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r THE FEDERAL RESERVE AND THE OBLEM OF INFLATION REMARKS BY John J. Balles PRESIDENT FEDERAL RESERVE BANK OF SAN FRANCISCO Joint Directors’ Meeting Luncheon San Francisco, California March 7, 1974 ;3 * * John J. Balles I am delighted that we could arrange to have a cross-section of bankers, business executives, and other professional leaders in the San Francisco area meet with us today. As you were informed, this is the occasion of the Annual Joint Board Meeting of the Federal Reserve Bank of San Francisco and its four branches. Chairman W ilson, as the historian in our group, has reminded us of the historic forces which preceded the establishment of the Federal Reserve and which brought it into existence over 60 years ago. He has also introduced the Boards of Directors of this Bank and its branches, which repre sent important elements in the structure of the Federal Reserve System. Today, I would like to describe some of the current forces operating on the Federal Reserve, and then examine the causes and possible cures for the dangerous infla tionary spiral we are now witnessing. How ever, before getting to these topics, I think that it would be appropriate to say a few words for our guests about the role of a Federal Reserve Bank and its directors in the context of today's problems. For I am often asked, "Just what does a Federal Re serve Bank do? And what is the authority and responsibility of your directors?" It happens that the Federal Reserve System has a policy of rotating its directors after a certain period of service. It is likely, there fore, that some of our guests today might be approached in the future and asked to consider serving as a director. If so, I hope you would give it favorable consideration. Role of the Directors The Board of Directors of a Federal Reserve Bank has a unique function in that it com bines some of the traditional responsibil ities of directors in a private corporation with the special responsibilities of contrib uting to the formulation of public policy. This dual role has evolved from the unique structure of the Federal Reserve itself— i.e., part government and part private, guided by a central authority in W ashing ton, but with twelve semi-autonomous Federal Reserve Banks. As the nation's central bank, the Federal Reserve System's basic responsibilities fall into three basic categories: (1) to regulate the flow of money and credit in a manner that contributes to econom ic growth without inflation; (2) to supervise and examine those commercial banks which are members of the System, to regulate bank holding companies, and to oversee the foreign activities of U.S. banks; and (3) to provide numerous "wholesale" central banking services, such as provision of cur rency and coin, operation of a check collection system, and service as fiscal agent for the U.S. Treasury. The central policy-m aking body in the Fed eral Reserve System is the Board of Gover nors, appointed by the President and con firmed by the Senate. The twelve regional Federal Reserve Banks share certain of the responsibilities relating to monetary policy with the Board of Governors, administer various regulations, and provide the "w holesale" banking services noted ear lier. Thus, the Federal Reserve System is characterized by coordinated control through the Board of Governors and by decentralized administration through the Reserve Banks. The affairs of each Reserve Bank are con ducted under the supervision and control of its Board of Directors, subject to general supervision by the Board of Governors. The Board of Directors of each head office of a Reserve Bank consists of nine mem bers, three of whom (including the Chairman and Deputy Chairman) are ap pointed by the Board of Governors as rep resentatives of the general public. The public members may not be officers, direc tors, employees or stockholders of any bank. The remaining six directors at each Head Office are elected by the member banks, which own all the stock in the Fed eral Reserve Bank. O f these six, three are representatives of the member banks and are usually actively engaged in banking; and the other three must be actively en gaged in com m erce, industry, or agricul ture, and may not be officers, directors, or employees of any bank. Sim ilarly, for each branch of a Federal Re serve Bank, the Board of Governors ap points certain directors as representatives of the public interest, while the majority of the branch directors are appointed by the Fiead O ffice Board. The affairs of each Branch office are conducted under the control of its Board of Directors, subject to general supervision by the Head Office Board. Thus, a Federal Reserve Bank is a privatelyowned institution with a public purpose. Except for a dividend on member-bank stock, which is limited by statute to 6%, the great bulk of our earnings is paid over to the U.S. Treasury. A Reserve Bank has a certain degree of regional autonomy, but it is also part of a national system. The Federal Reserve System is a unique blend of public interest and private repre sentation of "grass roots" interests. In meaningful ways, it reflects the traditional