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REMARKS ON MONETARY POLICY by M. S. Szymczak Member of the Board of Governors of the Federal Reserve System at a Conference on "National Economic Goals" Detroit, Michigan Center for Human Relations, University of Detroit Monday, 7:30 p.m., C.D.T. October 24, 1960 It is a distinct pleasure for me to be with the members of this Conference. I shall merely review things that I have been saying and doing for quite a long time. I shall not try to make novel statements or announce new economic discoveries. I really expect to benefit from the discussions. As we all know, we cannot of course consider economic goals in isolation from the social, cultural and moral aspirations of our society. Indeed, most of our economic objectives are desired princi- pally as means to broader ends such as the enlargement of individual welfare, the maintenance of world peace and protection against external dangers. The maintenance of a high level of employment opportunities and the protection of the value of carefully invested savings rank among the more important of our social and economic goals. As we know, monetary policy is of course only one of the means for aiding in the attainment of economic goals. The taxation and ex- penditure policies of the Federal government have a direct and perhaps more dynamic impact on growth in investment, consumption and employment. While my emphasis naturally will be concentrated on the Instruments, operations and purposes of monetary policy, I must stress the fact that its role is relatively indirect and much less positive than these other factors. It goes without saying that monetary policy directly Influences - 2 - the lending ability of the commercial banks. The volume of loans and # investments made by commercial banks is an important marginal factor in the determination of the amount of money and credit available to the economy. Changes in the supply of money and credit can influence the level of spending by consumers, businesses and government. In turn this can affect the level of employment, output and prices. If the amount of money and credit available is too small relative to the demand for funds, reductions in spending, output and employment may result. On the other hand, an increase in the supply of money and credit normally stimulates advances in output and employment. I say normally since there are two situations in which expansion- ary actions by the Federal Reserve have very little beneficial effect on output. During periods when labor and capital equipment are close to being fully employed, increasing the availability of money and credit leads mainly to a rise in prices, rather than to any significant expansion in output. And during the period of deep depression in the mid-1930's, making credit easier to obtain had little effect since there were relatively few businesses or consumers interested in additional borrowing. In practically all other situations, an increase in the liquidity of the economy has a stimulating effect, although we are never sure how large this effect will be. In my opinion it depends largely upon the confidence and the attitudes of industry and business. As you know, the Federal Reserve has three major instruments which it uses to influence the availability and cost of credit. They - 3 - are open market operations, discount rate operations and changes in the required reserves of commercial banks. The most flexible and continuously used of these instruments is open market operations, the buying or selling of short-term government securities in the open market. When the Federal Reserve buys government securities, its payments provide funds to the private banking system, which can use these funds as the basis for expanding its own loans and investments. When the Federal Reserve sells securities, it of course withdraws funds from the banking system. It follows, of course, that open market operations are used in close combination with the second major instrument of monetary policy discount rate operations. Commercial banks have the privilege of borrow- ing from the Federal Reserve System. Such borrowing normally occurs when banks are trying to avoid a deficiency in their required reserves — that is, in the proportion of their deposits which they are legally required to hold as reserves. The ability to borrow from the Federal Re- serve gives the banks great flexibility, especially during periods of peak seasonal demands for credit. However, both banking tradition and Federal Reserve policy limit the frequency, amount and duration of these loans. The discount rate is the price which banks must pay for loans from the Federal Reserve. Increases or decreases in the discount rate are likely to be accompanied by changes in the level of interest rates in credit and capital markets. So far as we are concerned, when the Federal Reserve conducts open market sales, funds are withdrawn from commercial banks - 4 - and pressure is placed on bank reserves. from the System. Banks then tend to borrow Their rising indebtedness and a higher discount rate will discourage them from making further loans to their customers. This works in reverse when the Federal Reserve is buying government securities in the open market in an effort to stimulate an expansion of credit by the banks. The availability of credit is also affected by changes in required reserves. The Federal Reserve