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Federal Reserve Bank of San Francisco MAY 9 1977 Pr o s p e r ity , \ PRICES AND x — PUBLIC POLICY 1 REMARKS OF John J. Balles PRESIDENT FEDERAL RESERVE BANK OF SAN FRANCISCO Meeting with Phoenix Community Leaders and Board of Directors, Los Angeles Branch, Federal Reserve Bank of San Francisco April 26, 1977 John J. Balles I’m delighted to be back in Phoenix again, and I'm glad that the Directors and Officers of our Los Angeles Office have this oppor tunity to meet with Phoenix community leaders to discuss matters of common inter est. Speaking as a resident of the Great Northern California Desert, I would say we might have a common interest in the sub ject of water. Actually, all I had in mind was taking a gallon or two home as a present for my family, but from what I've heard recent ly, your interest in the subject is more basic than that. Needless to say, I'm no expert on the sub ject of the Central Arizona Project, but I must say that I was impressed with the recent set of editorials in the Phoenix Ga zette which summarized the benefits ob tained from Arizona's past efforts in the field of water development. The editorials, as you might remember, described how Federal-local participation in the Salt River Project early in this century made the desert bloom like a rose (to coin a phrase), creat ing a prosperous metropolis where more than a million people now live and work. That project involved a Federal investment of about $10 million, but in the 20 years prior to the final payment on the debt in 1955, Valley residents paid more than 60 times that amount in Federal taxes. In more recent decades, the prosperity made possi ble by that investment in water resources has enriched the national and state treas uries by billions of dollars more, providing an example for all of us in the value of investment spending. Most of my comments today concern the health of the national economy and the Federal Reserve's attempts to keep the economy healthy. We are certainly faced with some major problems, as Wall Street has been telling us recently. (In fact, gallows humor is back in vogue on the Street. Here's a sample: What's the difference between Wall Street and the Titanic? An swer: They had a band playing aboard the Titanic.) But on Main Street, despite serious fears of inflation, there's an underlying tone of strength in the production and employ ment statistics, as the business community builds upon the generally admirable per formance of 1976. Strength in 1976— and 1977 The past year admittedly had its problems, including the well-publicized "pause." But not enough publicity has been given to the fact that total output, in real terms, in creased faster in 1976 than at any other time of the past two decades. Again, the year was marred by the continuation of a near record level of unemployment—yet not enough attention has been given to the fact that no other period in recent decades, except the 1973 boom year, could match 1976 in terms of job expansion. Inflation also was a difficult problem in 1976, yet relatively few commentators remarked on the fact that the inflation rate had been reduced more than half in a two-year timespan. Unfortunately, their optimism may have been misplaced, in view of the double-digit inflation we've experienced in the last several months. At any rate, the economy in early 1977 had a pretty strong foundation to build upon. As a result, my staff economists (like most others) originally saw the key 1977 estimates coming in at about “ five-andfive/' with real GNP growth of 5 percent or so, and an inflation rate of about 5 percent. Today, “ six and six” may be a more realistic bet. Over the year, real GNP could increase almost 6 percent, especially in view of the rapid recovery from the big winter freeze. But unfortunately, most observers now see the 1977 increase in prices coming closer to 6 percent than to 5 percent—and some inflation-watchers foresee much worse. In contrast to the gradual deceleration of last year, we have experienced a worrisome speed-up in prices in early 1977, reflecting such factors as weather problems, fiscal problems, and the importing of foreign inflation. I'll have more to say on that in a minute. The unemployment rate meanwhile should fall below 7 percent sometime this year, with or without any Administration tax stimulus, since basic expansionary forces should boost total employment about 3 percent for the second straight year—a very strong increase in historical terms. To get a good fix on the strength of the underlying economy, we should keep our eye on the doughnut instead of the hole; that is, on total employment rather than unemploy ment. Over the past two years, an expand ing economy has created more than five million new jobs, roughly equivalent to six times Arizona's entire workforce. In con trast to these hard employment figures, the unemployment rate is a rather mushy figure for analysis and (especially) policy pur poses. The statistics are inflated— in good times as well as bad—by women workers who move in and out of the labor force seeking temporary jobs, by teenagers who are priced out of the job market by high minimum-wage laws, and by some individ uals who might not otherwise look for work but who are induced to apply for benefits because of liberalized unemploymentcompensation laws. If we want an unem ployment figure that reflects the actual health of the economy, we should look at the proportion of household heads who are out of work; that figure declined from an uncomfortably high 6.2 percent two years ago to a more reasonable 4.6 percent last month. Post-Freeze Expansion The actual shape of the economy this year was probably decided several months ago by the Big Freeze. Now, the Big Freeze of 1977 will be long remembered in folk my thology as one of the nation’s most memor able physical disasters, but its economic effects may be short-lived, except for one thing. The severe winter interrupted and postponed a strong expansion that was evident around the turn of the year, and so it practically guaranteed a sharp rebound right about now. The recovery from the first-quarter shortfall, plus the continued growth of consumer and business demand, should generate a temporarily high