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E'oi ; r : e i § a s e on d e l i v e r y
ThtifcsJday, February 1 1 , 1982
10:0ti AM, EST
Statement by
Paul A, Volcker
Chairman, Board of Governors of the Federal Reserve System
before the
Coramittee on Banking, Housing and Urban Affairs
United States Senate
February 11, 1982
I appreciate the opportunity to meet with members of
this distinguished committee today to discuss the direction
of monetary policy and the prospects for the national economy.
I have submitted for the record the official report from the
Board in accordance with the Humphrey-Hawkins Act.
I would
now like to take a few minutes to underscore and amplify some
of the points in that report, as well as to offer some more
personal views on the problems -- and equally important, the
opportunities -- that are before us.
As you know, the economy has been in recession for some
months.
The recession has some of the characteristics of earlier
downturns.
But it seems to me plainly wrong to think of the
current state of the economy as simply reflecting "another11
recession.
Rather, we are seeing the culmination of a much longer
period of unsatisfactory economic performance extending well
back into the 1970fs -- performance marked by poor productivity,
growing unemployment, much higher interest rates, and pressures
on the real earnings of the average citizen and on the real profits
of our businesses.
A number of factors have contributed to that deterioration
in our performance, not all of them completely understood.
But
one pervasive element - - a n element particularly relevant to
monetary policy -- stands out:
we found ourselves in the midst
of the most prolonged inflation in our history, and that inflationaj
process had come to feed on itself.
Incentives were distorted.
-2-
Too much of the energy of our citizens was directed toward seeking
protection from future price increases and toward speculative
activity, and too little toward production.
Increasingly depressed
and volatile capital markets reflected the uncertainties.
Effective
tax rates increased as inflation carried taxpayers into higher
brackets.
But, in a sluggish economy, those revenues did not
keep up with our spending plans and programs.
Against that background, the notion that we might comfortably live with inflation -- or that we could accept inflation in
the interest of strong growth —
was exposed as an illusion.
I
believe it is fair to say a clear national consensus emerged that
turning back inflation had to be a top priority of economic
policy -- that a stable dollar is a necessary part of the
foundation of a strong economy.
Monetary policy has a key role to play in restoring that
stability, and our policies are directed to that end.
But recent
developments have confirmed again that ending an inflation, once
it has become deeply seated in expectations and behavior, is not
a simple and painless process.
The problems can be aggravated
if too much of the burden rests on one instrument of policy.
And the effort to restore stability will be more difficult to
the extent policies feed skepticism and uncertainty about whether
the effort will be sustained -- a skepticism rooted in past
failures to "carry through.11
Monetary, fiscal, and other public
policies are constantly scrutinized -- in financial markets and
elsewhere - - t o detect any signs of weakening in the sense of
commitment to deal with inflation.
To speed the transition to
-3-
lower interest rates and healthier capital markets, to reduce
the costly elements of anticipated inflation built into wage
and price contracts, to permit more confident planning for the
future -- to, in fact, lay the base for sustained recovery -credibility in dealing with inflation has to be earned by
performance and persistence.
That, essentially, is what public policy -- and monetary
policy in particular -- has been about for some time, and there
are now signs of real progress on the inflation front.
That
progress is reflected to greater or lesser degree in all the
widely used inflation indices.
Consumer prices rose 8.9 percent
last year, 3-1/2 percentage points less than the 1980 peak, and
the inflation rate seemed to be trending lower still as the year
ended.
Finished goods producer prices have had an average increase
at an annual rate of only about 4 percent for six months.
Expect
tations cannot 'be so easily measured, but earlier fears that
inflation might rapidly accelerate have plainly dissipated.
Those gains, to be sure, have elements that may not be
lasting.
Some prices are depressed by recession-weakened
markets, and some by the pressures of high interest rates on
inventories and speculative positions; exceptionally good crops
last year have held food prices down; and surpluses have emerged
in oil markets, following the enormous price increases of earlier
year s.
-4But we also see evidence of potentially more lasting
changes in the trend of costs as management and labor in key
industries come to grips with competitively damaging productivity
and wage trends.
I am aware that this process has just begun,
and it has been centered largely in areas where competitive
pressures are most intense.
