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Y, NOVEMBER 7, 1981



Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
before the
Ausschuss fuer Geldtheorie und Geldpolitik
of the
Gesellschaft fuer Wirtschafts- und Sozialwissenschaften
Verein fuer Socialpolitik

Frankfurt, Germany
Saturday, November 7, 1981



Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
before the
Ausschuss fuer Geldtheorie und Geldpolitik
of the
Gesellschaft fuer Wirtschafts- und Sozialvissenschaften
Verein fuer Socialpolitik
Frankfurt, Germany
Saturday, November 7, 1981

A convergence of views seems to be underway concerning U.S.
monetary policy.

Differences between monetarists and others, which at

one time seemed important, are in the process of being bridged.


that earlier seemed matters of principle are becoming questions of degree,
and are being revealed as amenable to a pragmatic approach.
This, at any rate, is how I view the progress of the discussion
that has been going on in recent years.

It has, of course, become increasingly

lively since the Federal Reserve adopted its tighter money-supply control
measures of October 6, 1979.
At a theoretical level, there remain, to be sure, many issues that
separate Keynesians, monetarists, rational expectationalists, and, of late,

I shall comment on these here only to the extent that they

have implications for the practice of monetary policy.


The Predominance of Money-Supply Targets
The evolution of monetary policy techniques in most major countries
has gone in similar directions.
of interest-rate objectives.

Money-supply targets have taken the place

Cyclical fine-tuning has given way to policies

aiming at steadiness, with priority given to gradual reduction in the rate of
In the United States, the shift to a money-supply target began in
1970, and since 1975, this target has been published and announced in periodic
Congressional hearings.

The frequently cited date of October 6, 1979, marks,

not a shift to a new policy or target, but to a new technique and more
vigorous pursuit of the money-supply target.

Monev-Supplv Targets and Interest Rates
One of the consequences of this more vigorous adherence to a moneysupply target has been a widening of interest-rate fluctuations.

In an

economy in which the demand for money does not grow perfectly stably, a
tighter control of the money supply is likely to make interest rates and
exchange rates more volatile even in the absence of major cyclical fluctuations
in the economy.

The degree of randomness in the system must find expression

in either quantity or price.

In the presence of pronounced cyclical fluctua­

tions, however, such as the United States experienced in 1980, steady
adherence to a money-supply track is likely to lead to wider fluctuations
in interest rates than have ever been deliberately set in motion by the
Federal Reserve under regimes in which interest rates played an important

Thus the anticyclical effects of monetary policy may at times have


been increased rather than diminished.

This tended to happen all the

more as United States financial markets became increasingly alert to
money-supply variations and reacted more rapidly and strongly both with
respect to interest rates and exchange rates.

Loosening Relation of Money and the Real Sector
In the United States the increasingly thoroughgoing application
of monetarist techniques was accompanied, however, by circumstances and
developments that did not, by themselves, seem to make the pursuit of
monetarist principles more plausible.

One such development was the

diminishing stability in the-relation between money and economic activity.
During the years 1975-76, the United States experienced a massive reduction
in the amount of money demanded at any given level of nominal income and
interest rates, the two principal determinants of the demand for money.
This shift was apparent in the overpredictions of most of the standard
money-demand equations.

That shift, as measured by cumulative over­

predictions to the end of 1976, was estimated at 7 percent, or on the
order of $20 billion.

Velocity increased accordingly.

This was one

of the principal reasons why the seemingly very tight money-supply targets
pursued by the Federal Reserve during those years ultimately proved to be
not tight enough«
Another major shift of this sort occurred in 1981.

The most

plausible explanation for permanent downward money-demand shifts is that
after each experience of very high interest*rates, holders of money balances
make renewed efforts to reduce their non-interest-paying balances.

At the



same time it appeared as if the lag between changes, in money growth and the
reaction of the real sector, which Friedman years ago had characterized as
"long and variable1 and which by rule of thumb was typically put at six to
nine months, had shortened, particularly in the housing sector.

Softening of the Honey Concept
Another development not in itself propitious to the pursuit of a
money-supply target was the softening up of the concept of "money1 itself
that has occurred in the United States in recent years.

