The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
THE FEDERAL RESERVE AND THE BUSINESS OUTLOOK REMARKS OF JOHN J. BALLES, PRESIDENT FEDERAL RESERVE BANK OF SAN FRANCISCO MEETING WITH SALT LAKE CITY COMMUNITY LEADERS SALT LAKE CITY, UTAH NOVEMBER 3, 1983 - 1 - INTRODUCTIQN The U,S, economy went through some pretty wrenching times in the LAST FEW YEARS. STILL, A REVIEW OF THE RECENT BUSINESS AND FINANCIAL NEWS SUGGESTS THAT WE'VE ACCOMPLISHED A GREAT DEAL LATELY IN CLEARING THE ECONOMIC LANDSCAPE OF ONE OF OUR MOST SERIOUS PROBLEMS "INFLATION — ALTHOUGH OF COURSE THE JOB IS FAR FROM FINISHED, SPECIFICALLY, OUR POLICY ACTIONS HAVE CUT THE RATE OF INFLATION IN HALF SINCE 1981, AND IN THE PROCESS ESTABLISHED THE BASE FOR A S U B S T A N T I A BUSINESS RECOVERY. YET UNEMPLOYMENT AND FINANCIAL PROBLEMS CONTINUE TO PLAGUE THE U.S. AND WORLD ECONOMIES, WHILE THE !:*NA'vJ!:\'3 OF A MASSIVE FEDERAL DEFICIT HAMPERS OUR TWO-FOLD TASK OF FOSTERING THE RECOVERY AND CURBING A RESURGENCE OF INFLATION. Strengths and weaknesses Reduced inflation represents our strongest Indeed, it is a remarkable achievement in light recent * vement. of wha'i *cnt before — that is, a seemingly unstoppable price spiral that badly undermined THE ECONOMY THROUGHOUT THE PAST DECADE. LAST YEAR, FOR EXAMPLE, THE CONSUMER PRICE INDEX AND THE WHOLESALE PRICE INDEX FOR FINISHED GOODS ROSE BY ABOUT 4 PERCENT AND 3.5 PERCENT, RESPECTIVELY (YEAR OVER YEAR), OR LESS THAN ONE-THIRD THEIR RATES OF INCREASE IN THE FIRST EIGHT MONTHS OF THIS YEAR THE CPI ROSE AT A 4,1 1980. DURING PERCENT ANNUAL RATE, WHILE THE WHOLESALE PRICE INDEX HAS ACTUALLY FALLEN AT AN ANNUAL RATE OF NEARLY ONE PERCENT FROM DECEMBER TO AUGUST, AS THE INFLATION NUMBERS CONTINUE TO BRING GOOD NEWS, ATTENTION IS BEING INCREASINGLY FOCUSED ON THE ECONOMY'S ABILITY TO SUSTAIN THE ECONOMIC EXPANSION THAT BEGAN AT THE END OF LAST YEAR. THE INDEX OF " 2 " LEADING ECONOMIC INDICATORS HAS BEEN MOVING UPWARD SINCE SEPTEMBER 1982, and since January has scored a very IMPRESSIVE GAIN OF GROWTH AT 9,7 9.0 PERCENT, GNP BUTTRESSING THAT EVIDENCE, REAL PERCENT IN THE SECOND QUARTER OF THIS YEAR IS THE STRONGEST IT HAS BEEN IN OVER TWO YEARS/ AND ESTIMATES FOR THE THIRD OIARTER INDICATE GNP CONTINUES TO EXPAND AT A HEALTHY 7,9 PERCENT RATE, ALSO, THE UNEMPLOYMENT RATE HAS DROPPED OUT OF DOUBLE-DIGIT TERRITORY TO ALMOST 9,3 PERCENT IN SEPTEMBER/ AS EMPLOYMENT INCREASED BY 2k MILLION BETWEEN MAY AND SEPTEMBER, THE SCATTERED SIGNS OF WEAKNESS THAT SHOWED UP IN AUGUST APPEAR TO BE DISAPPEARING AS THE SEPTEMBER NUMBERS COME IN, THUS THE FALL- OFF in A u g u s t a u t o s a l e s r e v e r s e d i t s e l f in S e p t e m b e r , s u g g e s t i n g t h a t the Au g u s t w e a k n e s s w a s c a u s e d by dea l e r s h o r t a g e s of ca r s ra t h e r t h a n ANY RELUCTANCE ON THE PART OF THE AMERICAN CAR-BUYING PUBLIC, S i m i l a r l y , p e r s o n a l i n c o m e g r o w t h b e g a n t o p i c k u p s t e a m a g a i n in S e p t e m b e r l e a d i n g m a n y o b s e r v e r s t o a t t r i b u t e