belief in this country in a system of checks and balances. This type of organization has served the country well, in my opinion. O ur directors are successful men in many fields of endeavor— business, finance, ag riculture and universities, to name a few. They provide counsel and advice to ensure that the Bank has clearly-defined goals and objectives, and programs for reaching them, and they have the responsibility for overseeing the efficiency of operation and quality of management. In the area of econom ic intelligence, our directors provide us with information on the economy weeks or even months before developments are reflected in national econom ic data. At other times their first hand information reminds us that ours is a diverse economy in which developments in many industries and regions of a country can run counter to nation-wide trends. O ur directors also provide information and insights on the proper course for public policy, and they can add substance to their views by recommending changes in the Federal Reserve discount rate. This is the rate which the Federal Reserve Bank charges for loans to its member com m er cial banks, and it is one of the tools of monetary policy. Although the Board of Governors in Washington has the ultimate authority to approve or disapprove a pro posed change in the discount rate, it is strongly influenced by the "grass-roots" reaction expressed by the directors, espe cially if the directors of a number of Federal Reserve Banks make the same recommen dation. One of the major strengths of the decen tralization of the Federal Reserve System is its ability to draw on the best talent in var ious regions of the economy to serve as directors with the foregoing responsibilities. The Federal Reserve as an Institution The unique structure of the Fed, which I believe gives it unusual strength in per forming its job, also subjects it to criticisms by those who do not appreciate its role and its structure. The Federal Reserve has at least two ele ments which make it institutionally unique. First, it is independent within, but certainly not from, the Federal Coverm ent. More specifically, it is an independent agency but with ultimate responsibility to the Congress, and it is not a part of the Execu tive Branch. Second, the decision-m aking process within the Federal Reserve System is decentralized in the sense that it is shared by the Board of Governors in W ash ington with the twelve regional Federal Reserve Banks. I'd like to say a few words about each of these functions. When Congress and the Administration established the Federal Reserve in 1913, it was deliberately made an independent in stitution within Government, in order to free it from day-to-day political influence. Senator Carter Glass, the architect of the original Federal Reserve Act, hoped that the System would act as a "Suprem e Court of Finance." That hope has been at least partly fulfilled over the decades. The estab lishment of the Federal Reserve System as the central bank indicated that Congress believed that monetary policy was too important to leave to private bankers. On the other hand, the fact that Congress, over the years, has specified 14-year terms for members of the Board of Governors in W ashington, and 5-year appointments for Presidents of the regional Reserve Banks, indicates that monetary policy also is too important to be left to the day-to-day pres sures from the political arena. The goal was to establish a Federal Reserve System which is responsive to the long-term eco nomic needs of the nation in an objective and non-partisan way. O ver the years there have been a number of attempts to erode the independence of the Fed. There have been repeated legisla tive proposals to retire the capital stock of the Reserve Banks, to eliminate their direc tors, to centralize all powers of the Fed in W ashington, and to make the System more directly amenable to influence by the C o n gress. A current example is a bill scheduled for vote in the House of Representatives in the near future, which would provide for a fullscale audit and review by the General A c counting O ffice of the finances, operations and monetary policy actions of the Federal Reserve System. Although we are com pletely in favor of audits in the traditional sense, we are opposed to the bill for sev eral reasons. With respect to financial transactions, the Federal Reserve Board is already thoroughly audited by a nationallyknown CPA firm, and the results are re ported to Congress. In turn the Board per forms exhaustive examinations of the Fed eral Reserve Banks, in addition to the work of the resident auditing staff at each Bank which reports directly to the Board of Directors. Secondly, The Federal Reserve System, both at the Board of Governors and at the Reserve Banks, has in place effective and hard-hitting programs aimed at operational efficiency. Thus a financial audit and an "efficiency" audit by the GAO would merely duplicate effective programs already in place. The really serious objection, however, has to do with the proposed policy review by the G A O . In our view, this could be an en tering wedge for direct Congressional con trol over