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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

United States Senate

March 15, 1978


Mr. Chairman, I welcome this opportunity to meet with the
Senate Budget Committee as it considers the Federal budget for fiscal
year 1979.

The Federal Reserve and the Congress both have important

parts to play in shaping the future course of the national economy.
Discussions, such as this today, of our economic prospects and problems
can enhance mutual understanding and thereby aid in the development of
constructive monetary and fiscal policies.
The performance of the economy over the past year or so has
been marked by some notable achievements.

Gross national product rose

5-3/4 per cent during 1977—about the same rapid pace as we experienced
on average in the earlier stages of the current economic expansion.
This brisk increase in production made possible a reduction in the over-all
unemployment rate of more than a percentage point despite extremely
large growth in the size of the nation's labor force.

Total employ-

ment increased more than 4 million, raising the proportion of our
population that is employed to the highest level of the postwar era.
The advance of production and employment last year was
broadly based, as most of the major sectors of aggregate demand registered good gains.

Consumer spending followed an uneven course during

1977, but for the year as a whole growth was substantial by historical

Residential construction continued to provide considerable

impetus to expansion, with single-family housing starts reaching an
exceptionally high level and multi-family building also posting appreciable gains from earlier depressed levels.

Business spending for

plant and equipment expanded more rapidly in 1977 than it had earlier

-2in the recovery, although such investment continued to lag well behind
its performance in previous cyclical upswings.

And the growth of

government spending on goods and services--at both the Federal and State
and local levels — also picked up last year.
Although last year's sizable gains in employment and income
brought a greater measure of prosperity to millions of American families,
we cannot afford to overlook some distinctly negative economic developments that occurred in 1977 and that will require our continued attention
in the months and years ahead.

As news headlines have highlighted in

the past few months, 1977 saw a substantial further widening of our
foreign trade deficit and a sharp decline in the value of the dollar in
international exchange.

Furthermore, the nation continued to suffer

from a disturbingly rapid inflation.
The deterioration in our trade balance, which really began
more than two years ago, partly reflects the success we have had in
rebounding from the deep recession of 1973-1975.

As domestic income

has recovered strongly, so too has the demand for imported goods.


of course, includes oil, for which we ! ve become increasingly dependent
on foreign sources.

Meanwhile, our trading partners by and large have

experienced more sluggish economic expansion, and this has both limited
their demand for U.S. exports and intensified their interest in penetrating the !LS. market*
The link between the U.S. trade balance and the international
value of the dollar is a loose one.

In fact, the average value of the

dollar in foreign exchange markets rose almost continuously from early

~31975 to mid-1976 and then remained steady through mid-1977, even though
the U.S. trade position was moving from surplus to substantial deficit
throughout this period*

Since mid-1977, however, a growing concern

about the persistence of our deficit appears to have contributed
importantly to the downward pressure on the exchange value of the
This concern is based in part on the fact that, in contrast
to the slower rates of wage and price advance recorded by some other
major industrial countries last year, inflation showed no sign of
abatement in the United States.

Moreover, as one surveys the economic

prospects for 1978, it is difficult to be optimistic about progress in
curbing inflationary pressures.

Because wage increases continued to

outstrip gains in output per hour worked, unit labor costs in private
industry rose by almost 6 per cent last year, and these higher costs
will be feeding through to prices for some time.

The recent increase in

the minimum wage has added further to labor costs.

The same is true of

increases in employer contributions for social security and unemployment
insurance, although they have some offsetting impact on inflationary
pressures through the reduction of the Federal deficit.

In addition,

the depreciation of the dollar is raising the prices of imports and
reducing competitive restraints on domestic prices.

And the surge over

the past several months in the prices of basic industrial commodities and
agricultural products suggests additional upward pressures on the
structure of costs and prices.


Even though the outlook for inflation is not bright and
must be regarded with concern, prospects for production and employment
in 1978 seem generally favorable.

It is the Federal Reserve's judgment

that trends in the economy favor continued expansion at a moderate
rate in real gross national product and a further reduction in the
rate of unemployment.
As 1977 drew to a close, aggregate demands for goods and
services were strong; final sales in the fourth quarter showed the
largest gain of the year.

Severe winter weather and the coal strike

have caused steep declines in some economic indicators in the past
two months; but if there is a prompt resumption of activity in the
coal industry, the favorable underlying trends in the economy can be
expected soon to reassert themselves.

Growth of employment and real

disposable income has been strong in recent quarters, and consumer
sentiment has remained fairly high.

Consumer spending, therefore,

is likely to grow at a reasonably good pace.

In the business sector,

new orders for nondefense capital goods have continued to trend upward,
pointing to further expansion in business fixed investment.


addition, the rate of inventory accumulation should accelerate in
coming months; inventory investment slowed in the fourth quarter,
and stocks are now lean in many product lines.

