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11:00 A.M., EDT


Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
National Mortgage Banking Conference
of the
Mortgage Bankers Association of America
Tuesday, 11:00 a.m., April 23, 1974
Washington Hilton Hotel

11:00 A.M., EDT

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
National Mortgage Banking Conference
of the
Mortgage Bankers Association of America
Tuesday, 11:00 a.m., April 23, 1974
Washington Hilton Hotel

I am grateful to your chairman and to my old friend Miles
Colean for providing me with an opportunity to speak to an important

Miles' wise counsel I have sought out from time to time ever

since I first came to Washington during the 1950's.

I hope to continue

to benefit from it during many years to come.
As mortgage bankers, you deal with one of the elementary
human needs -- shelter.

Your work has contributed to the splendid

achievement of the American economy that has made homeowners of six
American families out of ten.

None of the problems that may come up

from time to time can invalidate the fundamental fact that housing in
the United States has been a tremendous success story.

In no major

country in the world is so high a proportion of the population so
well housed as in the United States.

l/l should emphasize that in these comments I speak only for myself
and not for my colleagues on the Board.

Housing and housing finance have certain well-known
characteristics that must be borne in mind.

When you help a family

to finance a home, you are helping it to purchase the most durable
major good that it will ever acquire.

Durability is an attractive

But it also may give rise to occasional difficulties that

the industry is well aware of.

Durability means that the new supply

of housing constructed each year, in good years and in less good
ones, is necessarily small relative to the existing stock.


short periods, at least, the bulk of the nation's housing needs can
be met from the stock of housing already built.

This is so all the

more because people can control the rate of household formation and
can make more intensive or less intensive use, as they wish, of the
existing housing stock.

Shelter is an essential need, but the purchase

of a home is nevertheless highly postponable.

Thus, the goal of a

stable demand for housing and of stable construction activity, though
we must continue to pursue it, may perhaps be achieved only very
Durability has still another implication.
lends itself to being financed with debt.
skillful use of this possibility.

Housing ideally

Your industry has made

Financial technology involves no

less creativity because, unlike other forms of technology, it can all
be done with a sharp pencil.

The amortized mortgage is one of the

examples of this kind of technology to which innumerable families owe

their chance of acquiring a home.

Many of you will be aware that

the man who perhaps did most to build the amortized mortgage into
the American system of home finance, Winfield Riefler, passed away
only a few days ago.
Durability brings housing into contact with one of the less
admirable features of today's scene —

with inflation.

In a time of

rising prices, the market value of a home often rises far above its
original cost.

In the difficult times that savers have experienced

recently, home ownership has provided shelter in a financial as well
as in a physical sense.

But inflation creates many problems even for

the homeowner who purchased and financed earlier.

It creates very

serious problems indeed for the home buyer, for the housing industry,
and for the mortgage banker.

I would like to examine some of these

problems with regard to the supply of savings and the effect on interest
rates, including their term structure, which is important from the
point of view of the mortgage banking industry.

It has often been said that inflation discourages saving,
because people see the value of their existing savings shrink while
the price of the things they plan to buy is going up.

In the past,

this may have been one of the cases where it is better to be ignorant,
or at least suspend judgment, than to know something that isn't so.
There is some evidence that historically inflation

has encouraged rather than discouraged saving.

Consumer surveys

typically have elicited the response that a period of rising prices
is a bad time to buy.

That means more saving, not less.


attitude, however, in recent years seems to have shifted to one
that more nearly validates the traditional notion that inflation
discourages saving.

At least until the middle of 1973, there seems

to have been persuasive evidence that consumers had begun to buy ahead
in order to beat future price increases.

The high cost of energy for

the time being seems to have put an end to what may or may not have
been an incipient trend.

But in a country like ours, where the

consumer savings ratio usually is in the range of 5-6 per cent of
disposable income, in contrast to about 12 per cent in Germany and
about 20 per cent in Japan, even a small reduction in consumer saving
can have a substantial impact on the supply of investable funds.
Inflation also affects saving adversely by the way in which
it has affected corporate profits.

In "normal" times, net corporate

savings (excluding depreciation) have tended to account for something
like 2-3 per cent of the gross national product, or an amount roughly
one-half to two-thirds of personal saving.