But as the emerging patterns
spread, we will have succeeded in establishing one of the
major elements for success in the fight against inflation and
for reconciling, as we must, a return to greater price stability
with growth, reduced unemployment, and higher real wages.
Quite obviously, policies that encourage that process of cost
moderation will have a large n pay off11 in future economic performance ,
I am acutely aware that progress on the inflation front
has been accompanied by historically high levels of interest
rates and heavy strains on financial markets.
Those sectors
of the economy particularly dependent on borrowing -- especially
long-term borrowing -- have been hard hit.
The pattern of economic activity last year shows the
picture clearly.
Over the course of 1981, the overall level
of production of goods and services —
slight increase.
real GNP ~- posted a
But at the same time, home building dropped
to the lowest level in decades.
Sales of consumer durables --
car sales in particular -- fell markedly.
And now capital invest-
ment by businesses also appears to be adversely affected, running
contrary to longer-term needs.
-5-
It would be simplistic to cite high interest rates as
the sole cause of the difficulties in these vulnerable sectors.
Part of the problem arises from other, and longer-term, factors,
themselves associated with the inflationary process.
In housing,
for example, we have had a decade of increases in prices of homes
almost double the rate of inflation in the economy generally and
well in excess of the rise in average family income.
"Sticker
shock" still seems to be the major deterrent to new car sales
as the industry comes to grips with long developing competitive
and regulatory problems and the enormous challenge of adapting
to the higher price of gasoline.
In the best of circumstances, coping with deep-seated
inflation would pose difficulties.
At the same time, we have
had to adjust to the huge increases in the price of energy,
to meet the need for a stronger defense, and to deal with the
drag on incentives and investment resulting from rising marginal
tax rates.
All of that implies massive economic adjustments,
the^ threat of a .growing fiscal imbalance, and a difficult
transition period.
The high level, of unemployment generally,
and particularly distressing conditions in some of our older
industrial centers, are one symptom.
Lasting progress toward
price stability -- and other needed adjustments -- cannot be
built on prolonged stagnation, rising unemployment, and slow
growth.
The relevant question is not whether current conditions
are satisfactory" or tolerable -- they obviously are not.
It. is
whether our policies, and our policy mix, promise to. achieve the
-6-
needed results over time.
Monetary Policy in 1981 and the Targets for 1982
It is against that background that I would like to
review monetary policy last year and discuss our intentions
for 1982.
As you know, the main responsibility for dealing with
inflation has fallen on monetary policy.
I would emphasize
that the process of restoring stability will proceed more easily
and effectively, with less strain on financial markets and on
credit-sensitive sectors of the economy, to the extent the
effort is complemented and supported by other policies.
But,
in the end, history and theory alike confirm that no effort to
turn back inflation can be successful without appropriate
restraint on the expansion of money and credit.
I believe
the record of the past few years amply reflects the needed
monetary discipline.
The Humphrey-Hawkins Act specifically requires that we
translate our broad objectives into quantitative monetary and
credit targets.
More broadly, those targets have become one
means of communicating our intentions to the public in a comprehensible way.
The judgments involved in setting appropriate
targets are never simple, and they have been increasingly
complicated by the rapid pace of innovation in financial
markets.
Those innovations sometimes blur the precise meaning
of the various monetary and credit aggregates, complicate
their measurement, or change the economic significance of a
particular target.
In the circumstances, elements of judgment
-7are necessary in interpreting behavior of the aggregates,
particularly when their movements diverge somewhat.
The events of 1981 surely reflect those facts, but they
also seem to me to provide an unambiguous record of persistent
monetary restraint.
The targets we set for the year pointed
toward a reduction in the growth of the monetary aggregates
from the rates of expansion in 1980.
In our 1981 report to
the Congress, setting forth those targets, we also suggested
that changing preferences of the public for different types of
financial assets -- influenced by regulatory developments and
new "products" offered by financial institutions -- might tend
to push the broader aggregate M2 to the upper part of its
specified range, and that judgments about the course of the
narrow aggregates -- Ml-A and B .-- would require taking account
of shifts into NOW accounts, particularly during the early part
of the year when they were newly introduced nationwide.
