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2:15 p.m., EST
April 23/ 1985________

Current Issues in Monetary Policy

Preston Martin
Vice Chairman
Board of Governors of the Federal Reserve System

Presented at
National Foreign Policy Conference
Department of State
Washington, D.C.

April 23, 1985

Current Issues in Monetary Policy
Preston Martin
at the National Foreign Policy Conference
Department of State
Washington, D.C.
April 23, 1985

This is an especially appropriate time to meet to discuss
foreign policy issues because of the growing recognition of the cumu­
lative effect of iirport competition upon our economy and indeed our
whole society.

The current estimates of sluggish domestic economic

activity are evidence of the stepped up inpact of imported goods and
services on the U.S. economy.

Financial markets are adjusting to the

realities of massive foreign investments and the very idea of the
United States as a debtor nation.

The Eurodollar markets offer alter­

native sources of funding for companies like yours.

Finally, Treasury

Secretary Baker proposed further discussion of certain aspects of
international monetary matters at the OECD annual meeting in Paris.


there exists anyone who is not aware of international interdependence
today, let him contemplate Friday's news report of the rise in Swiss
Franc futures following news in the U.S. of slcwer-than-expected first
quarter real GNP growth!
The strength of the dollar and the changing conditions in
world financial markets are important considerations in both the struc­
turing and the implementation of U.S. nonetary policy.

In explaining

the circumstances leading to the two discount rate reductions within a
month of each other at the close of 1984, our Board was careful to
acknowledge the high level that then prevailed for the trade-weighted

dollar and also cited declines in commodity prices.

Similarly, the

Federal Reserve is aware that the high level of real interest rates in
the U.S. affects real rates in the markets of our trading partners
through the linkage of global investment decisions.

In turn, high

interest rates in Europe and market pressures for deregulation in Japan
affect growth rates in those countries, and thus your markets there.
Important as interest rates and foreign exchange market con­
ditions are, Federal Reserve policy objectives for 1985 emphasized dis­
inflation and sustaining the economic expansion, without differentiat­
ing them as to priority.

Target ranges were enunciated for three mone­

tary aggregates, and a monitoring range was specified for the growth of
domestic credit.

As in previous years, in each case, target ranges

were specified rather than a single growth rate, to preserve a degree
of flexibility in executing policy in a world characterized by unex­
pected developments.

Indeed, an important point of deliberation at the

February Federal Open Market Carmittee meeting was a concern that there
could be need for flexibility this year, as one or more of the monetary
aggregates moved along or somewhat above the upper boundary of its
range, especially early in the year.
Of course, our Conmittee's expectation was that the specified
ranges were consonant with feasible progress for the economy, a central
tendency of 3-1/2 to 4 percent for real GNP growth with stable infla­
tion, and some improvement in the unemployment rate.

As 1985 develop­

ments have disappointingly unfolded, the short-run demand for money has
grown rapidly conpared with GNP, as indicated by sluggishness in the


turnover of money— the so-called velocity of money— as I will explain a
little later.
The Framework of Monetary Policy
As you know, the Federal Reserve formulates and implements
policy primarily in terms of target ranges for growth in the monetary
aggregates (Ml, M2, and M3), and with an eye on growth in total domes­
tic nonfinancial debt.

We give narrower money measures, Ml and M2, the

most weight because they are found to have the most reliable relation­
ships with GNP and prices.
The inherent lags in monetary policy's impact on the economy
are an important reason for focusing on monetary aggregates. The con­
duct of policy is complicated by a normal lag of frcm 3 to 6 months
frcm policy actions to the subsequent growth in output, and of some­
where around 1-1/2 years to their associated effects upon inflation.
Because of these lags, it is not feasible to conduct effective policy
by looking only at current economic developments.

Such a policy would

be "fine tuning," overly reactive, and it could be destabilizing if
pursued on a quarter-to-quarter basis.

So the decisions made by the

Fed so far this year are relevant to real growth later in the year, but
are not likely to affect disinflation until after mid-1986.
But while recognizing the importance of the monetary aggre­
gates, it also seems to me that an eclectic approach to policy serves
the public interest best— it does not make sense to "throw away" infor­
mation or to follow mechanically any one school of thought.

