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For release on delivery (12:00 NOON E.S.T.) FEBRUARY 26, 1985 Remarks by Lyle E. Gramley Member Board of Governors of the Federal Reserve System before The National Association of Business Economists Seminar on Economic Policy In The Next Four Years Washington, D.C. February 26, 1985 It is a pleasure to address the distinguished members of the National Association of Business Economists on the occasion this seminar on "Economic Policy in the Next Four Years." My remarks today will not be tied to any particular four-year cycle — political, or otherwise, but they are designed to cf tie economic, in with the principal theme of the seminar. The current recovery is now a little over two years old. The overall average for rate the of economic comparable Inflation, however, expansion period of has not accelerated; has been earlier well postwar in fact, above the recoveries. it appears to have moderated somewhat during the course of the recovery. Interest rates have risen, as they typically do during a cyclical expansion, but the percentage increases in both short- and long-term interest rates are not, thus far, out of line with those in earlier postwar recoveries. While abound, difficulties in individual sectors and regions the performance of the macroeconomy during this recovery has been more trouble free than most of us had expected. The economy and financial markets have been subjected to an enormous amount of fiscal stimulus — the increase in the structural Federal deficit since The author gratefully acknowledges the assistance of Peter Hooper and Peter Isard in the preparation of this talk, while taking full responsibility for any mistakes contained herein. early 1981 period. has But been the of unprecedented dire financial dimensions consequences for a peacetime of those deficits that many economists and others had expected by and large have not happened. It international come. imports The would be sector have exchange have widely played value expanded at agreed of an the that developments important dollar an unprecedented account deficit has widened dramatically. has role in in this increased the out greatly; rate, and the current These events have had important effects on our overall economic growth rate, on the rate of inflation, and on interest rates. I must confess that I know less about the interaction between domestic would like. recovery, and international developments Perhaps some of you share that feeling. the need to worry acute than it is currently. make a small contribution area. economic about the than I Until this interconnections was less What I would like to . o today is to 1 to improving our understanding in this I warn you that I am only scratching the surface of a large and important subject. 3 - - A Measure of External Restraint From the fourth quarter of 1980 through the fourth quarter of 1984, the value of the dollar in exchange markets on a trade-weighted basis roughly 65 percent. in our using major foreign currencies rose by It did so despite steadily widening deficits merchandise consumer against trade prices and here current and abroad accounts. In real as measures of terms, inflation, the increase was about 60 percent. So large seem to have domestic measuring measures exerted output. it of that a change a good How large would stimulus or in the deal of the of restraint might permit value it be? Is comparisons restraint, such on with as dollar the there other those would growth of a of way familiar employed for fiscal policy? We all know that to analyze the effects of fiscal policy on the economy and on financial markets, the actual deficit in the Federal budget is a potentially misleading indicator. The actual deficit reflects the effects of the economy on the budget, -li as well as the effects of the budget on the economy. Measures of the high-employment deficit, also known as the structural or stan dardized deficit, are designed to get around this problem. Similarly, measures such as the current account defi cit, or the gap between GNP and domestic aggregate demand, reflect lines of causation running both ways between the domestic economy and the international sector. A measure of external restraint is needed that avoids this problem. In associated with constructed. exchange principle, a Take change an such in a the assumed, rate and multiply of exchange or external rate observed, can change restraint be in readily the real it by estimated price elasticities of demand for imports and exports. change measure The resulting estimates of volume for imports and exports are then multiplied by the prices of imports and exports expected in the absence of a change in the exchange rate. The course, an source of a change important issue to in which the I exchange will rate return is, of shortly. Setting that described issue (or its aside for equivalent the moment, performed with the the exercise just assistance of a model of the current account) yields an estimate of the impact of the change evaluated Thus, in the at exchange rate predetermined on the current account prices, without feedback deficit, effects. it measures the first-round effect on demands for goods and services produced in the domestic economy. Such a measure of external restraint (or ease) is analogous in all respects