In good part this

derived from the new techniques of economizing cash balances.

The old

definition of Ml as currency plus demand deposits became inadequate.


inflation and the effort of balance holders to obtain interest on trans­
actions balances that in most economic theorizing bear no interest were at
the root of this evolution.

Checkable interest-bearing transactions balances

such as NOW accounts (negotiable orders of withdrawal) and certain types of
money-market mutual funds expanded rapidly.

The Federal Reserve found it

necessary to include these new instruments in one or another of the monetary
In the process the aggregates were substantially redefined,


particularly in its new version first published in February 1980, jumped
from $960 billion to $1,520 billion as of year-end 1979.

Many users of the

statistic may never have become fully aware that its content had changed,


that it's behavior potentially might also have changed, even though that
behavior might not, in an immediate sense, be obviously different from that
of the earlier version.

Moderate reshuffling of some new or old components

-5would significantly alter the growth rates of Ml-B and M2 respectively.
That would be the effect, for instance, of inclusion in Ml of some moneymarket mutual funds or inclusion in M2 of retail RP's (repurchase agreements),
which exploded in August and Septenfcer of this year.

The old Ml, now Ml-A

(currency plus demand deposits), began to decline rapidly following the
introduction of nationwide NOWs at the end of last year.

Had a rigid money-

supply target been mandated by legislation or perhaps even constitutional
amendment, as had been proposed from time to time, the target would almost
certainly have been Ml and probably would have led to an extremely inflationary
policy if implemented in terms of Ml-A.
Some observers have seen in this development an economic analogue
to the Heisenberg principle of uncertainty which implies that the observed
object changes as a result of being observed.

The attempt to control a

monetary aggregate may well contribute to the motivation of market participants
to avoid this control.

More specifically, however, it is the high rate of

inflation and the consequent high level of interest rates interacting with
deposit interest-rate prohibitions or ceilings that has fueled these endeavors.

Unexplored Properties of Money
More fundamental uncertainties also underlie these shifts in the
relation of money to economic activity and changes in the components of
money itself.

Not much is known, or better is specifically agreed, concerning

the properties that an asset would have in order to be regarded as "money."
Academically, the usual approach seems to be that "money is as money does."
Econometric tests are rim to determine the relationship of money to economic

Whatever variable comes out ahead in the race, giving the best fit,


is declared "money."

One might have preferred a more fundamental approach,

examining different candidates for the title in terms of characteristics such
as liquidity, acceptability, character of the issuer, nature of the asset
being monetized, the rate of return, and many others.

At the Federal Reserve

Board, extensive and in-depth research was done in connection with the
redefinition of the aggregates in 1980« Currently, research is being
conducted into methods of weighting different components of the aggregates.
Whether the inverse of the rate of return, which features, as the principal
weighting variable in this technique, offers the best weighting system or not
is debatable.

But in any event one *is bound to suspect that there must exist

better systems of grouping, let alone weighting different types of money,
than are presently employed, even though at present it is difficult to say
which they might be or how the available data could be made to yield them.
It is hard to believe that the optimum is achieved by the existing system of
discriminating among deposits, characterized as transactions and nontransactions
balances, which is the distinction presently drawn between Ml and the higher
aggregates, or by the denomination and maturity of the instruments, which is
the distinction between M2 and M3.

Any process of weighting, of course, so

far is foregone altogether.
Likewise, there should be some information content in such
attributes of money as its ownership.

The Federal Reserve's data, which dis­

tinguish consumers , nonfinancial and financial businesses, foreign holders,
and others have bsen used effectively in research dons on money demand at the
Board, but overall do not ssem to have attracted many users, in part perhaps


because of the modest quality of the data.