Thus, in

addition to monetary variables, one looks at the myriad of monthly and

gutterly statistics on the progress of the economy, including indica­
tors of international economic developments.

Any well-reasoned discus­

sion of plans for policy in 1985 obviously must involve evaluation of
current economic conditions, and a variety of "leading indicators."
Let me turn, therefore, to the economic outlook.
Economic Outlook
It is widely recognized that over longer time spans, infla­
tion is a monetary phenomenon, and that the central bank can best con­
tribute to disinflation by reducing money growth rates gradually over a
period of years.

Since 1979, when monetary aggregates were emphasized

by the Fed, inflation has been reduced significantly from 9 percent in
1981 to around 3-1/2 percent in 1984 (as measured by the GNP deflator).
Along with the decline in recorded inflation, there also appears to
have been a drop in expected inflation.

The March 1984 "Decision

Makers Poll" by Richard Hoey and Helen Hotchkiss, for example, shews
10-year inflation expectations having dropped to 5-1/2 percent compared
with a peak of almost 9 percent in 1980.
Hie probability of inflation reaccelerating this year, or
even next year, seems smaller than has been characteristic of recent
expansions, and inflationary forces may even have sate downward momen­
tum, on balance.

Wäge inflation and productivity are among the most

important factors in the outlook for disinflation.

For 1984 as a

whole, favorable developments in compensation per hour and productivity
produced an increase in unit labor costs of about 1-1/2 percent in
1984, compared with a very high 9 percent average increase in 1978-82.


These trends seem likely to continue. Wages in major union contracts
agreed to last year were down even from their relatively low 1983

A respectable band of analysts now thinks that productivity is

on a new higher trend line, up frcrn its sluggish performance in the
On balance, the degree of slack in world markets for the fac­
tors of production also is favorable for disinflation.

In the U.S.

labor market, the civilian unemployment rate stood at a high level of
nearly 7-1/2 percent in March.

For total U.S. industry, the utiliza­

tion rate currently is well below its average or "full" utilization
value of the previous 15 years.

Moreover, excess capacity abroad also

keeps downward pressure on U.S. prices, since this capacity may be
"passed through" to U.S. consumers through a surge in imports.
Ccranodity prices and exchange rates have also applied down­
ward pressure to inflation in recent years.

Prices of industrial mate­

rials have fallen by about 14 percent over the past year.

In one im­

portant area, oil prices, the risks may still be somewhat on the down­
side, even given OPEC's recent steady performance.
Of course, a worrisome factor for reinflation is a possible
sharp, sustained decline in the value of the dollar.

The rising dollar

thus far in the 1980s, of course, has put downward pressure on infla­
tion but has contributed to massive trade deficits, which have helped
finance federal budget megadeficits and kept real interest rates in the
U.S. lower than they would otherwise have been.

The majority of ana­

lysts argue that the dollar eventually must decline by a significant


amount of its own weight, if large trade deficits persist.

They argue

that foreign portfolios eventually will become saturated with dollardencminated securities, and that as a consequence the demand for dol­
lars will fall.

B u s is a sensible argument; but the all important

question is of timing, about which unfortunately little seems to be

Will the saturation level be reached this year, in 2 years, or

in 5?
The dollar, in fact, has declined rather sharply in the last
six weeks or so.

There is no good evidence to attribute this decline

to the saturation of foreign portfolios with U.S. securities.

It also

seems unlikely to me, by the way, that it was primarily a function of
central bank intervention in the foreign exchange markets.


stemming from the Versailles summit indicate that such intervention
appears to have limited power to overcome fundamental factors affecting
exchange rates, although intervention can from time to time be benefi­
cial in stemming disorderly exchange rate movements or in reinforcing
market strength or weakness if used selectively.
Changes in several fundamental factors seem to have contrib­
uted to the dollar's decline.

One was the growing perception in the

markets that the U.S. economic growth had weakened somewhat, and thus
that the chances of the Fed tightening monetary policy had diminished.
In addition, the Ohio thrift situation raised the prospect in the minds
of some market participants that the stability of the U.S. financial
system might not be as absolutely secure as previously thought.


it was clear that the Ohio situation was delimited, this influence on
exchange rates seemed to wane.


