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Remarks by

HUGH D. GALUSHA, JR.
President
Federal Reserve Bank of Minneapolis

at the

Tenth Annual Controllers Conference
National Sand and Gravel Association
National Ready Mixed Concrete Association

Saint Paul Hilton
Saint Paul, Minnesota

July 23, 1968

As some of you m a y know, I came to the Federal Reserve System from
a lifetime in tax practice only a relatively short time ago--in M a r c h 1965,
to be exact.

This is only a little more than three years ago, and yet I

have moments whe n it seems as though I have been president of the Federal
Reserve Bank of Minneapolis for an eternity.

I have witnessed and helped

contend with m y share of crises, both domestic and international, as I am
sure you will agree.

But I also have moments when I think of m y self as

having been extraordinarily lucky.

From the beginning, I have had an exciting

time, both as president of the Minneapolis Bank and as a member of the Federal
Open Market Committee, which in large measure shapes mone t a r y policy.
had a rare opportunity to learn.

I have

And at the risk of seeming immodest, I will

say that I have learned two things.

What exactly?

The first thing is that

the Internal Revenue code at its incomprehensible worst is a child's primer
compared with some of the pronouncements by m o n etary economists on the events
of the last three years.

For another thing, too much should not be expected

of the Federal Reserve System.

It cannot be counted on single-handedly to

restrain inflationary pressures, or to forestall crises of confidence in the
dollar.
This last m a y strike you as a strange lesson for a Federal Reserve
official to have learned--or, having learned it, to confess publicly that
he has.

It is extremely important, however, that we confer upon our public

institutions--and the Federal Reserve System is that, a public institution-responsibilities no heavier than they can reasonably shoulder.

So, to begin,

let me explain why I believe that the System cannot be relied upon to, for
example, prevent inflation by itself, or why I believe, as I do, that it
must operate against the background of an appropriate fiscal policy.




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As I have learned--to m y sorrow, I might add--economists disagree
among themselves on m a n y things.

You might say they disagree on as ma n y

things as tax attorneys, except that they express their disagreements in
even more complicated language.

They disagree on how effective an increase

in interest rates, or the cost of borrowing, is in restraining total demand
for goods and services.

Some say that a change in the cost of borrowing

has an effect, that when this cost increases some businessmen postpone pur­
chases of plant and equipment, and possibly inventories as well; and that
some prospective house-buyers postpone their purchases.
though, who stress the availability of loanable funds.

There are others,
These economists

say that what restrains demand for goods and services is the simple unavail­
ability of funds.

A businessman or prospective house-buyer m a y be quite

willing to pay whatever it costs for funds, but if he cannot get the funds,
possibly because no bank has them to lend at any reasonable price, he will
not be able to purchase that new plant or new house.
For myself, I am inclined to side with those who stress the avail­
ability of loanable funds, or credit rationing, although I would certainly
agree that any increase in borrowing costs, if appreciable, must dissuade
at least a few would-be spenders from carrying out previously made plans.
The point, however, is this:

whether mo n e t a r y restraint works through an

increase in borrowing costs or an increase in credit rationing, it will be
reflected in increases in rates on marketable securities, both short-term and
long.

It must involve an increase in rates on Treasury bills and commercial

bills, and on rates on Treasury bonds and the bonds of corporations and
state and local governmental units.

And if total demand for the n a t i o n ’
s

output is greatly in excess of the n a t i o n 1s ability to produce, as lately
it has been, then m o n e t a r y restraint must involve sharp increases in market




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interest rates.

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Curbing inflationary pressures by means of m o n e t a r y policy

involves increasing interest rates--in proportion, as it were, to the strength
of the pressures.
Wh i c h brings me to the problem.

Increases in market interest rates,

if sufficiently rapid and sharp, can threaten the stability of the financial
system, and in addition severely alter the pattern of economic activity in
the nation.

Let me explain.

One of the remarkable advantages the U.S. enjoys

is that it has a broad network of thrift institutions which channel private
savings into the hands of those who want to invest, whether in new houses
or new plants.

These institutions offer savers highly liquid financial

assets; and at the same time they offer borrowers long-term loans.

To over­

simplify a little, these institutions borrow at short-term and lend at long­
term.

Which is fine, except that when market interest rates increase, b o r ­

rowing costs of these institutions increase more than do portfolio earnings.
This is simply because these institutions, if they are to m a intain their
share and deposit accounts, must pay something like what share and deposit
owners can earn on alternate investments.

But these institutions cannot

increase their portfolio income until their previously-made loans mature.
Of course, when market interest rates decrease, borrowing costs decrease
more than do portfolio earnings.

And over a long enough period borrowing

costs and portfolio earnings will, as it were, balance out.

But this is

small consolation to the thrift institution which during a period of rapidly
increasing interest rates has become in s o l v e n t - - o r , in the vernacular, gone
broke.
Over recent years we have accumulated a good bit of evidence,
both casual and statistical, that savers are sensitive to interest rate
differentials, and that some savers do shift their funds to take advantage




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of better opportunities.

