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POLICY PROBLEMS IN 1980

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

Supervision, Regulation and Credit Conferen
Federal Reserve Bank of San Francisco

San Francisco, California
February 21, 1980

As I look around the room, I'm reminded of what the Duke of Wellington
supposedly said when reviewing the troops before the battle of Waterloo.
"They may not frighten the enemy. Sire, but by Gad they frighten me."

I

hope that you people are as zealous in your supervisory and examination
activities as you appear to be when lined up on review.
In my remarks today, I'd like to cover some of the major policy
problems that will affect your operations during 1980.

Jack Beebe has

already given you a flavor of what to expect on the economic scene -- a
rather somber picture, I'm afraid.

I'd like to follow-up and discuss the

monetary policy implications of Jack's economic forecast.

But first, let's

stand back and review for a moment what happened in the decade just past,
to see how we got into the mess we're in today.
Cause of Today's Problems
Actually, the 1970's were not all bad.

On the positive side, the

national economy grew 32 percent (in real terms) between 1969 and 1979 -a substantial gain, even though it failed to match the 50-percent gain of
the preceding decade.

Again, real disposable per capita income — a key

measure of individual well-being — increased 28 percent in the 1970's,
or almost as much as it did in the I960's.

But the nation ate up much

of its seed corn in reaching its higher standard of living.

Real business

investment increased only one-third as fast, and worker productivity less
than half as fast, as in the preceding decade.

Worse still, the nation

became increasingly dependent for its raw materials on unstable and expensive
sources of supply, as evidenced by a 15-fold rise in the price of Middle
Eastern oil over the decade.




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Moreover, we're suffering today from the fact that economic growth
in the 19701s depended so heavily on public-sector spending.

In particular,

massive Federal spending increases outpaced tax revenues and created red
ink on the books for every single year of the decade.

Indeed, the combined

Federal deficit for the decade, $315 billion, matched the combined total
for the entire history of the Republic.

Inflation became an ever-worsening

problem, reflecting this prolonged series of deficits, the stimulative
monetary expansion that sometimes accommodated them, and a series of supplyrelated shocks.

Consumer prices practically doubled over the course of

the decade, in the worst peacetime inflation in the nation's history.
The impact of accelerating inflation has been felt everywhere.

In

our international dealings, the inflationary surge has led to a decline
in the power of the once-mighty dollar in the world's financial markets.
Here at home, it has undermined the strength of the economy and made the
task of monetary policy at times almost insuperable.

In addition, it has

undermined the strength of the Federal Reserve System itself by leading
to a massive withdrawal of member banks, which now seems to have reached
flood proportions.

Other factors, of course, help explain why membership

has become such a heavy burden — financial innovations, shifting competitive
patterns, and so on.

But the major cause has been the upsurge of inflationary

pressures, with their related high interest rates.

It has become progressively

more costly and more difficult for banks to justify continuing their
membership, especially to their stockholders, when as non-members they can
earn such high returns on their reserves.
Scope of Membership Problem
The numbers recently have been fairly sobering.

In the fourth quarter

of 1979 and the first few weeks of 1980, 69 banks with about $7 billion in



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deposits gave notice of withdrawal from System membership.

The loss of

deposits in this short period exceeded that recorded in any previous full
year.

Moreover, a recent survey by Reserve Banks indicated that many

more banks are considering withdrawal — altogether, some 670 banks, which
represent more than 10 percent of the System's membership and hold more
than $71 billion in deposits.

If these banks in fact withdraw from the

System, deposits of banks holding reserves with the Federal Reserve will
decline to 64 percent of banking-system deposits, compared with a 73-percent
share just three years ago.
What can be done to stem the membership decline?

The fight against

inflation is crucial, to help reduce the financial incentives which lead
banks to withdraw.

But new legislation is also essential in this regard.

Let's consider some of the basic principles which the System believes should
be achieved by such legislation.
First, reserves should be applied to all transactions accounts, with
perhaps some relatively low exemption level or a system of graduated
requirements for the smallest institutions.

