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For release at 5 p.m. EST
November 21, 1967




Dealing with Inflation
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
at the
University of Illinois
(Centennial Year Lectures)
Urbana, Illinois
November 21, 1967

Dealing with Inflation

Dealing with inflation is not a simple assignment for
citizens or public officials who are responsibly and particularly
involved.

Though inflation is hardly a rare economic malady,

doing something about it still involves overcoming complex and
intractible political obstacles and avoiding excessive strains
on financial institutions and credit-vulnerable sectors of the
economy.
Almost everyone's attitude toward inflation is affected
to some degree by the coloration of personal involvement in
inflationary or anti-inflationary measures.

But doing something

about inflation is not seriously thwarted by pro-inflation
self interest.

The major hurdles for an effective anti-

inflationary public policy are achieving a timely consensus
on the economic forecast, diagnosis and treatment.

And a

consensus is all the harder to reach because of imprécisions
in our analytical techniques and tools for measuring economic
activity and

inflationary developments.

For those who can agree that inflation should not
be a deliberately considered policy alternative there are
two choices, to avoid it in the first place or to arrest it
once it gets under way.

For those who believe inflation's

advantages outweigh its disabilities and that it should be
here for an indefinite stay, there is but one choice in the




-

2-

long run-~the ,,i.nstitutionalízation'•, of inflation.

This

involves restructuring saving and investment instruments
and institutions into equity formats and providing institu­
tional devices for continuously readjusting wage, price,
interest rate., tax and annuity relationships in -¡ome politically
and socially tolerable manner.
While no government, to my knowledge, has explicitly
set out to continuously inflate its price level for an in­
definite period of time, many have about slipped into such a
posture by adopting year after year less than adequate measures
to confine inflationary forces.

Such measures are usually

defended on the ground that inflation i s best curbed by
.
gradual steps which do not risk social and political upheavals
or disturbances inherent in more drastic measures.
It is not necessary to go far in time or space to
illustrate the problems that arise when inflation is persistent
if not endemic.

The cases of Argentina, Brazil or Chile are

all illustrative of persisting inflation of serious proportion
over the past twenty years or more.




This is evident in the

annual percentage increase (December to December) cost of
living in these countries since 1956.

-3-

Argentina

Chlle

Brazil

1957

26

14

15

1958

50

22

33

1959

102

43

33

1960

12

32

6

1961

19

43

9

1962

31

61

27

1963

28

81

45

1964

18

85

39

1965

38

41

26

1966

30

46

17

25

28

25

1967
(annual rate to date)

In all of these countries anti-inflationary policy
has been a continuing public issue and there is no better way
of savoring the nature of the inflation problem and controversy
than to quote some of the polemics.

Let me start with a quote

from Ambassador Alsogaray of Argentina, who was the architect
of economic policy in Argentina (Minister of Economy) in the
period when the annual rate of increase in prices dropped
from 102 to 12:




"Our problem stems from the fact that we have had
20 years of inflation which has generated in the country
certain expectations that are very hard to fulfill.

You




-4-

cannot measure those expectations with the same yardstick
as you measure inflationary signs that crop up in many
other countries, including the United States.

Here you

think in terms of stable money; inflation is considered
a pernicious ill that must be combatted, and it is taken
for granted that once the source has disappeared,
everything will be back to normal.

That way of thinking,

in itself, already constitutes a stabilizing mechanism.
In argentina, on the other hand, we speak of checking
inflation, but few really believe in the probability
of doing it.

Still fewer are prepared to make the

necessary sacrifices.

They have forgotten, besides,

how to live and to work under a stable regime.

They

think and reason with an eye on inflation, which in
itself also tends to unbalance the system even more....
"There is a strong tendency among some officials
and in certain spheres of economists and public opinion,
to proceed 'gradually'.

