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FOR RELEASE ON DELIVERY TUESDAY, JUNE 10, 1980 12:15 P.M. LOCAL TIME (7:15 A.M. EDT) MONETARY POLICY DURING HIGH INFIATION Remarks by Henry C. Wallich Member, Board of Governors of the Federal Reserve System to the Swiss-American Society Basel Basel, Switzerland June 10, 1980 MONETARY POLICY DÜRING HIGH INFIATION Remarks by Henry C. Wallich Member, Board of Governors of -the Federal Reserve System to the Swiss-American Society Basel Basel, Switzerland June 10, 1980 The U.S. economy has moved into recession after reaching what were probably the highest levels of both inflation and of interest rates in the history of the Federal Reserve. Throughout most of the past 18 months, a recession was being predicted without materializing. Instead, the United States experienced an unexpected and unpredicted acceleration of inflation. These events suggest that the threat of inflation was underestimated and the measures initially taken inadequate, even though the control of inflation had been singled out as the nation's number one economic objective. The escalation of the consumer price index during the first quarter of 1980 to 18 percent was not entirely a failure of policy. The rise in OPEC oil prices contributed substantially, and so did the domestic deregulation of oil prices which was an essential component of realistic energy policy. During much of 1979, however, there prevailed also a condition of excess demand that was not adequately recognized. unemployment at about 6 Because percent was high by historical standards and capacity utilization in manufacturing at 85 percent was somewhat low by -2h i s t o r i c a l s ta n d a rd s , i t had n o t been f u l l y r e a liz e d t h a t p re s s u re on c a p a c ity was n e v e r th e le s s d r iv in g up p r i c e s . E v id e n tly th e r e have been changes in th e Am erican economy, in c lu d in g th e demographic s t r u c t u r e o f th e la b o r f o r c e , improved unemployment co m p en satio n , reduced p r o f i t a b i l i t y due to h ig h e r energy p r i c e s , and o b s o le s c e n c e due to in ad eq u ate in v e s tm e n t, th a t have low ered th e th r e s h o ld , both in term s o f unemployment and i n d u s t r i a l c a p a c it y , a t w hich wage and p r ic e p r e s s u re s b e g in . A favorable factor was the relative moderation in wage increases. Real wages of the American worker fell by 4 percent during 1979 as in the face of a 13 percent rise in the consumer price index, compensation per hour rose by only 9 percent. American workers accepted a significant reduction in their standard of living. But productivity performance also was extremely poor, with productivity in the private sector falling by 1 percent during 1979, partly in consequence of government regulations and other actions that increased costs. Unit labor costs, therefore, rose by 10 percent in 1979, a rate that must be regarded as reflecting the so-called underlying rate of inflation. To round out the picture of the recent American inflation, it needs to be noted that the consumer price index has tended to overstate the price increase relevant for the great majority of the population because of the heavy weight that it gives to the price of homes and to mortgage interest rates. When mortgage rates come down, as they already have begun to do, the index will, with a lag, begin to understate the inflation. We should not be deceived by an improvement due to this source, just as we are entitled to make some allowance for the recent upward exaggeration of the index. A more meaningful index of the rise -3- in living costs for the entire population is the personal consumption expenditures deflator, derived in our national income accounts, which during 1979 was advancing at 9 percent. I t i s w orth n o tin g t h a t , d u rin g th e p e rio d o f a c c e l e r a t i n g i n f l a t i o n , i n t e r e s t r a t e s more o r l e s s k e p t p ace w ith th e r i s e i n p r i c e s , alth o u g h much o f th e tim e la g g in g somewhat b e h in d . D uring th e e a r ly p a r t o f 1979, r e a l i n t e r e s t r a t e s - - nom inal r a t e s minus i n f l a t i o n — p ro b ab ly w ere somewhat on th e n e g a tiv e s i d e . In 1980 th ey became somewhat p o s i t i v e , b e a r in g in mind t h a t a l l s ta te m e n ts about r e a l i n t e r e s t r a t e s a r e s u b je c t to a m argin o f u n c e r t a in t y . A s im ila r phenomenon can be observed in most c o u n tr ie s t h a t e x p e rie n c e d an a c c e l e r a t i o n b o th o f i n f l a t i o n and o f i n t e r e s t r a t e s d u ring 1979, alth ou gh th e d egree to w hich r e a l r a t e s were p o s it iv e v a r i e s c o n s id e r a b ly among c o u n t r ie s . To some e x te n t t h i s p a r a l l e l ism may be a t t r i b u t a b l e to t i g h t e r m onetary p o lic y aim ing to r e s t r a i n i n f l a t i o n . I n some m easu re, how ever, th e r e may be a more a u to m a tic mechanism at work r e f l e c t i n g p o s s ib ly th e g r e a t e r aw