t h e A u g u s t s l o w - d o w n in THIS KEY STATISTIC TO THE TELEPHONE WORKERS STRIKE, AND AS INCOMES HAVE REBOUNDED, SO HAVE RETAIL SALES, WHICH GREW 1,5 PERCENT IN September after falling 1,6 percent in August, T h u s it s e e m s c l e a r t h a t t h e c u r r e n t e c o n o m i c e x p a n s i o n is continuing, T h e IMPORTANT QUESTION a t t h i s p o i n t , h o w e v e r , is w h a t POTENTIAL PROBLEMS MIGHT LIE AHEAD, To MY MIND, THERE ARE THREE, F i r s t , is t h e r e a r i s k o f i n f l a t i o n r e - a c c e l e r a t i n g a s t h e e c o n o m y CONTINUES TO EXPAND? SECOND, DO HIGH INTEREST RATES RAISE THE POSSIBILITY OF RECESSION NEXT YEAR? AflD THIRD, DOES THE PROSPECT OF LARGE GOVERNMENT DEFICITS THREATEN TO DISTORT THE RECOVERY? I WILL RETURN TO THESE POINTS AFTER DISCUSSING WHAT I THINK ARE THE MOST U.S. LIKELY OUTLOOKS FOR THE 1983 and 1984 AND HAWAIIAN ECONOMIES. Outlook for nation At our Bank, we expect real GNP for the U.S. as a whole could grow close to about 5.0 6.0 percent in om_y modestly in 1983 percent during 1984. Plant 1983, and should continue to expand at and equipment spending has grown because of the current high levels of excess PLANT CAPACITY; AND NET EXPORTS HAVE ACTUALLY d e c l i n e d , o w i n g t o a s t r o n g e x c h a n g e v a l u e of the d o l l a r . has been the real leader recovery. In c o n t r a s t , c o n s u m e r s p e n d i n g in p r o m o t i n g a n d s u s t a i n i n g t h e c u r r e n t T h i s s t r e n g t h in c o n s u m e r s p e n d i n g r e f l e c t s t h e s u b s t a n t i a l improvement in r e a l c o n s u m e r dramatically, last incomes and w e a l t h , as inflation slowed J u l y 's t a x c u t s t o o k e f f e c t , a n d t h e s p a r k l i n g s t o c k m a r k e t r a l l y b o o s t e d t h e v a l u e o f h o u s e h o l d 's p o r t f o l i o s . Consumer spending grew at a robust of 1983. 6.4 W e expect this growth to slow to a last half of 1983 percent in the first half 3.5 percent rate over the and continue at this more moderate pace in 1984, as households turn their attention to restoring their savings patterns to MORE TRADITIONAL LEVELS. In THE SECOND QUARTER OF THIS YEAR, THE PERSONAL SAVINGS RATE FELL TO RECORDED. 4 PERCENT, ITS LOWEST LEVEL EVER VIE ANTICIPATE HOUSEHOLDS WILL NCW BEGIN TO REBUILD THIS RATIO BY PULLING BACK SOMEWHAT ON THE RATE AT WHICH THEY SPEND. S i m i l a r l y , t h e s u r g e in i n v e n t o r y i n v e s t m e n t w e h a v e e x p e r i e n c e d RECENTLY WILL NOT CONTINUE TO PROVIDE THE SAME SPUR TO THE GROWTH OF OUTPUT AND EMPLOYMENT IN 1982 1984 THAT IT DID THIS YEAR. At THE END OF BUSINESSES WERE RUNNING OFF INVENTORIES, CAUSING REAL GNP GROWTH TO BE DEPRESSED, In CONTRAST, BY THE THIRD QUARTER OF 1983, THEY WERE ESTIMATED TO BE ADDING SIGNIFICANTLY TO THEIR INVENTORIES, WHICH TENDED TO RAISE REAL GNP GROWTH. THIS TURN-AROUND IN INVENTORIES IS ESTIMATED TO ACCOUNT FOR NEARLY HALF OF THE GROWTH OF REAL GNP SINCE THE RECOVERY BEGAN, In 1984, HOWEVER, INVENTORY INVESTMENT WILL