monetary policy— with conse quent adverse effects on the economy if such control were to be influenced by par tisan goals and political pressures. Forty years ago, the Congress wisely decided to remove the Federal Reserve System from the scope of the G A O , in order to provide for independence of judgment on the part of the System in carrying out the responsi bilities delegated to it by Congress. We be lieve that it would be unwise to change that arrangement. A second unique feature of the Federal Reserve is the decentralization of policy making. The Federal Open Market Com mittee (FO M C), one of the two major policy-m aking bodies of the Federal Re serve, meets once a month in Washington to decide on the course of open market operations, the most important instrument of monetary policy. The majority of the FO M C consists of the seven members of the Board of Governors. The remaining five members are drawn from the twelve Re serve Bank Presidents, on a rotating basis. But those Presidents who are not currently voting members have an opportunity to attend the meetings and express their views. Thus, the formulation of monetary policy benefits from regional inputs and from a variety of viewpoints. Role of the San Francisco Reserve Bank The advantages of a decentralized Federal Reserve System extend beyond strictly policy-related issues. Let me describe some of those that I am most familiar with, using the experiences of the San Francisco Bank. Until very recently, banking structure in the Twelfth Reserve District, with its state wide branch banking, was relatively unique in the nation. The Federal Reserve Bank of San Francisco has brought these special institutional factors to the attention of the Board of Governors, and in most cases obtained regulatory treatment which is suitable to this particular bank structure. The Reserve Bank in San Francisco also has taken an active interest in developing the West Coast as an international financial center. It has encouraged a legal and regu latory environment favorable to interna tional banking operations, and has at tempted to get government and financial institutions to consider the longer-run developmental interest of our financial markets. The Bank itself is in the process of strengthening its own research capability with regard to the Pacific Basin area and will assist in the growing financial integra tion of trading partners in this region. Over 90 percent of the budget of the Fed eral Reserve Bank of San Francisco is ex pended to provide payments mechanism services, currency and coin, fiscal agency, and other services to government, banks, and to the econom y in general. In my view, the decentralized organization of the Fed eral Reserve System promotes efficiencies in these operations because the System's semi-autonomous Reserve Banks can ad just their procedures to local conditions; they can innovate in im proving the quality and reducing the cost of service; and they can recruit and challenge better staff. Two examples may illustrate this point. The Federal Reserve Banks issue virtually all new currency in circulation and are re sponsible for retiring and destroying unfit currency. More currency is issued and de stroyed in the Twelfth District than any where else in the nation. To do this job more efficiently, the Bank is experim enting with a number of methods, including some automated ones, for verifying and de stroying worn-out currency. Another ex ample is in the area of improving the pay ments mechanism. The San Francisco Reserve Bank operated the first automated clearing house in the nation, and elec tronic funds transfers were first processed by a Reserve Bank computer in the Twelfth District. We expect to continue to take a leading role in this field and to support commercial bank efforts to reduce the flow of paper checks. Perspectives on Inflation I would now like to turn to the major eco nomic problem facing the nation today— namely, rampant inflation that is occurring even in the face of a softening in econom ic activity. It may be helpful to put this problem in historical perspective, before attempting to assess the possible cures. Effect of Budget Deficits. During the first half of the 1960's, the United States en joyed a period of sustained and stable eco nomic growth, with very little inflation. The origins of our current problems seem to lie in the major escalation of the Vietnam war starting about mid-1965. Government deficits increased at an alarming rate in the Vietnam build-up pe riod of 1965-68, when the economy was at, or near, full employment. President Johnson perceived a lack of popular sup port for the war and was fearful that his "Great Society" spending programs might get scuttled if he asked Congress for a tax increase. He therefore elected initially to finance expanded military commitments in South Asia with government debt. The def icits which resulted from this decision were temporarily relieved by the belated in come-tax surcharge in mid-1968, and by a leveling off in military expenditures at about the same time. However, the fiscal situation deteriorated further in 1969-70 when outlays for civilian programs out stripped recession-reduced