2-1/4 million jobs so far this year has pushed the unemployment rate
substantially lower—as illustrated in the lower panels of the chart—

-2and supported brisk growth of personal income.

Almost all groups of

workers have benefited from improved job opportunities, though the
unemployment rate remains unacceptably high for minorities and youth.
. .

AND THE NEAR-TERM OUTLOOK APPEARS FAVORABLE
Not surprisingly, recent data indicate some slowing from the

extremely rapid growth of over-all activity during the spring rebound.
Even so, the fundamental determinants of final demand suggest that
economic expansion will be reasonably well maintained in the near term.
In particular, consumer demand remains strong.

Auto sales

continue at extremely high rates following the turnaround that began
in March.

Some of the surge in durable goods purchases appears to

have represented buying in anticipation of further price rises. Gains
in retail sales outside the automotive area have moderated somewhat
recently, but this was to be expected following the extremely rapid
sales pace of February and March.

With surveys indicating a con-

tinued high level of consumer confidence, sustained moderate growth
in income should support further expansion of consumer outlays over
the near term.
The business sector also should continue to be a source of
support to activity.

Inventory policies have been conservative over

the past several years, and businesses have in general thus avoided
the imbalances that interrupted previous expansions.

Various invest-

ment surveys, as well as data on equipment orders and construction

-3contracts, suggest moderate increases in capital spending over the
balance of this year.
In contrast, it appears likely that residential construction
will cease to be the source of support that it has been in this
expansion.

While housing activity currently remains at a high level,

mortgage markets have tightened considerably and it is likely that
residential construction will begin to slacken in coming months,
And growth in State and local government outlays is likely to remain
modest. These jurisdictions have pursued relatively conservative
spending practices and this reluctance to accelerate spending seems
unlikely to change, especially in light of tax relief mandated by
Proposition 13 in California and the possibility of similar actions
elsewhe re. But our net export position, which has deteriorated over
the past two years, should improve somewhat over the next year.
Imports are likely to rise at a slower pace. At the same time, exports
should pick up if activity abroad increases as expected and as the
changes in exchange rates which have occurred over recent months
improve the competitive position of U.S. goods.
. .

INFLATION CONTINUES AS OUR BASIC PROBLEM
On balance, the evidence suggests further moderate growth of

aggregate demand over the near term, sustaining one of the most durable
expansions of the postwar period.
clouded by the price situation.

But the longer term outlook is
During the first three years of the

-4expansion inflation rates were very high by historical standards,
and there has now been a further acceleration of price increases,
as shown in Chart 2.

So far this year consumer prices have

risen at a 10.2 per cent annual rate, as compared to 6.8 per cent
in 1977. A key element in the price surge this year has been the
adverse developments in the food sector, as meat production has
been constrained by an ongoing reduction in the nation's cattle
herds. However, prices outside the food area have also moved up
sharply recently. Retail prices of nonfood commodities and services
rose at an 8 per cent annual rate during the first five months of
the year—up appreciably from the 6-1/2 per cent rate in 1977.
We can expect some relief later this year from a slowing
of food price increases. But with the economy moving into a period
of heavy collective bargaining, the intensified inflation is likely
to be reflected in larger wage adjustments, and a more rapid increase
in labor costs. These costs also will be boosted early next year by
additional mandated increases in social security taxes and in the
minimum wage. The continued interplay of wage and price rises,
coupled with the legislated cost increases, makes it difficult to
anticipate much relief from underlying inflationary pressures over
the next year.
. .

RISING INFLATION AND RISING INTEREST RATES ARE TWO SIDES
OF THE SAME COIN
In the last year or so, private and governmental credit

demands have risen, putting upward pressure on interest rates.

-5At the same time, the recent and expected inflation also has been
an extremely important factor underlying the increase in interest
rates, contributing to money and credit demands and conditioning
the stance of monetary policy. Obviously, inflation increases the
volume of credit necessary to finance any level of economic activity.
Individuals have to borrow more to acquire houses, cars and other
durables. In the business sector, the rise in the dollar volume
of spending on inventories and fixed capital, a significant portion
of which represents rising prices, has outstripped internal funds
generation, producing a marked increase in borrowing this year.
In addition to the direct effect of rising prices on credit
demands, the prevalent expectation that the rate of inflation will
remain extremely high—if not accelerate—has also increased the
demand for goods requiring financing. As noted earlier, the extremely
strong pace of automobile sales recently appears to have reflected
consumer attempts to beat expected price rises. Home sales may
have been similarly buoyed by the perception that waiting can only
result in having to pay higher prices later. Such purchases have
contributed to record instalment debt financing and to substantial
additions to mortgage debt. The volume of borrowing also has been
strengthened by existing home owners withdrawing part of their rising
equity in the housing stock, partly to finance major expenditures
and to otherwise maintain living standards in an inflationary
environment.

