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For release on delivery
9:30 AM CDT (10:30 AM EDT)
Tuesday, October 9, 1979

A Time of Testing
Remarks by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System




before the
American Bankers Association
New Orleans, Louisiana

October 9, 1979

It is a very special privilege for me to have the chance
to address so many bankers in assembled convention —

but, just

in case there are any doubts, I did not arrange the Federal Reserve
announcements last weekend to honor this occasion.

• . ..
-

In fact, those measures were not designed to make your life
as bankers easier.

Their purpose is rather to deal forcefully

and responsibly with the economic and financial situation as we
see it:

sbrong inflationary pressures; concern, exaggerated

concern in my judgment, that excessive growth in money and
credit might be permitted by the Federal Reserve,fueling still
more inflation; and an emerging speculative atmosphere and unsettled markets that could only complicate the job of restoring
and maintaining orderly economic growth at home and stability in
the dollar abroad.
I need not review with you all the trends and developments
of recent years that have brought us to this crucial period for
economic policy, nor emphasize the relevance of policies beyond
the monetary and banking area.
plain to see.

The problems and dangers are

Indeed, in our perhaps understandable preoccupation

with what is wrong at the present time and in-our doubts about
the future, there may be another danger that is^not^so dbvicms;

ot

a justifiable sense of concern can spill over into a debilitating
and unjustifiable sense of impotence and weakness.




-2-

The simple fact is that, after months of focusing on our
economic problems:
More people are employed than ever before,
over 10 million more than five years ago,
—

An exceptionally long period of expansion has
helped encourage and sustain investment despite
inhibitions in the tax, regulatory, and inflationary
environment.
The Federal budget has come under better control,
with spending moving somewhat lower in relation
to the size of the economy, and with a substantially
reduced deficit over the most recent years.
In the face of unprecedented inflation, and enormous
new increases in energy prices, wage trends overall
have not appreciably accelerated this year, reflecting,
despite some disturbing exceptions, the discipline
and good sense of Americans in general in accepting
the need for restraint.

—

Amid the strains imposed by the high price of oil and
sometimes turbulent foreign exchange markets, a high
degree of international cooperation has been maintained
and protectionism has been checked —

enabling, among

other things,a substantial growth in American exports.
We would, of course, be blind if we failed to recognize that
all these achievements, and much more, will be jeopardized by any
failure to come to grips with the inflation that has become so




-3-

pervasive.

Monetary policy inevitably has an essential role

in the process of restoring stability.

The new Federal Reserve

actions are a part of that continuing process.
Those measures were specifically designed to provide added
assurance that the money supply and bank credit expansion would
be kept under firm control.

There will be one seemingly technical,

but potentially significant, change in procedure in conducting
open market operations.

More emphasis will be placed on limiting

the provision of reserves to the banking system —
limits the supply of deposits and money —

to keep monetary growth

within our established targets Cor this year.
discount rate —

which ultimately

We have raised the

and vd.ll manage it more flexibly —

so that

restraint on ban! reserves will not be offset by excessive borrowing
from the Federal Reserve Banks.

Vie have placed a special marginal

reserve requirement cf E percent on increases in "managed liabilities16
of larger banks (including U.£. agencies and branches of foreign
banks) because that source of funds has financed much of the recent
buildup in credit expansion.

That requirementr admittedly cumber-

some by its nature, will be maintained so long as credit expansion
is excessive.
None of these actions will prevent moderate growth in money
and credit commensurate with the needs of the economy; they are
designed to curb excesses that would otherwise spill over into
inflation.

Let me speak quite directly and frankly to the

responsibilities of the banking system and banking leaders in
that connection.



One of the glories and strengths of our system

4-

is that we rely on private markets and decentralized decisions,
responding to market incentives, in pricing and allocating credit.
But those decisions do have to be made by all of you individually
iAi your own institutions.

In a situation in which there could be

greater day-to-day or week-to-week volatility in money market
rates —

not in itself a matter of great consequence for the

economy -- pricing of your own loans seems to me more a matter
of responsible business judgment than of following a rote formula,
related solely to the cost of some small margin of loanable funds.
The Board of Governors has particularly stressed its own concern
that, in a time of limited resources, banks should take care to
avoid financing essentially speculative activity in commodity,
gold and foreign exchange markets.