Broadly this relation­

ship was again attained in 1973, after a prolonged period of unusually
low corporate profits and net savings.
with profits.

But inflation plays tricks

It has been estimated that, of the $125 billion pre-tax

corporate profits in 1973, something like $25 billion were the result

of inflation, in the form of inventory profits and under-depreciation
of business plant and equipment.

Corrected for this overstatement,

net corporate saving was much smaller.
In practical terms this has meant that business, not in fact
having the savings it thought it had, was compelled to borrow more
heavily in order to finance higher priced inventory.

It also had to

finance equipment investment that really represented replacement
rather than additions to the capital stock.

This sequence of events

is a form of income redistribution and is adverse to saving since
corporate business is a high saver.

It throws an additional burden

on the capital market, with the result that less investable funds
are left for housing.
Inflation cuts into the supply of saving available for
housing in still another way.

It pushes up the cost of government.

This has increased the pressure fo remove certair government or governmentally sponsored expenditures from the federal budget.

The financing

of these expenditures has then been thrown upon the private capital

It is crue that many of these "de-budgeted" expenditures

have been closely related to housing.

But the growing practice of

off-budget financing nevertheless cuts into the supply of savings
that are freely available through private channels, where the housing
industry would otherwise have a chance of absorbing a good part of

In summary, through its impact on household saving, corporate

saving, and government budget practices, inflation delivers a three­
fold punch at saving.
The supply of savings is one of the fundamental determinants
of interest rates.
fore obvious.
interest rates.

The effects of cutting down that supply are there­

This is one of the forms in which inflation bears on
But there are others.

In particular, on top of the

effect on saving, one must take into account the response of borrowers
and of lenders.
Everybody today is probably familiar with the simple proposi­
tion that the "real" interest rate is equal to the nominal rate,
i.e., the rate quoted in the market, minus the rate of inflation.
Lenders, so the story goes, will demand an inflation premium;
borrowers can afford to pay more.

Thus the interest rate is raised

in proportion to the rate of price increases.
Like all simple economic statements, this one is an over­

I would warn you against performing a calculation

that deducts the inflation of the last three or six or twelve months
from a market rate of interest and that then arrives at the conclusion
that the real rate is negative.
with respect to the past.

That calculation makes sense only

The depositor who has received five per

cent for his money while prices have gone up by 6 per cent has indeed
had a negative return.

Even then it would be somewhat questionable

to say that his negative return was one per cent, because the depositor
pays income tax on the nominal interest.

If he is in the 40 per cent

tax bracket, his return during a year when the nominal interest rate
was five per cent, and inflation six per cent, will have been minus
three per cent.
But what people really want to know about the interest rate
is its "real" value with respect to the future.

The rate of inflation

that must be deducted from the nominal rate then is not the inflation
that has already occurred, but the inflation that the lender or
borrower expects.

Since we cannot read investors' minds, their

expectations of future inflation are in effect unknowable.


try to estimate them by assuming, for instance, that people extrapolate
their past experience into the future, giving greater weight to more
recent than to more distant experience.

In that way, an estimate of

expectations can be derived and a "real" interest rate computed.
If we apply this reasoning fn the long-term rate of interest,
we must remember that it is also the long-term rate of price increases
that is relevant.

A short bout of inflation that is soon brought

under control does not affect the real return on a 20-year bond as
would high inflation continuing until maturity.

On the

basis of

this theory, therefore, it would not be surprising, during a spurt
of inflation, to find short-term rates high relative to long-term
rates, if investors have some confidence that inflation will eventually
be brought under control.

But again I must warn against taking estimates of this kind
too literally.

Investors may have every reason, based on their

expectations of future prices, to demand an inflation premium.


they can demand all year long and never get it if they cannot make
their wishes effective.

Like Owen Glendower, they can "call spirits

from the vasty deep, but will they come?"

The market may fulfill

investors' demands, if investors are able to withhold their funds
and so can compel borrowers to pay up.
not unlimited.

But investors' options are

Where can they go with their money?

Into short-term

assets, into the stock market, into real estate, abroad?

The review

of alternative outlets suggests that investors sometimes may not be
able to obtain the inflation premium to which they think themselves

In this case, too, the simple calculation that relates the

nominal and the real interest rate via expected inflation will not
add up.
Something similar can be observed on the side of the borrower.
He will be prepared to pay more during an inflation.

