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FRB:
SAN FRANCISCO.
RESEARCH STUDIES.
\
FEDERAL tESW Vt
of KANSAS CITY
NOV 1 1977
-
Research Libras#
* •
POLICY
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OVERVIEW
\ ------------ FOR 1978
REMARKS OF
John J. Balles
PRESIDENT
FEDERAL RESERVE BANK
OF SAN FRANCISCO
Twenty-fourth Annual Meeting
Georgetown University Bankers Forum
Washington, D.C.
September 30, 1977
John J. Balles
The best hope for prolonging the recovery
and lowering the unemployment rate is to
reduce the underlying rate o f inflation,
according to Mr. Balles. This policy p re
scription flows from the research finding
that the goals o f reduced unemployment
and lower inflation are mutually reinforc
ing, not conflicting. This finding implies
for 1978 that we should pursue a gradual
reduction in the growth rates o f the
monetary aggregates. M oreover, there is
no need for a more expansive policy
despite recent signs o f sluggishness in the
economy. For one reason, monetary p o li
cy already has been very expansive this
year. Again, excessive ease at this point
could prove dangerous, as it w ould have
been in the similar brief pause o f late 7976.
I am pleased to have this opportunity to
discuss the appropriate monetary policy for
the coming year, since we are approaching
a critical phase of the current economic
recovery. That recovery is now in its tenth
quarter, yet only one of the post-Korean
War expansions has lasted more than thir
teen quarters. I do not want to imply that
the current expansion is likely to end soon.
On the contrary, I happen to believe that
we are capable of repeating the experience
of the 1960's, when we enjoyed nearly a
decade of sustained economic growth.
Whether we will in fact experience another
such prolonged expansion will depend cru
cially, in my opinion, on the various policy
choices we make.
Still, choices are difficult in view of a basic
policy dilemma. On the one hand, despite
ten quarters of solid economic growth, the
overall unemployment rate still hovers
around 7 percent. Although the rate for
household heads is only 4.6 percent, the
rates for minorities, women, and teenagers
are disturbingly high. On the other hand,
despite these signs of slackness in labor
markets, the underlying inflation rate still
appears to be at least 6 percent. The persist
ence of high inflation suggests that a policy
of restraint is in order; the persistence of
high unemployment argues for a policy of
more stimulus. The arguments for a more
expansive policy have recently been but
tressed by fears that the recovery may be
running out of steam.
Unemployment-lnflation Trade-off?
Most of the discussions of whether it is time
for more stimulus or more restraint are
couched in terms of a trade-off between
unemployment and inflation. It is generally
assumed that we can reduce unemploy-
ment if we are willing to put up with a bit
more inflation, and vice versa. The question
then becomes: Which is the greater evil,
inflation or unemployment? The costs of
unemployment— individual hardship, lost
output, and social tensions—are obvious.
The costs of inflation are equally serious but
more subtle, including such things as the
erosion of household savings, the damage
to those on fixed incomes, and the creation
of distortions in financial, factor, and goods
markets. Not surprisingly, attempts to
weigh these costs against one another tend
to generate more heat than light.
A side issue, yet an important one, is the
need to interpret the unemployment fig
ures in the light of a changing labor force.
With the large influx of women and teen
agers into the labor force, the relatively
high levels of unemployment traditionally
experienced by these groups have raised
the overall unemployment rate. This fact is
surely not a reason for complacency about
the unemployment situation. But it does
suggest that, to a large extent, today's high
unemployment rate reflects the economy’s
difficult adjustment to a major secular
change. For example, last year the Council
of Economic Advisers raised its estimate of
“ full employment" from 4.0 to 4.9 percent
unemployed. It would be wrong for policy
makers to respond to these structural
changes in the economy with expansive
measures designed to combat cyclical
downswings. The best policies to help the
economy through this transition are those
aimed at promoting stable, sustainable
growth.
W hile recognizing that changes in laborforce composition might go far toward
resolving the current policy dilemma, I wish
to focus your attention today on an even
more basic point. Specifically, I would
argue that the very notion of a trade-off
between unemployment and inflation is
fundamentally misleading. Recent evidence
suggests that under some circumstances,
inflation may tend to increase rather than to
decrease joblessness. Research done at my
bank by Joseph Bisignano—which appears
in the Summer issue of our Econom ic
Review—gives such evidence for the U.S.
Recent experience in Great Britain, Canada,
and Italy suggests similar results. This per
verse impact of rising prices on unemploy
ment can be explained by the reactions of
both consumers and producers, who asso
ciate inflation with increased uncertainty
about the future. Households, more uncer
tain about the future value of their real
incomes, tend to cut back on their spend
ing plans. Businesses, more uncertain about
the rate of return on new capital, tend to
reduce investment in plant and equipment.
The actions of both groups lower aggregate
demand and thereby tend to raise the
jobless rate.
Since the relationship between inflation
and unemployment is central to my policy
prescription, let me take a moment to
examine it in more detail. Economists of
such different persuasions as Milton Fried
man and Franco Modigliani now agree that
there is no long-run trade-off between
inflation and unemployment. (For example,
that agreement was clear in the debate
between those two economists at the San
Francisco Fed, which was published as a
supplement to our Spring Econom ic R e
view.) But most economists probably still
feel that an unexpected increase in the
inflation rate will lead to a short-run reduc
tion in unemployment. As businesses see
that they can get a better price for their
products, they would be encouraged to
hire more workers to increase output.