NOT GROW BY NEARLY AS MUCH, SIMPLY BEACUSE INVENTORY" SALES RATIOS ARE NCW REASONABLY COMFORTABLE, D e s p i t e m o r e m o d e r a t e g r o w t h in p e r s o n a l c o n s u m p t i o n e x p e n d i t u r e s AND INVENTORY ACCUMULATION, WE EXPECT OVERALL. GROWTH OF THE ECONOMY IN 1984 TO BE NEARLY AS STRONG AS IN 1983, BUSINESS SPENDING ON PLANT AND EQUIPMENT, SPENDING BY THE FEDERAL GOVERNMENT, AND A MODEST REBOUND IN NET EXPORTS ARE LIKELY TO LEAD THE WAY, ALTHOUGH THE RATE OF CAPACITY UTILIZATION IS STIU. RELATIVELY LOW, BUSINESS EXPENDITURES TO INSTALL MORE EFFICIENT AND MODERN EQUIPMENT ARE ALREADY niJITE STRONG, PARTLY AS A CONSEOIENCE OF THE TAX INCENTIVES IN THE ECONOMIC Recovery Tax A c t o f 1981, A l s o , as e c o n o m i c recovery g a i n s m o m e n t u m ABROAD, OUR FOREIGN TRADE PICTURE SHOULD IMPROVE SOMEWHAT, EVEN THOUGH THESE GAINS WILL BE LIMITED BY THE CONTINUED STRENGTH IN THE INTERNATIONAL VALUE OF THE DOLLAR. ALL IN ALL, WE CAN EXPECT THE CONTINUATION OF SOLID GROWTH FOR THE REST OF THE YEAR AND NEXT YEAR, BUT CERTAINLY NO BOOM, U t a h Sc e n e Let m e t u r n n e x t t o th e U t a h s c e n e , T he Ut a h e c o n o m y has b e e n SHOWING SIGNS OF MODEST OVERALL IMPROVEMENT SINCE LAST SPRING, C o n t i n u e d l a y o f f s in t h e i m p o r t a n t m e t a l , a n d e n e r g y m i n i n g a n d - 5 - PROCESSING/ INDUSTRIES EARLIER IN THE YEAR TENDED TO DELAY THE RECOVERY/ AS DID THE DISLOCATIONS CAUSED BY THE FLOODS LAST SPRING, M o s t o f t h e i m p r o v e m e n t s o f a r h a s b e e n c e n t e r e d in r e s i d e n t i a l AND NONRESIDENTIAL CONSTRUCTION ACTIVITY AND IN THE DEMAND FOR HIGH TECHNOLOGY MANUFACTURED PRODUCTS FOR DEFENSE AND SPACE PURPOSES, LlKE THE REST OF THE NATION/ THE DROP IN MORTGAGE INTEREST RATES HAS SPURRED HOMEBUILDING AND SALES IN THE STATE, WHILE HIGHWAY AND POWER PLANT CONSTRUCTION HAS HELPED TO BOOST NONRESIDENTIAL CONSTRUCTION EXPENDITURES AND EMPLOYMENT, UTAH'S AIRCRAFT/ MISSILES/ AND SPACE INDUSTRIES ALSO HAVE BEEN BENEFITING FROM A SHARP INCREASE IN DEFENSE SPENDING. D e s p i t e t h e s e i m p r o v e m e n t s / U t a h 's o v e r a l l g r o w t h is l i k e l y t o b e MODEST THIS YEAR AND INTO 1984. MORE BUOYANT GROWTH WOULD REQUIRE A SIGNIFICANT PICKUP IN ITS METAL AND ENERGY MINING OPERATIONS, AND THE PROSPECT FOR THAT HAPPENING IS NOT ENCOURAGING. U.S. AUTO, HOUSING AND APPLIANCE INDUSTRIES HAVE BEEN INCREASING THEIR CONSUMPTION OF METALS BUT THIS HAS BEEN OFFSET BY BOOSTS IN FOREIGN PRODUCTION, SO THAT PRODUCER INVENTORIES ARE STILL EXCESSIVE AND PRICES REMAIN DEPRESSED, SIMILARLY, UTAH'S COAL PRODUCERS PROBABLY WILL CONTINUE TO OPERATE IN AN ATMOSPHERE OF ABUNDANT WORLDWIDE ENERGY SUPPLIES AND RELATIVELY LOW PRICES, WHILE URANIUM MINING WILL REMAIN DEPRESSED AS A RESULT OF THE PROBLEMS CONFRONTING NUCLEAR POWER PLANT CONSTRUCTION, R e l a t i v e l y l o w a c t i v i t y in t h e s e i n d u s t r i e s in t u r n h o l d s d o w n t h e demand for mining equipment and related supplies manufactured in Ut a h , P r o s p e c