revenues, and became still worse in the 1971-72 period when recovery from the recession got underway. The persistence of substantial government deficits regardless of the phase of the busi ness cycle has been a major source of the inflation that is now built into the U.S. economy, in my view. Monetary Policy Undermined. It can be argued that a tighter monetary policy ought to be able to offset the inflationary effects of large, sustained deficit financing. In theory this may be true, but in practice the opposite tends to occur. When huge Fed eral credit demands are added to those of a fully-employed private sector, interest rates tend to escalate. There are some sec tors of the econom y, such as housing con struction and programs financed with mu nicipal bonds, that are especially sensitive to such a development because they de pend heavily on long-term credit. When these sectors are confronted with high in terest rates, demands for relief are quickly heard. Moreover, the U.S. Treasury itself has a natural desire to finance its deficits at the lowest feasible cost. In short, large-scale deficit financing by the Government tends to bring great pressures on the central bank to keep interest rates from rising to “ unreasonable,” "unaccept able," or "dangerous" levels. You may re call that about a year ago there was a se rious threat in the Congress to freeze interest rates, or even roll them back to the level of January 1,1973. O bviously, the only way that mounting credit demands can be satisfied without an increase in interest rates is for the Federal Reserve to accelerate the growth of money and credit. If done for too long, or to an excessive degree, such action can generate inflationary pressures which may persist for a lengthy period. It has been my observation that large and persistent Federal deficits are a leading factor in pulling monetary policy off course, in the direction of excessive mone tary expansion, as the central bank at tempts to cope with the conflicting pres sures that develop from such a situation. Too often in practice, therefore, an expan sionary fiscal policy tends to generate ex cessive expansion in money and credit. Priority o f Employment Goal. A second factor which tends to inhibit the use of monetary policy in combatting inflation is an unresolved conflict in national goals as between full employment and stable prices. Since the early 1960's in the U.S., achievement of the "full employment" goal has usually contemplated an unem ployment rate of 4% or less. Such a rate was regarded by many as a practical mini mum, in view of normal shifting of workers between jobs and the lack of marketable skills of some job-seekers. However, pre sent evidence suggests that structural shifts in the labor force during the last decade would now make the "practical m inimum " about 4.5% or 5%, especially in view of the increase in the labor force represented by teen-agers and other new entrants into the labor force who often lack marketable skills. In my view, there has not been enough re fined analysis of the employment and unemployment data, concentrating on the "hard core" of our labor force— i.e., heads of households or "breadw inners"— for whom the social and econom ic costs of unemployment are highest. Am ong this group, the unemployment rate in January of this year was only 2.8%, in contrast to the conventional or aggregate unem ploy ment rate of 5.2%. Studies by the Brookings Institution indi cate that the conventional unemployment rate seriously understates the tightness of labor markets. Sim ilarly, studies by our Bank indicate that it takes a higher rate of inflation now to achieve a 4 percent unem ployment rate than it did ten years ago. This is due to two factors: first, the changing structure of the labor force has brought higher participation rates for workers with marginal skills; second, in creased inflation expectations have caused labor to demand larger wage increases even at times when the unemployment rate is relatively high. If we should now attempt to follow a monetary policy aimed at re ducing unemployment to 4%, the likely consequence would be to exacerbate pre sent inflationary pressures, which have al ready reached dangerous levels. For whatever reason, there has been a tendency for the goal of "full employment" to take priority over stable prices, in view of actions in recent years by the A dm inis tration and Congress— whose job it is to determine national priorities. Not enough attention seems to have been paid to the trade-off— i.e., the additional inflation that must be accepted to get a lower unemploy ment rate. In essence, my argument is that we have both a faulty diagnosis as well as the wrong medicine for the unemployment goal. First we need a more meaningful "target rate" for unemployment, as I've explained. Secondly, we need new percep tions and new remedies for unemploy ment. Rather than im posing inflation on everyone, by attempting to reach our em ployment goal through expansive mone tary and fiscal policies, our aim should be a more vigorous use of selective measures to deal with the problem. These measures could include low-interest educational loans to youth