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BANKING, INFLATION AND MONETARY POLICY Address by Theodore H. Roberts President Federal Reserve Bank of St. Louis Before the Midwest Banks Symposium of the Bank and Financial Analysts Association and the Bank Analysts Association Boston, Massachusetts November 3, 1983 This i s a r e a l pleasure f o r me. I always enjoy g e t t i n g together w i t h f i n a n c i a l a n a l y s t s , p a r t i c u l a r l y bank s t o c k ' a n a l y s t s . One o f my e a r l i e s t business assignments was serving as a " f i n a n c i a l analyst." I f o l l o w e d bank and insurance stocks p r i m a r i l y , but I also kept an eye on f i n a n c e companies, savings and loan a s s o c i a t i o n s , and mutual fund management companies. stock back t h e r e . I say " f o l l o w e d , " because we weren't buying much bank I d o n ' t t h i n k i t had q u i t e become acceptable t o buy another bank's s t o c k . A f t e r a l l , you might want t o s e l l i t some day, and then what would i t s management think? Time has sure changed t h i n g s . During those y e a r s , I was a card c a r r y i n g member of the Investment Analysts Society o f Chicago. How w e l l I r e c a l l the i n t r o d u c t i o n of the Chartered F i n a n c i a l Analyst program. A l l the older f e l l o w s were grand- f a t h e r e d as CFA's, and t h e young ones were subjected t o r i g o r o u s e n t r y t e s t i n g , r e q u i r i n g much advance study and concern about f a i l i n g . In r e t r o s p e c t , t h a t was a c l a s s i c case o f how t o use r e s t r i c t i v e e n t r y t o improve the s t a t u r e and value o f membership w i t h o u t s u b j e c t i n g current members t o t e s t i n g standards t h a t might have proved t h e i r undoing. There's probably an analogy t h e r e somewhere w i t h banking, although the bankers' " c h a r t e r c l u b " seems t o have l o s t some o f i t s value l a t e l y . I could make a whole speech about t h e e f f e c t of d e r e g u l a t i o n on banking. Since I understand t h a t others are already doing t h a t at t h i s symposium, I wi". 1 o n l y say t h a t t h e r e are now a l o t of f o l k s outside banking who are s e l l i n g t r a d i t i o n a l banking services and, o f n e c e s s i t y , the cost o f banking l i a b i l i t i e s appears t o be approaching market l e v e l s somewhat f a s t e r than t h e r e t u r n on assets, squeezing net i n t e r e s t margins. Add t o t h a t the r i s k from an enlarged spread between asset and l i a b i l i t y i n t e r e s t m a t u r i t i e s . - 2 - overhead l e v e l s t h a t look much t o o high i n t h i s new m a r k e t - s e n s i t i v e , t e c h n o l o g i c a l l y - o r i e n t e d environment, and you have an increased management challenge f o r bankers--before you f a c t o r i n the monumental challenge of c r e d i t r i s k s i n t h e i n t e r n a t i o n a l and energy s e c t o r s . As a former bank stock a n a l y s t and bank CFO, I marvel at the wealth o f i n f o r m a t i o n which i s now r o u t i n e l y made a v a i l a b l e t o y o u . One o f the biggest problems f o r an analyst today must be deciding what p a r t of a l l i n f o r m a t i o n you receive i s r e a l l y important. f o r some o f t h a t . that In a way, you have t o thank me I was a member of your Subcommittee on Bank Reporting many years ago along w i t h David Cates and others when we f e l t i t was an accomplishment j u s t t o get the banks t o t u r n out a decent earnings statement. Come t o t h i n k o f i t , we may have gone f u l l c i r c l e w i t h t h e SEC!s new required net income format. However, a l l t h i s n o s t a l g i a i s n ' t what I promised Frank Barkocy I would t a l k about t o n i g h t . Somehow, I dreamed up the t i t l e , "Banking, I n f l a t i o n , and Monetary Policy. 1 1 So I had b e t t e r get back t o my s u b j e c t . We have j u s t passed t h e one year mark i n t h i s business recovery. With several broad measures o f business a c t i v i t y now beyond the previous peaks, i t ' s probably f a i r t o s t a r t c a l l i n g i t a genuine expansion. economic gains appear t o be broad-based and w e l l - b a l a n c e d . i t ' s a t y p i c a l c y c l i c a l p a t t e r n i n most r e s p e c t s . inventory l i q u i d a t i o n t o moderate accumulation. O v e r a l l , the You might say, We've gone from severe The consumer s t a r t e d things r o l l i n g by buying houses again when the mortgage r a t e was s t i l l sky high and went on t o automobiles and other hard goods from there as rates came down. A f t e r a pause l a s t surrmer, o v e r a l l r e t a i l sales are r i s i n g again and most merchants are expecting strong Christmas s a l e s . With higher sales, inventory - 3 - levels began to fall and production had to be increased, at first by overtime, then by new hires. is rising. Unemployment has started down and personal