Moreover, with prospects

for our exports improved by the likelihood of stronger economic growth
abroad this year and by changes in relative currency values, we are

that our foreign trade deficit will not deteriorate further.


Our generally favorable assessment of the outlook for
economic activity is also based on our judgment that financial
conditions remain supportive of continued economic expansion.
for money and credit were exceptionally strong last year,


Total borrow-

ing reached record levels-—both in dollar terms and as a proportion of

And growth of the monetary aggregates tended to equal or, in

the case of the narrow money stock (M-l), to exceed the upper ends of
the ranges set by the Federal Reserve.
Recognizing that such rapid monetary expansion—if sustained—
would threaten a build-up of inflationary pressures, the Federal Reserve
between April and October exerted increasing restraint in the provision
of bank reserves relative to the strong demands for them.

More recently,

in early January, the System fostered a further firming in money market
conditions through adjustments in the discount rate and in open market
operations—these actions being taken to help stabilize conditions in
foreign exchange markets and to emphasize U.S. concern about the integrity
of the dollar.
Over-all, since last April short-term market rates of interest
have risen about 2 percentage points•

Intermediate- and long-term

yields also have risen, with the increases largest in the market for
Treasury securities, where rates have gone up 3/4 to 1-1/2 percentage

These increases in yields on long-term securities may well

have reflected some increase in the inflation premium, as investors


reacted to the lack of progress in reducing inflation.


despite the increases of the past year, most short-term rates are
still less than 1 percentage point above their levels at the beginning
of the present economic expansion in early 1975, and corporate and
municipal bond yields are significantly below their levels then.
Growth rates for all the monetary aggregates have slackened
appreciably, on average, in the last few months.

Growth of M-2 and

M-3 has slowed in part because the rise in interest rates on market
instruments has made them more attractive to some savers than interestbearing deposits at banks and thrift institutions.

At the same time,

however, demands for loans at depositary institutions have remained

Under the circumstances, these institutions have had to

supplement their deposit flows by borrowing and by reducing their
holdings of liquid assets.
Although these pressures may be causing depositary institutions
to become a bit more cautious in their lending policies, credit supplies
still appear to be ample.

Moreover, the financial condition of the

key nonfinancial sectors remains generally strong.

It is true that

household debt burdens, as measured, for example, by the ratio of
consumer and mortgage loan repayments to disposable income, are
historically high, and they deserve careful monitoring.

But to date,

there has been no rise in delinquency rates, so that families are
thus far handling their increased indebtedness well.



added further to their liquid assets last year, and corporate
balance sheets on the whole seem to be strong, although there is
considerable variation from firm to firm.

And State and local

governments, with record operating surpluses in 1977, appear in the
aggregate to enjoy a healthy financial position.
Last week, in testimony before the House Banking Committee,
I announced the growth ranges for the monetary aggregates that the
Federal Open Market Committee has established for the year ending with
the fourth quarter of 1978.

The range of increase specified for M-l

is 4 to 6-1/2 per cent; for M-2, it is 6-1/2 to 9 per cent; and for
M-3, it is 7-1/2 to 10 per cent.

Growth in each of the aggregates is

thus expected to be less than was experienced last year.

In the

judgment of the Committee, these ranges should be consistent with the
pattern of economic activity that I outlined earlier—namely, moderate
economic expansion, sufficient to produce some decline in the unemployment rate.

While it is not anticipated that any significant reduction

will be achieved in the rate of inflation this year, the Committee
believes that the deceleration in monetary expansion implied by the
current ranges will contribute to the ultimate achievement of reasonable
price stability.
We recognize, of course, the considerable uncertainties surrounding the shorter-term relationship between growth rates of the
monetary aggregates, on the one hand, and the behavior of output and
prices, on the other.

The Federal Reserve will continue, therefore,

-8to maintain a vigilant and flexible approach, putting the long-run
performance of the economy above the pursuit of any fixed monetary
I must emphasize? however, that the solution to the nation's
problems of high unemployment and rapid inflation does not rest with
monetary policy alone.

More stimulative monetary action would perhaps

have some positive effect on output and employment for a time, but the
resultant intensification
reversal of those gains.

of inflationary forces would soon lead to a
A significantly more restrictive monetary

policy, in the face of the strong upward trends built into financial
flows by rising costs and prices and the prospective heavy credit
demands from the private and public sectors, would run the risk of
serious market disruption and economic dislocation.

Clearly, other

tools of public policy must be marshalled in the effort to improve
economic performance.
A major objective of our efforts must be to quicken the
growth of labor productivity*

Improving labor productivity—besides

being the principal source of rising living standards for our people-serves to retard the advance of unit labor costs.

