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INFLATION

AND

HOUSING

Remarks of
John J. Balles, President
Federal Reserve Bank of San Francisco

Meeting with




Portland Community Leaders and

Board of Directors,

Portland

Branch

Federal Reserve Bank of San Francisco

Portland

Oregon

May 1,1980

I n f l a t i o n and Housing

I' m glad to have the opportunity to v i s i t Portland once again,
although I ' d much rather be here when the s t a t e ' s leading in d u st ry was
in better shape than i t i s today.

Later on, I ' l l

d is cu ss the problems

o f the housing i nd ust ry — and hence o f the for est-products in d us tr y
but I should emphasize at the outset that those d i f f i c u l t i e s are related
to the o v e r ri d i n g problem of i n f l a t i o n .

Thus, most o f my comments w i l l

focus on the steps we must take to overcome that major national problem.
But f i r s t ,

let m note one o f the good things about meetings such as
e

t h i s , which i s the chance i t provides our di r e c to r s to meet with P o r t l a n d 's
community leaders for a d i sc u ss io n of matters o f common in te re st.

Our

d ir ec to r s are an able and diverse group o f i n d i v i d u a l s , and they help in
many ways to improve the performance o f the Federal Reserve System.
The d i r e c to r s at our fi ve o f f i c e s are concerned with each o f the major
jobs delegated by Congress to the Federal Reserve.

That encompasses the

p r o v i s i o n of "wholesale" banking s e rv i c e s such as coin, currency, and check
processing; su p e r v i si o n and regulation o f a large share o f the n a t i o n ' s
banking system; adm inistration o f consumer-protection laws; and above a l l ,
the development o f monetary p o li cy .

W are fortunate in the advice we get
e

from them in each of these four areas.
Our dir ec to r s constantly help us improve the level o f central-banking
s e r v i c e s , in the most c o s t - e f f e c t iv e manner.
improve the workings o f monetary p ol icy .
provide us with pra cti cal

Most o f a l l , they help us

As one means of doing so, they

f i r s t - h a n d inputs on key developments in various

regions o f t h i s D i s t r i c t and various sectors o f business and pub lic l i f e .




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Our direct or s thus help us a n ti c i p a t e changing trends in the economy, by
p r ov id in g i n s i g h t s i n to consumer and business psychology which serve as
checks against our own analyses o f economic data.

Fundamental Economic Problems
At a time l i k e t h i s , we need al l the help we can get from our d i r e c t o r s
-- and indeed from all o f you.

W must deal with an i n c i p i e n t re c e ss i o n ,
e

which o r d i n a r i l y would sugg est the need f o r a p o l i c y o f stimulus - - but
also deal with a severe i n f l a t i o n , which d e f i n i t e l y c a l l s f or a p o l i c y o f
restraint.

To understand the s i t u a t i o n , we must remember that many of

our d i f f i c u l t i e s a r i s e from the fact that economic growth over the past
decade depended very h e a v i l y on p u b l i c - s e c t o r spending.

In p ar ti c u la r ,

massive Federal-spending inc rea se s outpaced tax revenues and created red
ink on the books for every s i n g l e y e a r o f the decade.

Indeed, the combined

Federal d e f i c i t f o r the decade, $315 b i l l i o n , matched the combined total
for the ent ire previous h i s t o r y o f the Republic.

I n f l a t i o n was the

in e v i ta b l e r e su l t of t h i s prolonged s e r i e s o f d e f i c i t s , the o ve rl y
s ti m u la t i v e monetary expansion that sometimes accommodated them, and a
s e r i e s o f su p p ly - r e la t e d shocks from the OPEC nations and elsewhere.

Consumer

prices p r a c t i c a l l y doubled over the course o f the decade, in the worst
peacetime i n f l a t i o n in the n a t i o n ' s h i s t o r y .
We're paying the p r i c e in 1930 o f f a i l i n g to deal more f o r t h r i g h t l y
with the problems which o r i g i n a t e d in the 1 97 0 's .