This idea is expressed thus:

'inflation must be checked, but it must be done "gradually"
so as not to become enslaved to monetary orthodoxy,
keeping in mind all the objectives of the economic
policy and defending those principles to the Inter­
national Monetary Fund, international organizations,




-5-

countries or groups of countries, and pressure groups
that act within and without the Government'.
"I do not agree with this thesis and much less do I
believe that it is applicable to the Argentine case,
where, as I have said, we have become accustomed to
living with inflation during the past 20 years.

The

first thing we must do there is to convince public opinion
that inflation is really going to be attacked and, in view
of the climate that has been created, the problem requires
a very special treatment that positively rejects the
adoption of 'gradual* measures....
"Checking inflation is to the social body what
surgery is to the human body.

No one thinks of performing

an operation gradually and by easy stages.

The patient is

not given anesthetic the first day, the area to be
operated on is revealed the second and the tumor is
removed a week later.

Everything is done quickly, in

one session, the quicker the better, which does not mean
to say that the patient will be 'drastically' cured.

It

is quite probable that he will have to undergo a long and
difficult convalescence.

But, if everything goes according

to plan, energetically and decisively done in order to get
to the root of the trouble, it is also quite probable that

-6-

he will be cured and that after a while he will regain
his maximum strength.
"The social body is no different.

Inflation is

a cancer that must be removed as soon as possible,
cutting in as deep as is necessary.

Moreover, the

operation should be performed in as short a time as
possible, however painful and risky it may be.

This

is the only way to avoid worse ills in the future and
to ensure that the patient suffer as little as possible,
in this case the worker, the businessman, the consumer,
the man in the street."
Ambassador Alsogaray's "gradualism" is not without
its advocates as well as detractors.

Official anti-inflationary

policy in Chile in recent years is often termed "gradualist" and
Carlos Massad, Vice President of the Central Bank of Chile, so
described it in that Bank's Monthly Bulletin in 1965.

He makes

a case for it as follows:




"Faced with an inflation problem which must be tackled
in an integral manner, that is to say, as much in its
basic factors as in the mechanisms through which it is
transmitted, there are at least two alternatives for
anti-inflationary strategy.
"The first is an alternative of violent and drastic
character: to end inflation with one stroke, crush all




-7-

of the sources of inflation and, from this moment on,
continue functioning in a stable economy....
* * *

"What would the adoption of the strategy of a drastic
approach against inflation signify In Chile?....

Unless

we use external resources to an extraordinarily important
extent, it would involve an excessively high level of
unemployment, a very heavy loss of purchasing power for
salaried groups and a most.grave decline in the levels
of production.
"All of this would not be too serious if, after a
period of readjustment of six months or a year, inflation
were eliminated or diminished and there followed a recovery
of the purchasing power of the least protected sectors and
a return to the current level of production.
"The problem is that, in Chile, the drastic approach
does not give time to resolve the basic problems of the
Chilean economy; and as long as these problems are not
resolved, inflationary pressures will continue to exist.
The drastic approach would involve, purely and simply,
a sacrifice, for a brief or long period, but with a
very high probability that it could be a sacrifice
wasted.

In short, so long as the basic defects of the

economy are not corrected in order to avoid the inflationary




-

8-

pressures that they generate, we do not have any hope
of maintaining an economy with permanent stability.
"The second alternative is one which could be
called that of gradualism and firmness.
difficult alternative.

This is a

To choose it implies, on the

one hand, a recognition that the basic weaknesses of
the economy must be resolved concurrently with the efforts
to contain gradually the rate of inflation.

This

alternative consists of an every day struggle against
inflation; and a policy which must be pursued with
all firmness.

And, what is more important, it requires

efforts in a large number of areas, concurrently.

It

must be in effect in the area of the foreign trade, in
agriculture, in wage policy, in price policy, in
monetary policy, in brief, in all of the areas of
the national economy.
"And since it is a policy which requires such a
complete focus, and of necessity opening so many fronts
in economic policy, this alternative requires the
collaboration of all of the sectors of the community«
"This alternative— in my view perhaps the only
reasonable one in the case of the Chilean economy—
requires in a special way the understanding, the effort
and the sacrifice of all the sectors of the community.