t s a r e s o m e w h a t b r i g h t e r in a g r i c u l t u r e / w h e r e U t a h g r a i n p r o d u c e r s are l i k e l y to earn mo r e b e c a u s e of h i g h e r p r i c e s c a u s e d BY - t h i s y e a r 's 6 - M idwestern d r o u g h t . But these same h ig h grain pr ices w i l l RAISE LIVESTOCK FEED COSTS AND MAY FORCE SOME REDUCTION OF UTAH HERDS AT BELOW BREAK-EVEN PRICES, Homebuilding -- an activity that has contributed greatly to Utah's and the nation's economic recovery this year — provide less stimulus in 1984, is likely to Given the huge increase in sousing starts already achieved this year, housing starts in Utah may be up a smaller percentage next year — and that gain will be dependent upon a decline in mortgage interest rates, Concern over the current and FUTURE STATE OF INTEREST RATES IS ONE OF THE TOPICS I WANT TO TURN TO NEXT, In f l a t i o n r i s k D e s p i t e a l l t h e p l u s s i g n s in t h e o u t l o o k , s e r i o u s c o n c e r n s REMAIN, AS I MENTIONED EARLIER, THERE IS THE CONCERN WHETHER INFLATION WILL PICK UP IN 1984, TYPICALLY, INFLATION DOES NOT BEGIN TO RISE UNTIL AT LEAST A YEAR AFTER A BUSINESS CYCLE UPTURN, VJITH THE RECOVERY NEARLY A YEAR OLD THIS WOULD ARGUE FOR A REBOUND IN INFLATION NEXT YEAR, THE STANDARD EXPLANATION FOR THE CYCLICAL UPTURN IN INFLATION POINTS TO EXPANSIONARY MACROECONOMIC POLICY AS THE FUNDAMENTAL CAUSE, THUS A MORE STIMULATORY POLICY FIRST INCREASES OUTPUT AND EMPLOYMENT, AND THEN SHOWS UP LATER — WITH A LAG IN OTHER WORDS ” IN HIGHER PRICES, VIITH THIS BACKGROUND IN MIND, SOME COMMENTATORS HAVE ARGUED THAT THE FED HAS ALREADY LET THE INFLATIONARY CAT OUT OF THE BAG, THUS FOR THE TWELVE MONTHS ENDING AUGUST OF 1983, THE Ml DEFINITION OF THE MONEY SUPPLY, WHICH IS COMPOSED OF CURRENCY AND ALL CHECKABLE - DEPOSITS/ GREW AT A 12,7 7 - ANNUAL RATE, THE HIGHEST SUSTAINED MONETARY expansion since World W a r II, The critical question is whether this FORETELLS A DRAMATIC RISE IN INFLATION SOMETIME IN THE FUTURE. IN MY OPINION IT DOES NOT/ BECAUSE MUCH OF THE OBSERVED HIGH MONEY GROWTH/ AT LEAST IN LATE 1982 AND THE FIRST PART OF 1983/ WAS MATCHED BY AN INCREASE IN MONEY DEMAND. LET ME EXPLAIN THIS POINT IN A LITTLE MORE DETAIL BECAUSE IT IS NOT WIDELY UNDERSTOOD OR PROPERLY APPRECIATED, I THINK In 1982 THERE WAS A SIGNIFICANT INCREASE IN THE PUBLIC'S DESIRE TO HOLD ( RATHER THAN TO SPEND) LARGER MONEY BALANCES. THERE IS SOME DEBATE AMONG ECONOMISTS AS TO WHY THIS OCCURRED. SOME WOULD ARGUE THAT THE INCREASED UNCERTAINTIES ASSOCIATED WITH HISTORIC HIGH UNEMPLOYMENT INCREASED THE PRECAUTIONARY BALANCES THAT PEOPLE WISHED TO HOLD, O t h e r s w o u l d a r g u e t h a t t h e d e c l i n e in i n t e r e s t r a t e s h a s m a d e it m o r e ATTRACTIVE TO HOLD MONEY RELATIVE TO OTHER ASSETS AND MY STAFF HAVE ARGUED STRONGLY FOR, DESIRE TO HOLD Ml — A VIEW WHICH I I n ANY EVENT/ THE PUBLIC'S INCREASED DRAMATICALLY IN 1982. As A RESULT/ THE RATIO OF INCOME TO MONEY “ IN OTHER WORDS/ THE VELOCITY OF MONEY — FELL SIGNIFICANTLY IN 1982. With the