income The consumer registers optimism in the sentiment surveys and his borrowing pattern. Even capital spending looks good for this stage of the business cycle, although high real interest rates and tough foreign competition are limiting factors in several basic industries. Labor costs are under good control, and productivity is increasing at a good pace, making possible a moderate 4 percent rise in prices during the past year. I say "moderate11 only in the context of the recent past when inflation rates were 10 percent and higher. Meanwhile, we have the curious situation of relatively high real interest rates despite subdued private credit demand. Businesses are flush with cash from good profits, low inventories, and deferred capital spending. Banks are looking for loans. The principal culprit, of course, is a huge structural federal deficit with no solution in sight even from an economy which reaches full employment. These high real interest rates also attract investment from abroad and hold up the relative value of the dollar in the face of our massive trade deficit. So, we have a vicious circle of high real interest rates dampening prospects for business investment needed to revitalize our basic industries, while increasing the value of our currency which impedes exports and strengthens the competitive position of imports. This environment also complicates the effort to deal with the international debt situation. Our U.S. banks hold about $100 billion of that debt and most of it is in dollars, paying dollar interest rates. You, of all people, know the difficulty several of these countries are having servicing their debt. You also know that our major bank holdings of this debt exceed their capital. - 4 - With t h a t business s e t t i n g as background, what are the prospects ahead? W e l l , f i r s t t h e economy can be expected t o slow i t s r a p i d pace of expansion. Over the y e a r s , we have managed t o s u s t a i n a growth r a t e i n t h i s country o f 3 t o 4 p e r c e n t . As we approach a f u l l e r u t i l i z a t i o n of resources next y e a r , we should see a slowing i n economic expansion t o near t h a t r a t e . I t ' s l a t e r next year and i n t o 1985 t h a t concerns me. We have added t o l i q u i d i t y a t a r a p i d pace since l a s t f a l l , measured by any monetary aggregate t h a t you choose—Ml, f o r example, grew a t a 13 percent pace from the second q u a r t e r o f l a s t year through the second quarter o f t h i s y e a r . Although some w i l l make arcane arguments about how new forms o f t r a n s a c t i o n balances have d i s t o r t e d money measurement and permanently a f f e c t e d income v e l o c i t y , I f e a r t h a t t h e seeds o f higher i n f l a t i o n are already planted i n t h i s excessive money growth and w i l l be r i p e n i n g i n t h e period ahead. Our research at the Fed o f S t . Louis suggests t h a t an i n f l a t i o n r a t e o f 6 t o 7 percent i s l i k e l y by the end o f 1984. Why i s i n f l a t i o n important? Why should we worry about i t anyway? f i r s t reason i s t h a t i t d e s t a b i l i z e s i n t e r e s t r a t e s , p a r t i c u l a r l y rates. The long-term I f lenders expect i n f l a t i o n t o a c c e l e r a t e , they w i l l t r y t o p r o t e c t t h e i r purchasing power by demanding higher nominal i n t e r e s t r a t e s . borrowers, under t h e same circumstances, w i l l pay the higher r a t e s . higher r a t e s w i l l be t r a n s l a t e d i n t o higher hurdle rates f o r investments, i n c l u d i n g stock market v a l u a t i o n s . And These capital You d o n ' t apply the same p r i c e - e a r n i n g s r a t i o s t o stocks when governments y i e l d 15 percent. I t ' s sobering t o consider t h a t stock p r i c e s i n t h i s country are about where they were 30 years ago a f t e r you adjust f o r i n f l a t i o n . the l a t e s i x t i e s and d e c l i n e d t h e r e a f t e r . While we have heard much about record market highs t h i s y e a r , these are o n l y nominal g a i n s . They peaked i n Since real - 5 - stock prices rose steadily in the period from 1950 to the late sixties, why have they fallen over the past 15 years? The chief difference between these two periods is that there was little or no inflation in the earlier period, but generally rising and erratic inflation in the latter period. The old adage about stocks being a good inflation hedge turned out to be dead wrong. A thorough explanation of why this is true is best left for another occasion when time permits a full analysis. You know the principal arguments, of course, about inadequate depreciation charges based on historical cost and dividends being paid out of inflated earnings which often means from capital in reality. Bank stockholders have not been immune from this general decline. real terms, bank stock prices peaked in the early seventies. In Thereafter, for more than a decade, their real value steadily eroded to about 