can lower or raise within limits the proportion of deposits which banks are legally required to maintain as reserves. Changes in reserve requirements are instituted infrequently since even a small change tends to have large and immediate effect on the lending ability of all commercial banks. The other two major instruments, therefore, are used with greater frequency. Flexibility is an important and advantageous characteristic of monetary policy. As you are doubtless aware, statistics often tell an inconclusive and contradictory story during periods when significant changes are taking place in the economic environment. Competent observers can reach quite different interpretations, and the danger of error in policy making always exists. However, the monetary authorities can con- tinuously readjust policy on the basis of economic developments, due to the ease with which changes can be introduced through open market operations. You will notice that the impact of Federal Reserve policy on the economy is indirect and impersonal. Monetary policy influences - 5 - the total amount of credit potentially available but it does not determine which individuals, businesses or industries receive loans. The actual allocation of credit is determined in the market place by the urgencies of demand and by the relative credit-worthiness of would-be borrowers. The level of interest rates is also determined by market forces. Changes in the level of interest rates reflect changes in supply-demand conditions for credit. wanted by borrowers. The demand is the amount of credit The supply is influenced by Federal Reserve actions taken to regulate the availability of bank credit. The major source of supply, however, is the volume of savings, current and past, available for lending. Purposes of monetary policy. The policy instruments of the Federal Reserve are used primarily to moderate the swings of the business cycle, to offset both inflationary and recessionary tendencies. The broad objectives of policy are to provide the monetary basis for economic growth at high levels of employment and production and to facilitate the achievement of a reasonably stable price level. In prac- tice this means that the Federal Reserve actions are normally directed toward stimulating economic activity. Restraint is placed on the ex- pansion of bank credit only when there is a need to inhibit inflationary pressures. Realistically speaking, the result of monetary and fiscal policy is the dampening and not the elimination of cyclical movements. In the present state of economic knowledge, it is not possible to - 6 - counteract completely all of the elements of instability in a free market economy. The Federal Reserve attempts to provide the economy with an adequate flow of money and credit, neither too much nor too little for healthy economic expansion. Of course, determining what is adequate is not at all a matter of simple arithmetic. For one thing, efforts to ease or to restrain the availability of credit may be partially offset by changes in the rate of use or velocity of money. During periods of credit restraint, and relatively high interest rates, for instance, businessmen and consumers tend to hold smaller cash balances and smaller sums in bank accounts than usual. do more work than it normally does. They will make a dollar And during periods of slack demand, when money and credit are being made readily available, businessmen and consumers may pay off debts and build up cash balances, rather than increase spending. These tendencies are taken into account when the Fed- eral Reserve decides how much expansion in bank credit is appropriate. The effectiveness of monetary and fiscal policy of course depends on the flexible and efficient operation of the private enterprise economy. Efforts to achieve economic stability and growth will be most successful if interest rates, prices and wages respond freely to change in supply and demand. Federal Reserve policy, as I have been describing it, plays a limited but indispensable role in our efforts to satisfy the first requirement of growth -- the maintenance of high average levels of - 7 - production and employment. In such an atmosphere of high level activity the demand for goods and services can expand at a rate sufficient to utilize our growing productive capacity. Since technical discoveries, savings and investments are the fundamental causes of long-run growth in output per person and productive capacity, let us summarize the influence of a flexible monetary policy on these factors. The Federal Reserve facilitates the expansion of the money supply at a rate as appropriate as possible to the potential growth in full employment output. This insures that sufficient funds and resources are generally available to meet investment demands. The availability of an adequate supply of funds permits, but of course does not guarantee, a high and stable rate of growth. Since economic growth depends upon the presence of investment opportunities, it occurs at an uneven rate. There are surges followed by periods of slower advance. The expansion of the money supply during recession and recovery periods is widely accepted as a positive contribution to the achievement of high levels of output. It is not as widely realized that policies of restraint designed to foster financial stability also encourage a higher long-term rate of growth. This is so because in- flation has an