These
expectations were borne out, but as the year progressed the divergences among some of the aggregates became even wider than expected.
Measured by comparing fourth quarter averages in 1980
and 1981, Ml-B growth (adjusted for the estimated shift of funds
into NOW accounts)* in 1981 was 2.3 percent, a little more than
*The "adjustment" allowed for shifts of funds into NOW accounts
and similar instruments included in Ml-B from sources outside of
Ml-B. The shift-adjustment was estimated on the basis of various
surveys of depository institutions and individuals, as well as
by statistical techniques. Ml-B without adjustment rose by 5
percent, also below its indicated range. While the adjustment
was necessarily estimated, we believe the "adjusted" data are
more appropriate for assessing the trend in the money supply,
particularly during the early part of the year when shifts
were large.
-8-
one percent below the lower end of the target range specified
a year ago (see Table 1 attached).
You will recall that I
reported to you in July that an outcome near the lower end of
the range would be desirable.
Measured in the same way, M2 slightly exceeded the
upper end of its range after rather closely following the
upper bound as the year progressed.
The subsidiary target
range for M3 was exceeded by a greater margin, reflecting
in considerable part some changes in the composition of
commercial bank financing patterns toward domestic sources
that had not been anticipated, while bank credit fell within,
but toward the upper part of, its range.
In judging trends over a period of time, annual averages
may be more meaningful.
As Table 2 illustrates, average annual
Ml-B (adjusted) growth has declined by an average of 1.1 percentage point since 1978, to a rate of 4.7 percent in 1981.
On the same basis, M2 growth was steady in 1979 and 1980, but
actually rose by more than 1 percentage point in 1981.
Over
those years, both aggregates have been affected by institutional
change.
Relaxation of interest rate ceilings applicable to time
deposits of depository institutions and the enormous growth of
money market funds (both included in M2) tended to raise the
trend of M2 over the period as individuals had incentives to
lodge a larger proportion of their assets in these instruments.
Assets in money market mutual funds are not included in Ml, but
the enormous growth jfjl Etiosa Kunds, providing virtually immediate
-9-
availability of funds and check-writing privileges, diverted
some money away from checking accounts in depository institutions
which are included in Ml.
Given the technical and institutional
changes bearing on Ml and its relative volatility, its movements need to be assessed in the light of developments
with respect to the other aggregates.
Indeed, a number of
analysts attach greater weight to M2.
Experience during 1981 also illustrates the variety of
forces impinging on interest rates and credit market conditions.
Over long periods of time, there should be a relationship between
interest rates and inflationary expectations -- that is, both
lenders and borrowers might reasonably anticipate a small positive
return on loanable funds in "real" terms, after allowing for
inflation.
When economic conditions were relatively stable in
the postwar period and inflation low, that relationship with
respect to long-term interest rates was fairly steady.
But
history is replete with deviations for a time in either direction,
and high levels of income taxation distort the comparison.
Before taxes, "real" interest rates (measured on the base of
actual inflation) were negative during part of the 1970's, but
recently have been extraordinarily high.
One factor, particularly
in long-term markets, appears to be concern about whether public
policy will, in fact, "carry through11 the fight on inflation.
Even with inflation subsiding, the threat of prolonged
large Federal deficits
as the economy recovers points to a
more imminent concern -- direct government competition for a
-10-
limited supply of savings and loanable funds.
The clear
implication is greater pressure on interest rates than
otherwise, with those interest rates serving to "crowd out"
other borrowers.
The most vulnerable, of course, are home-
buyers and others particularly dependent on credit.
But the
consequences for business investment generally are adverse as
well.
Monetary policy, of course, influences interest rates,
but the relationship has several dimensions.
As monetary
restraint reduces and eliminates the risk of inflation over
time, it will work powerfully toward a more favorable climate
for longer-term borrowing, and in the credit markets generally.
In the short-run, should inflation, economic growth or other
factors increase the need and desire to hold money, restraint
on the supply of money will ordinarily be reflected in pressures
on short-term rates.
However, to accept inflationary increases
in the money supply in an attempt to lower interest rates would
ultimately be self-defeating; even in the short-run, market
sensitivities might well give the opposite result.
