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FOR RELEASE ON DELIVERY TUESDAY, JULY 6, 1982 1:00 P.M. EST A PERSPECTIVE ON FEDERAL RESERVE POLICY Remarks by Henry C. Wallich Member, Board of Governors of the Federal Reserve System at a Meeting of the Steuben-Schurz Society and the U.S. Chamber of Commerce Frankfurt, Germany July 6, 1982 A PERSPECTIVE ON FEDERAL RESERVE POLICY Remarks by Henry C. Wallich Member, Board of Governors of the Federal Reserve System at a Meeting of the Steuben-Schurz Society and the U.S. Chamber of Commerce Frankfurt, Germany July 6, 1982 I am honored to have the privilege to address this distinguished Frankfurt audience on the subject of Federal Reserve policy. States is facing, at this time, a great opportunity. The United Inflation has been brought down significantly and the economy seems to be bottoming out. The stage therefore is set for entering upon a period in which the object ives of greater price stability, lower unemployment, and faster growth can all be achieved. An essential condition of success is a continuation of a stable and restraining monetary policy. Ending Inflationary Cycles The principal objective of the monetary policy that we must continue to follow, as I see it, is to put an end to the process which, over a long succession of business cycles, has led to a ratcheting upwards of inflation and unemployment, combined with diminished economic growth. would like briefly to sketch this process. I -2Since the middle 1960's, there have been at least four cycles of this kind. Today, there is good reason to think that the inflation component of these cycles is being broken. Inflation as measured by the Consumer Price Index has dropped from a recent peak of 12.8 percent (12 months rate) to 6.7 percent, measured by the GNP deflator, from 9.9 percent to 7.4 percent. These drops are not yet as large as those achieved during the 1973-1975 recession. Nevertheless they are important, particularly since inflation expectations seem to have become more firmly embedded over the last eight years. For unemployment, a similar reversal of the upward trend is not yet apparent. However, if inflation was the principal reason for the imbalances and the stagnation of our economy, its decline will help to reduce unemployment. Some of the unemployment that so deeply troubles our economy today, moreover, is the result of demographic factors. Some of these, especially the age composition of the labor force, will change as a larger portion of the labor force matures and moves to higher experience levels. Money Supply Targets The monetary policy that has been employed to achieve these objectives has had as its principal characteristic the pursuit of moneysupply targets. In a period of inflation, it has become apparent that interest rates can be very misleading as targets of monetary policy. Real interest rates, i.e., market rates after deducting inflation or inflation expectations, are difficult to discern when both the rate of inflation and expectations of future inflation are changing rapidly. The tax deductibility of interest, which includes the inflation premium, creates further ambigui ties. Firms with and without profits, consumers who do or do not itemize -3deductions, are in very different positions with respect to interest after tax. Thus, the money supply seems a better guide to «mti-Inflationary policy, at least so long as the inflation lasts. Inflation may have many roots, and by no means all of them monetary. restraint. But inflation cannot proceed very far if there is monetary One need not be a monetarist in order to accept this conclusion. Indeed, there seems to be a widespread acceptance of the simple proposition that less money is less inflationary than more money. If the rate of growth of the money supply is gradually reduced, so will the inflation. And, with declining inflation, interest rates will also come down. Interest Rates and Monetary Policy I see interest rates, in this framework, as playing a passive but nevertheless important role. In the short run, they are determined by the money supply and its interaction with the economy and expectations. In turn, they transmit to the economy the pressure emanating from the de celerating money supply. is not a direct one. The effect of money on the economy and inflation Interest rates and rates of return on nonfinancial assets provide the transmission mechanism. Given the impossibility to know the "right" interest rates for getting inflation down one must rely on a decelerating money supply to set interest rates that will do the job. Monetary authorities indeed have only limited ability to set interest rates. This seems hard to accept for the broad public. People are accustomed to hearing about interest rates as the result of monetary policy. Ergo, it seems plausible to assume that central banks can set interest rates where they want them. When interest rates are very high, it is natural to demand that the monetary authorities reduce them. -4But during inflation particularly, central banks have little room for maneuver in reducing interest rates. In the United States, indeed, there is some doubt whether, except for short-term rates in the very shortrun, the central bank can do it at all. The supposed means for "easing" monetary policy and lowering interest rates would be to provide liquidity by accelerating the money supply. Yet it is almost universally agreed that in the long run, an acceleration of the money supply is bound to accelerate inflation. Faster inflation, in turn, produces higher interest rates, not lower. Thus, a faster growth of money would have two conflicting effects. By providing more liquidity, it might in the short run bring down interest rates,. But by adding to inflation it would in the longer run raise them. Expectations of the longer run effect might defeat the contrary shorter run effect from the very beginning. This at least might be true of long term interest rates which are highly