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For release on delivery
9:30 AM EST
Thursday, March 4, 1982

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Statement by
Paul A. Volcker
Chairman, Board of Governors of the Federal Reserve System

before the
Committee on Appropriations
United States Senate

March 4, 1982

I appreciate this opportunity to discuss with you
important economic issues that are of concern to all of us.
Obviously, interrelationships among monetary, fiscal, and
other policies have important bearing on our national economic
performance and, especially, on the performance of our credit

The Federal Reserve has responsibilities only for

monetary policy.

This Committee has a leading role in deter-

mining federal spending and, through that avenue, in determining
federal demands on credit markets.

Although this Committee must

deal with a great many specific program details —

all of them

beyond the purview of the Federal Reserve -- the sum of your
actions and their longer-term implications are directly relevant
to monetary conditions and economic prospects.
Clearly, the economy is going through troubled times.
Unemployment is painfully high, particularly in older industrial

Interest rates are imposing severe strains on housing,

small business, and agriculture, and on thrifts and certain
other financial institutions.

These problems are in major part

a legacy of high inflation and lagging productivity growth over
a number of years.
I believe that there are strong reasons to expect a
cyclical upturn later this year.

Our monetary policy targets

will accommodate such an upturn.

And the deficit for the

current year, with its large cyclical component, should be
manageable; to a considerable extent, by supporting income
flows and spending during the recession, it can help stabilize
the economy and induce recovery.

- 2 -

For future years, the situation is quite different.



face the bleak prospect, as things now stand, and without strong
action to contain spending and to increase revenues, that budgetary
.deficits will rise very substantially, even assuming satisfactory
economic growth.

That prospect threatens the recovery in business

investment and housing we need by potentially preempting a sizable
fraction of our savings potential; moreover, the future implications
for congested credit markets feedback on
as lenders and borrowers "discount"
years ahead.

present interest rates,

what might happen in the

While it might be argued that larger growth in the

money supply, now or prospectively, could relieve the pressure,
one result would be to renew fears of inflation, just as marked
progress toward greater price stability is apparent.

An inflation-

ary increase in the money supply cannot substitute for real savings,
and, in time, would result in higher rather than lower interest
Clearly, the potential problem before us lies squarely
at the intersection of monetary and fiscal policy, and of our
respective responsibilities.

For that reason, I should like,

first, to review the recent and prospective course of monetary
policy and then to discuss its relationship to the fiscal problem.
Monetary policy has, of course, been directed toward
restraining growth in money and credit with the important
objective of reducing inflationary pressures and placing the
economy on a course toward price stability.

The hard fact is

that uprooting a deeply embedded inflationary process is difficult;


it is made even more difficult to the extent the effort is
concentrated on one policy instrument.

The fact that interest

rates have remained painfully high in the midst of recession,
restraining activity in credit-dependent sectors of the economy
is one reflection of the difficulty.
back over a number of years.

But the problem extends

As you know, the current recession

has been superimposed on a pattern of stagnation extending over
a considerable period.
In broad

terms, I don't think there is any great mystery

as to why the economy has behaved this way.

Beginning in the

mid-1960s, inflation increasingly became a way of life, and in
the process distorted economic incentives, sapped our productive
energies, and caused arbitrary and capricious transfers of income
and wealth.

For a time, as inflation gained momentum, real interest

rates were low or negative.

But after inflation took hold, and

became embedded in behavior and expectations, anticipations by
borrowers and lenders alike tended to propel interest rates

And, as monetary policy moved to deal more forcefully

with the inflation —
balance —

particularly in a context of fiscal im-

the strain on financial markets became more acute.

The alternative course of simply accommodating inflation
by providing it monetary sustenance would, however, offer no
lasting relief.

By feeding expectations of inflation and re-

inforcing the reluctance of lenders to commit funds for any but
the briefest periods of time, the high level of interest rates
(particularly long-term rates) would only become further embedded


in the economy.

The hard fact is that loss of our most important

financial yardstick —
interest rates.

a stable dollar —

bred high and volatile

Restoration and maintenance of lower interest

rates is ultimately dependent on greater confidence that
stability can and will be restored.
Developments during 1981 seem to me broadly consistent
with that effort.

While particular measures of money and

credit diverged, responding in large part to legislative,
regulatory, and institutional change affecting the way businesses
and individuals chose to hold their financial assets, the
general direction was consistent with the effort to curb the
monetary sources of inflation.

