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PROBLEMS AND POLICIES IN 1978

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

Meeting of
Executive Committee and Guests
Hawaii Bankers Association

Honolulu, Hawaii
April 10, 1978

Problems and Policies in 1978
I'm delighted to be here again in the Crossroads of the Pacific.
I'll be spending the next several weeks visiting four Far Eastern
countries, discussing problems of common interest with a number of
government officials and commercial bankers.

I'm also grateful, however,

for the opportunity to stop first here in Hawaii, to spend some time
with present as well as potential member banks.

But being a California

chauvinist, I'm not sure that I'll stop for a wine-tasting tour at the
winery that's been operating on Maui recently.
In preparing for my tour, I've become strongly impressed with the
interrelated nature of the economies of the world's major trading
countries.

Indeed, my remarks today about the U.S. economy also reflect

the major impact which foreign countries are having upon our nation's
future prospects.
here in Hawaii.

But none of this is news to the people who live
Now more than ever, Hawaii's future depends on the

events occurring on the Mainland, in Japan, and in many other countries
as wel1.
Factors Influencing Hawaii's Economy
Most analysts of the local economy expect personal income in Hawaii
to increase 10 percent this year, to about $7.4 billion.

Still, a

great deal depends upon such factors as the number of visitors and the
amount they spend here.

You can count on 17,000 bankers in October and

28,000 realtors in November, not to mention all of the nation's top




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volleyball players, but the shape of the economy elsewhere will
determine whether you get 3 million more visitors from the Mainland
and 660,000 visitors from Japan, as your planners here seem to expect.
Actually, those figures may be conservative, considering the substantial
amount of buying power in the hands of potential U.S. visitors, or
the very strong price advantage that Hawaiian vacations now offer to
Japanese tourists.
Outside influences will affect the health of other key Hawaiian
industries, such as sugar.

The price-support program, which assures

sugar producers at least 13^ cents a pound for their product, may
create somewhat optimistic expectations for the state's largest
agricultural industry.

But longer-term prospects are bound to be

affected also by the surplus of sugar in world markets and the failure
of the new International Sugar Agreement to stabilize the situation.
Again, in the construction industry, the strength of the upturn from
the relatively weak performance of the past several years undoubtedly
will depend on such factors as the state of the national mortgage
market, which has come under pressure in recent months because of
rising credit demands and rising interest rates.

And of course there

is that major questionmark--can labor peace be achieved on the docks this
year, without the type of disruption suffered during the prolonged
strike of six years ago?
I'm generally optimistic on all of these points, but I think it
wise that we keep always in mind the extent to which outside forces
determine the prosperity of the economy in which we operate.




The same

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is increasingly true of the national economy, as I hope to demonstrate
later on.

But first, let me take a minute to summarize what's been

happening on the Mainland, and what the broad shape of the future looks
like there.
Outline of 1978 Growth
First of all, the national economy has behaved remarkably well
the past several years, bouncing back from both the worst recession
and the worst inflation of the past generation.

Over this period, the

$2-tri11ion economy generated one of the strongest and most prolonged
expansions of the past several decades.

Last year, for example, total

production of goods and services increased almost 5 percent in real
terms, and this second straight larger-than-normal increase brought
into play more of the reserves of labor and capital that had been
left unemployed by the 1974-75 recession.

The jobless rate dropped

sharply to the lowest level of the past three years.

Again, employment

increased faster than at any time since World War II--up more than 4
million over the year--and a record 58 percent of the working-age
population held jobs at year-end.

But at the same time, a persistent

inflation constantly threatened to undermine this expansion and to
aggravate our many domestic and international problems.
We may see the same type of numbers in 1978, judging from the
forecasts made by my staff economists and various other forecasters.
Total real output may increase about 4^ percent above its 1977 average.
Thus, the economy would still be growing above its long-run potential,




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calculated in terms of a steadily expanding and more efficient workforce.
The pattern of business activity meanwhile may shift considerably
over the year.

Output suffered considerably during the first quarter

because of severe winter weather and a prolonged coal strike, but a
sharp recovery is almost certain this spring as business firms rush to
replenish their stocks, while a more moderate pace may develop later
this year.