In fact, most attempts to

subdivide financial assets into categories that ought to have some
informational content quickly seems to lead researchers into a flow-offunds approach, the relationship of which to the real sector and to
monetary policy making has remained frustratingly vague.
An examination of the data of the U.S.v
flow-of-funds statistics
very quickly reveals that the narrow money supply has represented a rapidly
shrinking fraction of total financial assets of domestic nonfinancial
sectors, while these total financial assets have retained a fairly constant
relationship to GNP. In other wbrds, the narrow money supply has lost some
of its importance as an asset. The chances, of course, that any financial
variable can exert a stable controlling influence over the real sector
diminish as the size of the supposedly controlling variable diminishes
relative to the size of the variable to be controlled. It is intuitively
more plausible that a large financial variable should have such an effect
than a small one. If a close correlation were to be found between such a
small variable and GNP, it would be more plausible to assume that the
causal relation was running from GNP to the small financial variable than
vice versa.
Inflation Requires Money-Supply Targets
It is remarkable that, in the face of all these unpropitLous circum­
stances and developments, the money supply has achieved its present preeminent
role as a central bank policy guide. The reason, I believe, is inflation.


Interest rates become an inappropriate policy guide, are hard to read,
dil'Iicult to justify, and likely to mislead. During inflation, a stable
rate of money growth means at least a roughly stable rate of inflation,
barring major shifts in the money demand function. A stable interest
rate very likely means an accelerating inflation, unless the interest
rate is set so high as to produce an accelerating price decline.
Even if the relationship of money to economic activity is not
stable over time, it will always be plausible in the short run that less
money means less inflation. Once the effort to bring down inflation has
become the number-policy objective, a constant policy of slowing the
growth of money becomes appropriate, largely independent of cyclical
considerations. All this helps to explain why, during inflation, central
bankers become monetarists. If and when prices are stabilized, the tempta­
tion will be great to return to interest rates as a guide.
Areas of Convergence of Views
To be sure, this ordering of priorities has still to stand the
test of both prolonged high interest rates and of recession.

It is

perfectly possible that, as has periodically occurred in the past, recession
might generate a public demand for reversal of priorities, and for action to
reduce unemployment. However, it is in the nature of a money-supply target
to accommodate such demands. In a recession, maintaining a stable growth
of money very likely means injecting into the economy much more liquidity
than is demanded at anything like prevailing interest rates. The very low
interest rates that would result from firm adherence to an unchanging moneysupply target would of themselves provide powerful stimulation to an economy


in recession.

Demands for antirecessionary policy would thus be met
Pursuit of a money-supply target, by sharply depressing

interest rates in recession and sharply raising them in expansion, builds
a floor and ceiling into the economy that tends to limit cyclical
The movement of U.S. interest rates in 1980 gives evidence of this,
even though the money-supply target was not continuously met.

More rigorous

adherence to the target would, in all probability, have produced even wider
swings in interest rates.

Thus, recession would probably not lead to demands

for abandonment of a money-supply target.

On the contrary, in recession

the vigorous pursuit of a money-supply target would probably satisfy the
popular demand for easy money and would most likely be interpreted by many
as an easy-money policy*
It is within.this broad framework of ideas that it is possible to
perceive the degree of convergence on a range of monetary-policy issues in
the United States.
(1) Priority of fighting inflation. The priority of fighting infla­
tion seems to be well established and accepted.

This contrasts with, in the

past, a predominantly anti-cyclical orientation of policy.

Steadiness in

the application of this policy is viewed as necessary.
(2) Moderate and declining targets. A need for a moderate moneysupply target, declining over time, seems to be generally accepted.


targets established by the Federal Reserve involve reliance on considerable
gains in velocity.

For instance, an Ml-B target of 3-1/2 - 6 percent

(adjusted for shifts into MOW accounts out of assets other than Ml) is


certainly a very moderate target In relation to a nominal GNP growth on
the order of 10 percent which this money supply is expected to finance.
Targets of 6-9 for M2 and 6-1/2 - 9-1/2 for M3 likewise are moderate.


annual velocity gains on the order of 5 percent for Ml-B have at times
occurred historically even without a sizable increase in interest rates.
On the contrary, failure to anticipate large velocity gains has contributed
to the expansiveness of monetary policy in the past and has repeatedly
frustrated efforts to curb inflation during the 1970's.

"Week by week and month by month?"

There seems to have been

some narrowing of the distance between those who believe that money supply
must be rigorously kept on target week by week and month by month, and
those who believe that deviations from target for one or even two quarters
have little Impact on die real sector.