areness o f i n f l a t i o n among borrow ers and le n d e rs and th e more ra p id upward ad ju stm en t o f i n f l a t i o n a r y e x p e c t a t io n s . The im p ortan ce o f r e a l i n t e r e s t r a t e s a f t e r t a x , how ever, v a r ie s among c o u n tr ie s and i s p rob ab ly g r e a t e s t f o r th e U n ited S t a t e s , where i n t e r e s t payments a re ta x d e d u c tib le no t on ly f o r b u s in e s s e s , b u t a ls o f o r home owners and o th e r consum ers. The s u b s id iz a t io n o f borrow ing through t h i s d e v ic e p rob ab ly h as c o n tr ib u te d to th e s e v e re d e c lin e in th e sa v in g s r a t e t h a t h as tak en p la c e in th e U n ited S t a t e s . By th e same to k e n , i t appears t h a t th e U n ited S t a t e s economy i s more v u ln e r a b le , in many r e s p e c t s , to th e damage wrought by i n f l a t i o n th an a r e o th e r econom ies. The ta x system has not been adapted to i n f l a t i o n , -4- except in the main for periodic personal tax cuts that have helped to offset the drift of taxpayers into higher brackets. Savings institutions have found it very difficult to cope with inflation, which has led to severe damage to the housing industry. Usury ceilings, only in part recently overruled by the Congress, have interfered with the flow of credit at high interest rates. Business profits are grossly overstated by an accounting system that ignores inflation. The development of an underground economy, which has helped some economies defend themselves against inflation in some degree, has been largely forestalled in the United States by the effective administration of a tax and legal system that, all pressures not withstanding, continues to perform effectively. It is not surprising, therefore, that among countries with high rates of inflation the United States probably has had the worst productivity experience. T h ree Rounds o f M onetary A c tio n Three rounds of monetary action mark the course of monetary policy over the last year and a half. The measures of November 1, 1978, represent the first round. November 1, 1978. The immediate objective of the steps taken on that date was the strengthening of the dollar, which over the previous five months had declined from 96 to 89 on its trade-weighted rate against the currencies of the G-10 countries and Switzerland. An important part of the action was executed by the Treasury, which undertook to borrow in foreign currencies, to use its SDR holdings, and to draw on the International Monetary Fund. Together with the swap lines available to the Federal Reserve and the Treasury, an intervention package of $30 billion was readied and a -5more f o r c e f u l approach to in te r v e n tio n was announced in su p p ort o f th e d o l la r which was regard ed as h aving d e c lin e d to u a j u s t i f i a b l e l e v e l s . The F e d e r a l R eserv e r a is e d th e d isc o u n t r a t e by a f u l l p e rc e n ta g e p o in t from 8 - 1 / 2 to 9 - 1 / 2 , an in c r e a s e matched o n ly once in r e c e n t h i s t o r y . During the period from October 1978 through March 1979, the monetary aggregates advanced very sluggishly. fell back again after May 1979. The dollar improved but The sluggishness of the aggregates conveyed an impression of monetary restraint which, coupled with the widespread expectation of a recession, created unduly optimistic expectations con cerning future inflation. Meanwhile, the moderate increase in interest rates failed to have its usual pronounced impact on the housing industry, because the institutions financing the industry had been permitted to issue market-oriented debt instruments that protected them against the outflow of low interest deposits that normally would have occurred at high market rates of interest. Thus, a level of interest rates that under other conditions might have been sufficient to slow the economy did not achieve this result. Shielding one sector of the economy against the impact of high rates evidently had as its consequence the need for still higher rates to do the same job. October 6 . 1979. In the spring of 1979 the monetary aggregates, until then dormant, began to accelerate once more. Their rapid growth during the summer made clear that further vigorous monetary action was needed in the face of rising inflation. After the dollar began to decline sharply and commodity prices began to climb rapidly in September 1979, the Federal Reserve on October 6 took a set of measures that constituted in effect the second round of monetary tightening. A new and more rigorous - 6- te ch n iq u e o f c o n t r o l l i n g th e money supply was i n s t i t u t e d , based p r im a r ily on th e u se o f bank r e s e r v e s in s te a d o f th e f e d e r a l funds r a t e . R ese rv e r e q u ir e ments w ere imposed on in c r e a s e s i n managed l i a b i l i t i e s above a b a se d a t e . The d is c o u n t r a t e was r a is e d from 11 to 1 2 . T h ese a c t io n s brought an im m ediate change i n th e bank c r e d i t p i c t u r e . Bank c r e d i t had