Recession, o r a s i t u a t i o n

c l o s e l y resembling r e c e s s i o n , i s an obvious consequence o f the past decade's
excesses, and of the s t r i n g e n t p o l i c y moves needed to cure those excesses.
The recent weakness of production, employment and r e t a i l s a l e s , plus a




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five-month-1 ong decline in the l e a d i n g - i n d ic a t o r s index which u s ua ll y
s i g n a l s c y c li c a l tu rn in g po in ts , suggest that the long-, awaited recession
may f i n a l l y be here.

In other words, overall business a c t i v i t y may

actua lly decline f or several quarters, follo win g the period o f s l u g g i s h
growth which has been evident since l a s t f a l l .

Bas ic Cause of I n f l a t i o n
I would emphasize, however, that recession i s not the ba si c problem,
but rather the consequence of our e a r l i e r actions.

The basic problem is

i n f l a t i o n , and t h i s has been true throughout the past decade and more.
I n f l a t i o n undermined the otherwise commendable record o f income and
employment growth achieved during the 1 9 7 0 's , when consumer prices doubled
within a s i n g l e decade.

Yet i f the past y e a r ' s trend continues,

prices

would double again within a half-decade alone.
Where do we look f o r the cause of t h i s severe problem?

Surging OPEC

o i l prices are p a r t l y res ponsible, o f course, but most o f the blame must
l i e with the Federal budget.

This has s e r i o u s l y aggravated the i n f l a t i o n

problem during the recent c y c li c a l expansion by generating a massive
s e r i e s of d e f i c i t s , which then induced a su b st an ti a l over-expansion o f the
money supply.

Part o f the problem was the monetization o f debt which

resulted from the Federal Reserve's former operating techniques, which
sometimes involved a slow adjustment to i n f l a t i o n a r y pressures because o f
the Fed's attempt to l i m i t the impact o f r i s i n g i n t e r e s t rates on private
sectors o f the economy.

This l i n k was broken l a s t October 6, when the Fed

s h i f t e d from an i n t e r e s t - r a t e operating technique to d i r e c t control o f
growth in bank res erves, and hence in the money supply.




The aim since that

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time has been to slow the growth o f the money supply to a point where i t
will

be c o ns is t en t with price s t a b i l i t y .
But we're s t i l l

e xp eri enc in g the r e s u l t s o f that e a r l i e r problem.

Moreover, much o f the run-up in i n f l a t i o n expectations e a r l y t h i s ye ar
could be traced to the b e l i e f that our budgetmakers had l o s t control o f
that engine o f i n f l a t i o n .

The fears about a runaway budget surfaced before

the ink was dry on the January document, when i t became apparent that
Federal spending would not be as "lean and austere" as projected a y ea r
ago.

For f i s c a l 1980, the o r i g i n a l budget document forecast a $40-bi 11 ion

d e f i c i t -- 44 percent l a r g e r than l a s t y e a r ' s d e f i c i t .

For f i s c a l

1981,

continued d e f i c i t fi n a n c i n g seemed i n e v i t a b l e , even in the face o f about
$50 b i l l i o n in tax in crease s - - e i t h e r from the s o c i a l - s e c u r i t y tax, the
w i n d f a l l - p r o f i t s tax, or i n f l a t i o n - r e l a t e d boosts in p e rs o n a l -t a x revenues.
I n f l a t i o n and Crowding-out
Now, s u b s ta n ti a l budget d e f i c i t s can be defended in deep recession
periods, because they support aggregate bu siness a c t i v i t y at times when
other cr e d i t demands are weak.

But that condition h a s n ' t e x i s te d in any

o f the l a s t several years of e s s e n t i a l l y f u l l employment.

Instead, heavy

d e f i c i t f i na nc in g has led to intense pressure on c r e d i t markets and to
greater i n f l a t i o n , by in ducing an e xce ssi ve monetary expansion - understandably, because the Federal

Reserve tended to lag in r e s t r i c t i n g

cr e d i t a v a i l a b i l i t y to the p r i v a t e s e ct or .