save one to the effects on the economy, and on financial budget deficit. markets, of a change In one very important in the structural Federal respect, however, the two concepts differ. A change in direct effect on prices, the structural Federal deficit has no so that its influence on interest rates, ignoring expectational effects, results from its impact on aggre gate demand for goods and services. An exchange rate change, how ever, directly affects both prices and aggregate demand. There is therefore a direct effect on real money balances that is absent in the case of a change in the structural budget deficit. Thus, a rise in the exchange rate reduces real GNP through its effect on relative prices of imports effect" of the appreciation. lowers the average level and exports. This is the "fiscal However, since the appreciation also of prices, other things equal, it increases real money balances and through that channel has a stim ulative effect on the economy. We may say, therefore, that the measure of external restraint I have described has fiscal effects on markets for goods and services, and also on financial markets, analogous to those of a change in the structural Federal deficit. But exchange rate changes also have monetary effects that need to be carefully considered. Estimation exchange rate restraint is subject to a particularly wide margin of error. This is true imports because and of calculated exports periods during which such a price measure of elasticities necessarily are based the dollar's exchange on of demand historical for time value changed consid erably less than it has in the past four years. - With Board staff's percent that caveat model of appreciation four years has 7- in mind, the of produced current the dollar an impact estimates generated account in suggest real terms that over by the the the effect on the current 60 past account deficit (at predetermined prices and without feedbacks) of approx imately trade $175 flows, domestic b i l l ion. V adjustment of not all of this impact effect has yet been felt in markets. The Because part that of lags has in already the been felt, around $140 billion, is approximately equal to the increase in the struc tural Federal budget deficit over the same period. If one took these estimates of external face value mean that rise had Federal (and the I do fiscal largely deficit not effects offset on suggest the economic that associated effects of activity, anyone with the and restraint should), the also it would exchange increased at rate structural on financial markets. Taking into account the fiscal effects of the exchange rate change TTThTs alone, however, would be misleading. The monetary figure may appear unusually large. However, It reflects estimates of price elasticities of demand of close to unity for both imports and exports, although only about half of a change in the exchange rate is reflected in changes in average import Drices, - effects are substantial. exchange rate quarter of The that occurred 1984 would 8 65 - percent increase in the nominal in the four years ended in the fourth ultimately reduce the level of prices by roughly 5 to 7 percent, according to Board staff estimates. How balances policy. years would large an depend, effect of this course, would on the have on response real of money monetary What monetary policy might have been during the past four had the dollar's foreign exchange value remained unchanged is, I submit, unknowable. If one given, however, takes the the growth of anti-inflationary nominal effect of money the balances rise in as the exchange rate, through its impact on real money balances, has had a significant stimulative effect on domestic aggregate demand. Esti mates derived from the Board staff's multi-country model (MCM) sug gest that the monetary effects of the four-year rise in the dollar on growth of the U.S. economy have thus far offset roughly half of the fiscal effects in markets for goods and services. In financial markets, on the other hand, the fiscal and monetary effects of the appreciation are not offsetting; they are additive. Both act to reduce nominal interest rates. If the estimate of the fiscal appreciation cited earlier esting conclusions follow. is effects of the dollar’s approximately correct, some inter First, the effect on economic growth of the rise in the structural Federal deficit was not fully offset by the combined change. fiscal Second, and monetary effects the impact on interest of the rates of exchange the rate increase in the structural Federal budget deficit, on the other hand, has been more than fully offset by the combined fiscal and monetary effects of the exchange rate change. There may be some of you who hold to the view that large and rising structural budget deficits do not affect interest rates, and disastrous that that results is why widely such deficits forecast uncomfortable with that hypothesis, have earlier. not To produced those I offer you another who — and the are in my view intellectually more satisfying -- explanation to consider. - 10 - Why Did the Exchange Rate Rise? Let me turn next to increase in the exchange rate. the question of what There are two principal one is that a widening differential between U.S. interest rates has been a major variety of possible reasons, ferences toward factor; the other