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FEDERAL RESERVE BAN K OF SAN FR AN CISC O
Office of the President

WORKING OUT A SOLUTION

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

Meeting with Los Angeies Community Leaders
and Directors, Los Angeles Branch,
Federal Reserve Bank of San Francisco

Los Angeles, California
February 24,1981

Working Out a Solution
I'm grateful for this opportunity to meet with the leaders of one
of the world's great cities, to discuss with you the steps being taken
by our representatives in Washington to work out a solution to the
nation's severe economic problems.

I for one am glad to see the many

forthright measures that are now being adopted to curb inflation.

But

I'm tempted to add that our problems would not be so severe today if
those same measures had been taken much earlier — as many people in
this audience have advocated for years.
Role of Directors
I'd like to pay tribute in this regard to the directors of our
Los Angeles office, who have consistently provided us with useful
advice on policy problems.

Indeed, the directors at all of our five

offices have become involved with each of the major tasks delegated by
Congress to the Federal Reserve System.

That encompasses the provision

of "wholesale" banking services such as coin, currency, and check
processing; supervision and regulation of a large share of the nation's
banking system; administration of consumer-protection laws; and in
particular, the development of monetary policy.

We are fortunate in

the advice we get from them in each of these areas.
Our directors constantly help us improve the level of centralbanking services, in the most cost-effective manner.

This is a crucial

role at the present time, because under the terms of the new Monetary
Control Act, the Federal Reserve is moving into a new operating environment.




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Over the next year, the Fed's services will become available to all
depository institutions offering transaction (check-type) accounts and
nonpersonal time deposits, and those services will be priced explicitly
for the first time.
Yet above all, our directors help us improve the workings of
monetary policy.

As one means of doing so, they provide us with practical

first-hand inputs on key developments in various regions of our ninestate district and in various sectors of the Western economy.

Our

directors thus help us anticipate changing trends in the economy, by
providing insights into consumer and business behavior which serve as
checks against our own analyses of statistical data.
Outlook for the Nation
Their advice is invaluable at the present time, because of the
uncertainty of the business climate confronting the new Congress and
the new Administration in Washington.

One Southern California executive

said during the inauguration festivities that President Reagan "would
be teeing off in a heck of a headwind."

Following through on that

golfing analogy, I would add that this competition (unlike the recent
Crosby tournament) won't be postponed because of weather; it will have
to be played in the teeth of the hostile elements.
At this point, near-term business prospects are hard to gauge,
battered as the economy is by the winds of inflation.

But there's no

doubt that the economy is somewhat stronger today than had been expected
six months to a year ago.

The turnaround in activity between the second

and fourth quarters of 1980 was one of the sharpest in recent history,




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and many of the early-1981 statistics indicate continued strength.
January's employment and retail-sales figures, for example, suggest
that the late-1980 momentum has been maintained, and thus cast doubt on
the standard forecast of early-1981 weakness in business activity.
Forecasting indeed is a tough chore at the present time.

A case

can be made for a continued upturn, based upon the likelihood of sub­
stantial tax cuts, the resumption of an inflation-caused "buy now"
attitude on the part of consumers, and the growing strength of certain
noncyclical sectors of the economy.

But a case can also be made for

the opposite movement — a resumption of the aborted recession of mid1980.

Consumer budgets have already been undermined by the inflation-

caused bracket creep of income taxes and a new boost in social-security
taxes — middle-income workers, for example, are facing a 24-percent
boost in social-security taxes this year.

Meanwhile, soaring prices of

food and energy are not leaving consumers too much for discretionary
purposes, which means continued weakness for the auto and housing
industries.

In addition, business plant-equipment spending plans appear

soft — not surprisingly, in view of the fact that business firms can't
count on getting a reasonable return on their investment in these
inflation-scarred times.
When we sort out all these conflicting trends, we're likely to
agree (with considerable hedging) that the consensus forecast for a
relatively sluggish year is the likeliest outcome.

Without doubt, we

can expect boom conditions in certain industries, such as energy, defense
and office-building construction.




Almost as certainly, we can expect at

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best a modest recovery in autos, housing and related industries.

On

balance, this means that real output of goods and services will rise
by a small amount during the year, and that pockets of unemployed workers
and unemployed machinery will remain scattered throughout the economy.
Outlook for the Region
The outlook for the Los Angeles market is somewhat stronger, as
befits the vast size and diversity of this $125-bill ion market, which
stretches from Palm Springs on the southeast to Santa Barbara on the
northwest.

(This Australia-sized economy accounts for six percent of

the U.S. economy, and for fully one-third of the Western economy.)
Despite the region's well-publicized housing problems, it stands to
benefit otherwise from its industrial structure, which is concentrated
in those sectors (energy and defense spending) which are growing fastest
on the national scene.

Another obvious source of strength is the

office-building boom, which is adding the equivalent of eight Empire
State buildings to the L.A. skyline.
Los Angeles appears uniquely qualified to develop answers to the
nation's long-term problems, because of its dominance of the high-technology
and "knowledge" industries.