The pace of business activity thus may be sharply influenced

by the pace of inventory spending, repeating much of what we've seen
the past several years.

Businessmen generally have been reluctant to

hold large inventories, and this has caused sudden depletions of stocks
whenever sudden shifts developed in supply or demand—followed shortly
thereafter by flurries of stockroom activity.

We saw that pattern last

year, and may see a repetition this year, although with some difference
in timing.
We should also witness a mixed pattern of spending in other sectors
besides inventories.

Consumer auto demand obviously has already

weakened, partly because of buyers' disinterest in scaled-down models
with scaled-up sticker prices.

Also, single-family home construction

could retreat from its record 1977 pace, as mortgage-lending institutions
adjust to the recent slowdown in savings flows.

Business spending for

plant and equipment may remain a question mark; projected spending plans
reflect a great deal of caution on the part of corporate planners, yet
some indicators, such as construction contract awards, look quite strong.
Meanwhile, spending by state and local governments should grow, bolstered




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by Federal grants and by the expanding economy's boost to tax revenues.
Again, defense spending seems more expansive, judging from the new budget
estimates and from the strong trend of new orders for defense products.
From all of this, we might expect continued growth but a change in the
character of the expansion--that is, a slowdown by the fast-growing
sectors of 1977 (such as autos and housing) but a speed-up by some of the
former slow-growing sectors (such as defense spending and state-local
government outlays).
Because of this scenario of moderate growth, most forecasters had
predicted earlier that the unemployment rate would drop to about 6%
percent of the labor force sometime in 1978.

Well, we were significantly

below that rate in the first several months of the year, and there's a
strong possibility that the jobless rate will fall below 6 percent later
in the year.

Of course, to some observers that still represents a sub­

stantial amount of slack in the economy.

But they are probably wrong,

because the published jobless rate is a much poorer guide than it used
to be, largely because of a number of shifts in our population mix.
The pressures already reached in the labor market can be measured by
the fact that the volume of help-wanted advertising jumped one-third
over the course of the past year—and that a record 58 percent of the
working-age population now holds jobs.

In fact, my economists argue

that we're already very close to the point of full employment—that is,
the point

at which further stimulus to the economy will only generate

more inflation without making any dent in the problem of unemployment
among unskilled workers.




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Inf1ation--Domestic and International
The greatest danger to the continuing recovery could be a
resurgence of inflation.

Compared to a few years ago, we're doing quite

well, because the inflation rate was cut in half between late-1974
and early-1976.

But we've made no real progress over the past two years,

and in fact there was some reacceleration of inflation in 1977 and early
1978.

Most analysts now agree that a 6-percent rate of inflation has

become imbedded in the overall economy, judging either from the past
year's trend of prices, or the increase in wage costs incurred by major
pattern-setting industries, or the amount of past fiscal and monetery
stimulus.

Moreover, we might see further price pressures from a

depreciating dollar, reflecting the much higher costs of goods from
Japan, Germany and other trading partners.
The recent steep decline in the value of the dollar was a shock
to most people, and there's still a great deal of disagreement concerning
the causes of the problem. Some people blame the shift in our merchanaisetrade balance, which went from a $9-bi11ion surplus in 1975 to a $31billion deficit in 1977.

For one reason, oil imports shot up 75 percent

between 1975 and 1977, because we didn't produce enough in this country
and instead purchased more and more from the OPEC nations.

For another

reason, imports of other products increased 48 percent above the 1975
figure, because of the strong expansion of our domestic economy.

And

for yet another reason, U.S. exports rose only 14 percent above 1975,
because of the sluggish growth of most overseas economies.




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We must remember, however, that the large U.S. trade deficit was
not the only or even the major factor in the steep decline of the dollar.
When we had a large trade surplus in 1975, the value of the dollar was
even lower than now, whereas in the opposite circumstances of 1976 and
early 1977, the value of the dollar actually increased.

Throughout that

recent period the trade imbalance was offset by a very substantial
capital inflow, explainable in terms of the high degree of foreign
confidence in our political and economic stability—including our price
stability.

But in late 1977, many of those foreigners suddenly lost

their confidence in us, and decided to get out of dollars.