On the one hand, it is becoming

increasingly apparent that very tight control is precluded by the inherent
instability of both money demand and money supply.

The amount of "noise"

in the system is reflected in a standard deviation of weekly Ml-B figures
of $3.3 billion although opinions may differ as to the degree to which
control could be improved by still more rigorous techniques governing
the supply of reserves.

Techniques are available and under study that might

serve this purpose -- the use of contemporaneous rather than lagged reserve
requirements, staggered reserve requirements, and a floating discount rate.
There are divergences of views as to whether these techniques, while improving
the accuracy of monetary control, would do so at the expense of greater
volatility of interest rates or whether interest rates also would move more

smoothly under these procedures.

It does seem to be increasingly recognized

that vide volatility of interest rates represents a cost that cannot be
On the other hand, those who stress the long lags between movements
of money and their real-sec tor. effects have eome to be aware of the damage that
prolonged deviations from target, even if economically innocuous, may cause
to the credibility of monetary policy in the current U.S. environment.


the first place, in a market that is highly sensitized to any deviations of
the aggregates from track, the danger of misinterpretation of a temporary
deviation as a policy move is always present.

It has been argued that this

kind of "Fed-watching" could be discouraged by foregoing the publication of
weekly data.

But aside from possible legal impediments to such action, the

chances are that it would be counterproductive, in addition to being inherently
distasteful to an economist.

The market very probably would construct its

own data and, if they turned out to be unreliable, would be in all the more
danger of misinterpreting policy.

Moreover, there is some evidence that the

market fundamentally interprets the data correctly, derived from the fact
that the term structure of Treasury bill futures, after each weekly publication
of the monetary data, tends to move in the direction of the spot rates that
eventually will materialize for Treasury bills at the respective future dates.
Thus, at least while the market remains highly sensitive to short-term devia­
tions from target, such deviations involve a cost in terms of possible misinter­
pretation of policy and loss of credibility which, if possible, should be


Fur themore, deviations from target remain without real-sector
effects only if the aggregates return to track subsequently, in the absence
of shifts in the money-demand function.

Otherwise, even though the original

growth rate may be reestablished after, say, a temporary upsurge, that growth
will thereafter proceed on a path with a higher level.

With more money

permanently in the economy, there will be real-sector consequences.


the aggregates back on track may not be easy, however, if the initial devia­
tion was the result of a shift in demand rather than of supply.
aggregates are pulled above their target by a

If the

surge in real spending, this

overshoot of the target presumably occurs despite Federal Reserve efforts
to hold them down.

To bring them back to track against the same strong pull

would take a much greater effort.

It is better, therefore, not to allow too

large a deviation in any case.
Finally, a money supply that is above or below target part of the
time will not remain without real-sector consequences even if from time to
time it is brought back on track.

On average, the money supply will have

been higher or lower than if the target had been continuously adhered to.
A deviation would be neutralized fully only if it were matched by an equivalent
deviation in the opposite direction.

This would not be easy to accomplish,

and represents one more reason for not deviating too much in the first place.

Credibility. Convergence of views seems to be occurring with

respect to the broad concept of "credibility," of which strict adherence to
the money-supply target is only one aspect.

It is increasingly becoming

realized that expectations, important as they are, are not formed by


announcements, but by observation of performance.

Expectations do shape

events, but primarily it is events that shape expectations.

A committee

of twelve in Washington cannot by either announcement or performance determine
the beliefs of 227 million people if the 227 million do not like what they
hear or see.

There is at present a bill in the House of Representatives

impeaching each of the members of the Federal Open Market Committee.
is a bill in the Senate that would fire the entire Board.
whether my colleagues and I would yield to such threats.


The issue is not
The fact i . that

Congress could make them come true and that the voters, moreover, conceivably
could change the Congress at the next election if Congress does -not.
Ultimate credibility, in a democracy, can be established only by the
(5) Direct effect of money vs. transmission via interest rates.
An incipient convergence of views also seems to be present in analysis of
the transmission mechanism of monetary policy.