The region's universities and think tanks,

which produce inventions and innovations out of such inputs as human
and electronic brains, can claim a large share of the credit for L.A.'s
recent growth record.

It helps, of course, that the area boasts the

largest concentration of Nobel prize winners of any area in the world,
plus hundreds of thousands of scientists, engineers and other professionals.




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Yet despite that reservoir of talent, even this Sunbelt capital
has problems paralleling those of all the other major metropolitan areas
in the country.

The most obvious problem is the impact of an uncertain

inflationary environment on municipal finances.

Nationwide, the impact

could be measured by a sharp rise in 1980 in financing costs, with the
Bond Buyer index of long-term municipal yields rising from 7.4 to 10.1
percent over the course of the year.

And municipal financing difficulties

seem bound to be aggravated by the interaction of the two key national
problems — severe inflation and massive Federal borrowing demands.
Problem of Inflation
Let's consider the current status of the inflation problem.
Inflation, as measured by the consumer price index, doubled within the
single decade of the 1970's, and would have doubled again within only
a half-decade if the early-1980 pace had been maintained.

Over the

second half of last year, the inflation pace began to slow down, according
to that index.

However, the pace continued to accelerate according to the

broadest measure of price pressures — the GNP price index, or deflator —
which rose from 9.5 percent to 10.2 percent between the first and second
half of 1980.

This evidence, plus the more recent evidence of early 1981,

thus indicates a strong reason for policymakers to maintain a tight
anti-inflation policy in the months ahead.
The danger is not just the continuation of external price "shocks" —
of which we've had more than our share — but also the uptrend in the
underlying rate of inflation.

American households are now suffering from

their second major oil-price shock, as evidenced by a two-thirds increase
in the energy component of the consumer price index over the past two




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Moreover, despite the current glut, most energy analysts expect

a sharply rising trend of prices over the longer-term, with the gradual
depletion of the world's low-cost oil reserves.

Food prices meanwhile

seem likely to rise substantially this year, as the result of a shift
in the cattle cycle and poor growing conditions worldwide.

By some

estimates, food prices could rise 15 percent over the next year — almost
double the increase of the past year.
Still, food and energy account for only about one-fourth of our
household budget, and inflation has worsened in other sectors as well.
Throughout most of the past decade, the underlying or core rate of
inflation, although accelerating, remained below six percent a year.

In

the last several years, however, that underlying rate has exceeded nine
percent.

This upsurge in inflation has gone hand in hand with an upsurge

in unit labor costs, because of sharp gains in labor compensation and
actual declines in the productivity of the nation's workforce.

The cure

for that part of the problem is productivity-enhancing tax stimuli,
such as those the President has just proposed.

But the upsurge in

inflation has also gone hand in hand with the excessive money growth
of past years, when monetary policy was pushed off course by the excessive
credit demands generated primarily by Federal deficit financing.

And

the cure for that part of the problem is to curb rapid money creation
by reducing deficit-financing pressures.
Problem of the Deficit
In an attempt to improve its control over money growth, the Federal
Reserve changed its operating techniques in October 1979 -- in effect,




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by placing more emphasis on controlling the quantity of bank reserves
than on tightly pegging the cost of those reserves (that is, the Federal
funds rate).

But the Fed was only partially successful in curbing money

growth in the face of sharp changes in inflation expectations and wide
fluctuations in credit demands.

Some critics argue that this occurred

because the Fed failed to apply its new operating procedures consistently.
Probably a better explanation, however, is the continuation of heavy
deficit-financing pressures.
A government deficit can be financed by attracting the savings of
the public, or it can be financed by creating money.

The latter approach

is followed in most underdeveloped countries, because they lack fullydeveloped capital markets.

But most industrial countries, with their

highly developed financial markets, are able to channel private savings
into purchases of government debt.

In this respect, the U.S. has behaved

like an underdeveloped country, whereas Germany and Japan have financed
their large government deficits through private savings.
Our country, in other words, has failed to break the link between
government debt and inflationary money creation as Germany and Japan
have done.

German and Japanese financial markets have succeeded better

than ours in mobilizing private savings to finance government deficits.
Over the course of the past decade, U.S. households sharply reduced their
savings rate, from 1H to 5% percent of disposable income.

In contrast,

Japanese households consistently saved more than 20 percent of income,
and their German counterparts saved between 12 and 15 percent of income.
This divergence reflects differences in tax policy and in inflation effects




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on savings incentives, which in this country have encouraged consumption
rather than savings, and thereby have discouraged productivity-enhancing
business investment.

Whatever the reason, we must reduce Federal deficit-

financing pressures if we want to reduce inflation and encourage domestic
saving and investment.
The President's new fiscal program represents an important step
in the right direction.

It includes personal-income tax cuts and

accelerated depreciation write-offs designed to stimulate a long-awaited
improvement in productivity-enhancing investment.

The program also

includes a broad and judicious mixture of spending cuts designed to keep
deficits from spiralling and creating even worse pressures on financial
markets.