Some of these inter-relationships were evident in 1981.
Short-term interest rates fluctuated over a wide range, but
generally trended down from peak levels in the spring or early
summer, falling particularly sharply as the recessionary forces
became apparent in the fall.
That was a period when pressures
on commercial bank reserve positions were easing, consistent
-11-
with our monetary and credit targets.
However, longer-term
interest rates continued to rise for months after the peak
in short-term rates, influenced in substantial part by growing
concern about prospective budgetary deficits.
As growth in the money supply rose more rapidly late
last year, and a very sharp increase developed early in January,
the reserve positions of banks came under some renewed pressure
as Federal Reserve open market operations constrained the supply
of reserves.
At the same time, there were scattered signs
recessionary forces might be waning.
Short-term interest rates
rose from early November lows, although they remain well below
levels prevailing during much of 1981.
Some long-term interest
rates -- notably those on government securities -- returned
close to earlier peaks, suggesting the impact of current and
prospective Treasury financing.
This was the setting for the decision on the monetary
and credit targets taken by the Federal Open Market Committee
last week.
The sharp increase in the money supply in January
carried the level well above the fourth quarter 1981 average,
the conventional base for the new target, and somewhat above
the lower end of the range specified for 1981.
A large increase
in the money supply, accompanied by higher interest rates, is
unusual during a period of declining production and economic
activity.
Moreover, the composition of the money supply increase
in the past three months is heavily concentrated in a rather
small component of Ml —
NOW accounts, which are held by individua
-12-
That increase in NOW accounts has been accompanied by a
reversal of earlier sharp declines in savings accounts -another highly liquid asset -- and by declines in small time
deposits, which provide a less liquid outlet for personal
funds.
Taken together, the evidence suggests some short-
term -- and potentially "self reversing11 -- factors may be
at work, inducing individuals to build up highly liquid balances
at a time of economic and interest rate uncertainty.
Taking those circumstances and others into account, the
Federal Open Market Committee decided to adopt the tentative
targets discussed last July:
for Ml, 2-1/2 to 5-1/2 percent;
for M2, 6 to 9 percent;
for M3, 6-1/2 to 9-1/2 percent.
The associated range for bank credit is 6 to 9 percent.*
The Ml target is lower than the range specified a year
ago for Ml-B (3-1/2 to 6 percent shift-adjusted), but it is
consistent with somewhat larger actual growth than experienced
last year with the "adjusted11 measure.
The lower end of the
range would now appear appropriate only if the pace of financial
innovation again picks up -- for instance, a rapid spread of
*While all of the monetary ranges were set, as in previous years,
on a fourth-quarter to fourth-quarter basis, the range for bank
credit is measured from the average level in December 1981 and
January 1982 to the fourth-quarter 1982 level. This adjustment
in the base for bank credit is necessitated by the opening of
International Banking Facilities on December 3, 1981, which led
to a shifting of certain bank assets, formerly included in the
domestic bank credit data, from U.S. offices to the IBFs.
-13-
arrangements for "sweeping" temporarily excess checking account
balances into money market funds or other liquid assets not
included in Ml.
Given the present level of Ml and the relatively
slow growth last year, the FOMC at this time feels that an outcome in the upper half of the range would be acceptable, and
that Ml could acceptably remain somewhat above the implied
"growth track" during the period immediately ahead.
In that connection, I would point out that an outcome
in the upper part of the range specified for 1982 would be
roughly the equivalent of a rate of growth of 4 percent from
the lower end of the range targeted in 1981, as illustrated on
Chart
xi.
Such a result would be entirely consistent with
the objective I stated to your Committee in July.
The FOMC anticipates somewhat slower growth in M2 than
a year ago, when the target was slightly exceeded.
At present,
an outcome in the upper half of the range appears more likely
and desirable.
Assets included in M2 account for a significant
part of individual savings.
Should total savings increase sub-
stantially more rapidly than now anticipated in response to tax
incentives or other factors-- or if legal or regulatory changes,
such as the wider availability of IRA accounts, result in a
substantial volume of funds shifting into depository institutions
from other sources -- growth might logically reach (or even
slightly exceed) the upper limit.