-9-

To the extent to which some groups are ready to make
the sacrifice and others are not, those that are
ready to make it are really and effectively swindled.
Because if this national collaboration does not exist,
then the group ready to make sacrifices will do its
part and will make them, in spite of which the global
program will not be able to succeed, or at least will
succeed only with difficulty."
It is apparent from these quotations that the "gradualists"
rely on essentially the same basic measures for curing inflation
that are used by those favoring the shock treatment.

Such

measures would include reduced government deficits, achieved
by expenditure reduction or re-direction and by tax reform or
a higher level of taxation, reduced rates of expansion of money
and credit and direct controls in those sectors of the economy
which are contributing to inflation but are relatively untouched
by general fiscal and monetary actions.
The difference is that the "gradualists" think the
impact of drastic action involves socially and politically
intolerable stresses to institutions and imposes disproportionate
sacrifices on some segments of the community.

They claim, too,

that only a gradual stabilization allows sufficient time for
avoiding serious distortions and spreading the burdens of
adjustment in a socially tolerable way.




-

10-

The major defect in the "gradualist's" approach is
its weak "business as usual" appeal for public support while
the institutionalizing of inflation as a part of the program
of amelioration further undercuts the case for urgency and
adequacy of action.

Once the evident injustices of inflation,

or at least the politically evident injustices, have been more
or less neutralized, the public zeal to deal with the causes
of inflation abates.

And the longer inflation continues, the

stronger grows the case for additional ameliorative measures.
Cost-of-living adjustments become universal and applicable not
only to salary and wage earners but also to annuitants, time
depositors in financial institutions and bond holders.

The

adjustments become more frequent or anticipatory of future
escalation; they are increasingly a matter of wage contract
negotiation or political pressure, not objective fact finding.
To a greater and greater degree, economic life and practices
reflect the assumption of continued inflation.
The experience of Argentina, Brazil and Chile over a
long period of time, to which could be added that of many other
countries, clearly indicates that if we fail to avert inflation
or to cure it, we, too, will have to fall back on methods of
living with it.

Some of these methods can be implemented by

individual decision— others, as I have been saying, become
institutionalized by cooperative effort or by Government action.




-

11-

Some individuals are less concerned with inflation because
they are in a position to arrange longer range investments and
obligations so as largely to neutralize inflationary risks.

Such

countermeasures involve a larger concentration of investment in
equities along with larger and longer term debts, the proportions
being indicated by a personal judgment of the probability and
severity of the inflationary threat.

However, a large proportion

of our citizens have limited opportunities for "inflation-proofing"
their long-term assets or debt positions.

Most insurance and

retirement contracts are heavily exposed and non-home owners
are especially disadvantaged*
While our economy has experienced serious inflation in
wartime we, as a nation, have taken no more than limited or interim
steps in peace time to institutionalize changes in the CPI, for
example.

Thus, in some industries and communities there are some

wage and salary adjustments tied to increases beyond a certain
threshold in the CPI.

There are also sporadic adjustments in

Social Security and Government employee retirement benefits,
reflecting both increases in the price level and in the scale of
living.

In all, these measures do not yet add up to acknowledging

that a continuing inflation requires modifications in our retire­
ment systems, saving instruments, or financial institutions.

Our

public policy is still implicitly and explicitly committed to
averting inflation or to holding it within a tolerance which we
judge may reflect the upward bias in the CPI.

This judgment is

reinforced by the stability of the WPI in most years of the postWorld War II period.




-

12-

Since inflation is easier to ward off than to cure
or live with, there is a considerable premium on early detection,
on being foresighted and knowing when inflationary forces are
brewing.

Unfortunately, there is no reliable early warning

system.

In some sectors of the economy, where expectations

are highly volatile, cries of "inflation”can be heard at almost
anytime but such cries are often not based on fact.
Our intuitive reactions to changing prices are usually
not very perceptive; too often they are conditioned by changes
in income status, geographical and social environment, or to a
general rise in the standard of living which may amount to as
much as 3.5 to 4.0 per cent per year.