Under the impact of high interest

rates, and their visible consequences, it is becoming increasingly obvious that
the effect of a restraining money-supply policy is transmitted to the
economy through interest rates, rather than through some direct effect.


a result, less is heard of the proposition that monetary policy by itself
should act to restrain inflation while fiscal policy should be eased to
stimulate investment.

It is recognized that interest rates affect investment,

and that they restrain inflation by restraining aggregate demand.
(6) Liquidity preference vs. Fisher effect. A pragmatic sort of
agreement seems to be on the horizon regarding the relation of money and
interest rates.

The classical Keynesian proposition that an increase in



the money supply lowers interest rates (liquidity preference) seems to be
challenged by the weekly observation of reactions to newly published moneysupply data. Whenever a strong rise is observed, and particularly if it
continues for more than one week, interest rates will go up.


interpretation of this phenomenon is that the market views the increase in
the aggregates as signaling more inflation ahead and discounts this
immediately by moving to higher interest rates (Fisher effect).

A more

mundane interpretation is that when the market sees the aggregates moving
above their track, it knows that reserve demands will tend to strengthen
relative to supplies as the Fed attempts to bring them down again and that
this effort will be associated with higher interest rates which the market,
therefore, implements immediately.
Both interpretations lead to the same conclusion -- an increase in
the money stock raises interest rates.

It is nevertheless important to

differentitate between them because an increase in the money stock may reflect
a shift either of the supply curve or the demand curve for money.
The first view —
Inflationary expectations —

that an increase in the money stock

raises the

implies a shift in the supply curve of money.

This occurs when the central bank supplies reserves at a faster pace or
the banks convert these reserves into deposits with a higher money multiplier
by demanding less excess reserves, or because more of the deposits shift to
banks with low or zero reserve requirements, or any of the other factors that
may increase the multiplier.

The second view —

that an increase in the

money stock will be followed by stronger efforts to bring it back on target

implies a shift in the demand curve for money.

An upward movement


simultaneously of price and quantity is the normal result of a demand

A supply curve shift normally causes opposite movements in price

and quantity.

It seems more plausible, therefore, to attribute a

simultaneous rise in money supply and interest rate to a demand-curve
shift than to see in it a supply-curve shift with instant repercussions
on inflation expectations and interest rates.
Nevertheless, there is enough plausibility to the supply-curve
shift/inflation-expectations nexus to make it an important factor in policy

The positive correlation between money and interest rates

that is observable almost every week when the money-supply data are published,
probably is due, as just noted, to demand-curve shifts and does not indicate
that any easing by the central bank, through accelerated money supply, is
immediately followed by higher interest rates.

But any such easing, if

and when it were to occur, would nevertheless be followed, with a lag, by
higher inflation expectations and therefore interest rates.

Thus the

inability of the central bank to influence interest rates by moving the
supply curve seems extremely limited.

An increase in the rate of growth of

money supply generated by the Federal Reserve in the face of unchanging
money demand probably brings down short-term rates for some period ahead.
But given the probably shortening lag between money and its economic effects,
inflation will soon increase and expectation of inflation will increase
even earlier.

Long-term rates, therefore, might hardly come down at all

in response to a Federal Reserve induced acceleration of the money supply.
An acceleration of inflation, moreover, would quickly compel the Federal
Reserve to reverse its expansionary action.

Thus, the ability of the


central bank to lower Interest rates by accelerating the money supply
is extremely limited.

That is the truth content of the statement that

"an increase in money raises interest rates."

Influence over interest rates. Following from the foregoing,

there is mounting recognition that die central bank can achieve a lasting
reduction in interest rates only insofar as it can bring down inflation and
inflation expectations.

Interest rates could come down also if the economy

should weaken significantly and with it the demand for money and credit.
This, of course, would not be a lasting solution —

if the economy should

recover without any abatement of inflation, interest rates would return to
their previous high levels.
At any given level of inflation and income, a lasting reduction
in interest rates could be brought about only by an increase in saving,
particularly the saving (or reduction in dissaving) of the government.
This indeed would produce a reduction in real interest rates.