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We have accumulated evidence that savers, small

and large, will switch from deposit or share accounts into, for example,
Treasury securities to gain an interest rate advantage, or from Treasury
securities into deposit or share accounts if this is what the going interest
rate spread dictates.

It is not clear that savers are quick to switch between

debt and equities, depending on what the outlook is, but it is enough that
some will not hesitate to switch between, on the one hand, deposit and share
accounts and, on the other hand, market securities.

It is this willingness

to shift which gives rise to the dilemma of thrift i n s t i t u t i o n s - - a n d , I
might add, the Federal Reserve.
If thrift institutions do not increase the rates they pay deposit
and share owners, they will lose funds, and when they have exhausted their
own credit lines will be forced to liquidate assets.

Even if possible,

liquidation can involve considerable capital losses, and so threaten solvency.
And, of course, liquidating mortgage loans is not always possible.

But if

rates paid deposit and share holders are increased to levels high enough to
keep savers hitched, the margin starts to disappear; and the increase in
costs has to be paid not out of current earnings but out of accumulated
surplus.

And quite obviously payments out of accumulated surplus cannot

go on forever.
I have stated the dilemma posed for thrift institutions, and
thereby for the monet a r y authority, the Federal Reserve System, starkly-too starkly perhaps.

I did not me a n to suggest that any increase in market

interest rates, however slight, threatens the stability of the financial
system.

I meant to suggest only that a sudden increase in rates, to sharply

higher levels, can do so.

But sudden, sharp increases are what we should

have in mind if we are thinking about the Federal Reserve, by itself trying




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to maintain price stability--or trying to offset,

in a full-employment

environment, a sharp increase in the federal g o v e r n m e n t s deficit.
No r did I have in mind that poor management of thrift institutions
is ultimately the explanation for the Federal R e s e r v e ’ inability to do all
s
that is necessary to prevent inflation.
have been poorly managed.

N o doubt some have taken extreme risks to maintain

impressive rates of growth.
been the exception.

N o doubt some thrift institutions

Poorly managed thrift institutions have, however,

But even among well-managed institutions, a sharp,

sudden increase in market interest rates can pose an awkward dilemma.
as I have indicated, the Federal Reserve faces a dilemma too.

And

A sharp,

sudden increase in market interest rates m a y be necessary to restrain infla­
tionary pressures.

But an increase in rates, if sharp and sudden enough,

can threaten the solvency of the financial sector.
Lest I be thought of as conjuring up unreal dilemmas,
for you the experience of 1966.

let me recall

Over the first half of 1966, market interest

rates were increased considerably, although less than was required to prevent
a general increase in prices.

W h y less than was required?

Because m a n y

thrift institutions lost considerable sums, and some were at the danger
point.

Losing funds as they were, they were hardly in a position to sustain

the flow of mortgage loans, and as a result the construction industry nearly
ground to a halt.

M y mother used to caution me about reminding people of

unpleasant personal history by saying one never speaks of a halter in the
house of one w h o fs been hanged.

The plight of the construction industry

in 1966 is such a halter to this audience, I suspect.

Let me say only that

the collapse of the construction industry in 1966 shows the inequity of
relying too m u c h on monetary restraint, or alternatively too little on fiscal
restraint.




It is pretty much inevitable that the construction industry is

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going to suffer more, much more, under mo n e t a r y restraint than, say, the
shoe industry or even the automobile industry.
This is of course because of the close link between the construction
industry and all institutional lenders, but especially the thrift institutions.
It is axiomatic that if the principal suppliers of funds to an industry are
in trouble so is the industry.

And in trouble these fund suppliers were.

As m o n e y market rates rose for bank CD's and for government and corporate
bonds, savers took their m o n e y from S

6c

L fs to the banks or to the market

and by-passed the intermediate thrift institutions.

This phenomenon was

glorified with the title of " d i s i ntermediation,1 and the suffering of the
1
patient was in direct proportion to the incomprehensibility of the name of
the disease.
That there has not been anything like as much disintermediation
so far in 1968 as there was in 1966, is partly because the Congress, spurred
by developments of early 1966, passed a bill in September of that year which
empowered regulatory agencies to set limits on rates paid by thrift insti­
tutions, and required that the Federal Reserve, the Federal Deposit Insurance
Corporation and the Federal Home Loan Bank Board jointly determine what
appropriate rate ceilings might be.

The aim was to limit rate competition

between commercial banks and thrift institutions at least.

It was felt that

in 1966 m a n y share and deposit owners switched not only to market securities
but to commercial bank deposits, and that this switch, made possible by an
increase in the rates banks could pay for time m o n e y in December 1965, had
itensified the problem of the construction industry.
Of late, then, thrift institutions have not had to contend with
as much competition from commercial banks as they had to in 1966.
aside,




As an

let me add here that commercial banks are better able to cope with

sharp increases in market interest rates than are thrift institutions.
for the obvious reasons.

And

Their loans are on average of shorter maturity.