claims at the theories: and foreign real is that, there has been a shift dollar-denominated rate differentials. caused given for a in asset pre real interest There is merit in both hypotheses. Supporting the asset-preference shift hypothesis is the fact that foreign dramatically crisis. in lending recent Moreover, by U.S. years, commercial reflecting the banks has declined international debt a number of Latin American countries have expe rienced larger capital outflows since 1981 from which the U.S. pro bably benefitted. There have been some regulatory changes that might have increased the net demand for dollar-denominated assets. The Japanese, for example, have relaxed restraints on their capital markets and on Japanese investors. Additionally, many money 11 - - market observers believe that the recent expansion of the U.S. vailing in economy contrasts Western Europe so that starkly with it has the attracted stagnation sizable pre flows of funds to our shores. If such sources of capital inflow helped to account for a rising dollar exchange rate in the face of burgeoning trade defi cits, foreign investors evidently held expectations that the U.S. is an attractive country likely to remain in which strong tudes and expectations, real interest rates to invest, for the near however, on U.S. and that the future at least. would also suggest financial assets dollar is Such atti that a rise in in relation to those abroad would also be a powerful magnet attracting inflows of funds. Estimates derived from the MCM, in which the exchange rate is determined endogenously,£/ suggest that both hypotheses have 27 The dollar *s exchange valued measured against a basket of major foreign currencies is proximately determined in the model as a func tion of U.S. & foreign price levels, inflation rates and interest rates. a role to play. Real interest rate differentials in the model explain a little over one-half of the rise in the real exchange rate over the past four years, although the confidence estimate remainder reflect is wide.3/ shifts in The asset band around is unexplained, preferences at existing that and might thus interest rate differentials. 3/ By one measure, the difference between U.S. and average foreign long term real interest rates had risen by nearly 7 percentage points from its low point in 1979 to its peak in mid-1984. In recent months U.S. real rates have declined about 2 percentage points relative to rates abroad, but the differential remains 5 per centage points above its 1979 trough. 13- - Effects of Endogenous Exchange Rate Changes For rise in rates the in ease of exchange the reference, rate United due States let to the the us call that increase ’endogenous" ’ in part real part. of the interest Endogenous exchange rate changes are likely to be a characteristic feature of future business cycles, and they will have a bearing on the cycli cal significant movements bles. When cyclical of the changes abroad, cyclical dampened. The some dollar's in exchange relative movements dampening of economic value levels in of prices interest and financial responds interest and rate sensitively rates interest swings varia here rates also to and are implies a moderation of cyclical changes in money velocity. Assuming a given growth smaller rate of the money stock, that also means cyclical swings in nominal GNP. The more difficult effects on nonfinancial questions variables. to answer pertain Obviously, smaller to the cyclical swings in interest rates mean less cyclicality in housing and other credit-sensitive sectors of the economy. expansion phase of the recovery partly "Crowding out" during the takes the form of reduced net exports, as has been the case during the current recovery. -1 4 What is not so cleat-, however, tude of crowding out is affectecu increase less during the exchange rate, a recovery Thus, because is how the total magni although nominal GNP will of an endogenous prices will also rise less, rise in so that the effect on real GNP is indeterminate. Simulations this question. period of They several done with suggest years the MCM provide some that coming the from, rise say, in real an increase insight on GNP over a in private spending propensities is reduced if the exchange rate is driven up by rising fact that effects of U.S. real over a interest period dollar of rates. That result several years, the appreciation outweigh the stems from negative positive The principal of an however, rise in the exchange rate, fiscal monetary effects in markets for goods and se rv ic esV endogenous the effect is to alter the form of crowding out, rather than its overall magnitude. ¥7 This conclusion would not necessarily hold for all models, or even for a particular model over different time periods. For example, in the Board staff's MPS model, the interest elasticities of investment are much higher than in the MCM model. As a result the monetary effects of an exchange rate change dominate the fiscal effects in goods markets even over very short time periods. In the MCM, moreover, the monetary effects increase gradually over time and eventually become as large as the fiscal effects. - 15- Looking to the Future Let me turn now to what the line of analysis I have pur sued might suggest for the course of the economy and economic policy in the years ahead. The around $100 