How much more,

however, he will pay depends on the rate of return he can get from
the use of the borrowed funds.

During an inflation, real estate may

appreciate, inventories may go up in value, machinery and equipment
may depreciate less rapidly than at other times.
tions are very uncertain.

Moreover, as I pointed out earlier, business­

men may miscalculate their true profits.

But these expecta­

Investors therefore can have

no assurance that borrowers will offer them interest rates containing
an adequate inflation premium.
Studies done in the research department of banks (including
the Federal Reserve Bank of St. Louis and Morgan Guaranty Trust Company)
tentatively suggest that prior to the present severe inflation the
"real" interest rate had been in a range of about 3-4 per cent*
According to those calculations, the excess of market rates beyond
that range could be considered, very broadly speaking, as a premium
for credit risk and for inflation.

Nobody can be sure, of course,

whether lenders regard as adequate the inflation premium that they
get today.

But to the extent that they do, one may perhaps draw

the moderately comforting conclusion that investors do not expect
inflation over the longer run to persist at rates comparable to
those we have experienced in recent months.

In other words, an

analysis of interest rates in "real" terms suggests that investors
expect that the rate of inflation will come down.
There are plausible reasons why investors should hold this

The present almost unprecedented rate of inflation is in good

part the result of events on the supply side of the economy.
crops, the simultaneous occurrence

of national business


booms, and

the quadrupling of oil prices by the OPEC countries all played a

In the course of these traumatic events we discovered that our

own supply capacity, especially in the basic materials sector, is

smaller than had been assumed.

A recent study by Lionel Edie & Co.

of real capital outlays by manufacturers shows that» after making
allowance for capital expenditures aimed primarily at meeting
environmental standards and for the increase in the price of capital
goods, real expenditures for expansion and modernization have shown
no increase since 1967.
There is good reason to think that the supply situation will
come into line in many sectors.

The food picture is brighter for the

second half of 1974 than it was for the early

of the year.

Economic activity all over the world is no longer straining the
limits of capacity as hard as it did in 1973.

OPEC oil prices

should come down if the producers correctly analyze their own long­
term interests.
Much will depend, of course, on fut.uro vage increases.


cost of living has risen dramatically, the real in«-'nie of the average

h«r- fallen, and it would bo underst*..1

try to maKf up for all this.

.*bor should ni’

Such an effort, however, would be largely

The shortfalls

that the economy suffered because of

supply difficulties cannot be made up by higher wages and higher
consumer demand.

The shortfalls reflect events in the real sector

of the economy that must be accepted for what they are —

a temporary

slowing in our standard of living that can be overcome only by
investing more and producing more in the future.

If wage increases

behavior during the coming months reflects an understanding of these
fundamental facts, we can avoid building recent price increases into
a continuing wage-price spiral.

The road will then be open to a

continuing reduction in the rate of inflation.
The outlook for bringing down inflation rests also on the
willingness of businessmen to do their part.

If I read the legis­

lative record correctly, controls over prices are likely to expire
on April 30.

It would be self-defeating if businessmen were to

respond to this event with massive markups.

They would then set in

motion forces that, by one route or another, would perpetuate inflation.
They would end up by depressing the profit margins that their short­
sighted pricing policy had tried to enlarge.

A realistic evaluation

of long-run self-interest is needed on the side of business as well
as on labor.
Even the rise in the cost of imported oil, which has
contributed so much to inflationary pressure, may eventually provide
something on an antidote.

Large balances are likely to build up in

the hands of countries that for a number of years will be unable to
spend them.

These funds will seek outlets in ways that so far are not

clearly defined.

But directly or indirectly, they can contribute to

the financing of investment in this country as well as elsewhere.
When a large addition is made to the world's pool of investable
resources, an addition that many analysts estimate in the tens of

billions of dollars, the supply of investable funds will become
more plentiful almost everywhere.
Appropriate public policies will be required to bring down

As Chairman Burns said before the Subcommittee on Inter­

national Finance of the Committee on Banking and Currency on April 4,
the Federal Reserve intends to pursue a policy that will permit only
mocerate growth of money and credit.

In the face of strong demand

for bank credit, such a policy may at times lead to greater pressures
in the financial markets.

