View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

For Release on Delivery
Expected at 1:00 p.m. (E.D.T.)
September 5, 1979

Statement by

Paul A. Volcker

Chairman, Board of Governors of the Federal Reserve System

Before the

Committee on the Budget

House of Representatives

September 5, 1979

Mr. Chairman, members of this distinguished Committee:
I am pleased to be able to participate in these hearings on the
Second Concurrent Budget Resolution for fiscal 1980.

I might say that on

receiving your invitation, I felt it a bit incongruous that my first appearance before a committee of the House as Chairman of the Federal Reserve Board
would occur in the context of consideration of fiscal, rather than monetary,

But the plain fact is that our nation faces serious problems that

require interrelated governmental action, involving all of the main instruments of economic policy.

No place are the interrelationships more important

than in the area of fiscal and monetary policy.

I hope that our dialogue

this afternoon will help throw light on the proper role for those instruments
in today's setting.
Surveys and other evidence indicate that the most pressing economic
concern of the American people today is the persistent and rapid rise of

In n y judgment, that concern is not misplaced.
As you know, the acceleration of inflation this year can be traced

in considerable part to so-called exogenous forces—the rise in food prices,
and much more importantly the decision of the OPEC countries to raise oil
prices in an amount that, in absolute terms, approaches the increase in 1973
and 1974.

But even in appraising these sources of inflationary pressure, I

believe it would be wrong to consider them independent of more general
inflationary pressures in the United States and elsewhere.

For instance,

the desire of oil suppliers to recover losses in real income implied by rising
prices of other goods and the weakness of the dollar appeared to be one factor
contributing to the OPEC pricing decision.

Moreover, part of the challenge to

- 2 -

economic policy today is to avoid to the extent possible a kind of "leapfrogging" process whereby rising prices and costs in one sector—energy is
the notable case--set off a whole sequence of adjustments in wages and
prices in Other sectors as workers and business engage in a vain attempt to
achieve and maintain levels of real purchasing power that simply cannot be
sustained in an economy experiencing higher real energy costs and virtually
no growth in productivity.
To be sure, the impact of inflation is juneven.

Those on fixed

incomes suffer, while some people who are well positioned—either by clever
design or by good luck—do manage to increase their wealth.

Even for the

fortunate, however, such a result is at best precarious, frequently built
on heavy indebtedness or highly speculative investments.

In an environment

of virulent inflation, such as we find ourselves in today, there are no
reliable havens, and so the discomfort of our citizens is hardly surprising.
Even these capricious effects on individuals and the related concern reflected in the surveys do not capture the insidious and debilitating
effects of inflation and inflationary expectations on our economic performance
and growth prospects.

It is not entirely a coincidence that we can observe

in these recent inflationary years a declining tendency in the profitability
of investment.

Calculations differ because of the accounting problems asso-

ciated with changing prices.

However, one estimate indicates that the

annual after-tax return on corporate net worthy measured, as it reasonably
should be, against the replacement cost of inventories and fixed assets,
has averaged 3*8 percent during the 1970s, a period characterized by rapid
inflation, as compared to 6.6 percent in the 1960s.

At the same time,

the uncertainty about future prospects associated with high and varying

- 3 -

levels of inflation tends to concentrate the new investment that does take
place in relatively short, quick pay-out projects.

Or firms may singly

delay investment commitments until the pressures of demand on capacity are
unambiguously compelling—with the result that capacity pressures can become
strong even before the labor force is fully utilized.
In other areas, inflationary expectations are reflected in a
diversion of energies into essentially speculative activities—ranging from
the "froth" of investing in art objects to the considered purchase, at the
expense of heavy indebtedness, of larger or second homes as an inflation hedge.
When returns from these activities are often judged greater than from usual
patterns of work and saving, normal incentives are plainly distorted in a
manner inconsistent with orderly growth.
Another obvious result of our distressingly poor price performance
has been the recurrent weakness of the dollar in foreign exchange markets.
During much of 1978, the cumulating decline in the value of the dollar abroad
added an important further element of uncertainty and instability to the
United States and other economies.

Following the vigorous program intro-

duced in November of last year, the dollar rose somewhat against other
major currencies, helped by an improvement in our current account and by
indications of a relative strengthening of economic expansion abroad.


the value of the dollar internationally began to be questioned again as
the trend of U.S. inflation worsened noticeably, and as many of our trading
partners acted forcefully to retard inflationary tendencies in their own

Although the situation in exchange markets appears to have

stabilized recently, that stability ultimately rests on our ability to
cope with inflation.

- 4 -

We need to deal with inflation and a vulnerable dollar in the
context of the slowing in domestic economic activity that developed in
recent months.