However, the research by Bisignano, which
I alluded to, suggests that this positive
supply response will be quickly undone by
reactions on the demand side.
Impact on Consumers and Producers
Briefly, the unanticipated inflation leads
consumers to spend less and to save more,
as a hedge against uncertainty. As they do
so, the increased output of producers piles
up in the form of unintended inventory
accumulation, and then businesses scale
back their production plans and begin to
lay off workers. Again, in this inflationary
environment, producers find it more diffi
cult to gauge the profitability of new invest
ments in plant and equipment, and they
consequently hold off on their capitalspending plans.
The effects of inflation on personal savings
and, hence, on unemployment, became
strikingly evident during the 1973-75 reces
sion. That recession was not only the most
severe of the past generation, but the pre
ceding inflation had no parallel since the
price upsurge following World War II. First,
the U.S. suffered from a worldwide inflation
which peaked domestically at nearly a 14percent rate in late 1974. A large part of that
inflation was unanticipated. As the rate of
inflation increased, so did the rate of per
sonal savings. And, as the inflation declined
in 1975-76, the savings rate followed it down
and consumer spending then recovered
dramatically.
In 1974, an absolute reduction in real con
sumption spending contributed to a sharp
build-up in inventories. But part of that
build-up could be explained as a specula
tive response to expectations of further
increases in materials prices. Some of it no
doubt also reflected producers’ difficulties
in making sound management decisions at
a time when rapid inflation was rendering
cost-accounting figures meaningless. By the
time that the need for an inventory correc
tion finally became evident, the size of the
adjustment was much greater than it would
have been if producers had cut back soon
er. The result, of course, was a severe
plunge in real output.
If rapid inflation causes businesses to over
invest in inventories, it has, on balance, a
depressing effect on capital spending deci
sions. It may boost plant and equipment
expenditures temporarily as businesses ac
celerate those investments they have al
ready decided to undertake, so that they
can get the new facilities at a better price.
But as inflation persists, it makes businesses
(like consumers) more uncertain about the
future. Will price controls be imposed to
stop the inflation? Will fiscal and monetary
policy suddenly turn sharply deflationary?
Will consumers cut back on their spending
plans? All of these unknowns increase un
certainty about the expected return on any
proposed investment. And the more doubt
ful a business becomes about future profits,
the less likely it will be to commit resources
to long-term investments. Yet increased
investment is vital to the creation of more
employment opportunities.
A clear message for policymakers emerges
from this discussion—namely, that the goals
of reduced unemployment and lower infla
tion are mutually reinforcing, not conflict
ing. The best policy is one which aims at a
continued, gradual reduction in the under
lying rate of inflation. Such a policy pro
vides our best hope for prolonging the
recovery and lowering the rate of unem
ployment.
Monetary Policy Prescription
What does this general prescription imply
for monetary policy? Quite simply, that we
should pursue a gradual reduction in the
growth rates of the monetary aggregates, to
a level consistent with long-run price stabil
ity. This is the course on which the Fed set
out in March 1975, when it began the
practice of making quarterly reports to
Congress regarding our targets for mone
tary growth over the year ahead.
But what about the signs of a faltering
recovery, such as this summer's softness in
retail sales and durable-goods orders?
Shouldn’t monetary policy become at least
slightly more expansive in the face of such
indications of softness? My answer to that is
"N o ,” for two reasons. First, monetary poli
cy has already been very expansive in 1977.
In the past twelve months, the narrow
money supply, or M i, has grown over 7
percent. The more broadly defined money
supply, M 2, has grown almost 11 percent.
These rates are not only high by historical
standards, but are also above the upper
bounds of the current targets which the Fed
has set for long-term monetary growth.
But—and here I come to my second
reason—suppose we were to expect a slow
down in real growth in the months ahead,
despite the recent record of generous
monetary growth. In that case, I still do not
believe that any special actions by the Fed
would be called for. Recall what happened
about this time last year, when many ob
servers became alarmed about the “ pause”
and called for a change in monetary policy.
Had the Fed responded to the slowdown in
the second half of 1976 with a more expan
sive policy, the effects would have been felt
in the first half of this year, when the
economy was booming and inflation reaccelerating. In retrospect, it is clear that the
“ pause" was really a mini-inventory cycle.
Although real GNP growth slowed to 1.2
percent in the fourth quarter of 1976, real
final sales were increasing at a rate of 6.3
percent. As a result, inventories were
brought back into line quickly, and the
recovery proceeded. I do not believe that
monetary policy should try to offset quar
terly variations in economic growth caused
by such mini-inventory cycles. Instead, I
believe that it must aim at establishing a
stable environment conducive to sustained
economic expansion over the long haul.
Fiscal Policy Prescription
Needless to say, monetary policy cannot do
the job all by itself. When fiscal policy
results in chronic, massive budget deficits,
the Fed comes under tremendous pressure
to provide more reserves to the banking
system to help finance such deficits. This
reserve expansion increases the rate of
monetary growth and ultimately leads to
more inflation. The independence of the
Fed within the government gives it some
room to resist these pressures. But if we are
to bring inflation under control, it will be
necessary for fiscal policy to complement
monetary policy. The achievement of fiscal
restraint is perhaps the greatest policy chal
lenge in the years ahead.
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