been easy a t h ig h r a t e s . I n t e r e s t r a t e s r o s e d r a m a t ic a lly . I t now became l e s s r e a d i l y a v a i l a b l e . The m onetary a g g re g a te s came under good c o n tr o l. M eanw hile, how ever, th e h ig h nom inal i n t e r e s t r a t e s to w hich th e economy was m oving, w h ile b a r e ly p o s it iv e i n r e a l term s and a p p a re n tly s t i l l i n s u f f i c i e n t to cu rb a d e q u a te ly th e a g g re g a te volume o f c r e d i t , began to c r e a t e problem s f o r p a r t i c u l a r l i n e s o f b u s in e s s and some f i n a n c i a l i n s t i t u t i o n s . Home b u il d e r s , fa rm e rs , sm a ll businessm en and au to m o b ile d e a le r s found th e h ig h nom inal c o s t o f c r e d i t and, in some c a s e s i t s n o n a v a ila b ili t y to p a r t i c u l a r b o rro w e rs, e x tre m ely burdensom e. Sav in g s i n s t i t u t i o n s and many sm a ll banks found th em selv es squeezed betw een th e r i s k o f lo s in g t h e i r d e p o s its to h ig h e r paying in v estm en t m ed ia, e s p e c i a l l y money m arket m utual fu n d s, and, on th e o th e r s id e , th e danger o f a t t r i t i o n o f t h e i r e a r n in g s , as th e c o s t o f th e money th ey were a b le to r e t a i n began to exceed th e income from t h e i r p o r t f o l i o o f f ix e d i n t e r e s t r a t e lo an s and m o rtg ag es. T h is dilemma was th e co n se q u en ce, in good p a r t , o f an e a r l i e r e f f o r t to s h ie ld th e s e le n d in g i n s t i t u t i o n s a g a in s t " d is in te r m e d ia tio n " by a llo w in g them to is s u e money m arket c e r t i f i c a t e s and o th e r o b lig a t io n s a t m ark eto r ie n te d i n t e r e s t r a t e s , w e ll in e x c e s s o f th e d e p o s it r a t e c e i l i n g s imposed by R e g u la tio n Q. T h e ir e a r l i e r l i q u i d i t y problem r e s u l t i n g from w ith d raw al o f d e p o s its now became co n v e rte d in to an e a rn in g s problem due to th e in c r e a s in g i n t e r e s t c o s t o f th e s e new o b l i g a t i o n s . -7In a d d itio n to th e s e d i f f e r e n t i a l im pacts o f h ig h nom inal i n t e r e s t r a t e s on d i f f e r e n t ty p es o f le n d e rs and b o rro w e rs, th e im pact o f r e a l a f t e r - t a x i n t e r e s t r a t e s on d i f f e r e n t b orrow ers became in c r e a s in g ly a p p a re n t. H igh- b r a c k e t ta x p a y e r s , in c lu d in g la r g e c o r p o r a t io n s , were s h ie ld e d by th e ta x d e d u c t i b i l i t y o f h ig h nom inal i n t e r e s t r a t e s w hich f o r them s i g n i f i e d m ainly a ca sh flow s tr in g e n c y . L ow -brack et ta x p a y e r s , and firm s w ith o u t p o s it iv e e a r n in g s , f e l t th e f u l l b ru n t o f h ig h nom inal r a t e s b o th i n term s o f c a sh flow and c o s t . T h u s, i t became ap p aren t th a t a t i g h t m onetary p o lic y may fin d i t s e l f lim ite d by th e s id e e f f e c t s i t produces b e fo r e r a t e s have become h ig h enough, e s p e c i a l l y in r e a l term s and a f t e r t a x e s , to cu rb i n f l a t i o n . Moreover, it became apparent also that the availability constraints which the second round of measures, of October about had begun to wear off. 6 , 1979, had initially brought Credit once more became freely available at least to large borrowers at very high rates. strong in January and February 1980. Bank credit expansion continued The monetary aggregates, which had been under good control following the October 6 measures, broke out on the upside in February. March 14, 1980. T hese were th e c o n d itio n s t h a t le d to th e th ir d round o f c r e d i t t ig h t e n in g . The p r in c ip a l p a rt o f th e new m easures too k th e form o f d i r e c t c r e d i t c o n t r o ls a u th o riz e d by th e P r e s id e n t under th e C r e d it C o n tro l A ct o f 1969. A " v o lu n ta r y " l i m i t o f s i x to n in e p e r c e n t, in ten d ed to be fir m ly a d m in is te re d , was p laced on th e exp an sio n o f d om estic bank lo an s to d om estic c u sto m e rs. Consumer c r e d i t was r e s t r a in e d by im p o s itio n o f th e e q u iv a le n t o f a r e s e r v e req u irem en t on c r e d i t card and o th e r r e t a i l le n d e r s . Nonmember banks were s u b je c te d to th e e q u iv a le n t o f a r e s e r v e re q u ire m e n t, a s were money m arket m utual fu n d s. The m a rg in a l r e s e r v e re q u irem e n ts - 8- established in the second round of measures were tightened. A penalty discount rate was established for large banks frequently using the discount window. The cooperation of foreign banks in not undermining the 6-9 percent loan expansion limit was sought through their respective central banks. It is too early to assess fully the specific effect of the imposition of credit controls. In particular it is difficult to distinguish their effect from the cumulative impact of earlier monetary actions and from the impact also of developments