Perhaps the most obscuring

factor is the overlooking of "quality" changes in goods and
services.

As consumers, we often term "inflationary" higher

prices than we have previously known for certain items.

But,

in fact, although certain of these items have the same name,
they do not have the same utility we associate with the earlier
lower price.

In reality, of course, we do not want the fabrics of

the Thirties, the transportation modes of the Twenties, or the
pre-supermarket food era, nor pre-miracle-drug medical care.
The official price indexes are the best early indicators
of inflation forces but they, too, have short-comings.

The OTP

deflator and the Consumer Price Index have well-known upward
biases.




The latter has risen continuously since 1955 at an




-13-

average annual rate of about 1.8 per cent; but some of this
rise is due to a change in the products and services measured
rather than a rise in prices.

The Wholesale Price Index is

notoriously sluggish in registering early firming or softening
of prices even though it still provides the most useful basic
data available for a careful analysis of the breadth and
persistency of price trends.

The behavior of the industrial

commodity and manufactured goods components of the WPI are
particularly significant for this purpose.

These components

indicate that our main bout with inflation in the post-World
War II period was in 1950 and early 1951.

Lesser, but more

sustained rises occurred in 1955-56 and in 1965-66.

Since the

middle of this year industrial commodities have been rising at
about a 3 per cent annual rate.
Some observers believe that inflation or deflation can
be predicted from prior changes in the rate of growth in the
money supply.

While this theory is plausible enough to attract

quite a following it is not the type that can be easily
dismissed or endorsed.
As a general proposition, increases in money or, in
more general terms, in liquidity, are likely eventually to lead
to increased demands for goods and services.

If the economy

cannot readily expand to accommodate such an increase in demands
because resources are already fully, or nearly fully, employed




-

14-

we should expect evidences of inflation to begin to appear.
The difficulty with using changes in the money supply
or liquidity, as an early indicator of inflation, lies in the
inability to predict with consistency and accuracy the course
of the economy from changes in the money supply alone.

How

much money or liquidity is appropriate to a particular economic
environment depends on a host of factors: stocks of wealth,
expected income flows, possible shifts in spending propensities,
interest rates and Government fiscal policies to mention some
of the most important.
Given traditional central bank operating procedures,
the dominant factor accounting for period-to-period changes in
the money supply or its rate of growth is often the change in
the transaction and buffering money needs of individuals,
corporations and governments that accompany changes in economic
activity.

There is no reason to attribute to money supply

changes reflecting changes in such needs any significant positive
or negative influence on decisions to spend or not to spend, or
to defer or accelerate some previous investment or spending
decision.

Changes in the money supply to accommodate trans­

action needs are "caused" by the forces emanating from the
tempo of the economy and from decisions made prior to the
recorded changes in the money supply.

In other words, changes

in money are, more often than not, a function of changes in
the economy, rather than the other way around, as some would
have it.

-15It is possible that changes in money stock to
accommodate transaction needs complement a different and more
economically significant type of change in money supply or
mirror, in some complicated pattern, such a change.

If this

were the case, money supply changes might be a useful proxy
variable but it is neither a likely nor very apparent probability.
While some monetary students profess to see in every
country, and at every state of economic development, an under­
lying pattern of money causation of economic behavior, this
possibility seems less and less likely as alternatives to money
as sources of liquidity proliferate and as money itself becomes
less and less desirable in this respect.
Since money statistics are not disaggregated by type
of owner nor segregated so that stocks held for transaction
needs can be distinguished from those held to satisfy liquidity
or other needs, users of money statistics perforce lump all
money holdings together thus masking the statistical evidence
we have available for regarding changes in money supply as a
significant economic variable.

However, it is possible to

achieve some disaggregation of money holdings pertinent to
estimating transaction and liquidity uses.
For example, regardless of what might have been true
in some past periods, it is impossible to believe that coins,
today, perform any liquidity function.

Coins are no longer

treasure or precious metal but purely tokens of a metallic alloy







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16-

best suited to circulation requirements.