rate of growth during the current quarter and set the stage for a healthy advance in late 1977 and early 1978. The consumer was the hero of the 1975 recovery but for a while looked to be the villain of 1976’s "awesome pause.” But in late 1976 consumer spending strengthened again, and this pace has now been re gained. Favorable consumer attitude sur veys suggest one reason for further strength, but the major reason is the recent improvement in employment and consum er income. Homebuilding is another sup port of the expansion. Most of the earlier weakness in this market centered in multi unit construction, because of builders’ widespread wariness over rental-unit pros pects as a result of overbuilding and the specter of rent controls. But this sector of the market has begun to recover recently with the help of a boost in Federal subsidy programs, while single-family construction continues to show boom tendencies. Business capital spending, a late arrival in this business expansion, is expected at last to show some strength this year. There is still some excess capacity in the economy, but that factor should be less of a constraint on spending plans as more and more capac ity is called into play by the expansion in demand. For that matter, businessmen seem to be concentrating less on expanding capacity and more on modernizing facili ties, as a means of offsetting cost pressures and improving profit margins. Meanwhile, business spending for inventories should expand gradually in line with the growth of other sources of demand, and thus should cease being the source of volatility in total spending that it has been throughout much of the last several years. Inflation and Fiscal Policy Generally, we seem to be faced with a very favorable situation, except for that one major fly in the ointment— inflation. The recent price statistics are indeed sobering, even allowing for the special circumstances which pushed up prices at a double-digit rate in early 1977. Consumer prices have increased at a 6.5-percent annual rate since last fall—a full percentage point faster than in the preceding six-month period. Part of the problem is the weather-induced sharp rise in food costs, but the prices of other consumer goods have also accelerated, while the prices of services have continued to outstrip those of other consumer pur chases. And households may expect further difficulties in coming months, since the wholesale prices of consumer goods have accelerated recently, rising at an 8.2percent annual rate since last fall. Many of the fears now expressed on Main Street and on Wall Street concern the price implications of the Administration's new energy program. That program recognizes the fact that energy has become relatively more expensive because of major shifts in basic supply-and-demand factors in the past decade or so. But we should remember that inflation does not simply reflect the rise in price of one single commodity, crucial as that commodity may be in our industrial society. Inflation is a rise in the general price level, and it has to be attacked by appropriate governmental policies—by overcoming supply bottlenecks, as the A d ministration proposes, and more basically by adopting moderate fiscal- and monetary-policy measures. My own fears center around the long-term inflation threat created by the proliferation of Federal programs—and the consequent unprecedented string of substantial deficits—over more than a decade. The $112-billion combined deficit of the 1975-76 fiscal years might be explained in terms of the need to overcome recession, but how can we defend a deficit of like size in the expansionary 1977-78 period? The danger is that overly expansionary policies will rekin dle inflationary expectations among con sumers and producers—understandably enough, in the light of recent history—and that these inflationary expectations will distort purchasing decisions and under mine the long-run growth and stability of the national economy. In a word, a policy of heavy fiscal stimulus is risky and flies in the face of experience. All the research done by my research staff shows that with such a policy, the "good news" comes first in the form of increased employment and output, but “ bad news" inevitably follows in the form of resurgent inflation. Money and Interest Rates Excessive fiscal stimulus tends to restrict the freedom of action of monetary policymak ers, for we cannot afford to lean too far in the direction of short-term ease to stimu late economic activity as long as massive budget deficits still exist to generate new inflationary pressures. The Federal Reserve has made several adjustments over the past year in the long-run growth ranges for the monetary aggregates, partly to take account of the many changes in financial technolo gy now affecting the financial system, but also to create the conditions for a return to general price stability. The latest an nounced projections include a growth range of 4 1/2 to 6 V2 percent for M t (currency plus bank demand deposits) and a range of 7 to 10 percent for M2 (M-, plus bank time deposits except large CD's). But as Federal Reserve Chairman Arthur Burns has argued in several Congressional appearances, the long-run strategy calls for a gradual reduc tion in these monetary growth ranges in an attempt to unwind the inflation that still bedevils the economy. The carefully fashioned monetary policy followed during the economic recovery period helped dampen inflationary expec tations, and also helped finance the large gains in employment and output that I've already mentioned. Our policy, in addition, contributed to a general pattern of lower interest rates during 1975 and 1976. This of course is contrary to our usual experience during a period of cyclical expansion. Vet here again, the Federal budget situation casts a cloud over the outlook. Federal demands on credit markets could be roughly the same this year as in calendar 1976, in contrast to the usual cyclical de cline in such borrowing during a recovery period. That projected demand comes just at the time when private credit demands are rising, and thus generates significant upward pressure on interest rates when coupled with the demands generated else where. On top of that, any inflationary fears created