susceptible to expectations. One would wish that economics, in addition to the agreement that prevails for longer run mechanisms^ could also arrive at an agreed short-run prediction on the effect of money on interest rates. is not the case. Unfortunately, that Different econometric models tell different stories and make different short-run interest rate predictions. The standard macro models employed for much econometric forecasting say that a sustained increase in money growth will reduce short-term rates for several years and long-term rates for even longer. come later. But these models in large part use data from an earlier noninflationary period. The turn toward higher rates will Their application to the present may be misleading. - 5 - Markets today are far more sensitive to inflation than they were !n the past. Reactions to any hint of a change in the inflation outlook are now almost instantaneous. Monetarists' models show a very different response of interest rates to changes in the growth of money. According to one such model, short-term rates rise with a lag of one quarter after the money supply accelerates, while long-term rates rise even within the same quarter. This model reflects the empirical fact that money growth and nominal interest rates are indeed highly correlated. The theoretical interpretation mone tarists give to this is that the market responds almost instantly to any acceleration of money by raising its inflation expectations and, therefore, nominal interest rates. There would not be enough time, therefore, during which a rising money supply could depress interest rates through the liquidity effect on which the macro models rely. Of course there is an alternative explanation that could be given to the observed correlation between a rising money supply and interest rates. It is that a rise in the actual money stock usually reflects a rise in the demand for money rather than in the supply. In any market in which volume fluctuations are primarily the result of changes in demand rather than in supply, price and quantity will tend to move in the same direction, whether we are talking about a rise in the demand for potatoes and their price, or for the money supply and interest rates. Given the many factors that may influence short-run demand for money, such a primarily demand-determined character of short-run money-supply fluctuations would hardly be surprising, even in the face of an effort by the monetary authorities to keep the money supply constant. In any event, however, while there is little agreement on the short-term influence of money growth on interest rates, the longer term influence, it is agreed, can only be upwards. Therefore, any debate can be only about how long the monetary authorities can depress interest rates by monetary expansion. Under today's conditions, that period, to the extent that it exists at all, is likely to be short. The central bank's room for maneuver in reducing interest rates is correspondingly limited. The only reliable and lasting way to bring interest rates down is by bringing down inflation and, if the central bank has credibility, by bringing down inflation expectations. Cyclical Effects of Money-Supply Targets When the Federal Reserve, in late 1979, introduced its more rigorous form of money-supply targeting through a reserved guide, one might have expected the relationship of the money supply and interest rates to reveal itself as strongly anti-cyclical. In an economy in which the quantity of money demanded fluctuates with the business cycle while the supply is kept on a steady target, interest rates could be expected to rise during cyclical expansions and drop during contractions. This seemed all the more likely the more effectively the money supply was prevented from following its natural procyclical tendency, i.e., to expand in economic expansions and slow down in contractions. during the year 1980. Indeed, this was the experience A sharp contraction during the first part of the year was accompanied by a more than halving of short-term interest rates. The rapid expansion of the economy in the second half of the year, to which this drastic drop in interest rates no doubt contributed, was associated with a sharp rise in interest rates. -7But during the cyclical downswing that began in July 1981, the decline in interest rates was much more moderate, even though Ml remained below target through the rest of the year. Indeed, by early 1982 interest rates had turned around and were rising despite the con tinuing decline in the economy, as the demand for money apparently increased contrary to normal cyclical expectations. happened Quite likely, this because the severity of the recession engendered feelings of insecurity among money holders which caused them to increase their precautionary transactions balances. Taking such precautions was made more attractive by the fact that interest bearing checkable deposits NOW accounts - had meanwhile acquired considerable acceptance and made the holding of idle balances less costly. Considerations like these raise the question whether present monetary targets may actually be somewhat tighter than they appear. However, any such tightness would have been counteracted, at least in part,by the fact that the narrowly defined money supply, Ml, has run moderately above the upper end of its target so far this year. Since the mid-1970s, any errors in setting targets, to the extent they may have occurred, were on the upside rather than the downside. Over this span, the Federal Reserve at times found that targets that seemed to be a very tight fit for the monetary needs of the economy were too loose because nev techniques in the holding of cash balances permitted substantial economies. They therefore caused a decline in the demand for money at a given level of income and interest rates. Historically, sudden shifts of the velocity of money away from its usual steady upward trend -8generally have been toward higher rather