Piggy bank hoards,

bureau drawers with Kennedy half dollars and collectors'
"standards" have less than a nominal effect on over-all coin
demand— they certainly have no liquidity effect.
Nor can one attribute much, if any, liquidity
significance to changes in the public's demand for paper currency.
With confidence in the banking system restored, few but the zany,
those wary of the Internal Revenue, and foreigners abroad, have
any desire to use currency to fill or drain a liquidity pool.
None of these incentives to hoard currency are of the type to
generate or dissipate spending proclivities--in short, changes
in the demand for currency and coin are a passive response to
non-economic factors, to technological changes in money settle­
ment methods, or to changes in the tempo of economic activity.
The statistics on coin and currency in circulation bear
this out.

They show that coin has been the most rapidly growing

segment of the money supply throughout the current decade.

This

is mainly because of the vastly expanded requirements for meter
and vending machine operations and accompanying pools of inactive
coin.

Since 1963, coin stock has had an average annual growth

rate in excess of 12 per cent.
At the end of 1966, coin outstanding was almost 100 per
cent above the 1959 level; the comparable increases for small
bills ($1, $2, $5, $10) was 24 per cent, for $20's and $50's,




-1735 per cent, and for large bills ($100 and over), 42 per cent.
In the same interval GNP rose 55 per cent, personal consumption
expenditures 50 per cent and personal consumption expenditures
on nondurable goods 41 per cent.
The inferences to be drawn from these relationships
are almost entirely related to transaction developments.

The

exceptionally large increase in coin is to accommodate metering
and vending machines.

The slower rise in lower denomination

currency reflects an increase in the average size of currency
transactions, and the greater rise in largest denominations
suggests the possibility of some foreign, or concealment use,
of $100 denominations.

The slower growth in the total for all

currency denominations relative to GNP or personal consumption
expenditures certainly does not reflect more efficient paper
money use, as in the case of demand deposits, but a steady shift
toward the substitution of convenience credit and checks for cash.
Coin and currency growth in the decade thus far amounts
to 33 per cent of the total change in the money supply.

Obviously,

this ratio is highly variable on a period-to-period basis mainly
because of the nature of changes in privately-held demand deposits.
However, if the calendar year is taken as the period, and 1960 is
omitted, the proportions from 1961 to 1966 are 16, 50, 34, 27, 28
and 56.

-

18-

The disaggregation of demand deposits to identify
the size and change in private balances for transaction uses
involves more hypothesis and inference than is needed to
evaluate the transaction role of the coin and currency component
of the money supply.

This deficiency we are working to remedy

in the near future by resumption of

our efforts to trace more

accurately and frequently the changes in major categories of the
ownership of bank deposits.

Using information presently available

it can be noted that demand deposits of State and local govern­
ments, for example, are inappropriately included in conventional
money supply definitions because they are not segregated in
daily, weekly or monthly banking statistics.

But these holdings—

largely transaction conditioned— are not inconsiderable.

Call

report data indicate that such balances are about 10 per cent
of the demand deposit component of the money supply.
Demand deposit balances of the Federal Government are
excluded from most money supply definitions; but the frequent
rapid shifts from private to Government accounts around tax
and financing settlement dates, followed by the buildup in
private accounts as Government balances are drawn down, often
dominate short-run changes in the money supply.

On some

occasions they seem to have more than a transaction significance.
The most useful detail on demand deposit balances
would enable the analyst to distinguish among a few major
ownership- and account-size groups.

We know, for example,

that large corporations manage their demand balances more
efficiently than most individuals, and that unneeded balances




-19for transaction purposes are promptly invested in market
instruments or time deposits.

In fact, the size of the

typical corporate balance is based on anticipated transaction
needs including whatever balance requirements are imposed by
banks for services rendered or future access to bank credit.
This behavior of corporate balances is reflected
in the New York City banking statistics which are dominated
by corporate financial transaction.