Nevertheless, this experience serves to warn us of the impor­
tance of the safe-haven motive for holding dollars, and highlights the
difficulty in anticipating exchange rate movements in detail.

As I

mentioned, this uncertainty about exchange rates raises doubts about
future inflation.

A decline in the trade-weighted dollar erodes the

profit margins of foreign vendors and perhaps those of their distrib­
utors in the U.S.

This process is not likely to produce instant infla­

tion, however, as sellers may accept smaller margins on sales to hold
their shares of U.S. markets.
Finally, let me note that some analysts became concerned that
reinflation was suggested by the Conroerce Department's "flash" estimate
for the first quarter of this year which showed the OSIP deflator
advancing at a 5-1/2 percent rate (confirmed by the revised estimate
released last week). However, this should not be overemphasized, since
in large part it reflected distortions due to large shifts in the com­
position of inports.

A more accurate picture is given by the gross

domestic business product fixed-weight price index, which increased at
a lower 3-3/4 percent rate in the first quarter.
Turning to the outlook for the real economy, there seems to
be a reasonable chance that GNP will shew a healthy but moderate in­
crease for 1985 as a whole, hopefully enough to avoid a growth reces­
sion (defined as slowly rising GNP and a rising unemployment rate later
this year).

In broad terms, this possible outcome seems to be sup­

ported by reductions in real interest rates since mid-1984, and recent
rapid growth in the monetary aggregates.

Despite increases in long­


term interest rates in the past two months, the inflation-adjusted 10year Treasury rate still is over 100 basis points below its May 1984

Although Ml decelerated in March, it has grown at a rapid 10

percent rate since last October 1984.
However, a growth recession must be considered a real threat.
In fact, the data currently available suggest that the economy is on
the edge between healthy, sustainable growth and a growth recession.
If the Coranerce Department is roughly correct in its 1-1/4 percent
estimate of first quarter real GNP growth, the economy has advanced at
only about a 2-1/2 percent rate over the past three quarters.

I am not

aware of solid analysis suggesting that 2 percent growth would produce
a perceptible reduction in unemployment rates.
Hie index of leading economic indicators also presents a
mixed picture of the future.

Despite recent strength, the index still

is below its peak of last May.

The sharp rise in new orders for nonde­

fense capital goods in February was encouraging.

However, one should

not become too optimistic since these orders had fallen on balance over
the previous two quarters.

Hie sharp increase in housing starts in

March might be considered encouraging, except that nearly all of the
increase came in multi-family units.

Given the apparent overbuilding

in U.S. submarkets, it is difficult to see how the most recent high
level of starts can be maintained.
In the first two years of the recovery, the strong dollar and
the associated trade deficits were considered by many to be an "engine
of worldwide expansion" whereby our trading partners could stimulate


tardy recoveries, and a source of dollar exchange for less developed

But, as our trade deficits have escalated to unprecedented

levels, the dialogue has turned to the loss of American production and
jobs, seme of which appears to be permanent.

To the extent that sec­

toral imbalances adversely affect the prospects for growth in the U.S.
economy, it will be especially burdensome for future "debtor-nation"
generations to pay off the large debts, seme of which are owed to for­

Thus the strong dollar not only is one source of uncertainty

about price developments as I mentioned earlier, but also about trends
in the real economy in the near term and beyond. *
The Monetary Target Ranges and Velocity
The outlook I have just described— essentially risky for
economic growth, with a chance of further disinflation— conditions an
interpretation of the target ranges for the monetary aggregates in

The 4-7 percent range for Ml involved a one percent reduction

from 1984 in the upper boundary, while M2's 6-9 percent range was un­
changed from last year; and there were slight increase in the ranges
for M3 and domestic credit.

Congressional testimony by Chairman

Volcker included the caveat that one or more of the aggregates might
grow in the upper parts of their ranges during the.year.


Reserve charts show the ranges as moving within parallel bands, in
addition to the cones or wedges displayed in the past.