outside the monetary sphere. Interest rates rose further following the March 14 controls but quickly peaked and thereafter dropped dramatically. The monetary aggregates, which had been expected to expand further, declined in March and showed an unprecedented drop in April. Bank credit slowed sharply. The sudden c o n t r a c t io n o f th e m onetary a g g re g a te s co n fro n te d th e F e d e r a l R ese rv e w ith a dilem m a. To meet i t s s h o r t-r u n money supply t a r g e t s , th e F e d e ra l R ese rv e would have had to supply r e s e r v e s to th e banks through open m arket o p e r a tio n s on a much en la rg ed s c a l e , s in c e w ith f a l l i n g money m arket r a t e s i t was to be exp ected th a t th e banks w ould, as indeed th ey d id , sh a rp ly red u ce th e volume o f r e s e r v e s th ey p re v io u s ly had o b ta in e d through th e d is c o u n t window. E x ce ss r e s e r v e s would have r e s u lt e d a t l e a s t te m p o ra rily . S iz a b le e x c e s s r e s e r v e s would have caused money m arket r a t e s as w e ll as o th e r s to drop even more s h a r p ly , posin g a th r e a t to th e d o l l a r . F a il u r e to fo r c e r e s e r v e s upon th e banks in o rd e r to avoid an extrem e drop in i n t e r e s t r a t e s , on th e o th e r hand, would cau se th e F e d e r a l R ese rv e to f a l l s h o r t , a t l e a s t te m p o ra rily , o f i t s money supply t a r g e t . -9- In setting its short-run money supply targets, at monthly FOMC meetings, the Federal Reserve had established upper and lower limits for the federal funds rate (interbank rate); These limits started out at 11-1/2 - 15-1/2 percent in October 1979 and had moved to 13-19 percent by April 1980. The lower limit was subsequently reduced to 10-1/2 percent by a telephone conference of the Federal Open Market Committee on May 6 , 1980, but it did serve to limit the precipitous drop in interest rates in some measure. Meanwhile, the decline in interest rates has also brought alignments that are indicative of the market's expectations. The drop in 90-day rates amounted to approximately three times the drop in long-term rates. At present, the normal upward sloping yield curve has been reestablished, with the highest rates at the long end and a spread, as of June 3, 1980, of about 2-3/4 percentage points between 90-day and 30-year governments, and 1-1/2 percent between commercial paper and long-term bond rates, high in historical terms. This configuration is indicative of market expectations that rates are more likely to go up than down. That message is underscored by the prices quoted for Treasury bill futures, which show a mildly rising trend in the 90-day Treasury bill rate beginning in mid-1980. Problem s o f D ir e c t C r e d it C o n tro ls The change in th e econom ic c lim a te fo llo w in g th e in tr o d u c tio n o f q u a n t it a t iv e c r e d i t c o n t r o l s , w hether i n i t i a t e d o r m erely a c c e le r a t e d by t h e s e c o n t r o l s , v e ry q u ic k ly has posed th e q u e s tio n o f t h e i r d is m a n tlin g . T h is "Encadrem ent de C r e d i t ," as i t i s known in F r a n c e , o r "Window G uidance" a s i t i s c a l l e d in Ja p a n , i s n o t s u i t a b l e as a permanent in stru m e n t o f m onetary p o lic y in th e U n ited S t a t e s , even though in some o th e r c o u n tr ie s - 10- such techniques constitute a permanent part of the monetary policy toolchest. The brief experience of the Federal Reserve with the administration of these devices bears this out. of borrowers. They involve credit allocation to competing groups This is a political decision that should not be required to be made by the central bank. But when made by the political process, credit is likely to be allocated not where it produces the most goods and services, but where it produces the most votes. Any rationing of credit other than through the price, i.e., the interest rate, is bound to be arbitrary and probably in many instances unfair. Unrealistic decisions have to be made as to what types of loans are "productive" and "unproductive." The productivity performance of the American economy, already very inferior, would become further depressed. The market, moreover, can be relied upon to learn to circumvent whatever controls are imposed. If the banks are controlled, credit will move out of the banking system, perhaps permanently reducing the banks' role and their capability to serve the economy. If other domestic sources of credit are also controlled, the business will be driven abroad. like wage and price controls. Credit controls are They may provide short-term relief, but in the long run they are not only ineffectual but damaging. They present a temptation to politicians, because they seem to offer a means of fighting inflation without high interest rates. If that temptation is not resisted, the consequences will have to be added to the already long roster of damages caused by inflation. The Federal Reserve moved in the direction of dismantling the controls by enacting measures