The proposed cuts.range across a wide range of programs, from

food stamps to synthetic-fuel development, from extended unemployment
compensation to the space-shuttle program, and from public-service jobs
to postal subsidies.

Still, the Administration's budget proposals result

in large fiscal deficits for the next three years, with no balanced
budget in sight until 1984.
up to almost $100 billion.

For the 1981-82 period, the deficits add
This suggests that Federal demands in credit

markets will continue for some time to press upward on borrowing costs —
at a time when the Federal Reserve is committed to an anti-inflation
objective of gradually and steadily reducing the growth in monetary stimulus.
Need for Spending Cutbacks
The necessity for substantial spending cutbacks in nondefense
programs is obvious, given the Administration's commitment to a defense
buildup coupled with tax reductions.




Fiscal 1981 admittedly is almost

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half-over, but a running start seems necessary to achieve results in
the next fiscal year.

Incidentally, outlays for fiscal 1981 will exceed

earlier estimates by a wide margin, mounting to $655 billion in the
Administration's new estimate -- $75 billion more than the fiscal-1980
figure and some $20 billion higher than the figure adopted in last fall's
Congressional budget resolution.
In coming budget debates, Congress will have to deal with
some politically sensitive entitlements programs — "payments for
individuals" — simply because that's where the money is.

Such payments

amounted to 70 percent of total outlays, aside from defense and interest
payments, in the last fiscal year.

Entitlement programs increased

eight-fold over the past decade and a half, and they accounted for
virtually all of the real increase in budget spending recorded over
that period.
The upsurge in these programs reflects the fact that roughly 90
percent of payments to individuals are now subject to indexation formulas.
Indeed, this means further budgetary problems in the years ahead.
According to Congressional Budget Office estimates, such payments could
be $192 billion higher in 1985 than in 1980, and roughly three-fourths
of that amount will represent the cost of automatic escalation.

The

problem is compounded by the choice of an inappropriate index — the
consumer price index, which has overstated inflation recently by virtue
of the heavy weight it gives to mortgage interest rates and home prices.
(Certainly it's inappropriate for those recipients who generally reside
in rented quarters or paid-up homes.)




Indexing will be expensive in any

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case, but a single reform designed to adjust for this overweighting
could save $30 billion over the 1980-85 period alone.
Several uncertainties still surround the Administration's program.
The full details of the budget-cut proposals won't be sent to Congress
until March 10.

In addition, the budget proposals are still just that,

since they must still run the Congressional gauntlet.

The shape of the

final budget package — specifically, the Federal government's actual
financing needs — will determine the pressures the Federal government
will place on the financial markets and the environment in which the
Fed will have to conduct monetary policy.
Monetary Implications
Failure to curb

Federal deficit spending will have dire consequences —

crowding out private borrowers if the Fed holds to its policy goals, or
leading to spiraling inflation if the Fed loosens up and accommodates
the Treasury borrowing needs.

At present, when efforts to restrain

monetary growth confront strong private credit demands, large new Federal
borrowings would inevitably aggravate interest-rate pressures.

Total

Federal and Federally-assisted borrowing in the nation's credit markets
approached $120 billion last year — roughly 30 percent of all credit
demands — and comparable figures may again be seen in the present
period of strengthening credit demands.

Indeed, the Treasury will need

to raise $36 billion of new money in the present quarter alone — onethird more than in the year-ago period.
The credit demands of the Federal government, the nation's prime
borrower, definitely will be met.




The question is how many other potential

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borrowers -- many with more productive uses of money — will be shouldered
aside by market pressures.

In that situation, there's a danger that the

Fed's restraints on money and credit creation will jeopardize future
prospects for business expansion and private job creation.
the alternative.

But consider

If we did not restrain money growth, we could contribute

to an inflationary process that would lead to a prolonged period of
soaring interest rates.
Concluding Remarks
Chairman Volcker will discuss the policy dilemma facing the Fed
in the semi-annual report -- the Humphrey-Hawkins report -- which he will
present to Congress tomorrow.

Without revealing any numbers, he has

already indicated in a recent Congressional appearance that the Fed will
continue its policy of gradual reduction in the growth rate of money,
because that is a necessary ingredient in a successful effort to bring
down the rate of inflation.

But I would add that the Fed's policy can

be workable only if the Congress and the Administration cooperate by
reducing deficit-financing pressures on the credit markets.
If the Federal Reserve hits its money-supply targets and if the
Federal debt continues to grow at a rapid rate, we could experience severe
upward pressures on interest rates.

With the supply of funds constrained

by the Fed's tight-money actions, and with the demand for funds rising
because of growth in the Federal debt, the price of funds (the interest
rate) would rise and crowd interest-sensitive borrowers out of the market.
The pressure on the markets could be relieved temporarily if the Fed overshot




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its monetary targets, but that would simply postpone any progress in
the fight against inflation, and might even worsen the situation.

The

alternative is to reduce deficit-financing pressures on the market by a
major program of spending cutbacks.

In other words, the Fed can no

longer play the role of "the only game in town" — fiscal policy also
must play a role as the nation works out a solution to its inflation
problem.




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