Also, their borrowing costs do not increase as much.

They do not pay interest-

directly at least--on demand deposits.
But when Congress passed the Interest Control Act, it did not solve
the Federal Reserve*s problem.

If it insulated thrift institutions from

commercial bank rate competition,

it did not insulate either the thrift

institutions or commercial banks from market rate competition.

For banks

too, however better able to compete with the bond market than the thrift
institutions, must inevitably lose deposits to the market place when their
rates fall behind.

All along there has been a danger that savers would

shift to market securities, as to some small extent they have.

To date,

there has not been a massive shift, but in good part because the Federal
Reserve has not forced market interest rates way up above the m a x i m u m rates
which can be paid by thrift institutions and commercial banks.

It has been

careful not to, even though inflationary pressures have continued strong.
I have outlined why, in m y opinion, the country cannot rely on
the Federal Reserve to keep the price level stable, or to prevent inflation,
and why in the future it must rely more than in recent years it has on fiscal
policy.

But please understand me.

cannot be relied upon at all.

I am not saying that the Federal Reserve

Indeed not.

As the recent past clearly shows,

it can help restrain inflationary pressures, and deflationary pressures too.
There is a world of difference, however, between asking the Federal Reserve
to help in the task of maintaining economic stability and asking it to
shoulder the whole task by itself.
Let me also add here by way of qualification that time and change
could make one unlearn this lesson I have learned.




By changing lending and

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borrowing practices, thrift institutions might to some extent insulate them­
selves from sharp, sudden increases in interest rates.

There is the p o s s i ­

bility certainly that they were caught, as it were, off guard in 1966, and
they do seem even since then to have changed their practices somewhat.

One

can be hopeful, then, that in the wake of the experience of 1966 and to a
lesser extent 1968 the thrift institutions will change somewhat, that they
will shorten the average m a tu rity of their asset portfolios, maintain stronger
liquidity positions, and diversify somewhat their liabilities.

To the extent

that they do, the mo n e t a r y authority will gain freedom of maneuver.
But only with a national fiscal policy geared to the necessities
of the economy can we avoid the lurching, wrenching impact of excessive
reliance on m o n e t a r y policy.

Not the least of the benefits of the tax bill

just passed has been the easing of the m o n e y markets--not much to be sure
on the long end, but the 20 or so basis points off the short government
market is an encouraging sign.
It might be thought that Federal Reserve speakers and writers of
market letters will be at a loss for subjects now that Congress has finally
reacted.

However desirable you or I might regard this, there is no hope

for us.

During these last three years, central bankers of the free world

have been forced into the realization that no m a jor industrial nation of
the west can pursue its own mo n e t a r y and fiscal ends oblivious of the impact
they m a y have on others; or, conversely, in ignorance of the impact monetary
and economic policies of other countries will have on it.

Out of this

realization has come patterns of cooperation that made it possible for the
international mone t a r y system to survive--so far--British crises, d e v a l ­
uation of the pound, disintegration of the London gold pool, the current
French crisis, and of course our own intractable balance of payments deficit.




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I have spoken of the threat posed by sharp, sudden increases in
interest rates.

I would not want to leave you with the impression that,

out of fear, the Federal Reserve is henceforth going to work toward m a i n ­
taining roughly constant interest rates.

The truth is it cannot, for over

the postwar period the U.S. has become the dominant international lender and
banker.

To put the point differently, the U.S. balance of payments and U.S.

official reserves of gold and foreign exchange are importantly affected by
the spread between U.S. interest rates and rates in the rest of the world.
And what this means is that, to some extent anyway, U.S. rates have to be
changed when rates in other important countries are changed.

This would

not be so bad were it not for the inclination of some governments, part i c u ­
larly in Europe, to rely greatly on monet a r y restraint, or for the inclination
of some governments to increase interest rates to check inflationary pressures.
Looking ahead, then, you should not expect even roughly constant
interest rates in the U.S.

U.S. M o n e t a r y policy will have to be changed

as mone t a r y policies in other countries are changed.

And to repeat what

I said before, m o n e t a r y policy has an important role to play in promoting
economic stability.

But to repeat m y major point, which is a point made by

the record of the past few years, it is no good hoping that mone t a r y policy
can substitute for an appropriate fiscal policy.

Which is why the Federal

Reserve has all along supported the P r e s i d e n t ’ call for a surcharge and
s
why in the future it will continue to urge an appropriate fiscal policy.
For in the delicate balancing of domestic and international
economic pressures, the job of the Federal Reserve will be made easier, and
more importantly,

less likely disruptive of highly vulnerable industries

like yours, if major shifts in the direction of the domestic U.S. economy
are accomplished by tax and spending changes of our government--that is to




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say fiscal policy.

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But one thing has been made abundantly clear--we cannot

expect quick responses from fiscal policy.

This means m o n e t a r y policy will

continue to attempt the dampening of domestic and international events on
our mon ey markets; and given the magnitude and frequency of these events,
there is little reason to expect stability of either rates or availability
of funds.