-14-
Identifiable "structural11 influences of that sort on M2,
or other aggregates, must appropriately be taken into account in
formulating policy steps and judging actual developments.
For
example, should developments in coming months provide solid evidence
that the recent exceptional growth of Ml is indicative of some
more fundamental and lasting change -- such as a desire by individuals to continue to hold more liquid "savings11 in the form of
NOW accounts -- the FOMC would, of course, reconsider that growth
target at or before the regular mid-year review.
These technicalities should not confuse a simple message:
consolidating and extending the heartening progress on inflation
will require continuing restraint on monetary growth, and we
intend to maintain the necessary degree of restraint.
The
growth ranges specified are, we believe, consistent with an
economic recovery later this year, although we do not anticipate,
by historical standards, a sharp "snap back."
What is more
important is that the recovery have a firm foundation -- that
it be sustained over a long period.
There will be more room
for real growth -- and much better prospects for sustaining that
growth over many years -- the greater the progress on inflation.
The Course Ahead
In approaching the future, the lessons of the past bear
repeating.
We cannot buy or inflate pur way out of recession --
not without ratcheting up both inflation and unemployment over
-15-
time.
We cannot turn the effort to deal with inflation "on
and off" -- not without adversely influencing the decisions
of those in the marketplace who commit funds for investment,
with consequences for the recovery and productivity we want.
What we can do is set the stage for a much more favorable
outlook - - a future in which progress toward price stability,
lower interest rates, greater productivity, slower growth in
nominal wages but higher real wages, all benignly interact to
support growth and reduce unemployment.
That's a process we
have not seen sustained in this country for many years.
Today, we are acutely aware of disturbed capital markets,
high interest rates, economic slack, and a poor productivity
record.
But, when the economy begins to expand, productivity
should rise; tax and other measures already in place or under
way should help reinforce a better trend.
Productivity growth,
in turn, will permit prices to rise more slowly than wages -more modest wage and salary increases in dollars will then be
consistent with more growth in real earnings, encouraging further
moderation in wage demands and sustaining the disinflationary
process.
As confidence returns to securities markets, prices
of bonds and stocks should rise, and lower interest rates and
more favorable capital market conditions will in turn support
the continuing growth in investment and productivity.
With
appropriate budgetary and monetary discipline, the process
could be sustained for years.
-16-
That is not an impossible vision.
of it in the early 1960's.
We saw something
As recently as the mid-1970 f s,
coming out of a deep recession, we seemed to be moving in
the right direction -- and then lost bur way.
Some of the
essential elements of a brighter future -- as well as some of
the hazards on the way -- are reflected in the longer-term
projections of both the Administration and the Congressional
Budget Office now available to you.
From the standpoint of public policy, much of the
groundwork has been laid.
I have spoken of the key role for
monetary policy, and of our record and intentions in that
regard.
The tax program enacted last year can, in the right
context, have favorable effects on incentives and on investment.
The excessive burden of regulation is being addressed.
But, of course, for the process to get fairly started
we need to resolve some large outstanding questions as well -questions that hang heavily over financial markets and prospects
for interest rates, inflation, and early recovery.
I have referred on many occasions to the key importance
of winding down the cost and wage pressures that tend to keep
the inflationary momentum going.
The process appears to be
starting, and the faster it takes hold the better the outlook
for growth and reduced unemployment.
But, clearly, prospects
for early and sustained expansion - - a n expansion that can be
broadly shared by industries now severely depressed -- is
dependent on access to capital and credit on more favorable
-17-
terms.
Pumping up the money supply cannot be the answer to
that problem -- excessive money and the inflation it breeds
are enemies of the real savings needed to finance investment.
What we can do is relieve the concerns the markets
understandably have -- concerns reflected so strongly in the
budgetary documents before you from both the Administration
and your own Budget Office•
Without action to cut spending --
or, if that fails, to raise new revenues -- we would face the
prospect of deficits rising to unprecedented amounts, whether
measured in dollars, in relation to the GNP, or as a proportion
of our limited savings and the supply of loanable funds.
We
can debate among ourselves just what level of deficit is
tolerable in coming years and what is not.