adverse effect on the quality of investment and savings decisions. Inflation also tends to make cyclical swings more extreme, and thereby increases the risks associated with investment. A higher level of risk means that in the long run less investment will be undertaken. - 8 - While inflation has been the major problem in most recent years, deflation would have equally undesirable consequences. Any change in the price level which continues over a sufficiently long period of time or is sufficiently sharp as to result in destabilizing expectations represents a hindrance to growth. Even when prices are relatively stable, the economy experiences wide swings in confidence. It is only natural that pros- pects for the future should be overevaluated during economic expansions and underevaluated during recessions. Inevitably some premature and ill-considered investment is undertaken during expansionary periods factories and equipment, office buildings, apartments and shopping centers are built -- which in the long run because of their cost, nature or location, will not be able efficiently and profitably to satisfy final demands. Likewise, during recessions when the cost of capital construction is generally considerably lower, businessmen motivated by pessimism will often postpone investments -- in research, in modernization and replacement, and in expansion -- investments which would be highly profitable in terms of long-run demands and would contribute to long-run economic growth. Inflation and deflation accentuate these tendencies. In- flation encourages ill-advised investments not only because it breads overexuberance and speculation, but also because it impairs the functioning of the price system. In a free enterprise economy changes in - 9 - prices and in profit margins normally are due to changes in final demands and in productivity. They consequently help direct invest- ment expenditures to these areas where expansion of capacity is most desirable. During periods of financial instability, however, changes in relative prices often reflect the speed or lag of adjustment to inflationary pressures, rather than more fundamental changes in supply and demand conditions. Under these circumstances, there is a greater than usual opportunity for miscalculation in investment decisions. This means that we obtain less growth potential per dollar of investment. At the same time, if expectations of inflation become prevalent, savers attempt to hedge against the erosion of their purchasing power. They tend increasingly to place their funds in common stocks and in real estate, rather than in fixed financial claims such as savings deposits, shares in savings and loan associations, and insurance policies. As a result, a smaller amount of savings becomes available for iise in business investment. The undesirable consequences of inflation are most apparent during the following recession when the willingness to save generally exceeds the willingness to invest. The normal lessening of confidence and of the willingness to invest is intensified for several reasons. The sharpness of the inflationary runup may require a severer than usual downward adjustment, particularly if there has been excessive - 10 - accumulation of inventories. The previous over-building of plant and equipment also serves as a drag on the profitability of new investment. Of course, I am not arguing that absolute stability of the general price level is necessary for economic growth. The historical record clearly shows that economic growth has occurred during periods of widely different price behavior. This is hardly surprising when we consider the many other important factors which influence the amount and quality of education, research, technical discovery, investment and savings that take place in our economy. Nevertheless, if we desire as high and as stable a rate of growth as is feasibly obtainable, we must always seek to maintain a high degree of financial stability. The Federal Reserve System is, of course, constantly working to help in attaining the ends I have described. This year, the System has taken a number of steps not only to enable an increase in member bank reserves to support a renewed expansion in bank credit and the money supply but also, at the same time, to offset the drain on reserves from a substantial outflow of gold. In early August, for instance, the Board announced actions to implement a 1959 Act of Congress relating to vault cash and reserve requirements, Those actions, effective as of August 25 and September 1, made available some $600 million of additional reserves for expansion of bank credit. - 11 - Since early June, there have been two reductions in discount rates at the Federal Reserve Banks, reducing those rates from 4 per cent to the present 3 per cent at all Reserve Banks. Since well before then, the System's open market operations have been directed toward enlarging the capacity of the member banks to expand their loans. In the process, System holdings of Government securities have been increased by some $2 billion since early March. The Federal Reserve, I should like to note in conclusion, has a significant role to play at all times in encouraging growth. The private free enterprise economy, however, must provide most of the dynamic ingredients for growth — and the risk-taking ability. the ingenuity, the confidence
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