by continued large Treasury deficits obviously would cause lenders to try to get higher inflation premiums for their funds. These effects have already been reflected in higher interest rates in the first quarter of 1977, and I have difficulty seeing any rever sal of that trend, at least as long as inflation jitters continue to dominate the money and capital markets. An Independent Monetary Policy Monetary policy, through its impact on the reserves held against bank deposits, helped support the growth of the economy during 1975 and 1976, while gradually squeezing out its inflationary excesses. In this endeav or, monetary policy showed itself to be far more effective than fiscal policy, which has several important drawbacks even apart from its creation of inflationary deficits. Manipulating government spending tends to be a rather clumsy way of dealing with rapidly changing economic developments, while the process of reaching a consensus on needed tax changes usually turns out to be complex and time consuming. We've recently witnessed a vivid demonstration of that point, with continued discussion of expansionary programs long after the need for stimulus has passed. Fortunately, monetary policy is relatively free of these shortcomings, because of its great virtue of flexibility. We can change monetary policy promptly and (if need be) frequently. The independent Federal Re serve can make the hard decisions that might be avoided by decision-makers sub ject to the day-to-day pressures of political life. And we've seen that when there are substantial changes in the supply of money and credit, the effects are speedily transmit ted through financial markets to the na tion's factories, farms and commercial en terprises. The founders of the Federal Reserve System were well aware of the dangers that could arise from the creation of a monetary au thority subservient to the Executive branch of government, and thus subject to political manipulation. Consequently, they took several steps to ensure the independence of the central bank within the structure of our Federal Government. For example, Board members have 14-year terms of of fice, long enough to minimize the threat of political pressure, and they also have stag gered terms to avoid Presidential "packing” of the Board. Again, the Federal Reserve accounts for its actions to Congress, and not to the Executive branch of government. But in this connection, the Fed's operations are financed from its own internal sources, and thus protected from the political pressures that may be exercised through the Con gressional appropriations process. This system of monetary management seems to be working just the way the foun ders of the Federal Reserve intended. Cer tainly, the Fed has stumbled on some occa sions, but it's hard to imagine that our problems would have been solved if we'd followed the suggestion of the Fed’s critics and turned control of the monetary author ity over to the Executive branch or to Con gress. Specifically, if the spending propensi ties of Federal officials had been given freer rein through easier access to the “ printing press," our inflation problem of the past decade probably would have been aggra vated even more. Every nation in the world has suffered severely from inflation in recent years. But it's interesting to note that the two industri al nations with the strongest central banks—Germany and the United States— are also the two with the strongest records of curbing inflation. Great Britain, whose central bank was taken over by the Govern ment several decades ago, has recently suffered from a chronic case of double digit inflation, with prices rising at times at a rate of 20 or 30 percent a year. In some other countries, in Latin America and else where, where the monetary authority has always been dominated by the executive or the legislature, triple-digit inflation holds sway, bringing economic and political chaos in its wake. In our democratic society, of course, the independence of a governmental agency can never be absolute. The Federal Reserve is subject not only to the Federal Reserve Act, but to other statutes as well. The foun ders of the System recognized this duty by requiring the Fed to account for its steward ship to the Congress. As you know, we now have a formal reporting system, with Chair man Burns traveling up to Capitol Hill once every quarter to discuss the course of monetary policy, including growth projec tions for the major monetary and credit aggregates for the year ahead. The present system is effective because it provides am ple scope for the exercise of Congressional oversight, yet keeps political pressures away from day-to-day involvement in the details of monetary policy. Concluding Remarks To sum up, the national economy is in relatively good shape today, with produc tion, employment and retail sales pointing upward, and with manufacturers' orderbooks growing increasingly bulky. Indeed, the present solidly-based expansion could continue for the rest of the decade if only— and it’s a big if—we could get prices under control. And as I've suggested, one of the best ways to stop inflation is to get the Federal budget under control, thus reduc ing the pressure on the Federal Reserve to finance those deficits through the printing press, and reducing the pressure on finan cial markets induced by heavy Treasury borrowing. The Federal Reserve has a major role to play in the fight against inflation. To help the economy recover from a serious recession, we earlier adopted monetary growth ranges which were considerably higher than they should be over the long run. Ideally, the increase in the money supply (along with the increase in turnover of that money supply) should approximate the long-term growth rate of physical output, which is about 31/2 percent a year. Now that the recession has been overcome, we are de termined to move towards a gradual reduc tion in the growth of the money supply. To do so, however, we must be able to main tain our present independent policy stance, free of short-term political pressures. Oth erwise, if those pressures for perpetual rapid expansion should succeed, we would have few defenses left against the destruc tive inflation that has brought chaos to so much of the world.
@FedFRASER