on May 22, 1980, which reduced a significant portion of them without, however, materially altering the 6-9 percent bank loan limit. - 11 - Implications for Monetary Policy Recent U.S. experience with a rigorously pursued money supply target highlights some of the salient characteristics of this form of monetary policy. In general, it is true, of course, that in a period of high inflation a money supply target is preferable to an interest rate target. Inflation plays havoc with the meaning of interest rates, since nominal, real and real after tax rates all have different impacts on different borrowers and lenders. It is then good policy to follow a money supply target that can be counted on to bring down inflation in the long run. It will do so by inducing interest rates in the market that will impose a restraint on economic expansion adequate to the purpose. It would be difficult to define those interest rates a priori. It remains true, however, that the economy is steered by interest rates, in their broadest sense, including rates of return on physical capital. Money does not exert some mysterious diverse effect in determining the demand for goods and services. Interest rates, therefore, continue to be important. When the Federal Reserve went on a rigorous money supply target in October 1979, it was aware that this might lead to greater volatility of interest rates and so informed the market. Interest rates would be more volatile under a rigorous money supply target even if the economy were moving along normally and only the demand for money fluctuated around its trend, as it usually does. Small differences between the amount of money supplied and the amount of money demanded will then be eliminated by interest rate movements. But when the demand for money changes drastically as a result of a major cyclical swing, interest rate movements can indeed become very wide. major swings occurred late in 1979 and early 1980. Such First, accelerating -12inflation, canbined with rising economic activity, greatly increased the demand for money. A sharp rise in interest rates was the result. Then, during the second quarte.r of the year, a turn toward recession caused the demand for money to drop sharply. Interest rates, therefore, came down dramatically. Both the earlier upswing and the subsequent decline in interest rates probably were larger than central banks normally would seek if they were pursuing an interest rate target. of a rigorous money supply target: This makes clear the implicit purpose to induce very wide swings in interest rates that can be expected to have strong anti-cyclical effects. Short-term interest rates that within a few months can move from 1 0 to 2 0 medicine. percent and within a few weeks back to less than 1 0 are strong They certainly seem capable of stopping an expansion. effective they can be in ending a contraction remains to be seen. How But past history suggests that a decline in interest rates indeed can promote a shift from contraction to expansion once other necessary adjustments in the economy, such as the clearing out of excess inventories, the working off of unprofitable investments, and the restoration of better balance in business and household balance sheets has occurred. A rigorous money supply target, in other words, is anything but a neutral, do-nothing, or even benign neglect policy. It is a highly activist policy which is likely to affect a cyclical economy with much greater strength than the kind of interest rate oriented monetary policy historically conducted by central banks. high inflation. This is particularly the case during -13- The acid test of the ability of a rigorous money supply policy in dealing with inflation is yet to come. It may well come soon after the American economy turns around and resumes its expansion. Unless the inflation by that time has been greatly reduced, there will be a strong demand for money fueled by both real growth and continuing inflation. Together these would add up to a rate of growth of nominal income probably well in excess of cent. 1 0 per This will be a sizable amount of nominal growth to be financed with a money supply expanding at a rate of 3-1/2 - percent, the present M-1A target 6 range. A large rise in velociLy wi.iL be needed to make this possible. Historically, to be sure, velocity often has risen strongly during the first year of a cyclical recovery, probably because a certain amount of idle liquidity is accumulated during the recession. But over longer periods a rate of money growth substantially below the growth rate of GNP in nominal terms is likely to cause interest rates to rise. It is precisely such restraint that will be needed to keep the economy from going off into another wave of inflation. But this will require a willingness to move out of the recession slowly, and to accept some slack as growth is resumed until the inflation has been wrung out of the system. objective. That must remain the principal The acid test of whether it can be attained is likely to occur, not during the recession, but during the succeeding upswing. #