As a r e s u l t , i n t e r e s t rates

have come under sus tai ne d upward press ur e, and higher i n t e r e s t rates have
"crowded out" many p r iv a te borrowers from the money and capita l markets,
because they could not pay what the Treasury could pay f o r funds.




Over

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time, t h i s has helped cause a g r e a te r portion o f aggregate savings to go
to the public sec tor , and thus has led to le ss productive investment and
to a decline in the n a t i o n ' s real-growth po te n ti a l .
The "crowding out" argument was widely d is cu ss e d - - and a l s o frequently
ignored -- in the mid-19701s .
of that t h e s i s .

But now we're f ac e- to -fa c e with the truth

At a time o f t i g h t Federal Reserve monetary p o l i c y , and

of a continued high level o f p r i v a t e c re di t demands, the Federal

government's

borrowing demands have been r i s i n g rather than d e c l i n i n g , with severe
consequences f o r the markets.
Much of the Federal borrowing pressure comes from Federal e n t i t i e s
which are c l a s s i f i e d " o f f budget," but which are s t i l l

financed by the

U.S. Treasury, such as the group o f c r e d i t agencies operating under the
wing of the Federal

Financing Bank.

Other pr ess ur es come from p r i v a t e l y -

owned but government-sponsored e n t e r p r i s e s , p r i m a r i l y those operating in
the mortgage market.

In any event, total

Federal and f e d e r a l l y - a s s i s t e d

c r e d i t demands could reach $95 b i l l i o n or even more in calendar 1980.

In

other words, the Federal government and i t s agencies could pre-empt almost
one-fourth o f al l

cr e d i t demands, compared to l e s s than a one- si xth share

during the f i r s t h a l f o f the 1970' s .

Thus, none o f us should be su r p r i s e d

at the s t r a t o s p h e r i c level o f i n t e r e s t rates which r e s u l t s when money
growth i s ob vio u sl y slowi ng, and when the Federal government is ta k in g a
l a r g e r share o f a v a il a b l e funds.
These co ns id era ti ons in d i c a t e why the d r i v e f o r a t r u l y balanced
budget i s at the heart o f our a n t i - i n f l a t i o n s t r u g g l e .

I t may be d i f f i c u l t

to reach that goal in l i g h t o f the need f or real increases in defense




spending, but that simply means that s t i f f cutbacks elsewhere are e s s e n t i a l
i f we are ever to reduce the government s e c t o r ' s ex cessive demands on the
n a t i o n ' s resources.

The Ad min istratio n has made a good s t a r t by reopening

the books on the 1981 budget, and proposing a $16 1 / 2 - b i l l i o n su rp l u s
rather than a $16 - b i l l ion d e f i c i t .

Yet most o f that s h i f t represents a

sharp increase in revenues rather than spending cutbacks - - and f o r that
matter, there i s no c e r t a i n t y that Congress w i l l
balancing measures.

approve the proposed budget-

F i n a l l y , and most impor tan tly , l i t t l e has been done to

date to cut Federal spending and a l i k e l y d e f i c i t o f $37 to $43 b i l l i o n in
the current f i s c a l year.

Despite recent s i g n s o f rec es si on, the problem o f

rampant i n f l a t i o n and s k y- hi g h i n t e r e s t rates i s s t i l l

our major concern.

I would argue that the government could make a greater co nt rib u tio n
to the a n t i - i n f l a t i o n f i g h t by r e s t r i c t i n g spending rather than by b o ost ing
revenues.
here.

Our elected represe nt ativ es in Congress should take the lead

F i r s t , they must overhaul the l e g i s l a t i v e process i t s e l f -- e s p e c i a l l y

co ns id eri ng that, in 1979, Congress passed three times as many b i l l s that
contributed to i n f l a t i o n as did the reverse, according to a recent study
by the National A s s o c i a t i o n o f Business Economists.