same amount of money doing less work than before, the Federal Reserve had to supply more ojring 1982 than it originally INTENDED IN ORDER TO AVOID BEING MORE RESTRICTIVE THAN WAS DESIRABLE OR NECESSARY. THUS, RATHER THAN FORCE SPECIFIED RANGE OF PERENT IN 1982. Ml TO GROW IN THE ORIGINALLY- 2% TO 5 PERCENT, THE FED ALLOWED IT TO GROW 8^ The DECISION TO DO THIS WAS A JUDGMENT CALL THAT WAS RATIFIED BY THE VERY POSITIVE RESPONSE OF THE FINANCIAL MARKETS AS SHOWN BY THE DECLINE IN LONG-TERM INTEREST RATES AND THE RISE IN STOCK PRICES IN THE LATTER HALF OF WITHIN THE ORIGINAL 2k TO 1982, I n MY JUDGMENT, FORCING PERCENT RANGE IN 1982 Ml TO STAY WOULD HAVE RISKED DOING DAMAGE TO AN ALREADY WEAKENED ECONOMY AND PRECLUDED THE ECONOMIC RECOVERY WHICH BEGAN AT THE TURN OF THIS YEAR, IT IS IMPORTANT TO UNDERSTAND THAT THIS DOWNWARD ADJUSTMENT OF VELOCITY TO LOWER INFLATION RATE IS A ONE~TIME PHENOMENON. ONCE THE ADJUSTMENT IS COMPLETE MONEY GROWTH SHOULD BE MADE TO RETURN TO RATES THAT ALLOW US TO CONTINUE TO MAKE PROGRESS AGAINST INFLATION, As Chairman Volcker noted in his midyear monetary policy report to the Congress in July, the decline in velocity appeared to have largely abated by the end of the first ^jarter of 1983, suggesting that the adjustment of money demand to lower inflation WAS more or less complete by then. I n recognition of this, the FOMC decided to ESTABLISH A NEW BASE FOR THE fourth quarter of 1982 [11 GROWTH RANGE, MOVING IT FROM THE to the second quarter of 1983, As Chairman V o l c k e r NOTED, THIS REBENCHMARKING "REFLECTED A JUDGMENT THAT THE RAPID GROWTH ( IN Ml) OVER THE PAST SEVERAL QUARTERS SHOULD BE TREATED AS A ONE-TIME PHENOMENON, NEITHER TO BE RETRACED OR LONG EXTENDED," E a r l i e r t h i s y e a r , I h a d a r g u e d t h a t if m o n e y g r o w t h d i d n o t APPEAR TO BE SLOWING DOWN AFTER THE FIRST QUARTER, THE FEDERAL RESERVE SHOULD TAKE STEPS TO ASSURE THAT IT DID, EVEN IF THAT MEANT SOME MODERATE INCREASE IN INTEREST RATES, By THE LATTER PART OF THE SECOND QUARTER, MONEY AND CREDIT WERE SHOWING TENDENCIES TO INCREASE MORE RAPIDLY THAN SEEMED CONSISTENT WITH LONG-TERM PROGRESS AGAINST INFLATION AND SUSTAINED ORDERLY RECOVERY, AGAINST THIS BACKGROUND, - the FOMC in 9 - Ma y b e g a n t o t a k e a l e s s a c c o m m o d a t i n g m o n e t a r y p o s t u r e , Th e s e s t e p s w e r e a c c o m p a n i e d b y i n t e r e s t r ate i n c r e a s e s r a n g i n g f r o m 3/4 to 1 percent or m o r e , But as I had argued e a r l i e r , the prospects FOR SUSTAINED GROWTH AND ULTIMATELY LCWER INTEREST RATES OVER TIME WOULD BE ENHANCED BY TIMELY ACTION TO RESTRAIN EXCESSIVE GROWTH IN MONEY/ GIVEN ITS INFLATIONARY POTENTIAL, T h e EVENTS OF THE PAST FEW MONTHS TO MY MIND HAVE OM_Y SERVED TO CONFIRM THIS JUDGMENT, SlNCE MARCH, Ml GROWTH HAS AVERAGED AT AN ANNUAL RATE, COMPARED TO A PRECEDING. l4,9 7.9 PERCENT PERCENT RATE IN THE SIX MONTHS AS A RESULT/ FOR THE FIRST TIME SINCE lQol, FELL WITHIN ITS LONGER-RUN MONITORING RANGE SET BY THE f'il FOMC. F inancial m arkets appear to have