than lower velocity. However, as inflation diminishes, it would not be surprising to encounter the reverse phenomenon. In any event, of course, lower interest rates would tend to lead to a higher demand for money and therefore lower velocity even without shifts in the demand for money. For all these reasons, it is part of wisdom not to rely on a single money supply definition such as Ml. The Federal Reserve is guided also by broader concepts of money and to a lesser extent also by bank credit. This minimizes the risk of being mislead by any one particular aggregate. In 1981, the narrower and broader money supply concepts indeed moved rather differently, with Ml undershooting and M2 and M3 overshooting their targets. In 1982 so far, all three definitions have moved more or less together, currently being at or slightly above their annual targets. Monetary Policy and the Budget Movements of the money supply are not, of course, the sole determinant of interest rates. another much-cited factor. The prospective budget deficit is It affects interest rates directly through prospective demands by the Treasury in the financial markets. It affects interest rates indirectly because many people believe, rightly or wrongly, that a very large deficit will ultimately lead to more inflation. Fiscal policy offers an opportunity, at any level of inflation, for reducing pressures on the capital markets. It would not be plausible, however, to expect very quick and precise reactions in the market even from the initial steps taken by the Congress recently to resolve t tapasse. There are many slips -9betwixt cup and lip, especially where budgets are concerned. Just as the Federal Reserve has had to work hard to establish credibility, by remaining firm in the face of pressures, so will the budgetary authorities. What can monetary policy do as the budget picture improves, in order to enhance the tendency of interest rates to decline as Treasury borrowing diminishes? From what I have said before about the uncertain power of money to reduce interest rates, it is very doubtful whether the objective of lower interest rates would for long be served by monetary expansion under these conditions. If the market perceives it as an in flationary development, the action could quickly be counterproductive. It could stymie the beneficial effect that a lower deficit should have on interest rates. A surer way probably would be to maintain the established policy, which has acquired credibility, and rely on the improvement in inflation expectations to achieve the desired objective. The International Impact of United States Interest Rates Let me conclude by examining, in an American perspective, the impact of United States monetary policy upon Europe and particularly upon European financial conditions. begin by looking backward. I hope you will forgive me if I once more In years gone by when exchange rates were fixed, it was indeed true that interest rates could not differ very much inter nationally. A rise in United States interest rates then tended to raise European interest rates in a very direct sense. Any major differential would have caused flows of funds to the United States that would have denuded Europe of monetary reserves. Under a regime of floating exchange rates, such as we have now, this simple and direct effect is absent. The impact of rising United -10States interest rates is tempered, if not altogether eliminated, if advantage is taken of the flexibility of the exchange-rate system. Under a flexible exchange-rate system, moreover, countries can have very different rates of inflation, which are determined by their domestic monetary and fiscal policies. Differences in inflation rates naturally will over time lead to movements in exchange rates. Though one would prefer stability, such movements are normal phenomena in a flexiblerate system. It is always open to a country to keep the international value of its currency from falling by reducing its rate of inflation. If it does so, it will not need to match any rise in interest rates abroad. On the other hand, if a country is willing to see the international value of its currency decline, it may also thereby avoid importation of higher foreign interest rates. At a time when it has been principally the dollar which has been rising against most other currencies, any increase in European import prices would be limited to imports from the United States which for most countries are not large. This is particularly the case at a time when the price of oil, which is fixed in dollars, has declined appreciably. Under such circumstances, it has been possible, within reason, for the Federal Republic and some other countries to "uncouple" from the dollar and dollar interest rates. The rise in the dollar, meanwhile, will have its expected effects on international trade. American exports become less competitive, although a lower United States inflation rate should counteract this effect in part. United States imports will tend to rise, especially as the American economy -11begins to expand. Corresponding benefits go to European, Japanese, and other exporters who will find it easier to compete in Unittd States and third-country markets. In a broad view, all sides would be better off if interest rates in the United States were lower. In the course of time, I expect this to come about as the inflation abates and confidence in this process is established, and as the budgetary problems of the United States are resolved. In conversation with German friends, I have been encouraged by the fact that, while many have expressed concern about United States interest rates, none has urged that they should be brought down by monetary expansion that sooner or later would be inflationary. The only sound way to reduce United States interest rates is to go forward toward lower inflation and better budgetary balance. I believe that we are well embarked on that road.
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