Again, Congress would

do well to follow-up on the Congressional Budget O f f i c e ' s l i s t o f 58 areas
of p o s s i b l e budget cutbacks -- in c lu d i n g , f o r example, the modification
o f indexing requirements for soci a l - s e c u r i ty b e n e f i t s and other Federal
programs, which could y i e l d $70 b i l l i o n in sav in gs over a f i v e - y e a r period.
(Almost $40 b i l l i o n o f that total could be saved by g r an ti n g s o c i a l - s e c u r i t y
r e ci p ie n ts an 85-percent adjustment in stead o f a 100-percent adjustment f o r
increases in the consumer price index, which i s l o g i c a l




because of the C P I ' s

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tendency to ov erstate the actual i n f l a t i o n rate.)

Such cutbacks are

p o l i t i c a l l y d i f f i c u l t to enforce, o f course, but they are a ls o e s s e n t i a l
to our long-term economic health.

I n f l a t i o n and Monetary P o l i c y
Monetary p o l i c y meanwhile has a c ruc ia l

role to play in r e s t o r i n g

price s t a b i l i t y , e s p e c i a l l y in view o f the fact that excess money creation
helped create the problem, in the wake o f the excess c r e d i t demands
generated by Federal d e f i c i t fi n a n c i n g and other forces.

Over the 1975-79

business expansion, the M-1B measure o f the money supply grew at more than
a 7-percent annual rate —

f a s t e r than in the 1970-74 period, and almost

twice as f a s t as in the les s i n f l a t i o n a r y period of the 1 9 6 0 's .

The M-1B

measure, i n c i d e n t a l l y , c o n s i s t s p r i m a r i l y o f currency plus demand and other
check-type d e pos it s.
The Federal

Reserve, reco gni zing that p ri ce s t a b i l i t y

requires a

progre ssi ve reduction in money-supply growth, moved a g g r e s s i v e l y l a s t
October 6 to enforce i t s tight-money p o l i c y d e c is i o n s .

In p a r t i c u l a r ,

i t placed more emphasis on c o n t r o l l i n g money-supply growth, and placed
l e ss emphasis on minimizing short-term f l u c t u a t i o n s in i n t e r e s t rates.
The e a rl y returns are quite heartening.

In the six-month period p r i o r

to October 6, the M-1B money supply increased at more than a 10-percent
rate; in the subsequent s i x months, the estimated growth rate averaged
roughly 6 percent - - which means that at present we are wi th in the 4- to 6 1/2 percent range set by the Fed f or 1980.

Moreover, according to

Chairman V o l c k e r ' s recent testimony to Congress, the Fed's de sired target




growth rate for t h i s measure in 1980 i s the midpoint o f the 4 - t o - 6 1/2
percent range, implying f u r t h e r dece lera tio n of monetary growth.

We're

already seeing some r e s u l t s from t h i s p o l i c y o f monetary d i s c i p l i n e , with
i n f l a t i o n expectations being squeezed out of the economy, and with i n t e r e s t
rates f a l l i n g shar ply from the s t r a t o s p h e r i c highs reached in the l a t e winter months.

In the past month and a h a l f , f o r example, T r e a s u r y - b i l l

rates have dropped about 5

percentage p o i n t s , and corporate-bond rates

have f a l le n about 1 1/2 percentage p o in ts .
The most heartening

recent development in t h i s area was the passage

a month ago of l e g i s l a t i o n which should provide a permanent source o f
strength to the n a t i o n ' s monetary p o l i c y .

The l e g i s l a t i o n goes by the

to n gu e- tw is ti n g t i t l e of "The Depository I n s t i t u t i o n s Deregulation and
Monetary Contro'1 Act o f 1980," and despite being almost overlooked in the
media, i t represents the most important piece of f i n a n c i a l
the past generation.

l e g is la t io n of

I t helps to so l ve the problem of d e c l i n i n g Federal

Reserve membership, by reducing the cost o f reserve requi rements f o r
member banks.

I t helps to support equi ty and to improve monetary c o n t r o l ,

by extending reserve requirements to a l l

depository i n s t i t u t i o n s with

tr a n s a c t io n s accounts (check-type accounts) and non-personal time deposits.
And i t helps to promote g r e at e r competition in fi n a n c i a l markets, p r i m a r i l y
by phasing out deposit i n t e r e s t - r a t e c e i l i n g s and by broadening the asset
and payments powers o f banks and t h r i f t i n s t i t u t i o n s .