been heartened by these d e v e l o p m e n t s , S i n c e A u g u s t , s h o r t -t e r m i n t e r e s t r a t e s h a v e t e n d e d t o f a l l a s t h e market perceives that the Federal Reserve has more room to m an eu ve r WITH MONEY NOW ON TARGET, A t THE SAME TIME, HEIGHTENED INVESTOR CONFIDENCE THAT THE FED WILL NOT GIVE UP ON THE FIGHT AGAINST INFLATION HAS PULLED DOWN LONG-TERM YIELDS AS WELL, LET ME NOTE HERE THAT IT REMAINS THE INTENTION OF THE FEDERAL RESERVE TO MAKE FURTHER INROADS AGAINST INFLATION, CHAIRMAN VOLCKER MADE THIS VERY CLEAR IN HIS SPEECH TO THE AMERICAN BANKERS ASSOCIATION HERE IN HONOLULU A COUPLE OF WEEKS AGO, AND I CAN OM_Y REAFFIRM OUR COMMITMENT TO THIS GOAL, H i g h In t e r e s t R a t e S y n d r o m e D e s p i t e r e c e n t d e c l i n e s in n o m i n a l , o r m a r k e t , i n t e r e s t r a t e s , YIELDS IN a VERY IMPORTANT SENSE RE,MAIN DISTURBINGLY HIGH, I REFER TO REAL INTEREST RATES “ INTEREST RATES WITH THE MARKET PREMIUM FOR - INFLATION TAKEN OUT OF THEM, 10 - THESE REAL RATES MEASURE THE TRUE BORROWING COST FOR HOUSEHOLDS AND FIRMS, AND THEY REMAIN HIGH BY HISTORICAL STANDARDS, ESPECIALLY FOR THIS STAGE OF THE BUSINESS CYCLE, T h e IMPLICATIONS OF THESE HIGH RE/I. RATES ARE NOT CONFINED TO THEIR DIRECT EFFECTS ON BUSINESS AND CONSUMER SPENDING, HlGH REAL INTEREST RATES ATTRACT MASSIVE FUNDS FROM ABROAD, CAUSING THE DOLLAR TO BE OVERVALUED, THE RECENT INCREASE IN THE DOLLAR EXCHANGE RATE, FOR EXAMPLE, HAS PUSHED THE DOLLAR'S INTERNATIONAL VALUE ABOVE THE RECORD LEVEL OF NOVEMBER 1982, An OVER-VALUED DOLLAR MEANS THAT IMPORTS ARE ENCOURAGED AND EXPORTS DISCOURAGED — WHICH IN TURN MEANS CONTINUED DISTRESS FOR SUCH BASIC INDUSTRIES AS STEEL, AUTOS, AND OF COURSE TOURISM. THUS, THE U.S, TRADE SURPLUS ON GOODS AND SERVICES FOR THE FIRST HALF OF THIS YEAR HAS DROPPED TO $4,3 BILLION FROM $3l,6 BILLION IN THE SAME PERIOD LAST YEAR, N o r ARE THE EFFECTS OF AN OVER-VALUED DOLLAR CONFINED TO THE U.S, T h e CORRESPONDING DETERIORATION IN THE EXCHANGE VALUE OF FOREIGN CURRENCIES MEANS HIGHER INFLATION FOR THESE COUNTRIES AS THEY FIND THE COST OF THEIR IMPORTS GOING UP, THE ALTERNATIVE FOR THESE COUNTRIES IS TO PROTECT THEIR CURRENCIES BY KEEPING THEIR REAL INTEREST RATES HIGH, BUT THAT MEANS DEPRESSED OUTPUT AND EMPLOYMENT FOR THEM AT HOME, HARDLY AN ATTRACTIVE ALTERNATIVE, T h e r e h a s b e e n a g r e a t d e a l of e d i t o r i a l c o m m e n t r e c e n t l y a b o u t WHETHER THOSE HIGH REAL RATES RISK A RECESSION IN 1984, F e d e r a l R e s e r v e Ba n k of San F r a n c i s c o At THE we have always c a u t i o n e d that HIGH INTEREST RATES BY THEMSELVES DO NOT FORECAST A RECESSION. THEY COULD JUST AS WELL REFLECT A STRONG ECONOMY RATHER THAN A WEAK ONE - 11 - T h a t i s , if a s t r o n g e c o n o m y i n c r e a s e s t h e d e m a n d f o r c r e d i t , l e a d i n g to high interest r a t e s , that will not by recovery, i t s e l f s h o r t -c i r c u i t the O m _y if t h e h i g h i n t e r e s t r a t e s a r e d u e t o a s h o r t a g e o