From late

September on, the dollar declined steeply and steadily against almost
all major currencies except the Canadian do!1ar— 11 percent against the
German mark, the Japanese yen, and the British pound, and even more
against the Swiss franc.

The market then stabilized in early January,

when the Federal Reserve and the Treasury undertook support operations
in the market and the Fed underscored this move with a half-point rise
in its discount rate.
But why did market expectations turn so suddenly and steeply against
the dollar?

Perhaps because market participants feared that the trend

of inflation was worsening here compared to other major countries.
After all, there was the evidence of the several bulges which developed
in the U.S. money supply in 1977, which to many observers represented
a loosening of monetary policy and therefore an unleasing of price
pressures.




Monetary growth accelerated in the U.S. between 1974-75

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and the subsequent two-year period, contrary to various other major
countries.

Also, our price performance last year was worse than in

year before, contrary to various other major countries.
market sentiment turned against the dollar.

Consequently,

And once again the dollar

showed that it is especially sensitive to changes in inflation expectations,
because its usefulness as an international store of value and medium of
exchange depends heavily on its stability and negotiability.
We can see the elements of a solution simply by citing the causes
of the dollar problem.

But since the basic cure--curbing inflation—at

times seems so unattainable, the experts try to develop secondary
strategies as a means at least of ameliorating the disease.

One such

solution would be the government's issuance of foreign-currency denominated
securities.

For example, if the U.S. government issued Deutschemark-denominated

securities, it would remove an important transitory pressure from the foreignexchange market.

At present, people who wish to move out of dollars into

Deutschemarks have to do so by selling dollars and buying Deutschemarks in
the foreign-exchange market.

This tends to drive the exchange value of the

Deutschemark up, so that some German exporters and importers come to be
priced out of the market.

These firms therefore adopt a protectionist stance,

which could lead to a reversal of the 30-year trend toward freer trade.

But

if the U.S. Treasury sold DM-denominated securities, it would allow investors
to shift their portfolio out of dollars into Deutschemarks directly without
causing a major impact on the exchange rate.

Under this approach, exchange

rates would not have to adjust as much to accommodate shifts in asset demands
for dollars, and thus would be able to move more in line with the relative
coirmodity value of the dollar.

But basically, this type of action would do

nothing to correct the fundamentals that have caused the dollar's problems,




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such as the trade deficit and (especially) inflationary expectations.

So

once again, we're faced with the basic prescription of curbing inflation if
we are to solve either our foreign or domestic problems.
Financial Market Developments
Let's consider the situation in domestic financial markets, which
have performed so well these past several years.

In 1977, for example,

conmercial-bank credit expanded by a record $82 billion, exceeding even
the exuberant performance of 1973—and almost all of the growth was in
loans.

In 1978, loan demand should continue strong but perhaps shift

into different channels, with less emphasis on the mortgage and consumer
sectors and more emphasis on corporate borrowing.
Financial markets last year generally exhibited the same strength
visible in bank-lending activity, although at a rising level of short-term
interest rates.

These rates increased about two full percentage points

during the year, reflecting the growth of business activity and the
firming of monetary policy which followed in the wake of the several
spurts in money-supply growth.

Still, long-term rates increased only

slightly in 1977, despite the heavy volume of financing in the capital
markets, before rising noticeably in early 1978.

This leads to the key

question--can a strong business expansion continue in 1978 without sig­
nificant upward pressures on rates?

The answer depends in large part

on the markets' view of how well the fight against inflation is being waged.
Too few people clearly understand the long-term effects of price
expectations on interest rates, and the way in which such expectations
can offset other market influences.

But the basic point is quite clear.

With prices expected to rise at (say) 6 percent a year, lenders will
demand a 6-percent inflation premium plus some basic "real" rate of



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interest, to protect themselves against an expected loss in the purchasing
power of their money.

But borrowers will be willing to pay this inflation

premium, because they expect to repay their loans with dollars that are
worth (say) 6 percent less each year than the dollars they originally
borrowed.
Policy Problems
Curbing inflation expectations thus is a must if we are to solve
our domestic as well as our international financial problems.

But

this means that we must get at the basic causes of inflation.