and minority groups, re training programs directed toward skills where job vacancies are high, and steps to facilitate worker mobility. Lags in Monetary Policy Impact. A third factor which tends to inhibit the use of monetary policy in combatting inflation, and to call for its use by the Administration or the Congress to provide short-term sti mulus to the econom y, is a technical one. This factor has to do with the lags in the impact of a change in monetary policy on production, employment, profits and prices. W hile the technical reasons are complicated and while our knowledge in this area is imperfect, it seems reasonably clear that the lags are longer for an impact on prices than for the impact on the other measures noted. Thus, the "good news" about easy money appears first— i.e., favorable effect on pro duction, employment, and profits; while the "bad news" comes later— i.e., infla tion. Conversely, if a tight money policy is adopted, the bad news comes first— i.e., unfavorable effects on production, em ployment, and profits; whereas the good news is delayed— i.e., a reduced rate of in flation. Under these circumstances, it is not surprising that elected officials who must face the voters at a given time would prefer to see easy money. Has Monetary Policy Been Too Expansive? Thus, it may be asked, has monetary policy been a principal cause of our inflation problem, and is there a simple cure in the form of tight money? In recent testimony before the Congress, the Chairman of the Board of Governors, Arthur F. Burns, ac knowledged that, with the benefit of hind sight, monetary policy may have been overly-expansive in 1972. Some of our critics, such as Professor Milton Friedman, would go much further— alleging that the money supply has grown too fast since about 1970, and that this played a major role in pro ducing the current inflation. Such criticism, whether or not justified, is easy enough to make, based both on m on etary theory and statistical studies. But it seems to me to ignore real problems in the real world. No central bank can be or should be wholly independent of Govern ment. The elected representatives of the people of the U .S., both the Congress and Administration, must have the ultimate responsibility for econom ic policy, and that includes monetary policy. In today's world, a central bank that consistently de fied its government on major issues would quickly be taken over by the government. I have been attempting to convey an un derstanding of some of the forces that im pinge on the freedom of action of the Fed eral Reserve System in using tight money to combat inflation. W hether by accident or design, our Federal budget has been char acterised by large deficits in most recent years, giving rise to very large financing needs and to higher interest rates, to a point where serious damage was threat ened in some sectors of the econom y and where many members of Congress were in a mood to freeze interest rates. Also, whether based on a faulty analysis or a misplaced emphasis, those elected officials with ultimate responsibility for econom ic policy have placed a high priority on the “ full employm ent" goal, even at the ex pense of stable prices. Central banks cannot completely ignore such imperatives — even against their better judgm ent. It seems to me that our best hope lies in a better understanding of the long-run infla tionary damage done to our economy by excessive monetary and fiscal stimulus and by over-emphasis on employment targets, whatever the short-run benefits. It is vital that this matter be thoroughly appreciated not only by the Congress and the A dm inis tration, but also by the business and finan cial community and the general public. It is only in this way that we can get support for the belt-tightening measures needed to overcome the corrosive problem of rampant inflation. Price C o n tro ls-H id d e n Inflation. In com pleting the analysis of the basic causes of inflation in recent years, I would note that the problem was com pounded by price controls. The “ new econom ic policy" im plemented by the Admi nistration in August of 1971 had some favorable price effects in its initial two phases because excess ca pacity existed in the economy and because the inflationary pressures were largely of the cost-push variety in 1971 and early 1972. However, by late 1972 and early 1973, the economy was at virtually full employment, and continued wage-price controls led mainly to a misdirection of resources and to artificial shortages. Further, the illusion of stable prices tended to conceal for a while the effects of continued expan sionary econom ic programs. This illusion was rather rudely shattered by the price freeze experience last summer when, for example, certain agricultural sectors quite literally began to shut down. By now, pop ular support for wage-price controls has declined to a point where they probably will be dropped almost entirely this year. Special Causes of Inflation, 1972-73. In ad dition to fiscal problems and the nation's misadventure with wage-price controls, three other factors deserve special men tion in analyzing the origins of our present inflation problem. The