Second, any reserve requirements

imposed on time deposits should be confined to short-term non-personal
accounts, and should be relatively low.

Third, reserve requirements should

be equal for all depository-institutions offering comparable accounts, in
order to create a "level playing field."

Fourth, the System's reserve

base should be large enough to implement monetary policy efficiently and
effectively.

Fifth, all depository institutions holding transactions accounts

should have access to Federal Reserve services, with the Federal Reserve
recovering the full cost of those services from pricing.

Finally,

institutions snould remain free to choose a state or Federal charter, so
that System membership remains voluntary.



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Implementing Membership Principles
Translating these principles into reality can be quite time-consuming
and difficult.

What banks should be covered under the proposed legislation?

What proportion of deposits should be held by those banks?
the reserve base be in relation to deposit totals?

How large should

We have no formula for

deciding precisely how large reserve balances need be, or how they should
be distributed to insure effective monetary control and a well-functioning
banking system.

But as Chairman Volcker told the Senate Banking Committee

several weeks ago, reserve requirements must be more equitably distributed
among the nation's banks, even though the Federal Reserve can meet its
responsibilities with a smaller reserve base than it now has.
In the System's view, monetary policy could still be conducted
effectively with a reduction in reserve balances held at Federal Reserve
banks to as little as $10-15 billion (expressed in 1977 terms) — provided
the reduction is distributed equitably across depository-institutions
having transactions accounts.

That level of balances would be about 4 to

6 percent of transactions balances, and less than 1 1/2 percent of total
deposits in depository institutions.
thin.

However, that may be cutting it too

F<Dr that reason, the System urges at least stand-by capacity to

obtain somewhat larger balances, up to $20 billion or more in 1977 terms.
The several pieces of legislation now being considered, either in the
House or the Senate, do not meet this type of requirement.
In any event, the System wants to apply reserve requirements to
depository institutions on a universal and mandatory basis.

This approach

is important because it applies reserve requirements equitably to comparable
accounts -- thrifts as well as banks, and non-member as well as member




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institutions.

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This is especially important with respect to the rapidly-

growing components of the nation's basic money supply — NOW accounts and
ATS accounts, many of which now escape reserve requirements altogether.
It's hard to predict what will happen to membership legislation in
the near future, at least partly because of the even-split in the Senate
Banking Committee over the best means of solving the problem.

We may

know more after a scheduled March 4 meeting of House and Senate conferees.
Perhaps at that time the log jam will break.

But there's no question

whatsoever about the need for reform legislation.
Among other reasons, legislation is needed because of the Federal
Reserve's decision last October 6 to adopt new operating procedures.
These new procedures place much greater emphasis on reserves as the
instrument for controlling money growth.

Thus far, they have worked

reasonably well, but their effectiveness will be undercut with further
increases in the share of money not subject to reserve requirements.

It

is thus essential to obtain legislation to maintain Federal Reserve control
over the nation's reserve base, as one essential element in our basic
anti-inflation program.
Improving Monetary Control
You'll remember that the "Saturday Special" of October 6 came
about, in large part, because of the 1979 upsurge of inflation.

Contrary

to expectations, the U.S. economy heated up during the third quarter, with
a buy-now spending boom which reflected an upsurge in inflationary
expectations.

As consumer prices rose at a 13-percent annual rate,

households and businesses boosted their purchases and speculative pressures
developed in commodity markets.




Despite policy efforts to control the

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situation — measured by steady increases in the Federal-funds rate —
money growth actually accelerated; the annual growth of the M2 money
supply jumped from 8.9 percent to 12.5 percent between the second and
third quarters of the year.
The Fed thus had to act decisively on the monetary front to put a
brake on inflation expectations.

On October 6 the System introduced its

three-part policy package, which included a 1-percent increase in the
discount rate and an 8-percent marginal reserve requirement on certain
managed liabilities.