-6Borrowers appear to be counting on the general rise in
nominal incomes that accompanies most inflations to help service
their growing debt burden.

This, in fact, has been a major ingre-

dient in the upward pressures on interest rates.

Borrowers are

willing to pay higher interest rates because they expect that their
future debt burdens will be eased by rising nominal incomes;

mean-

while lenders seek higher interest rates in order to protect their
real position.
. .

CURRENT BORROWING LEVELS IMPLY FUTURE RISKS
Moreover, such borrowing has contributed to worrisome distor-

tions in the financial positions of consumers and businesses. For
example, the ratio of consumer and mortgage loan repayments to disposable income is now at a near record level (Chart 3).

Thus far, house-

holds have apparently been able to service this debt with little
problem.

Recently, however, delinquency rates have edged higher,

although they remain well below previous peaks. Nonetheless, the
level of household indebtedness is of concern, since it may constrain
future spending, and could give rise to more widespread financial
difficulties—especially if the rate of income growth were to slow.
In the business sector, the pattern of financing has similarly
begun to cause some concern.

An increasing share of business credit

requirements recently has been met through short-term borrowing,
especially at banks, and businesses have slowed their accumulation
of liquid assets. As a result of these changes in the composition

-7of business assets and liabilities, corporate liquidity has deteriorated recently, although balance sheets remain in considerably
stronger condition than they were in 1974 (Chart 4).
. .

RESPONSE OF MONETARY POLICY
While one would expect strong credit demands as a normal

counterpart of a healthy and growing economy, a significant—and
I am afraid expanding—share of recent credit growth is both the
direct and indirect result of inflation. Moreover, mounting inflationary expectations raise the specter of possible speculative
excesses, leading to a short-run explosion of credit and output,
and subsequently to recession.

The Federal Reserve's firming of

monetary policy has been designed to minimize the possibility of
such an outcome.
In the presence of strong credit demands, the worsening of
inflation, and the Federal Reserve's efforts to contain excessive
monetary expansion, market interest rates have risen signficantly
further.

Most short-term rates have increased by 1 to 1-1/2 per-

centage points since the beginning of the year and long term bond
yields have followed much the same pattern, as illustrated in
Chart 5.

The rise of market interest rates has been accompanied

by slower growth of savings and small-denomination time accounts at
banks and thrift institutions.

As a result, growth rates of broader

monetary aggregates—M-2 and M-3—have remained within the Federal
Reserve's long-run ranges.

-8The slower rate of growth of savings and small-denomination
time deposits has threatened to retard housing activity.

Therefore,

in an environment of rising interest rates, the Federal regulatory
agencies have recently taken action to increase the competitiveness
of bank and thrift deposits subject to regulatory ceilings in order
to maintain the flow of credit to housing.

Two new savings instru-

ments were authorized effective June 1—a variable-ceiling, six-month
certificate, with weekly ceiling rates tied to yields on newly issued
Treasury bills, and an eight-year certificate carrying ceiling rates
of 7-3/4 and 8 per cent for banks and thrifts, respectively.

The

limited available evidence suggests that these new instruments,
especially the defensive six-month certificates, are playing a significant role in helping to sustain net deposit inflows to thrift
institutions, even as market interest rates have risen further.
. .

CONTINUED HIGH DEFICITS A MAJOR PROBLEM
The persistence of large Federal budget deficits at this

advanced stage of our economic expansion Is a disturbing problem.
Businesses and households have had to compete for funds in credit
markets with the public sector, whose borrowing this year has continued at a high level.
During the last recession, large deficits were both a consequence of and a reasonable policy response to the under-utilization of our productive resources.

The Federal government cut taxes

and increased the size of public employment and other spending

-9programs.

Continued large Federal deficits were justified well into

the recovery period, since the expansive impact of Federal fiscal
policy was offset in part by sizable budget surpluses by States and
localities, together with an increasing foreign sector deficit, both
of which drained purchasing power away from the private sector of the
economy. Developments this year, however, suggest that the Federal
government should be moving with deliberate speed to rein in compensatory policies. The level of private sector activity has risen markedly
over the past several years, and there now appears to be much less
usable slack in the economy.

Moreover, the over-all surplus of States

and localities appears likely—in the wake of Proposition .13 in California and related developments—to be swinging back toward balance.
. .

WE MUST REDUCE GROWTH OF FEDERAL EXPENDITURES
Positive steps are thus in order to lessen the government's

competition with the private sector for resources.

The Federal govern-

ment has a constructive role to play in moderating the ups and downs
in economic activity.

In the present circumstances, a damper on

further expansion of Federal expenditures would help to assure a continuation of sustained long-term economic growth.
In my view, the task of reducing the Federal share of GNP
should begin now.

A careful, systematic review must be undertaken

to reduce or eliminate those Federal programs that are ineffective
or that have outlived their usefulness.