Bankers familiar with their

own markets can, without doubt, make judgments that none of us in
Washington can, or ever could, make about what loans best serve
the continuing needs of customers, business and personal, and
the country alike.

But my general feeling is that this is hardly

the time to search out for exotic new lending areas or to finance
speculative or purely financial activities that have little to do
with the performance of the American economy, and indeed may
detract from it.
This is a time of testing —

a testing not only of our

capacity collectively to reach coherent and intelligent policies,
but to stick with them.

In approaching this test, the facts do

not justify the skepticism, and even cynicism, that is heard on
so many sides.




Some would suggest that we, as a nation, lack
the discipline to cope with inflation.
I simply do not accept that view.
Second, some would argue that inflation is so
bound up with energy prices, sluggish productivity,
regulation, and other deep-seated forces that
monetary and fiscal policies are impotent.
I do not accept that view.
Third, some would stipulate that we face impossible
choices between prosperity and inflation.
The simple facts of the past, in the United
States and elsewhere, refute that view.
Let me take the first point.

I do not claim any special

expertise in reading public opinion.
of national concern about inflation —

But the dramatic swelling
a concern that seems to

transcend economic, social and indeed political philosophies

—

seems to me unmistakable.
We need not rely on opinion polls or personal impressions.
We have been assailed almost daily for months with learned and
not so learned analyses about the prospects for a downturn in
business activity.

I understand the reasons for concern, partic-

ularly given the high level of inventory accumulation in recent
months.

But the Administration and the Congress have united in

clearly rejecting the seductive course of budgetary easing and
tax reduction in recognition of the ultimately greater threat




-6-

to stability inherent in the inflationary process.

Restrictive

monetary policies are never calculated to win popularity contests;
yet there has been acceptance of the need for restraint even at
rates of interest that are almost outside the range of our historical
experience.
Indeed, the Congressional committees responsible for oversight of the Federal Reserve have been among the strongest voices
urging that we set forth and adhere to monetary targets, reducing
them over the years ahead as an essential part of the effort to
restore price stability.

I believe we are coming to understand

that our only real prospect of early and sustained declines in
interest rates lies in coming to grips with inflation.

I would

note too that the "National Accord" recently reached between the
Administration and American labor leadership plainly recognized
the threat to full employment, incomes, investment and growth
inherent in the inflationary process, and for those reasons gave
"top priority" to the "war on inflation."
Of course, the skeptical can suggest that the consensus
will buckle and fracture under the first real strains.

But

in assessing the prospects and policies, let us be clear on one
important analytic point.

There is clearly a time when, if

business activity should recede, some of the outward manifestations
of fiscal or monetary policy —

the size of the budget deficit or

interest rates —

Built-in stabilizers in the budget

will change.

come into play, increasing the deficit temporarily.

When the

money supply is brought clearly under control and expectations




-7-

of inflation dissipate, interest rates will tend to decline,
and our recent actions should bring that day §Qpner, whatever
the initial impact on interest rates.

Developments of this

sort are in no sense inconsistent with maintaining the firm
discipline on Federal spending and growth in the money supply
that will be required over a long period of time to restore
price stability.
Some have raised the question of tax reduction.

If earned

by sustained spending restraint, well-structured tax reductions —
by which I mean changes that would help stimulate investment,
cut costs, and offset the effects of inflation in moving people
into higher tax brackets —
future.

could be welcome at some time in the

That time has not yet come, nor is it useful now to

speculate when it might.

What we need to guard against is

premature and excessive stimulus, during expansions as well
as recessions —

and it does seem to me that we have come a

long ways, at the very least, toward learning that lesson.
I do not minimize the influence of more structural factors
in our inflation —

least of all the deplorable performance of

productivity and the impact of energy- pgtrices, now j^isipg at a Ci
rate of 70 to 80 percent a year.

The traditional i*i3t^uments

;

r -

of monetary and fiscal policy can do little directly to influence
productivity or the supply of oil.




-8-

But let us not lose sight of the fact that inflation not
only grows in part out of these factors, but that oil pricing
and productivity performance are themselves influenced by the
instabilities and uncertainties related to the underlying
inflationary process.

Attempts to pin all the blame for

inflation on factors outside of our control would only doom
our efforts to futility.
We can take some comfort from the fact that the rate of
inflation in most sectors of the economy is today substantially
below the levels so depressingly reported month after month
in the headlines; energy alone has added about 3 percent to
the consumer price index in the past three months.
rate of increase in energy prices subsides —
coming months —

As the

as it should in

the inflation rate as a whole should also

decline appreciably.