60 percent of the earlier high point. And this measurement ends before the recent sell off reflecting increased specific concern over bank credit quality. In addition to the factors affecting stocks in general, banks suffer in an inflationary period from a net monetary creditor position which tends to erode capital. As interest rates rose under inflation, banks also suffered significant unrealized capital losses from the mismatched "duration" between asset and liability maturity structures. This was also reflected in their income statements as competition from nonregulated competitors paying the prevailing higher market interest rates forced deregulation of bank deposit rates with a resulting squeeze on net interest margins. If inflation is bad for stock values, what can we do about it? are two things that we know about inflation. a monetary phenomenon. There First, inflation is primarily While there are a wide variety of non-monetary factors that influence price behavior from year to year, these influences essentially net out over longer time periods. The chief driving force - 6 - behind inflation is excessive money growth.. For example, from 1954 to 1966, money growth was 2.5 percent per year and inflation averaged 2.2 percent per year. From 1967 to 1982, the money stock grew about 6.4 percent per year and prices rose about 6.5 percent per year. Thus, if we want to determine what causes persistent inflation, we must find out what causes persistent high growth rates in money. Second, we know that changes in money growth have little or no immediate effect on inflation--money affects inflation with a fairly long lag. Our research at the Federal Reserve Bank of St. Louis shows that persistent changes in the money stock are followed initially by changes in real output. It takes roughly three years before the full impact of changes in the money stock show up in prices. Thus, while the long-run link between inflation and money growth is close, the short-run relationship is fairly loose and, at times, tenuous. Accordingly, one should not view the combination of current low rates of inflation and the 11 percent money growth over the past year as an anomaly. The full impact of that money growth should show up in 1984 and 1985 price levels, not in the present ones. The natural question to ask at this point is what precipitated the acceleration in money growth starting in the late 1960s? Those of us with long memories will recall that, around the middle 1960s, fiscal policy decisions were made which entailed greater spending for both domestic and international programs. The rise in expenditures, unaccompanied by higher taxes, produced greater deficits and upward pressure on interest rates. From that time, until late 1979, the Federal Reserve attempted to "lean against11 these interest rate movements. more like spitting into the wind. In retrospect, the net effect was - 7 - In g e n e r a l , monetary p o l i c y i s implemented through supplying and withdrawing reserves o f depository i n s t i t u t i o n s through open market operations. These changes i n reserves produce an expansion or c o n t r a c t i o n of c r e d i t by these i n s t i t u t i o n s . Since i n t e r e s t r a t e s are the p r i c e of c r e d i t , the net i n j e c t i o n o f reserves and subsequent increase i n the supply o f c r e d i t , everything e l s e remaining c o n s t a n t , should cause a downward pressure on i n t e r e s t r a t e s . A net withdrawal o f r e s e r v e s , during periods of downward pressure on r a t e s , holding everything else constant, should produce the opposite r e s u l t s . I f t h i s l i n e of reasoning i s pursued t o i t s logical c o n c l u s i o n , then i t appears t h a t t h e Fed could hold i n t e r e s t rates at some d e s i r e d l e v e l f o r e v e r by simply supplying or withdrawing reserves i n appropriate amounts. U n f o r t u n a t e l y , as we now r e a l i z e , there i s a f a t a l f l a w i n t h i s analysis. The f l a w i s t h a t everything e l s e does not remain constant. In p a r t i c u l a r , supplying or withdrawing reserves has p r e d i c t a b l e e f f e c t s t h a t produce s i g n i f i c a n t changes i n the economy and, not s u r p r i s i n g l y , f i n a n c i a l markets as w e l l . in When reserves of depository i n s t i t u t i o n s r i s e , these i n s t i t u t i o n s a c t i v e l y expand t h e i r loans and investments. In so d o i n g , they also create a d d i t i o n a l checkable d e p o s i t s — t h a t i s , they create a d d i t i o n a l money. And an increase i n the money supply impacts the economy i n p r e c i s e l y those p r e d i c t a b l e ways t h a t I j u s t d e t a i l e d . Initially, it induces an increase i n r e a l economic a c t i v i t y — i n output and employment; u l t i m a t e l y i t produces an increase i n i n f l a t i o n . A decrease i n reserves, o f course, produces opposite and symmetrical changes. Thus, prolonged and repeated attempts t o