f THE SUPPLY OF CREDIT WOULD THEY INDICATE THAT THE RECOVERY MIGHT BE IN TROUBLE, W E DO NOT BELIEVE THAT THIS IS WHAT IS HAPPENING IN THE SECOND HALF OF 1983. Th e r e are a n u m b e r of r e a s o n s for o u r h o l d i n g t h i s p o s i t i o n . F i r s t , t h e h i g h l e v e l s o f r e a l i n t e r e s t r a t e s w e 'v e h a d f o r t h e l a s t YEAR HAVE NOT PREVENTED A TYPICAL BUSINESS CYCLE EXPANSION FROM OCCURRING, T h a t SUGGESTS THAT THE h i g h r a t e s ARE d j e m o r e t o a n INCREASE IN DEMAND FOR CREDIT THAN TO A RESTRICTION IN SUPPLY, S e c o n d , one does not have to look very far for one o bviou s source of STRONG CREDIT DEMAND — MASSIVE DEFICITS. THE FEDERAL GOVERNMENT'S NEED TO FINANCE ITS THUS THE TREASURY WAS IN THE MARKET FOR ABOUT $44 BILLION IN THE THIRD QUARTER, AND FOURTH QUARTER FINANCIAL REQUIREMENTS ARE EXPECTED TO BE $45 BILLION. FOR 1983 AS A WHOLE, THE UNIFIED BUDGET DEFICIT CURRENTLY IS PROJECTED TO BE $207 BILLION AND ONLY SLIGHTLY LOWER - $183 BILLION — IN 1984, FINALLY, THE TOTAL SUPPLY OF CREDIT HAS INCREASED SUBSTANTIALLY IN THE UNITED STATES IN THE LAST YEAR, FROM ABOUT 11 PERCENT OF GNP IN MID~1982 TO 18 PERCENT IN MID~ 1983, On BALANCE, THEREFORE, IT WOULD SEEM HIGH REAL INTEREST RATES REFLECT STRONG CREDIT DEMAND, NOT WEAK CREDIT SUPPLY, D e f i c i t s a n d Ec o n o m i c D i s t o r t i o n s As I o u t l i n e d e a r l i e r , t h e c u r r e n t b u s i n e s s c y c l e e x p a n s i o n is LED BY A LARGE INCREASE IN CONSUMER SPENDING, FOLLOWED BY A SMALL INCREASE IN INVESTMENT SPENDING, AND A DECLINE IN NET EXPORTS, THIS - represents 12 - A DISTORTED BUSINESS CYCLE SITUATION COMPARED TO THE TYPICAL RECOVERY OF THE PAST, IN WHICH THERE WAS A MUCH MORE BALANCED GROWTH OF CONSUMPTION, INVESTMENT AND EXPORTS, CONCERNS THAT THE CURRENT DISTORTED PATTERN WILL HURT THE ECONOMY ARE IN MY OPINION, WELL TAKEN, T h i s r e c o v e r y is j u s t t h e o p p o s i t e o f t h e s u p p l y - s i d e e c o n o m i s t s ' EXPECTATIONS THAT THE REAGAN TAX CUTS WOULD LEAD TO AN INVESTMENT-LED RECOVERY, High REAL INTEREST RATES HAVE MORE THAN OFFSET THE STIMULUS OF LOWER TAXES ON BUSINESS INVESTMENT, THE REASON FOR THIS DISTORTION IS nUITE EASY TO SEE, UNDER THE REAGAN ADMINISTRATION, GOVERNMENT SPENDING AS A SHARE OF 6NP TO 25 PERCENT OF GNP, HAS GONE UP 2 PERCENTAGE POINTS — FROM 23 THAT ADDITIONAL ABSORPTION OF RESOURCES BY GOVERNMENT MEANS THAT PRIVATE DEMANDS MUST BE REDUCED AN EQUAL AMOUNT, I n OTHER WORDS, SOME FORM OF PRIVATE SPENDING HAS TO BE "CROWDED OUT" BY THE INCREASED DEMANDS OF GOVERNMENT, THAT CAN BE ACHIEVED IN THREE DIFFERENT WAYS — BY RAISING TAX RATES, BY INCREASING THE INFLATION RATE, OR BY RAISING REAL INTEREST RATES, A RISE IN TAXES WOULD CROWD OUT THE SPENDING OF THOSE WHO BEAR THE BURDEN OF THE TAX, A RISE IN THE INFLATION RATE WOULD CROWD OUT THOSE WHOSE INCOME GROWS MORE SLOWLY THAN INFLATION. AND A RISE IN REAL INTEREST RATES WOULD CROWD OUT THE INTEREST-SENSITIVE SPENDING, WHICH IS LARGELY FOCUSED ON INVESTMENT, HOUSING AND EXPORTS, The