Looked at another way, the immediate

challenge is to avoid imbedding the current rate of inflation
in expectations and wage and pricing decisions, before the
current bulge in prices subsides.

That is not an unrealistic

objective, but it is one that will require discipline over the
months ahead.
That necessary discipline seems to me challenged by what
I think of as the theories of "either/or":
—




Either we fight inflation or we prevent a
recession.
Either we seek a strong and stable dollar
internationally or we attend to our problems
at home.

-9-

Either we do what's good for the long run or
we follow short-run expediency.
There was a day when our problems seemed to fall into
such convenient analytic compartments.

Most economists of.

my generation have made a career of analyzing so-called
"tradeoffs" between inflation and employment, between external
and domestic stability, between the long and short-run.
that theorizing has been rooted in certain assumptions
assumptions that are now suspect —
expectations.

But
—

about the stability of

When expectations of future inflation are so

strong and potentially volatile as they have become, the
"tradeoffs" disappear, or they appear in a much different
light.
The lesson of the 1970's —.here and abroad —

simply

does not bear out the "either/or" approach.
—




More inflation has been accompanied not by
less, but by more
growth.

unemployment and lower

We have not "traded off" one for

the other.
A weak dollar externally aggravates inflation
at home, and a weak dollar at home undermines
the dollar abroad.

Fundamentally, what disturbs

Peoria disturbs Zurich.
After years of inflation, the long run has caught
up with us. We can no longer blithely assume we
can 'buy15 prosperity with a little more inflation,

-10-

because the inflation itself is the greater
threat to economic stability.
The real message of these lessons seems to me more hopeful
than discouraging.

Let me state the propositions in a more

positive way.
As we turn the corner on prices, upward pressures on wages
and other costs —

including interest rates —

should subside.

As confidence in the currency is strengthened, improving conditions in money and capital markets will help support investment activity, and we should have a firmer base for investment
planning, improving the outlook for purchasing power and
productivity.

A stronger dollar at home will bring it renewed

strength internationally, and a strong dollar abroad will support
our efforts to combat inflation at home.

Appeals for moderation

in petroleum pricing would have a new force and substance.
I do not delude myself that is yet the world in which we
live.
What we can do, and I see no reasonable alternative, is to
start the process —

to turn the corner —

to demonstrate the

conviction that we have the wisdom and fortitude to maintain
the financial discipline required to cope with inflation.

In

the process, we must, of course, be mindful of the business
situation in the United States —

and I count on you to make

the lending decisions that distinguish between the support your
customers require and the excesses that only aggravate and distract
the adjustment process that is underway.



-11-

When I accepted this invitation to speak to you, I had
a quite different address in mind —

one focusing on the so-

called "membership" problem and the necessary restructuring
of reserve requirements.
light of recent events.

I decided to fpjrggp, tb§;tr t]ie^nfja
But let me note the obvious —

•
7 avoide

that

the problems are not unrelated, for they both concern the role
and effectiveness of monetary policy and a strong central bank.
The central purpose of the proposed legislation is, after
all, to strengthen our ability to conduct monetary policy in
all foreseeable circumstances in the years ahead, and to do so
in a context of fair and evenhanded treatment of competing
depository institutions.

That seems to me a practicable, achiev-

able objective in this Congressional session.

I am greatly

encouraged by the convergence of views among affected institutions

—

what has seemed so controversial for years now approaches consensus.
That in no small part reflects the responsible efforts of the
leadership of this Association and individual bankers throughout
the country.
In the weeks ahead, I welcome your efforts and your support
together with that of other affected institutions —

in seeing

this vital piece of legislation move ttrhirougfc *ihe jQongiresg ei
acceptable form.

cr

1 .K

~r

No industry in America plays a more pivotal role in our
overall economic performance than our banks.
ments underscore the point —
decades ahead as it -is today.




Current develop-

but it will be as true in the
The implied responsibilities are

—

-12-

heavy.

But seldom are we offered the opportunity to meet a

major immediate challenge to our prosperity and stability,
while at virtually the same time strengthening the base we
need for effective policy in the decades ahead.

We can

afford to do no less than rise to those challenges.




* * * * * *


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102