A moderation in the growth of aggregate demand was welcome

this year—even essential—if the economy was to avoid the kind of pressures
on capacity that could only aggravate inflationary forces.
monetary and fiscal restraint were directed toward that aim.

Policies of
Now it is

apparent that the drain of purchasing power implicit in the sudden run-up
in our oil import bill and in energy prices generally—•combined with the
actual and feared shortages of gasoline—has led to a contraction of real
inaomes and final demands.

During the second quarter, real gross national

product fell, primarily reflecting a drop in consumer spending, and further
declines in some areas of business activity continued into the summer.


sales falling, businesses have experienced some involuntary accumulation of
inventdries^—most strikingly in the auto industry, but to a lesser degree
in other sectors as well.
Our reading of the most recent economic indicators suggests that a
correction of these inventory imbalances is well under way.

Orders have

been reduced, production schedules have been cut back, and hiring has

These adjustments need not by themselves set in motion a deep or

prolonged contraction in activity.

Indeed, while the inflationary process

itself has introduced important new uncertainties, some of the economic and
financial dislocations and imbalances that usually have presaged severe
cyclical declines have been avoided.

To be sure, the transfer of income to

foreign oil producers will continue to exert a depressing effect on aggregate
demand over the near term.

But the position taken in the Board's midyear

- 5 -

report to the Congress—that the economy should grow moderately in 1 9 8 0 —
still seems reasonable.
In the present circumstance, we need to be especially cautious in
interpreting any business forecast; there are vulnerabilities in the present
situation on the downside, and there is also the possibility that the downturn
will prove shorter and shallower than many now expect.

The shaping of policy

must appreciate and take account of the risks on both sides.

For instance,

the traditional response throughout the postwar period to any prospect of
declining production and rising unemployment has been a sharp shift in
monetary and fiscal policy toward expansion and the enhancement of aggregate
demand—even at the risk of adding to inflation.

A decade or two ago, with

prices historically fairly stable, that risk was discounted.

But now we

have to face squarely the adverse consequences of premature or unduly large
moves to stimulate the economy.

In exacerbating the already serious problems

of inflation and the dollar, such moves would also feed back on the underlying
problems of investment, productivity, and growth.
Some observers have suggested that this situation presents an
intractable dilemma for policymakers: the need to sacrifice one set of
economic goals in the pursuit of another.
apparent than real.

But this dilemma seems to me more

Even in the relatively short run, premature stimulative

actions could well prove ineffective rather quickly, and even counterproductive, as their force is dissipated in higher prices rather than real
growth—in more uncertainty, rather than less.

Ultimately the perceived

"trade-off" between unemployment and inflation would only be worsened.


is the lesson of the 1970s, not just in the United States but elsewhere.

I think we would all agree that, over the years, labor and product
markets have developed an increasing sensitivity to inflation.


about inflation are an important factor in wage bargaining, in price setting
for many goods and services, and certainly in interest rates.

The plain dan-

ger is that actions rightly interpreted as doing little or nothing toward
dealing with our underlying persistent problems of productivity and investment,
but all too likely to produce more inflation, will in fact have only a small
and short-lived expansionary effect, regardless of their intent.

Our ability

to avoid future instability in employment, or to deal with chronic unemployment in urban areas and among our young, would be damaged, not enhanced.
Similar behavior dominates the foreign exchange markets: exchange
rates usually respond quickly—and sometimes excessively—when incoming
economic data or news about policy actions alter the outlook for inflation.
Adverse repercussions on the dollar generate in turn new uncertainty and
inflationary pressures, partly because of the direct effects on costs of
imports and partly through the reduced competitive restraints on prices of
domestically produced goods.

We have tasted too much of the vicious circle

of domestic inflation and external depreciation to want to see that pattern

The dangers would extend beyond the domestic economy.

Because of

the dollar's role as an international store of value and medium of exchange—
a role we cannot simply shrug off or dismiss consistent with our own interests
and those of our trading partners—its instability could pose a major threat
to the world system of finance and commerce and even to our political leadership.
Obviously, then, our current economic difficulties are tightly

They will not be resolved unless we deal convincingly with

- 7 -


Progress won't come easily or suddenly; among other things the

adjustment in prices of energy and petroleum-based products is far from

But what we can do—what we must do—is begin the process and

prevent the inevitable rise in real energy prices from fanning out into an
acceleration of general inflation.
Monetary and fiscal policies are not the only tools we should bring
to bear.

But both monetary discipline and fiscal discipline—policies that

are seen to be disciplined—are absolutely basic to restoring and maintaining
a greater sense of stability.
For its part, the Federal Reserve intends to continue its efforts
to restrain the growth of money and credit, a growth that in recent months
has been excessive in terms of our own 1979 objectives—objectives that
have only recently been reviewed by our Congressional oversight committees.
Those efforts, combined with heavy credit demands, have had the visible
consequence of some increases in short-term interest rates as the availability
of reserves has been limited through open market operations.