Specifically, M1B growth

(adjusted for the estimated shift of funds into NOW accounts)
decelerated further last year, averaging a little more than 1
percent lower than the previous year —
year of such deceleration.

the third consecutive

Growth of the broader aggregate M2

averaged a bit higher than in 1980, but that rise, at the margin,
reflected extraordinary growth in money market funds and regulatory and legislative changes affecting the attractiveness
of time deposits, which pulled into M2 some funds that otherwise would have been placed elsewhere.
Despite the slow growth of the narrowly defined money
supply, short-term interest rates fell substantially from midyear peaks, particularly sharply after the recession took hold.
As you know, however, short-term rates retraced part of that
decline late in the year and early in 1982.

The money supply

rose particularly sharply in the early weeks of -1982, and as a
result, bank reserve positions came under renewed pressure.

- 5 -

A spurt in money growth is unusual in a context of weak production
and income, and it appeared at least partly related to uncertainties
on the part of individuals, leading them to shift a portion of
.their financial assets into the most liquid form.

More recently,

the excessive growth has appeared to be subsiding, and interest
rates have turned somewhat lower.

But a characteristic of the

past year has been the persistently high level of intermediateand long-term interest rates, an area of the market most heavily
affected by expectations.
Those interest rates have remained high despite visible
progress —

and potentially lasting progress —

on the inflation

To be sure, some of the progress against inflation

reflects the more immediate, and potentially reversible, effects
of recession-weakened markets, current surpluses in petroleum
and grain production, and reduced commodity speculation and
pressures generally for inventory liquidation due to extraordinarily high interest rates.

However, we can now also see

encouraging signs of more lasting progress.

Attitudes of business

and labor toward pricing and wage bargaining, and toward work
rules that hamper productivity, seem to be changing.

Not sur-

prisingly, that is most clearly apparent in industries where
costs and wages have been most clearly out of line and where
international competitive pressures or those resulting from
regulatory change are particularly intense.

But —

so long as

monetary and fiscal policies are appropriate -- I believe these
changes will be reflected in a spreading pattern of cost and

- 6 -

price restraint.

Individually, workers and businessmen are

naturally reluctant to maintain such restraint, partly for
fear their concessions will not be matched by those of others.
But collectively, such restraint, combined with higher productivity, will be amply repaid in the form of higher real
wages and better prospects for job security.

This is the

foundation on which we can expect to build a sustainable
If these brighter prospects are to be achieved, however,
we cannot afford —

just as the disinflationary process is

beginning to take hold —

to abandon our monetary vigilance.

Past failures to "carry through" have left a legacy of skepticism
and uncertainty among workers and businessmen, among consumers, and,
not least, among participants in financial markets where lenders
demand "inflation" and "uncertainty" premiums when committing their

That is one important factor holding up longer-term

interest rates.

Credibility in dealing with inflation will

have to be earned by performance and persistence over time.
And, I believe, it is broadly and rightly recognized that
appropriate restraint on the expansion of money and credit

will continue to be fundamental to restoring price stability.
Our intentions with respect to money and credit growth
in 1982, reported to Congress three weeks ago, seem to me
consistent with that need.

The monetary targets are, we believe,

consistent with recovery in real business activity over the
second half of the year; in fact, the target range for Ml is


consistent with somewhat larger growth in that aggregate than
actual growth of the adjusted measure during 1981.

At the

same time, the targets do assume, and are designed to encourage,
further progress toward price stability.

In that sense, they

are a "tight fit."
The performance of the credit markets in 1982 and
beyond, in a framework of disciplined monetary policy, will
be heavily influenced by supply and demand forces other than
the course of inflation and inflationary expectations.


among these is the size of the federal deficit.
Government borrowing and private borrowing compete for
a limited supply of available savings and credit.

That competition

is usually ameliorated in the midst of recession because private
credit demands are reduced.

But a more prosperous economy also

implies much stronger needs for mortgage and business credit;
indeed, sustained recovery of the private economy, and the investment we need to support productivity, is dependent on more favorable
financial market conditions.

It is precisely those more favorable

market conditions that are threatened by prospects for sharply
rising deficits in fiscal 1983 and the years beyond.


of this Committee are acutely aware that all of the familiar
projections, by the Administration, the Congressional Budget
Office and private forecasters, point to historically huge
deficits, assuming the Administration's defense plans are broadly
carried out and no new steps are taken to curtail


- 8 -

spending or raise revenues.