We also need to recognize

the limits on government resources when considering alternative
spending proposals.

-10I believe that we should strive to reduce the Federal
government's share of GNP from more than 22 per cent at present
to 20 per cent or so over a period of five to seven years. As
can be seen in Chart 6, such a reduction would not fully return
the government proportion to that of the early 1960's.
As spending is brought under tighter control, government will become less prominent as a borrower in credit markets.
A lower government profile will facilitate the flow of credit to
the housing sector where it is becoming scarce, and to the business sector where it can be put to use in rebuilding our currently inadequate stock of fixed capital.
. .

MEASURES NEEDED TO ENCOURAGE INVESTMENT
Moreover, private capital investment should be encouraged

directly by offering incentives to business to expand their stock
of plant and equipment. Capital accumulation is the chief engine
of long-range growth of labor productivity and rising living standards.
Yet for an extended period, the nation's tax policies have not provided adequate incentives for business investment. In particular,
depreciation guidelines and the resulting deductions have not
approached actual replacement costs in periods of inflation. Present
depreciation-tax laws should be liberalized. For example, businessmen
could be permitted to use a shorter write—off period for machinery,
equipment and structures.

Careful consideration also should be given

-11to present laws that tax corporate profits twice—first at the firm
and then at the stockholder level.
Given the neglect of investment which has eroded the nation's
capital stock, as well as the need to accommodate to the reality of
scarcer and more expensive energy, a larger share of GNP must be
devoted to capital investment. It will not be enough simply to reach
the investment proportion of 10-1/2 to 11 per cent that has been characteristic of past periods of prosperity and low unemployment.

In

my opinion, the nation must set an ambitious goal o f , say, 12 per
cent of GNP for an extended period—a level that would support
increased growth and productivity.
. . STRUCTURAL REFORMS ARE ALSO NECESSARY
Establishment of a high-growth, low-inflation economy would
be facilitated by extensive reform of costly governmental regulations.
Regulatory activities in the health, safety and environmental protection areas may not always achieve the desired outcome at minimum
costs, and they need to be reviewed with that thought in mind.

Simi-

larly, market- and price-regulation programs should be carefully
reexamined to ensure that their benefits outweigh their costs. In
this connection, the President's recent executive order to improve
the regulatory process is most encouraging and it deserves the fullest
possible support and cooperation.

-12In the same vein, it is important that we carefully consider
alternatives for those programs that tend to limit competition and
raise prices.

Notable examples are import controls, price supports,

and the Davis-Bacon and Walsh-Healy Acts.

In addition, it seems

appropriate to consider deferring the increase in the minimum wage
that is scheduled for January 1, 1979, given its implications for
costs and for youth employment opportunities.
To conclude, it is my belief that a reduction of budget
deficits and restructuring of taxes to help investment, along
with prudent monetary management by the Federal Reserve, should,
over time, lead to an economy that enjoys sustained growth, price
stability and a sound dollar,

Chart t

CURRENT ECONOMIC INDICATORS
Per cent change

Per cent change

8

Total Construction Spending

Industrial Production

2.0

1.0

fin
nnnn

+
o

n

n

1.0
J

1977

F

M

A

J

M

1978

+
o

fin

1977

F MAM
1978
Millions of units

Billions of dollars

Auto Sales
10

Foreign

19 77

J FMAM J
1978

J

F

1977

M

A M

J

1978
Per cent

Millions of workers

Unemployment Rate

1977

J F MAM J
1978

J

1977

F

M

A M

1978

J

Chart 2

MEASURES OF AGGREGATE INFLATION
PERCENTAGE CHANGE FROM PREVIOUS PERIOD, ANNUAL RATE
GROSS DOMESTIC BUSINESS PRODUCT
Fixed-Weighted Price Index

I l
i
1975

1977

1976

Q1

1978

'79

CONSUMER PRICES
All Items

I ,
1975

1976

Docember—
May change

1977

1978

'79

PRODUCER PRICES
Total Finished Goods

. illl.
llll

DecemberJune change

1975

1976

1977

1978

'79

Chart 3

HOUSEHOLD BORROWING

Annual rate, billions of dollars

Instalment Debt

1974

1975

1976

1977

1978

HOUSEHOLD DEBT REPAYMENTS

* Monthly net change in amount outstanding of Total Consumer Instalment Credit

Chart 4

CORPORATE FINANCE

Balance Sheet Ratios

Per c e n t

Short-Term Debt to
Total Debt
1974

1975

1976

1977

1978

Chart 5

Per cent

INTEREST RATES

Aaa Utility Bonds
New Issue

Prime Commercial Paper

90-119 Day

,

3-Month Treasury Bills

1974
• Week of July 5th

ii
•

1975

1976

1977

1978

Chart 6

BUDGET OUTLAYS AS A PER CENT OF GNP

Per cent

25

15

'55

'60

'65

'70

75

'78