Reagan a d m i n i s t r a t i o n a p p e a r s a d a m a n t l y o p p o s e d to tax h i k e s , AND IN ANY EVENT IT IS UNLIKELY CONGRESS WILL BE IN THE MOOD TO RAISE TAXES AS THE 1984 ELECTION NEARS, As I INDICATED EARLIER, THE FEDERAL R e s e r v e r e m a i n s r e s o l u t e in i t s d e t e r m i n a t i o n t o c u t i n f l a t i o n - 13 - FURTHER, AND AS CHAIRMAN VOLCKER INDICATED IN RECENT TESTIMONY TO C o n g r e s s , b e l i e v e s it is u n w i s e t o f i n a n c e b u d g e t d e f i c i t s t h r o u g h MONETARY EXPANSION. ALL OF THIS MEANS THAT HIGHER GOVERNMENT SPENDING HAS BEEN FINANCED BY BORROWING IN THE FINANCIAL MARKETS, RESULTING IN A RISE IN REAL INTEREST RATES, As A RESULT ALL OF THE CROWDING OUT CAUSED BY INCREASED GOVERNMENT SPENDING HAS BEEN DIRECTED ONTO INTEREST-SENSITIVE AND EXPORT-SENSITIVE INDUSTRIES, WHICH REPRESENT OUR INDUSTRIES WITH THE GREATEST COMPARATIVE ADVANTAGE, AND OUR FUTURE SOURCES OF GROWTH. THE DISTORTED RECOVERY THEREFORE THREATENS THE GROWTH IN THE STANDARD OF LIVING AND THE PRODUCTIVITY OF THE U S. ECONOMY. IN MY OPINION, THAT IS THE MAJOR RISK IN THE CURRENT SITUATION “ NOT AN ACCELERATION OF INFLATION, OR A BUSINESS CYCLE RECESSION IN 1984, BUT THE LONG, SLOW EROSION OF AMERICA'S INDUSTRIAL BASE, Co n c l u d i n g R e m a r k s To SUM UP, WE CAN BE THANKFUL FOR HAVING BROKEN BOTH THE UPWARD SPIRAL OF INFLATION AND THE DOWNWARD SPIRAL OF RECESSION DURING THE PAST YEAR. Much REMAINS TO BE DONE OF COURSE We MUST DEAL WITH THE PROBLEM OF LONG-TERM UNEMPLOYMENT IN ALL. OF OUR BASIC INDUSTRIES, This c a n b e s t be a c c o m p l i s h e d by havi n g f i n a n c i a l m a r k e t s , PARTICULARLY LONG-TERM CAPITAL MARKETS, THAT ARE NOT PLAGUED WITH RENEWED FEARS OF FUTURE INFLATION, THERE ARE ALSO A NUMBER OF UNUSUAL INTERNATIONAL PROBLEMS CONFRONTING US AS WE PROCEED INTO THE RECOVERY, T h e m o s t i m p o r t a n t o f t h e s e is t h e s e v e r e f i n a n c i a l d i f f i c u l t i e s s o m e DEVELOPING COUNTRIES ARE EXPERIENCING IN SERVICING THEIR HUGE FOREIGN DEBT A CONSIDERABLE PORTION OF WHICH IS OWED TO U,S, BANKS, - 14 - It IS d i f f i c i l t t o s e e h o w a b a l a n c e d r e c o v e r y in t h e U.S. ECONOMY WILL BE POSSIBLE WITHOUT FURTHER DECLINES IN REAL INTEREST RATES. HOWEVER/ THE FEDERAL RESERVE'S POLICY OF PROVIDING ENOUGH MONEY TO SUSTAIN A NON"INFLATIONARY RECOVERY CANNOT CONTRIBUTE TO REDUCING REAL INTEREST RATES. OPLY A DECLINE IN THE FEDERAL GOVERNMENT'S VORACIOUS DEMAND FOR CREDIT CAN DO THAT. the I f CONGRESS AND Ad m i n i s t r a t i o n f a i l to c u r b e n o r m o u s b u d g e t d e f i c i t s / th e RESULTING SQEEZE ON CAPITAL INVESTMENT THREATENS TO UNDERMINE OUR LONG-TERM PROSPECTS FOR REAL GROWTH AND HIGHER STANDARDS OF LIVING. T h e m a j o r r i s k in t h e c u r r e n t s i t u a t i o n is n o t a n a c c e l e r a t i o n o f INFLATION OR A BUSINESS CYCLE RECESSION IN 1984/ BUT A LONG/ SLOW DETERIORATION IN THE ABILITY OF THE STANDARD OF LIVING FOR ALL OF US. U.S. ECONOMY TO DELIVER A RISING
@FedFRASER