This, then, is a

key element in slowing inflation and in increasing the competitiveness
of U.S. industry in international trade.
Despite some pickup in productivity growth recently--as
usually occurs during a business upswing--the longer-term pattern
has not been encouraging.

During the past decade output per hour

worked in the private business sector rose at an average annual rate


of only 1-3/4 per cent, roughly half the rate of advance recorded
over the preceding 20 years.

A significant cause of this lagging

productivity growth has been the poor performance of business capital

For many years, the United States has invested a smaller

proportion of its total output in new plant and equipment than have
most other industrial nations.

Though international comparisons are

imprecise, it is clear that the share of GNP devoted to nonresidential
fixed investment in the United States has been less than half the
share allocated in Japan and considerably less than the shares in
Germany, France, and Canada as well.
Experience has taught us that substantial investment in plant
and equipment is a critical ingredient for longer-term economic growth.
Furthermore, an ample capital stock is necessary if we are to avoid
production bottlenecks that stifle expansion in output and employment
and that aggravate inflationary forces.

The encouragement of greater

capital spending must, therefore, be an integral part of any comprehensive national policy to achieve full employment, price stability,
and a sound dollar internationally.

Our efforts in this regard should

be directed at both increasing the flow of savings available to private
businesses and increasing the willingness of firms to undertake
productive investment.
An important step toward assuring an adequate flow of savings
to the private sector is the careful management of Government finances.

-10The record here has not been good.

As the members of this Committee

well know, the Federal budget has been in deficit every fiscal year
but one since 1960.

In periods of high unemployment and inadequate

total demand, Federal deficits may provide a needed stimulus to
aggregate economic activity.

As the economy moves toward fuller

utilization of its resources, however, Federal deficits beome competitive with private capital formation.

The Congress has made progress

in reducing an evident bias toward deficit spending by establishing
improved procedures under the Budget Act of 1974.

This Committee,

which was created by that Act, has worked hard to exert better control
over the Federal budget.

I hope that its efforts, in combination with

a growing public awareness of the danger of persistent governmental
deficits, will prove effective in helping to narrow the gap between
Federal outlays and expenditures as full employment is approached.
Along with freeing financial resources for use by the private
sector, we must encourage businesses to step up their spending on new
plant and equipment.

New investments are made when the prospective

rate of return is sufficiently attractive and predictable.


traditional Government approach to increasing the rate of recovery of
fixed investment costs has been to reduce corporate income tax rates, to
accelerate depreciation allowances, and to liberalize the investment
tax credit.

These policies would help induce an acceleration of capital

spending today.

-11The effect of such actions, however, would be blunted unless
measures also are taken to reduce business uncertainty about the future.
In the past few years, heightened uncertainty has become a significant
impediment to the willingness of

businesses to undertake new capital

While this uncertainty has a variety of causes, including

unresolved tax and energy policies, one important source is the fear
of high and volatile future rates of inflation over the life of the

Rapidly rising prices bring unpredictable costs and

uncertain profit margins; they exacerbate public pressures for controls;
and—as we have learned—they increase the likelihood of subsequent

It is most difficult for businesses to calculate a rate of

return that is acceptable in an environment of rapid inflation.


over, inflation also contributes directly to the cost of modernizing
and replacing obsolete equipment.

With depreciation allowances based

on the original cost of equipment, the gap between the original cost
and resources available for replacement x>ridens as prices rise.
Our attempts to restrain inflation by using conventional
stabilization techniques have been less than satisfactory.


years of high unemployment and underutilized capital stock have been
costly in terms both of lost production and of the denial to many
of the dignity that comes from holding a productive job.

Yet, despite

this period of substantial slack in the economy, we still have a serious
inflation problem.


Prudent monetary and fiscal policies are, of course,
essential if inflation is to be controlled.

But such policies need

to be complemented by programs designed to enhance competition and to
correct structural problems in particular labor and product markets.
And ; any program to control inflation would be incomplete without a
conscious effort to avoid, where possible, those government initiatives
that place upward pressure on prices.

There can be little doubt that

government has become a significant contributor to the inflationary
bias of the economy—-not only by incurring persistent budgetary
deficits, but also through regulatory and other actions.

It is time

to search for alternative, less inflationary methods to achieve our
social goals.
Mr. Chairman, I have discussed today a number of economic
difficulties confronting the nation.

However, our history amply

demonstrates the x*esilience and problem-solving capacity of the
American people and their economic institutions.

The prospects for

overcoming our current difficulties thus are promising, if government
pursues policies that provide a stable and healthy environment.for
American enterprise.

We must recognize, of course, that results will

not come quickly; but if we set our course and pursue it with patience,
we can look forward to a better economic future for our nation.