But in addition, it included a greater emphasis on

controlling bank-reserve growth, and less emphasis on minimizing short­
term fluctuations in the Federal-funds rate.

Most important, it was

announced that the Fed's intent was to slow the rate of monetary growth,
so as to keep within the target ranges originally announced for 1979.
Under the new approach, the Fed attempts to hit certain target growth
rates for the quantity of bank reserves.

Once this quantity is expanding

at a set rate, the rate at which banks can issue deposits (the main element
in the money supply) will be largely determined -- at least over the
short-term.

In contrast, under the previously used funds-rate instrument,

the Fed attempted to influence deposit growth not through the quantity of
reserves but indirectly through the cost of these reserves.
Economists have argued for some time about which technique does a
better job of controlling money.
to be a draw:

As a technical matter, the race seems

using either the funds rate or reserves as the operating

instrument could produce equally good results, provided that the funds
rate is permitted a wide enough range of movement.
important qualification.




However, that is an

In recent years, the Fed generally moved the

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funds rate in the right direction -- raising it in recoveries to restrain
monetary accelerations, and reducing it in recessions to hold back monetary
decelerations.

But these actions were not sufficiently aggressive to

keep money growth from moving in tandem with the business cycle.

As a

result, monetary policy generally added to inflationary pressures during
cyclical expansions, and to unemployment during recessions.
This raises an obvious question.

Why didn't the Federal Reserve

move the funds rate more actively in the past?

Partly because of the

understandable uncertainty about the exact condition of the economy at
any point of time, and about the precise timing and impact of policy
actions.

In addition, institutional factors contributed to this cautious

movement in the funds rate.

For one reason, with policy being made by

a committee (the FOMC), typical committee compromises frequently led to
only modest changes in the level or range of the funds rate.

Again,

policymakers wanted to avoid changes in policy, which impose costs on
the private sector by forcing it constantly to revise its decisions, and
so tend to undermine the performance of the economy.
Altogether, our past experience has shown that a cautious funds-rate
strategy can lead to swings in money and reserves which accentuate
cyclical movements and ultimately lead to undesirable economic results.
In contrast, a cautiously-controlled reserves instrument should work in
the opposite direction -- it will tend to resist rather than accede to
the forces producing procyclical swings in money.

With the supply of

bank reserves expanding at a relatively stable rate, the maximum rate
at which banks can issue deposits will be relatively stable also.
ultimate result thus should be less inflation.




The

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Financial Markets After October 6
How much success have we had with this new policy?
important respect, it has worked unequivocally.

In the most

I've been very encouraged

by the post-October 6 slowdown in money growth, which has brought the major
monetary aggregates within the boundaries projected by the Fed a year ago.
The narrow definition of money, M-j , slowed to a 5.2-percent rate of gain
in the fourth quarter in contrast to 10.0-percent growth in the third quarter.
The broader M2 measure of the money supply also slowed, from a 12.5-percent
rate of growth in the third quarter to a 9.2-percent growth in the final
quarter of 1979, and it decelerated even further in early 1980.

The Fed has

delivered on its promises, and it will persist with a gradual orderly
diminution of growth in the months ahead.
Nonetheless, the public has not been persuaded of the success of the
new policy, somewhat to the surprise of the many proponents of the new look
in the academic community.

For example, immediately after October 6 the

stock market nose-dived, while rates rose steeply in other financial markets.
After a period of stability, the sense of turmoil arose again in early 1980,
even though not everywhere.

The money markets and the foreign-exchange

market have remained relatively stable, but the bond market has experienced
a blood-bath -- for example, with yields on corporate Aaa bonds increasing
by 100-130 basis points in the last several weeks.
How can we expalin this big cost increase in long-term credit financing?
Obviously, long-run inflation expectations have worsened, with marketmakers deciding, on the basis of the Administration's new budget, that
we're in for a repetition of Vietnam-style, guns-and-butter financing
which laid the basis for our present inflation problem.

The problem has

been aggravated by some inflation-related structural changes in the bond




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market.