But in the longer run, a slowing of infla­

tion will bring down iiv.erest rates,

is likely alau c > restore

the relationship between short and long rates that has prevailed
during most of the years since World War II and that has been of

importance for housing finance and for the mortgage banking

Appropriate fiscal policies will likewise be required.


the immediate Lurur*, budgetary policy should be guided by what is
visible in the economy in the present time.

Whit ¿e 4« e today implies

a good deal more strength than many observers seemed to anticipate
a few months ago.

The oil crisis had severe sectoral impacts,

especially on automobile sales and on housing.
spread out to the rest of the economy.

It has not, however,

Consumer demand has moderated

only slightly, while business spending remains very strong.


the oil embargo has been lifted and the most general forecast is for



acceleration of economic activity in the second half of the year.
That is the period, of course, when monetary and fiscal policy
measures taken now would have their principal effect.

Under these

circumstances, it would be difficult to make a case for a tax
For the longer run, we must recognize the fact that monetary
policy cannot stabilize the economy, if it does not receive adequate
cooperation from the fiscal side.

This becomes all the more apparent

if we consider the impact on the housing industry that more than once
has resulted from the need to seek economic stability chiefly by
means of monetary policy.
Fiscal policy must avoid excessive expansionism, and it must
in particular become more responsive to cyclical movements in the

I would like to refer you to proposals made by the Federal

Reserve Board for an anti-cyclical use of the investment tax credit,
contained in its March 1972 report to the Congress on "Ways to Moderate
Fluctuations in the Construction of Housing.1 While there have been
some comments to the effect that changes in the investment tax credit
would create excessive uncertainty for business investment, the fact
is that changes in interest rates cause similar uncertainty.
has been able to live with this uncertainty.


The difference would be

that the impact of a variable investment tax credit would be exclusively
on business investment, while the impact of changing interest rates
affects both business and the housing industry.

While offering good advice to the makers of fiscal policy,
it is incumbent upon us not to overlook things that could be done
closer to home.

1 need hardly tell you that the Federal Reserve

is at all times very conscious of how its monetary policy actions
influence housing from a cyclical point of view.


structural changes in housing finance have been suggested in the
Financial Institutions Act which grew out of the Hunt Commission

While the legislative achievements of this great endeavor

so far have been unimpressive, the basic principles there expressed,

at greater flexibility on interest rates, greater freedom

of portfolio action for thrift institutions, and greater competition
all around remain valid.
Meanwhile, the thrift industry is not without opportunities
to generate greater flexibility on its own.

The thrift industry

has been heavily dependent upon an aspect of the term structure of
interest rates that historically has been less than completely
use —

The thrift industry has banked —

if that is the word to

rather heavily on short-term rates being lower than long­

term rates.

Economics tells us that there are good reasons why

this relationship should prevail a good part of the time.


tells us that from the early 1930's to the middle 1960's the upward
sloping yield curve was the rule with very few exceptions.

But a

look at earlier history, before the Great Depression, shows that



the yield curve quite often was downward sloping.

Economics tells

us that a downward sloping curve is likely to occur from time to
time, even though the opposite can probably be regarded as the more
normal situation.

Essentially, an upward sloping yield curve can

be interpreted as risk aversion on the part of investors.


want to be paid for taking on the market risk of longer term

A downward sloping curve, on the other hand, may develop

under circumstances of which I would like to mention only two.


is a condition in which investors expect long-term interest rates to
fall; in that case, they will demand the premium for staying short
instead of taking advantage of the anticipated rise in the bond

The other possibility is a simple demand-supply phenomenon.

If funds of all maturities become scarce, short-term interest rates
are likely to rise more than long-term, because they reflect a less
permanent commitment and therefore have greater flexibility.


would not want to speculate which of the two explanations fits the
present situation better.

Perhaps both are at work.

Like so many other financial problems, that of the down­
ward sloping structure of interest rates is likely to yield to a
decline in the rate of inflation.

The effort to bring inflation

under control, as I said before, may generate temporary pressures.
But just as it seems obvious that our present interest
rates are the product of inflation, so it must be regarded as

obvious that a slowing of Inflation, and only such a slowing, will
bring us back to the rates with which we have been familiar all
our lives.

Thank you very much.