The parallel

bands give room for faster money grewt^ early in the year than do the


The reduction in the Ml range is consistent with the Fed's
policy of disinflation, of gradual reductions in monetary growth over
the long run.

Even in the case of Ml, growth in the upper part of the

range would exceed the 5-1/4 percent growth rate last year.

Ml grew at

a 10-1/2 percent rate in the first quarter compared with its 7 percent
upper boundary, and M2 grew at a 12 percent rate compared with its 9
percent upper boundary.
These observations naturally raise a question about the
thrust of policy:

now that inflation seems to be better under control,

is the Fed implicitly or subtly deemphasizing its objective of further
reductions in the inflation rate?

Not at all.

My main point this

afternoon is that there are solid technical reasons for these changes
in monetary ranges and for the flexible implementation of policy exer­
cised thus far this year, which do not indicate complacency about in­

In fact, in the February FCMC directive, I supported somewhat

higher upper boundaries for the narrow aggregates than those adopted,
in order to reduce the risk that the economy could slip into a growth
My main reason for this view is that the velocities of those
aggregates, the ratios of GNP to Ml and to M2 respectively, may grow
more slowly than their historical trends.

This would mean that faster

money growth would be necessary to achieve an acceptable rate of eco­
nomic growth; it does not mean taking one's eye off the danger of rein­


The megadeficits in our balance of trade and in our federal
budget complicate the problem of forecasting velocity and thus money

If significant progress is made in reducing the budget deficit

this year, interest rates might fall and this could further reduce

Even if the budget deficit is not reduced substantially this

year, a continued trade deficit and the associated inflow of foreign
savings could put downward pressure on interest rates.


if the dollar continues to fall as it has in recent weeks,
begin to put sane upward pressure on interest rates.

this could

There are too

many uncertainties attached to the domestic and international situation
to forecast interest rates with certainty and in turn to anticipate the
impact of changing rates upon velocity.

However, on balance, I would

not be at all surprised to see flat or even slightly declining velocity
for the year as a whole.

Certainly the results for the first quarter

have moved things in that direction.
Policy Implication
A prolonged decline in velocity would require a comparable
period of rapid money growth to avoid an overly contractionary monetary

Thus Ml and M2 easily could have to exceed their upper boun­

daries in 1985.

To illustrate this point consider one of many possible

outcomes— a 7 percent increase in nominal income growth this year.


Ml and M2 velocities grow at their expected trend rates, this would
require about 6 percent Ml growth, and M2 growth of about 7 percent.
If, for example, interest rates are unchanged on balance over the year,
the negative cyclical-velocity component coming from last year's


interest rate declines would most likely hold Ml and M2 growth to sctnewhat above their respective 7 and 9 percent upper boundaries.
And this is precisely my point:

such rapid monetary growth

during a period of declining velocity and reasonably stable interest
rates would not inevitably lead to a reacceleration of inflation.

As I

have said, the more rapid money growth would be necessary to counteract
the contractionary effects on real GNP of weak velocity.
following the 1982-83 surge in Ml support this point.

The events

Partly in

response to a large decline in velocity in 1982 and early 1983— which
in my view was in good measure a response to the decline in inflation
and interest rates in 1982— the Fed permitted rapid Ml growth.


then, money growth rates have been much more moderate, and there was no
increase in inflation.
A decline in the income velocity of the narrow aggregate
associated with the recent drop in interest rates or any possible
future decline also would not imply permanent distortions in the moneyto-income relationship.

The distortion would occur only during a tran­

sition period, in which the public's demand to hold money would rise to
a higher level, in response to interest rates falling to a lower level.
It could take a year or so for this adjustment to be completed, after
which VI should resume more normal rates of growth, as in 1983-84.
We have what I consider a splendid opportunity to continue
along a path of healthy economic growth, with low rates of inflation.
There are some signs of somewhat faster expansion in the economies of
our trading partners.

However, greater convergence in fiscal and even

monetary policies is still a goal to be further pursued.

The interde­

pendence of the global economy among both the developed as well as the
developing nations demand no less.

The opportunity for a prolonged

period of growth is important enough to warrant exercising the flexi­
bility in the conduct of national policies necessary to attain such a
desirable end.