As is well known, demand

deposit balances in New York have changed little in recent
years--rising only 12 per cent since 1960 and through 1966.
Much of that change probably came as a result of the stiffening
of compensating balance arrangements, either in observance or
enforcement.

But this modest rise in deposits has been adequate

to accommodate a 125 per cent rise in debits because of the
increased efficiency in money management and changing settlement
technology.

These factors are evident in the nearly 100 per

cent rise in turnover.
The behavior of balances outside of money centers,
where corporate balances do not dominate trends in deposit growth,
comes closer to reflecting the average individual depositor's
attitude toward his demand deposit balance and the closeness
with which he manages it.
Increases in deposit balances in over 200 of these
cities averaged 24 per cent which, supplemented by a rise in
turnover of 44 per cent, accommodated the 80 per cent rise in




-

debits.

20 -

This transaction increase compares to a GNP rise of

55 per cent in the same period.
The inferences to be drawn from these proxy measures
of corporate and individual deposit behavior suggest quite clearly
that demand deposits in the United States today are heavily
oriented toward transaction needs.
corporate holdings.

This is especially true of

Liquidity objectives increasingly can be

met with profit and adequate availability by the use of time




deposits in banks and savings and loan associations, and by
investment in money market instruments.
The conventionally defined money supply thus is losing
its liquidity significance.

While it may still incorporate

changing elements o£ great significance for appraising economic
trends the odds are that any such elements are less and less
likely to be discernible.

Rather, the more significant

developments in banks' and other depositories' assets or
liabilities appear to be taking place in the shifting flows
and terms for near monies and the direct participation of
individuals and corporations in money market instruments.
To return to our problem of a short recognition lag,
the answer to the question, is inflation coming, is never
likely to be settled by

some single economic barometer such as change

in the money supply growth.

As of now, the public, Congress

and, to some degree, economists are divided in evaluating the
inflationary implications of the current economic environment
and the projections of future economic activity.

This typical




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21 -

division of view is the characteristic factor that gives
inflationary pressures a head start and lessens the possibility
of warding them off with a minimum of disruptive consequences.
Even if a public consensus could somehow be reached
at an early stage that inflation was coming, the prescription
for a public action would still be controversial, as it is now.
Changes in public spending, taxing, in credit conditions, or
direct restraints on the private economy would be debated as
they are now

along with the proposition that there is no need

for any action.
We have been very fortunate in the current situation
that financial institutions and consumers have been following
conservative lending and spending policies and that the ultimate
objective of monetary restraint— the postponement of some creditfinanced spending— has been achieved to a significant degree
without vigorous Federal Reserve intervention.

In fact,

developments in the capital markets have been productive of
restraint comparable, so far as nominal long-term rates and
postponement of corporate and municipal flotations are concerned,
beyond that experienced in 1966.

Up to this point the consumer

saving rate has been holding at or near 7 per cent but this fact
may become less reassuring insofar as restraint on inflation is
concerned as the rise in disposable income spurts in the months
ahead unless the rate of saving rises also.
historical precedent this is not likely.

And on the basis of




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22 -

With very few exceptions the managements of financial
institutions have been sufficiently concerned about future
depository flows to have added rate and other inducements to
attract time deposits while avoiding terms which might become
disequilibrating.

These steps have produced large flows of

funds and, in the main, have done so without unduly enlarging
institutional exposure to disintermediation even though the
market rates for many maturities of market instruments have
become highly competitive.
On another front lenders generally are observing more
caution in future commitments to their loan customers.

They

are doing so because of a conservative appraisal of the
uncertainties with respect to their own sources of funds, and
just recently because of uncertainties growing out of the
British devaluation.
Despite the assist from financial institutions and
consumers, the source of inflationary pressure today— the
disproportionate deficit in the Federal Government's budget-will soon have to be eliminated in one way or another.

This .

is the easiest way of dealing with inflation and the longer
we delay curative measures the more drastic the subsequent
alternatives become, for, if we will not avoid inflation nor
cure it, we will be forced in the end, and to our great
disadvantage, to live with it and institutionalize remedies
for its injustices as best we can.