We can debate whether the estimates

of the Administration or the Congressional Budget Office are more

But the point is that there is no disagreement that

deficits would rise to $150 billion and beyond, in a context of a
steadily expanding economy, under either set of assumptions, and
deficits of those magnitudes cannot be acceptable —

not if we,

in fact, want to see the rise in investment and housing we want.
Projecting the federal budgetary position for several
years ahead necessarily involves a range of uncertainty about
spending and tax programs, the level of interest rates, and overall

Moreover, there is

a range of possible outcomes with respect

to our savings potential and sources of funds in the credit markets,
even with given assumptions regarding the GNP.


some general implications of the budgetary outlook as it stands
are clear enough.
In the absence of action, the projected deficits would
be outside the range of peacetime experience for good business
years, whether measured in absolute terms or in relation to
the potential GNP and savings.
In r e c o g n i t i o n


those concerns,

the A d m i n i s t r a t i o n

has proposed large cuts in spending and some measures to increase

Such action would go a long way toward bringing the

deficits down, cutting them by one-half or so in fiscal 1984
according to Administration estimates.

But even with such

forceful action, the size of the projected deficits would remain
large, relative to savings and the GNP, for a relatively prosperous business year.

While a few years in the 1970s appear


roughly comparable, there would appear to be little or no
"safety margin" for meeting expanded investment requirements.

Should the deficit trends be more adverse, as the Congressional
Budget Office suggests, the potential for "crowding out" private
investment would be greater.
A substantial increase in savings could help protect
against the implied squeeze on financial markets.

Indeed, busi-

ness saving is likely to be enhanced substantially by the provisions
of last year's tax bill and personal saving should also be increased
as inflation declines and in response to other incentives.


we also need to remember that the larger savings potential should
not be dissipated in financing government purchases or transfer
payments when our investment needs are so urgent.
The hard fact is we cannot escape a choice —


we want to encourage more favorable financing conditions for the
private sector or whether we are willing to risk seeing our
savings and financial resources diverted in large measure to
financing a federal deficit.
While it is the deficits for fiscal 1983, 1984, and
beyond that loom so large, action is needed now for several

First, as you know, the budgetary momentum cannot be

curbed without planning ahead.

Steps to achieve large reductions

in spending or higher receipts in fiscal 1983 —
off —

need to be put in place soon, and

only six months

measures of spending

restraint should be undertaken during the current Congressional
session to be fully effective in fiscal 1984.


Second, deficits of the projected magnitude are in some
degree self-reinforcing.

Prolongation of high deficits and

high interest rates feeds back into future debt service and
budget expenditures.
Finally, and most important, uncertainties about future
credit market pressures cloud the planning of investors today.
Strong actions taken now to assure that deficits can and will
be reduced as the economy recovers can go far toward galvanizing
investor attitudes in a favorable direction.

Paradoxical as it

may seem in the light of some past economic analysis —


developed when inflation and high interest rates were not a preoccupation —

prospects for recovery can be speeded by decisive

action by this Committee and your Congressional colleagues to
curb future deficits, for the result would be to relieve apprehension in the market that contributes to today's high rates.
As I noted earlier, if enacted, the proposals by the
Administration for deficit-reducing measures totaling over
$55 billion in fiscal 1983 and approaching $85 billion in 1984
would go a long way toward ameliorating the potential problem.
They represent a major challenge to the Congress, but I would
urge upon you the desirability of going even further to reduce
demonstrably the pattern of deficits as the economy recovers.
The appropriate target, it seems to me, would be to restore
the prospect of budgetary balance as a high level of economic
activity is restored.


On purely economic grounds, I believe that lower taxes
will enable the economy to perform more effectively and that
higher marginal tax rates distort incentives and impede economic

But you must weigh many considerations, and I

recognize the choices before you are extremely difficult and
involve detailed considerations of social objectives and
program objectives beyond the purview of the Federal Reserve.
To the extent that the job cannot be accomplished by further
steps to reduce spending growth, I see no alternative but
action to bring the trend of revenues into better alignment
with spending prospects.
In concluding, I would emphasize that the main directions
of economic policy laid out last year seem
appropriate to the challenge before us.

to me broadly

We are making progress

against inflation, and sustaining that progress is fundamental
to a brighter future.

Tax and other policies developed last

year should contribute to a more productive, competitive economy.
Some steps have been taken to slow the strong upward momentum
in Government spending.
At the same time, the agenda for action is clear.


Federal Reserve will maintain the needed degree of monetary

We need decisive action to curtail budget deficits.

As we approach that agenda, I can only be encouraged
by the degree of understanding of the nature and the urgency
of the problems before us.

I believe there is a sense that,

difficult as it is, the Congress and the Administration have
an opportunity in coming weeks to seize the initiative with a


strong budgetary program.

We in the Federal Reserve mean to

do our part in fostering confidence in financial markets.
Together, we can move from challenge to conviction that the
base has been laid for national recovery.