Luckily,

we're not likely to see again the unusual combination of circumstances
that made the 1973-74 inflation so severe—the worldwide industrial
boom, the worldwide crop shortages, and of course the OPEC oil-price
upsurge.

But we must still contend with long-term price pressures,

especially the major pressures arising from continued large-scale Federal
deficit financing.
At this mature stage of the business expansion, Congress and the
Administration face some difficult fiscal choices.

A substantial tax

cut may be necessary to maintain economic momentum, considering the
drag imposed by $40 billion or more of tax increases—the socialsecurity tax hike, the projected package of energy taxes, and especially
the severe "tax" imposed when inflation pushes people into higher tax
bracket.

At the same time, a substantial reduction seems necessary in

the combined Federal budget deficit of $114 billion projected for the
1978-79 fiscal years, considering the pressures on the Federal Reserve
to finance such deficits through excessive monetary expansion.
Over the past decade, deficit spending frequently worked to pull
monetary policy off course in an expansionary direction, by supporting




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excessive growth of money and credit.

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This happened because interest

rates generally rose whenever large-scale Federal borrowing was piled on
top of expanding private-credit demands.

Higher rates then undermined

the strength of certain sectors of the economy which are especially vul­
nerable to the high cost of credit, such as housing, agriculture, and
small business.

Under pressure to minimize this type of impact, the

Federal Reserve sometimes delayed taking firm action to head off excessive
growth of money and credit, and the eventual result was more inflation.
Accordingly, while Congress and the Administration face some dif­
ficult fiscal choices at this stage of the expansion, the Federal Reserve
for its part faces some difficult monetary-policy choices.

If prices

should accelerate, and if the Fed should move aggressively to tighten
credit, "crowding out" might become a reality rather than only a distant
threat to the financial market.

In that case, Treasury financing demands

could dominate the market and deny credit to the vulnerable industries
I just mentioned.

Alternatively, if the Fed should try to accommodate

all credit demands in this inflationary atmosphere, the result might be
another excessive bulge in the money supply and a further boost in
inflation expectations—setting the stage for another possible cycle of
economic instability.

And now that we've received a warning from the

foreign-exchange market, any resurgence of domestic inflation could
lead to a severe and lasting deterioration in the value of the dollar—
which in turn could give another push to the vicious spiral of inflation.
To avoid just such a scenario, monetary policymakers today are
striving for a gradual reduction in the growth ranges of the monetary
aggregates, to a level consistent with long-run price stability.




In his

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initial appearance before the House Banking Committee last month,
Chairman Miller reported the Federal Reserve's intention to stick with
the lowered growth ranges for the monetary aggregates adopted last year-4 to 6h percent annually for M] and 6h to 9 percent for I^-

(M] equals

currency plus bank demand deposits, and M2 equals currency plus all bank
deposits except large CD's.)

The actual figures for 1977 were on the

high side in relation to the target ranges set the year before, but the
performance in this regard has improved considerably since last fall. Yet
given the fiscal and economic environment that I've described, further
progress towards the Fed's long-term goal could at times be difficult
in the year ahead.
Concluding Remarks
To sum up, we seem to be moving into a year that holds considerable
promise, providing that we keep a good grip on the reins guiding our
$2-tri11ion economy.

Admittedly, the expansion is now about three years

old, which brings it into the realm of middle age.

But we should remember

that business expansions don't just die because of old age, but rather
because of riotous living during their earlier stages.

In the present

context, that means we must bring the economy down off its inflation
high by administering the right fiscal and monetary-policy medicine -that is, through a slow but certain reduction of fiscal deficits and
monetary growth.
To accomplish our goals, we must maintain a large measure of dis­
cipline in our fiscal and monetary policymaking.




Among other things,

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that requires maintaining the independence of the Federal Reserve within
the structure of the Federal government.

Over the decades, we in the

Fed have been able to make prompt and (if need be) frequent changes in
monetary policy, in contrast to the necessarily ponderous processes of
fiscal policy.

We've also been able to make the hard decisions that

might be avoided by decision-makers subject to the day-to-day pressures
of political life.

A number of such decisions may have to be made in

the years ahead, but that is the price required for sustaining a period
of domestic and international prosperity into the 1980's.




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