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Life-insurance companies, which typically are big buyers of

long-term bonds, have smaller amounts available today because they've
been hit by an upsurge in loans against their outstanding insurance
policies.

Moreover, pension funds and insurance companies, with their

large commitments to buy mortgages, are now preempting funds they might
have otherwise put into bond purchases.

The U.S. government also has

become a larger borrower in long-term bond markets.

And finally,

individual investors have practically withdrawn from the market —
in contrast to their heavy purchases in earlier periods, such as
1970 and 1974-75, when they didn't have the alternative of buying moneymarket certificates or money-market mutual funds.
Some observers have referred to the "Europeanizing" of the bond
market -- that is, a disappearance of long-term debt financing.

The

market could be restructured to include floating-rate bonds and bonds
with shorter maturities and faster repayment schedules.

Again, many

corporations could turn increasingly to commercial banks for funds.
This could reduce the liquidity of the banking system, since part of
their liquidity depends on corporations being able to borrow long in
the bond market in order to pay off bank debt.
Concluding Remarks — Inflation and Policy Problems
Underlying all the problems that I've mentioned is the severe and
continuing problem of inflation.

The inflation rate exceeded 10 percent

last year, even if we adjust for the fact that the consumer-price index
overstates certain factors such as housing costs.




At any rate,

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the inflation rate will probably be in double-digit territory again this
year, with oil-price increases adding perhaps 2 percentage points to the
projected increase of 8 percent or so resulting from previous monetary
acceleration.

And with the declining likelihood of a recession, we are

not likely to get enough of reduction in demand to reduce the pressure
on prices.
This raises the basic question:

what can we do to bring about a

deceleration of this price upsurge?
from fiscal policy this year.

Apparently, we will get little help

Already, the forecast for the fiscal 1980

deficit has been raised from $29 billion to $40 billion.

(The famous

spending shortfalls of several earlier years are now only a memory.)
More importantly, the projected figures for fiscal 1981 -- that is, a
$16-bill ion deficit with total spending of $616 billion — may also be
out-distanced by events.

The deficit could balloon under the spur of

sharper-than-expected defense spending, higher unemployment benefits,
and perhaps also an election-year tax cut.
Once again, as in the past, monetary policy will face a difficult
task ahead.

Now, monetary policy will not solve all of our problems,

but it's indispensable to a solution.

Monetary and economic factors

can not be forecast precisely -- after all, there are lags and
institutional changes to consider.

But inflation can be sustained only

by an excessive increase in money and credit flows.

As I've already

indicated, we have seen the beginning of a gradual, orderly reduction
in money growth.

If we continue along the same lines, we can expect

long-term success in containing inflation.




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Chairman Volcker said as much when he announced the annual target
ranges for the monetary aggregates, in testimony Tuesday before the House
Banking Committee.

M-1A (currency plus bank demand deposits) is targeted

within the range of 3.5 to 6.0 percent for 1980, compared with last year's
growth of 5.5 percent.

M-1B (currency, demand deposits and other checkable

deposits) has a target range of 4.0 to 6.5 percent, compared with last
year's growth of 8.0 percent.

And the new M-2 (currency, demand and other

checkable deposits, small time and savings deposits, money-market fund
shares, and overnight repurchase agreements and Eurodollars) has a target
range of 6.0 to 9.0 percent, compared with last year's growth of 8.8 percent.
As the Chairman noted when he reported these new target ranges, there is "no
alternative to a progressive slowing of growth of the monetary aggregates to
lay the base for restored stability and growth."
Meanwhile, we must reinforce the signals which the money-growth
statistics are now giving the financial markets.

We must in some way

reinforce the public's perception of the Fed's willingness to fight
inflation.

One useful way of doing this is just what we did last Week --

utilize the discount rate for its announcement effects.

We didn't have

to raise the discount rate at that time to stem any massive increase in
member-bank borrowing.

However, we did have to act, as we did, to let

the public know of our determination to end inflation once and for all.




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