current billion. account Most deficit in projections 1984 apparently anticipate current account deficits in 1985 and 1986. still was larger In subsequent years, it is possible that changes in relative economic growth rates here and abroad might help to reduce those deficits somewhat. however, it seems unlikely that external lished at any time in the foreseeable Realistically, balance can future without be reestab a substantial decline in the real value of the dollar in exchange markets. Current tudes would nonresident imply net foreign wealth. some point resisted by or account deficits substantial claims on Portfolio remaining increases the during years magni ahead in foreign GNP balance considerations suggest that, at holdings will be future investors unless relative the current to other, U.S. near increases real further relative to those abroad. in interest such rates in the U.S. and rise - 16 - Based on that line of reasoning, forecasts of an immi nent fall in the value of the dollar have been common for at least two and a half years. evidently because Those forecasts have been decisively wrong, there has been a large and continuing shift in preferences for dollar-denominated assets, relative to assets deno minated in foreign currencies, at given interest rate differentials. I have no idea how long it will our external exchange debt rate. to But begin when States may have already exerting downward I contemplate become a net take the for the rise of pressure fact that international on the the United debtor,5/ that our country is borrowing abroad at a rate of $100 billion a year or more — which debt to $1 in ten trillion years or would more — increase I wonder our if we net may international not soon be approaching a day of reckoning. 5/ Official measures of our international assets and liabilities suggest that, at the end of 1984, the United States was still a net international creditor. However, to the extent that statistical discrepancies in balance of payments accounts during recent years may largely reflect unrecorded net capital inflows, the United States may already have become a net international debtor. - Imagine, of balance in our 17- if you will, what it would mean if restoration external real value of the dollar accounts to its required level four a reduction years ago. in the We would then be facing a source of external stimulus whose fiscal effects in markets for goods and services, and in financial markets, be larger than years the in those stemming structural from the increase Federal budget might in the past four deficit. The monetary effects of a decline in the dollar would offset the fiscal effects in goods markets, markets. but would add to the fiscal effects in financial That is because prices would be driven up by the fall in the exchange rate, real money balances would decline, rate pressures would and intensify. credit-sensitive sectors and interest Net exports would be crowded in, of the domestic economy would be crowded out. If the structural deficit in the Federal budget were still when rising the dollar began to fall, the impact economy, and financial markets, would be that much larger. on the 18 - - I do not hold to an apocalyptic spects for the years ahead. view of economic pro A significant decline in the dollar is probably necessary and desirable to help restore external balance, and to ease the strains on agriculture and other sectors suffering from strong price competition from foreign producers. But an abrupt decline may be avoidable if the U.S. follows sensible macro- economic policies. complacency. In this Reduction respect, in the there structural is little deficit room in the for federal budget is badly needed for reasons unrelated to potential develop ments in the dollar international could fall sector. substantially But the possibility over the next few that the years adds urgency to the discussions of deficit reduction presently underway in Washington. Possible sector policy. have One future implications sometimes developments for hears more room to be expansive now, monetary statements in policy the as international well that monetary since inflation as fiscal policy is under good has con trol, or that monetary policy should be easier because the exchange - rate is so high. 19- There is a germ of truth to such arguments, but danger lies ahead if they are taken too literally. Let us remember that weakness stemming from a rising exchange in the domestic rate tends economy by itself to create a more expansive monetary policy, by reducing prices and raising the the stock of real money balances. anti-inflationary rise over the benefits past four Let us remember that we have enjoyed years may prove to be also that the from the dollar's transitory to the extent that reestablishment of external balance requires a decline in the international value of the dollar. Progress against inflation over the past five years has required problem a is achieved, tough not battle. yet behind and developments The costs have us; price stability in the international years ahead seem likely to create inflation under control. been very has high. not yet The been sector during the renewed difficulties in keeping We in the Federal Reserve would be well advised to keep that in mind in our current decisions on monetary policy. //*#################