On this

analysis a growing consensus is emerging in light of the response of
financial markets to the prospect of a much enlarged federal deficit.
Under prevailing conditions, the enduring power wielded over interest rates
by the budget far exceeds that wielded by the central bank.

Fiscal policy,

although of late regarded by many as having less power than monetary policy
in the determination of interest rates, is revealed to be more powerful.
This should not be surprising, since monetary policy cannot, in the long
run, influence real variables whereas fiscal policy can.

The growing

realization that this is so nevertheless makes an important contribution
to the convergence of views on monetary policy.



What Is "Easing?1 One area remains in which little convergence

of views is apparent so far, possibly because it is a question of semantics,
or at least definition. .This is the interpretation of "easing" and "tightening"
of monetary policy.

In terms of money-stock targeting, an upward deviation,

i.e., an acceleration of money growth, presumably should be viewed as easing,
a downward deviation as tightening.

If such deviations occur at the initiative

of the central bank, i.e., represent a shift in the supply function of money,
interest rates, or at least short-term rates, at least initially will move
in directions suggesting the same interpretation as the movement of the
aggregates, i.e., interest rates falling when the aggregates accelerate,
and vice versa.

If, however, the cause of a deviation from the money-supply

target is a shift in demand, interest rates will move in the same direction
as the aggregates and will thus throw off an opposite signal.


aggregates would signal tightening; falling interest rates would signal
Probably the great majority of observers and certainly the general
public interpret monetary policy in terms of interest rates.


sophistication is required to ignore interest rates and be guided by the
money supply.

Moreover, interest rates do, of course, exert a stimulating

or restraining influence on the real sector.

Thus, in the case of a recession

and a consequent demand-induced deceleration of the aggregates, with a simulta­
neous drop in interest rates, one could speak of a tightening action only
in the sense that the drop'in interest rates does not go as far as it would
have had the aggregates not decelerated.


Fund amenta lly, this issue raises the question how "easy" or
"tight" monetary policy should be during cyclical expansions and contrac­
tions, to which reference was made earlier.

Should interest rates move as

far down and up as they would have to if the money supply is to be kept
rigorously on track?

Or should interest-rate fluctuations be more moderate,

in order to avoid, during recessions, conveying to the public the impression
that the central bank had given up fighting inflation.

This issue arose in

the second quarter of 1980, when interest rates dropped precipitously but
the money stock nevertheless fell below target.

Flooding the economy with

liquidity under such conditions reduced the danger of a deeper and more
prolonged recession.

But it may have sent out the wrong signal to the

public and laid the groundwork for an excessive subsequent expansion, in
addition to possibly causing wide swings in exchange rates.

Such swings

carry the risk of doing damage to markets, financial institutions, and
sensitive sectors of the economy at home and abroad.
Moreover, a policy allowing or indeed promoting very wide swings
in interest rates poses the issue of negative real rates.

Are negative

real rates ever appropriate when the continuing objective is to fight

In the absence of inflation, even the easiest of easy-money

policies cannot make real rates negative.

Is it possible to fight inflation

with interest rates that are lower, in real terms, than the lowest that can
be attained when prices are not inflating?

Or do negative real rates,

especially taking tax deductibility into account, while preventing further
contraction of the real sector, just prepare the ground for a resurgence of
inflation during the next expansionary phase?

Convergence of views on these

issues is necessary to avoid serious misunderstandings about policy.


In conclusion, it is necessary to reemphasize that the analytical
and policy issues on many of which there is now a convergence of views
pertain to a period of high inflation.

Inflation gives preeminent importance

to the money supply as a target and instrument of policy.

In conditions of

credibly stable prices, interest rates would again play a major role in
central-bank policy.

But the lesson of experience surely is that both need

to be considered in some degree at all times.

During inflation, a money-

supply policy that ignores interest rates altogether and, for instance,
during a recession, generates severely negative real rates, lacks credibility.
In times of stable prices, an interest-rate policy that leads to excessively
high money growth is likely to come to grief.

The debate over the respective

merits of the new kinds of policy guides may continue, but a compromise
position, weighted one way or the other according to the rate of inflation,
seems appropriate at all times.