But I would also

note that the impact on longer-term securities markets, generally considered
more important for business decisions, has been small.

We seem to have here

an illustration of the more general proposition that actions to deal with
the sources of inflationary pressure should over time have a constructive
influence in restoring more stable and healthier financial and economic
I frankly do not know whether needed restraint on monetary growth
will be reflected in further increases in short-term rates; that will depend
on the course of economic activity, credit demand, and other factors.

But I

- 8 -

do know that credit flows at present are generally well maintained, and no
sustained decline in nominal interest rates can reasonably be expected in
the absence of a discernible slowing in the underlying trend of inflation.
Meanwhile, the moves in the direction of fiscal restraint by the
Congress and the Administration have been a key ingredient in setting the
stage for a successful anti-inflationary effort.

Substantial progress has

been made in the past year toward reduction of the federal budget deficit.
Potentially more significant, in terms of the longer-range outlook, is the
sense of greater control on spending that has been achieved by the efforts
of this Committee and others.
Of course, the deficit has remained high, even after years of
business expansion, and reductions in spending relative to GNP have been
modest so far.

Moreover, with the economy likely to be sluggish in the

months ahead, the operation of automatic stabilizers could lead to a temporary widening of the gap between expenditures and receipts.

That in

itself need not be disturbing—if budgetary decisions do not seem to throw
us off the track of restoring budget balance and restraining expenditures
as the economy picks up.

However, legitimate doubts would be raised

by sizable new spending programs not matched by savings elsewhere; indeed,
such an approach would directly challenge our ability to eliminate future
deficits and could only add to skepticism over the commitment to contain

Similar doubts would be aroused by a premature commitment to

tax reduction—welcome as such reductions would be over a period of time.


believe that we should be particularly wary of tax reductions that might have
a transitory effect in adding t< the puir&hasing power of consumers but that
would accomplish little or noQiifii tawsard stimulating investment, cutting

- 9 -

costs, or improving work incentives.

For these reasons, the members of the

Federal Reserve Board believe both the Administration's budget proposals
and the Second Concurrent Budget Resolution recommended by the Senate
Budget Committee represent a broadly appropriate and desirable commitment
to hold the line on spending, to avoid premature tax cuts, and to contain
the size of the deficit.
As I noted earlier, a broad range of uncertainty must be assigned to
any forecast of economic events, particularly in view of the obvious vulnerability of the economy to a variety of exogenous forces.

In that connection,

we cannot entirely exclude the possibility of recessionary tendencies cumulating and intensifying, even if it would be wrong to have current policy
decisions dominated by that single possibility.

There is much more danger—

in terms of aggravating the inflationary momentum—in prematurely anticipating
the most unfavorable hypothesis than in dealing in the most orderly and
effective way we can with the clear and present fact of inflation.
Should economic trends develop in a clearly unfavorable direction
and action come to be needed to deal with sharp declines in output and
employment, it would be crucially important that those actions be integrated
with the longer-term needs of the economy.

Specifically, any fiscal actions

should be designed to minimize any inflationary impact in the short run
while helping to deal positively with some of the sources of inflationary
pressures in the long run.

Cost-cutting and incentive-building tax reductions

broadly meet this criterion; few spending programs do.

We need to give much

more weight than in the past to the need for both tangible capital formation
and research and development, for these aqtivities underlie productivity

- 10 -

I need not emphasize that even well designed tax reduction—reduction that could have important payoffs over time in improved productivity and
reduced cost pressures—has a cost in terms of transitional deficits and
increased competition in the credit markets.

Tax reduction, however desir-

able over time, needs to be earned by a sustained commitment to spending

Prematurely timed or poorly structured, the potential gains could

be swamped by adverse effects in an inflation-prone economy.
The monetary and budgetary policies that I have discussed seem to
us in the Federal Reserve essential if our commitment to controlling inflation
and stabilizing the dollar is to have meaning.

They would lay the groundwork

for changing expectations about inflation in the short run and for renewed
growth and stability over a longer period of time.

I would emphasize that

other efforts, in the areas of wage-price policy, regulatory reform, and the
encouragement of market competition, are important as well.

We also must deal

with our energy situation, one that today leaves us vulnerable to foreign
sources of supply.

But none of these policies, important as they are, can

substitute for commitments to fiscal prudence and restraint on the money
Public concern is high—but out of that concern grows awareness of
the pressing need to solve our inflationary problem.

Therein lies our oppor-

I would suggest the American people are coming to understand that

there are no easy answers, but that failure to act consistently and forcefully
can only lead to worse results, both for the vitality of our economy and for
our world leadership.
the process.

Your budget making is quite clearly a key element in

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