The new l e g i s l a t i o n

makes a number of basic s t r u c t u r a l changes, and in the pr oc e ss, i t increases
the e ffe c tiv e n es s of monetary p o l i c y in co nfronting the i n f l a t i o n problem.
The measures taken on March 14 represent yet another segment o f the
over all a n t i - i n f l a t i o n program, with the Federal




Reserve broadening i t s

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p o l i c y of r e s t r a i n t , as a means o f sprea di ng the impact o f i t s p o l i c i e s
more evenly throughout the c r e d i t markets.

The consumer-credit r e s t r a i n t

program for many lenders and r e t a i l e r s was designed to di minish excess
c r e d i t demands a r i s i n g from unsecured loans, but not to discourage worthwhile
loans where c o l l a t e r a l
improvement loans.

i s in vo lv ed , such as auto, home-appliance and home-

The voluntary c r e d i t - r e s t r a i n t program f or banks was

designed so that banks would l i m i t themselves to productive l o a n s - - e s p e c i a l l y
those f or farmers, small b u si nes ses and home-b uil der s-- wh ile av o i d i n g
a c q u i s i t i o n loans and those i n v o l v i n g sp e c ul a ti on in commodities and
inventories.

Yet despite t h i s increased atten tio n to l en di ng p o l i c y , the

Fed w i l l continue to base i t s c r e d i t - r e s t r a i n t program mainly on i t s control
of rnoney-supply growth.
Tn_e_ Housing Problem
Now, what are the i m p l i c a t io n s for Oregon of a l l these developments?
Despite the s t a t e ' s i n c r e a s i n g l y d i v e r s i f i e d economy, Oregon s t i l l

suffers

when scarce and h i g h -c o s t mortgage money cut int o national housing demand,
and hence in to f or est -pr od uc ts demand.

The n a t i o n ' s home-building se c to r ,

which had held up r e l a t i v e l y well throughout most o f s l u g g i s h 1979, has
now experienced a 45-percent drop in housing s t a r t s sin ce l a s t f a l l , and
worse seems to be in store.

Many a n a l y st s expect s t a r t s t h i s y e a r to f a l l

below a 1 . 0 - m i l l i o n annual rate - - only o n e -h a l f the average o f the 1977-78
period.

And according to the p r esi de nt o f the National A s s o c i a t i o n of Home

B u i l d e r s , the housing decline has the same meaning f o r the national economy
as four C h r y sl e r bankruptcies.
To understand

t h i s s i t u a t i o n better, we should r e a l i z e that the

n a t i o n ' s housing i nd ust ry has j u s t completed a very productive decade.




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The ind ustry produced 17.8 m i l li o n housing units during the 1 9 7 0 's , or
24 percent more than in the preceding decade.

Also, the f i n a nc ia l

markets supplied more than $284 b i l l i o n f o r home financing in the period,
so that the home-mortgage share o f total cr ed it flows grew from an average
o f 19 percent in the 1 9 6 0 ' s to a 20 1/2-percent share in the 19 70 's.
However, that fina nc in g record was achieved only with the help o f
government-sponsored i n s t i t u t i o n s , which financed almost one-fourth o f
al l home mortgages over the e nt ire decade, and almost one-third o f the
total l a s t year.
This year has been considerably d i f f e r e n t , with mortgage-financing
i n s t i t u t i o n s s u f f e r i n g a crunch s i m i l a r to that o f 1974.

Many such

i n s t i t u t i o n s are in trouble because o f the mismatch between the high rates
that they c u rre n tly pay on short-term sources of funds, and the low rates
they earn on long-term mortgages made perhaps years ago.

In the second

h a l f o f 1979, f o r example, the typical savings-and-1 oan as so c i a ti o n faced
a 7.7-percent average cost o f funds -- only about one percentage point
below the average y i e l d on i t s loan p o r t f o l i o .