first is the unprece dented world-wide grain crop failure in 1972 that sent agricultural prices through the roof. The second is the fact that the business cycle in virtually all industrial countries was in a coincident boom phase in 1973, which placed extreme pressure on the supplies and prices of internationally traded goods. The third factor, of course, was the unanticipated imposition of the Arab oil embargo last fall. Inappropriate fiscal policies and overstaying the useful ness of wage-price controls would have created difficult price problems in any case — but these policy mistakes in conjunction with the special factors I've noted pro duced an inflation problem of epic dim en sions. Inflation and the Current Outlook How do we get out of the apparent box we have gotten ourselves into? The first thing to remember is that at this time our main econom ic problem is a shortage of oil, not money. The current rise in unemployment and the cutbacks in production to this point have resulted primarily from supply problems which cannot be solved with monetary policy. Even if a deficiency in aggregate demand develops from the supply-induced slowdown in the economy, monetary policy could do little to relieve the situation this year because of the lags in its impact on the economy, which I men tioned earlier. In these circumstances, monetary policy should be directed to wards 1975 and beyond when the policies we adopt now will have their major impact. If we wish to overcome inflation, it is going to be a long, hard uphill battle, and our monetary-economic time horizon must be expanded to at least three years to see the success of our actions. Also, since there is a trade-off between inflation and unem ployment, we must be prepared to accept at least a temporary rise in the unemploy ment rate— even after the energy problem is solved— and to use special programs to ease the plight of those affected. Such pro grams could include liberalization of wel fare payments, increased unemployment benefits, and more public employment. Whatever is done in this regard, it is vital that we not try to solve the unemployment probiem of the few, by imposing inflation on everybody through expansionary fiscal and monetary measures. In the final analysis, it will not be possible to solve our inflation problem without fiscal and monetary restraint. For that rea son, I found it encouraging to note the recent testimony before Congress by the Secretary of the Treasury. He warned against broad-based increases in spending programs or tax cuts as means of pum ping purchasing power into the economy at this time. O ne can only hope that his point of view will prevail over that of an official of the O ffice of Management and Budget who was widely quoted recently to the effect that the Adm inistration would "bust the budget," if necessary, to combat unem ployment and any downturn in the econom y in the months ahead. O ne can also hope that the budget reform bill which has passed the House will be enacted. Under present procedures, a large number of appropriations bills are considered separately, without regard to an overall expenditure target, any as signing of priorities, or sources of fi nancing. The budget reform bill would, for the first time, give members of Congress a chance to vote on fiscal policy. Until such a measure is passed, the balance between expenditures and revenues will continue to be a "happening" rather than a policy— and with a high likelihood of chronic deficits. Sim ilarly, if we are to overcome inflation, the Federal Reserve System must be free to pursue a non-inflationary growth target for money and credit— even if higher interest rates are necessary in the short run, as in flationary forces are wrung out of the econom y. It is particularly vital that we not be pulled off course toward excessive credit ease by the two major forces that have done so in the past— i.e., the ne cessity to finance large-scale budget defi cits, and the tendency to call for easy money to solve unemployment problems that could be handled better through selective measures. Conclusion The fight against inflation this year and in the years immediately ahead will not be easy, but it is absolutely essential. As Chairman Burns stated in recent testimony before Congress, continued inflation will "reduce the dollar's strength in foreign exchange markets— destroy the gains we have recently made in strengthening our competitive position in world markets— . . . undermine confidence .. . send in terest rates soaring and wreck our chances of gaining a stable and broadly based pros perity in the near future." We are now on the verge of Latin-American style inflation, measured in two digits. We must bite the bullet now, because it will be much harder to fight inflation the longer we wait. This effort will require less expan sionary monetary and fiscal policies than we have been following in recent years. If we are not prepared to take these actions, we will be faced with turmoil, uncertainty and econom ic instability for years ahead. I am confident that the people of this coun try, and its leaders, have better sense.
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