keep s h o r t - t e r m i n t e r e s t r a t e s from r i s i n g a c t u a l l y produces, over the longer r u n , a c c e l e r a t i n g i n f l a t i o n , higher and more v o l a t i l e i n t e r e s t r a t e s and lower share p r i c e s . - 8 - For example, in a recovery, when credit demands are rising, an attempt to hold interest rates constant by accelerating reserve and money growth, simply fuels the recovery even further. It generates increased inflationary expectations and causes prices and interest rates to rise even higher than otherwise. In an economic contraction, attempts to keep interest rates from falling will produce an even deeper contraction and eventually a drop in interest rates. In other words, attempts to use monetary policy to stabilize short-run interest rates produce, in the long run, unstable prices, unstable employment, and unstable long-run interest rates and lower real stock values—precisely the pattern we have observed, at considerable expense, until recently. Why is this past history relevant today? Because we face virtually the same pressures now that we faced 15 years ago. government deficits, both current and projected. Today we have large Today, although interest rates have currently retreated from the recent peaks, we face projections of higher rates for next year. And, each time interest rates tick upwards, we see increased political and financial market pressure on the Fed to control these rates, to keep them from rising by accelerating credit and money growth. Virtually everyone wants stable interest rates and rising real stock values. You and I, the financial markets, politicians and monetary authorities all do. It is precisely this desire that mistakenly underlies the demands that the Fed should stabilize rates. stabilize the Fed funds rate has a cost: But, attempting to it produces increased fluctuations in long-term rates, accelerations in inflation and reductions in the wealth of shareholders. It has produced 15 years of real stock market losses. - 9 - Should monetary p o l i c y attempt t o d i r e c t l y s t a b i l i z e short-term i n t e r e s t r a t e s or t o i n d i r e c t l y s t a b i l i z e long-term r a t e s by d i r e c t l y focusing on longer-term money growth? Where do the greater costs l i e ? W can continue t o demand s t a b i l i z a t i o n o f s h o r t - t e r m i n t e r e s t r a t e s . e But then we ought t o remember t h a t chances f o r r e a c c e l e r a t i o n of or appearance of recession increase s u b s t a n t i a l l y . inflation Neither of which would bode w e l l f o r the stock market. I , f o r one, p r e f e r long-term i n t e r e s t r a t e s t a b i l i t y and r i s i n g r e a l stock values. This can be achieved only through s t a b l e money growth and lower i n f l a t i o n . While we may debate endlessly the d e f i n i t i o n of money and what happens t o v e l o c i t y , even an e l u s i v e monetary t a r g e t i s preferable t o attempted s t a b i l i z a t i o n o f s h o r t - t e r m i n t e r e s t r a t e s . In summary, i f we want t o have stock markets t h a t are e f f i c i e n t , that perform t h e i r f u n c t i o n o f channelling savings i n t o long-term investments, and t h a t increase the wealth o f shareholders over t i m e , we must maintain low and s t a b l e r a t e s o f i n f l a t i o n . And t h a t cannot be achieved by a monetary p o l i c y t h a t reacts t o every wiggle o f the f e d e r a l funds r a t e ! Our present s i t u a t i o n appears t o be an o p p o r t u n i t y t o accomplish everyone ! s desired o b j e c t i v e - s u s t a i n e d economic expansion w i t h o u t undue inflation. The economy i s doing w e l l . I n f l a t i o n i s subdued, and the monetary aggregates are squarely w i t h i n t h e long-term p o l i c y bands set by the Federal Oper, Market Committee. In my o p i n i o n , t h e best way t o keep them t h e r e i s t o concentrate on management of reserve growth--not the l e v e l of s h o r t - t e r m i n t e r e s t r a t e s — s i n c e , over t i m e , t h i s w i l l determine money supply growth. This i s a two-way s t r e e t . I f money growth lags f o r too l o n g , we could p r e c i p i t a t e a r e c e s s i o n . - 10 - As I review the changes in the principal monetary aggregates, I note that t h e i r rate of growth has slackened in each successive month since May. However, I also note that growth of the monetary base has picked up considerably since i t s low point in July. This leads me to conclude that growth of the monetary aggregates w i l l increase at a more appropriate rate i n coming months. I leave i t to you t o decide what t h i s means f o r interest rates and the stock market. One of the offsets to what is euphemistically termed the "public sector discount11 to Federal Reserve Bank Presidents salaries is the f a c t that we don't make our l i v i n g predicting interest rates and stock prices.
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