The s i t u a t i o n obv iously

has worsened in more recent months, and some in d i vi d u a l t h r i f t s are now
in d i f f i c u l t circumstances.
Over the long run, these problems should be overcome with the help
o f the new l e g i s l a t i o n which I mentioned a minute ago.

Disintermediation

- - the outflow o f deposit funds int o market instruments during h i g h - i n t e r e s t rate periods -- should no longer be a danger as i n t e r e s t - r a t e c e i l i n g s are
phased out over the next half-dozen years.

The t h r i f t s should be helped

also by several other features o f the new law - - which, among other th i n g s,
permits t h r i f t s to o f f e r check-like NOW accounts and pre-empts state usury




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c e i l i n g s on mortgage loans.

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Another favorable move i s the Federal Home

Loan Bank Board's recent approval o f a new kind o f home-mortgage loan with
an in t e r e s t rate subject to change every three to fi ve ye ar s, but with
certain protections to the borrower over the 30-year l i f e o f the loan.
In the more immediate future, the housing in du st ry should benefit
from the i n c re a s i n g s lu g g is h n e s s of business a c t i v i t y and from the Federal
Reserve's success in squeezing spe cula tive excesses out of the economy.
These developments are now freeing up resources f o r t h i s c y c l i c a l in d u st ry ,
as evidenced by recent sharp declines in i n t e r e s t rates.

But we cannot

maintain a high and stable level o f housing a c t i v i t y without b r i n g i n g
i n f l a t i o n under control - - unless we want to make the i nd ust ry a complete
ward o f the Federal government.

Admittedly, i n f l a t i o n at times has

a r t i f i c i a l l y stimulated the i n d us t ry , by holdin g out the promise to
buyers o f large capital gains on t h e i r home purchases.

But i n f l a t i o n

has also forced many buyers out o f the market by generating an upsurge
in home prices and in mortgage i n t e r e s t rates.

Altogether, a l a s t i n g

improvement in the i n d u s t r y ' s s i t u a t i o n - - and in Oregon's prospects —
depends on a favorable r es o lu ti on o f the n a t i o n ' s f i g h t aga ins t i n f l a t i o n ,
because high and r i s i n g mortgage rates b a s i c a l l y r e f l e c t high and r i s i n g
i n f l a t i o n rates.
Concluding Remarks
To sum up, my remarks today suggest that strong measures are needed
to overcome the new outburst of i n f l a t i o n which has undermined the economy
so badly in recent months.

The Administration has taken an unprecedented

step by re-opening the books on i t s 1981 budget document only a month and




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a h a l f a f t e r sending i t to Congress, with the intention of ending the
i n f l a t i o n stimulus created by continued massive Federal d e f i c i t s .

But

as I ' v e suggested, much more remains to be done along that l i n e , with
increased emphasis on spending cutbacks rather than tax boosts.
The Federal Reserve meanwhile has broadened i t s p o li cy o f r e s t r a i n t ,
as a means of spreading the impact o f i t s a n t i - i n f l a t i o n p o li c y more
evenly throughout the cr e d i t markets.

S t i l l , these measures must be

considered secondary to the Fed's basic p o li cy of c o n t r o l l i n g money-supply
growth.

That p o li cy has begun to show some success in reducing spec ula tiv e

excesses and i n f l a t i o n expectations, as evidenced by recent declines in
i n t e r e s t rates.

But u nf o rt u n a t e l y , we cannot expect such an approach

to y i e l d immediate r e s u l t s on the price front.

H is t or y shows that there

i s an unavoidable la g between the imposition o f a program o f monetary
r e s t r a i n t and the eventual return o f price s t a b i l i t y .

(For example, the

i n f l a t i o n rate was cut in h a l f following the 1974 tight-money period, but
i t took two y e a r s ' time to accomplish that t a sk .)

In any case, i t i s

imperative that we continue to follow t h i s basic cure f o r i n f l a t i o n , with
the steady applic at ion o f d i s c i p l i n e d monetary and f i s c a l p o l i c i e s .




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