We can be tempted
to sit back and let a year pass as we discuss what programs
should be cut or where revenues can be raised.
But I think we
all know that, without action, we would be on a collision course
between our need for new plant, equipment and housing and our
capacity to save -- and it would be more difficult to reconcile
the requirements for a sound dollar with our desire to grow.
It could be argued we have a little time.
A large
deficit in the midst of recession should be manageable; it
indeed provides some support for the economy in a time of stress.
There are also large potential sources of demand in the private
economy.
were.
The latest economic indicators are not so weak as they
We can see we are making some progress against inflation,
perhaps as fast as could reasonably have been anticipated.
all these circumstances,- a degree of patience is needed —
justified*
In
and
-18-
But delay is another matter.
In my judgment, the
more progress we can see in restraining costs, and the more
resolute your budgetary action, the earlier we can be assured
a prompt and strong recovery.
The course of action we have set in the Federal Reserve
seems to me consistent with that sense of direction and urgency.
But no single instrument of policy can, alone, do the job.
We look forward to working with you and your colleagues in the
weeks and months ahead to meet these challenges constructively.
it it it it it it
Table 1
Monetary Growth 1981
1981 Ranges
Ml-B
Ml-B (shift adjusted)
M2
M3
Bank Credit
6 to 8-1/2 percent
3-1/2 to 6 percent
6
to y9 percent:
percent
o uo
6-1/2 to 9-1/2 percent
6 to 9 percent
1981 Actual*
5.0
2.3
9.4
y .<+
11.3
8.8
percent
percent
percent
percent
percent
percent**
*Fourth quarter to fourth quarter
**December level used for calculating this 1981 growth rate
incorporates an adjustment to abstract from the shifting
of assets from domestic banking offices to International
Banking Facilities.
Table 2
Growth of Money and Bank Credit
(percentage changes)
Ml-B*
M2
8.3
2.3
8.3
8.4
9.1
9.4
8.2
7.7
5.9
4.7
8.8
8.5
8.3
9.8
M3
Bank Credit
11.3
9.8
9.9
11.3
13.3
12.6
8.0
8.8**
IX.8
10.3
9.3
11.6
12.4
13.5
8.5
9.4**
Fourth quarter to
fourth quarter
1978
1979
1980
1981
7.5
6.6
Annual average to
annual average
1978
1979
1980
1981
-Growth rates for 1980 and 1981 adjusted for shifts to other
checkable deposit accounts since the end of the preceding year,
**December level used for calculating these 1981 growth rates
incorporates an adjustment to abstract from the shifting of
assets from domestic banking offices to International Banking
Facilities.
Table 3
Monetary Growth Targets 1982
Ml*
M2
M3
Bank Credit
2-1/2 to 5-1/2 percent
6 to 9 percent
6-1/2 to 9-1/2 percent
6 to 9 percent**
*The objective for growth of narrowly defined money
over 1981 is set in terms of Ml. Based on a variety
of evidence suggesting that the bulk of the shift to
NOW accounts had occurred by late 1981, the Federal
Reserve is publishing only a single Ml figure in 1982
with the same coverage as the former Ml-B.
**The bank credit data after December 1981 are not
comparable to earlier data because of the introduction
of International Banking Facilities. Thus, the targets
for 1982 are in terms of growth from an average of
December 1981 and January 1982 to the fourth quarter
average of 1982,
Chart 1
Growth Ranges for 1981 and Actual
M1 -BSHiFT-AD JUSTED
Billions of dollars
440
January {est.)
430
420
410
January 1982 estimated on a basis comparable to shift-adjusted M1-B in 1981
1
1
I
1980
1
I
I
1
1
1
1
1
1
I
1
1
1 1
—— 1700
— 1650
I
I
I
I
f
f
1981
I
I
I I f
1982
Chart 2
Growth Ranges for and Behavior of i l l , 1981 and 1982
Billions of dollars
470
5%%
460
450
21/2%
440
M 1 - B (not shift-adjusted)
430
420
M 1 - B (shift-adjusted)
410
11
1980
t t i i
it
1981
ii
it
t
i
if
it
t
1982
ti
i
t
@FedFRASER