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Frorn: Federal Reserve Bank of Cleveland
Cleveland, Ohio 4410I Tel: Z4l -2800
MONETARY POLICY IN A CHANGING WORLDII
Braddock Hickrnan, President
"V. Reserve Bank of Cleveland
Federal
By
(Fotlowing is the cornplete text of a talk to be
given by Mr. Hickrnan to students, bankers,
and faculty rnernbers at the Ohio State University on Wednesday afternoon, May 3, 1967,
His talk was one of a series of I'Distinguished
Lectures on Bankíng and Monetary Policyrr
sponsored by the Ohio State University and the
Ohio Bankers Association. )
RELEASE: THURSDAY AMs, and After ,
I arn delighted to
be
Il;/.ay
4,
1967
with you today, and honored to participate in the series
of ¡rDistinguished Lectures on Banking and Monetary Policy.'1
Before launching into the rnain part of rny talk, let rne ernphasize how
irnportant the university and the scholar are in the general scherne of things today.
I arn referring specifically to you students andteachers, and your counterparts in
other colleges and universities. Although sorne rnay dispute it, I personally
believe that the solutions to rnost of our social, political, and econornic problerns
wiII be found through higher education and research-related activities,
rnore
-zThe irnportance of the university in the rnodern world has long been
recognized by cornrnercial bankers in Ohio, as well as by the tr'ederal Reserve
Bank of Cleveland. The joint sponsorship of this eeries of lectures by The Ohio
State University and the Ohio Bankers Association points up the key role of the
university ín the thinking of cornrnercial bankers. These lectures are, in effect,
a cross-pollination of ideas, a dialogue between bankers and scholars about the
rnajor problerns of banking and rnonetary policy. Hopefully, they will prornote
rnutual understanding of basic difficulties, identification of the significant variables relating to thern, and ultirnately solutions to sorne of the cornplex questions
that are puzzlíng us today.
MONETARY POLICY AND UNCERTATNTY
My topic today is otMonetary Po1icy in a Changing 'World. ¡' More precisely,
it should be ca1led t'Monetary and FiscaI Po1icy in a Changing World,rr since
one cannot be discussed without the other; but
the
I will try to ernphasize rnonetary
policy and thus conforrn rrlore closely to the title of the lectures. I shall touch
briefly and inforrnally
on the elernentary textbook theory of
fiscal and rnonetary
policy and indicate sorne of the problerns that arise when we atternpt to apply pure
theory in a world of uncertainty and change. I shall then review the record of
recent years and point out sorne of the errors that I think have actually been rnade
in this area. And finally, I sha1l identify what seem. to be the principal sources
and causes of the
errors.
rnore
-3Let us start with the conventional wisdorn as it is described in the
elernentary textbooks. There is today alrnost cornplete agreeûrent that rnonetary
policy and fiscal policy share the sarne general objectivesi to help the econorny
achieve econornic growth without inflation and with reasonable equilibriurn in the
international balance of payrnents. The textbooks tell us further, that an
appropriate rnix of rnonetary and fiscal policy is needed to achieve these objectives.
On sorne occasions,
it rnay be desirable to have a little rnore fiscal policy and a
littte less rnonetary policy, and on sorne occasions, the reverse. But the point
is that the state of the economy is assurned to be known with alrnost cornplete
certainty, so that there is virtually no uncertainty about the appropriate econornic
policy rnix.
A nurnber of problerns arise when we atternpt to apply textbook theory i,n
practice, due largely to the difficulty of predicting econornic events. The econorny -instead of rnoving along a steady path at a constant rate of growth - - rnoves at
a
constantly changing rate, which is difficult to forecast accurately. This is not
reaIly surprising since the principal pararneters of the econornic systern are not
rea1ly stable, econornic relationships are not fully understood, and unexpected
developrnents affect the systern at various tirnes and in various \Mays" As a
general rnatter, rates 'of growth of population change over tirne; technologically
deterrnined production functions change with innovations; and consurnersr attitudes
and tastes shift
erratically. Most irnportantly of all, Federal spending and
taxing are deterrnined in part by social, political and international considerations
and only in part by what would be good econornics.
rnore
-4The basic problern
of.
an appropriately coordinated rnonetary and fiscal
policy is to deterrnine the course of the economy over a finite period ahead. If
the period is as long as a year and a half (as in the Presidentrs annual budget,
for exarnple), this is an extremeiy difficult job when you consider the kinds of
exogenous factors at
work. To illustrate: the step-up of our defense effort in
Vietnarn had major influences on dornestic econornic activity in the second half
oî. 1965 and
in all of
1966 (influences that were largely rnissed
forecasts rnade at the beginning of both years).
'W-hat
in the standard
isin store for
1967?
Frankly, I do not know. But I do know that with the future rnagnitude and duration
of our rnilitary effort unspecified, there is a wide rnargin for error in any forecast of econornic activity in the period ahead. Another illustration of an exogenous
and unpredictable - - influence on the econorny
is the fact that we are faced this
year with rnany rnajor labor negotiations and the possibility of work stoppages"
These, too, have serious unknown irnplications for the pace and direction of
econornic activity in 1967. Another cornplex of factors -- partly exogenous and
partly endogenous -- has to do with consulrler spending plans. Given the uncertainties of Vietnarn and possible labor stoppages, as weII as the current lower
Ievel of the structure of interest rates and the uncertain course of disposable
personal incorne, it is difficult to predict how consurners wiII behave in the rnonths
ahead. Any or aII of these factors could easily and appreciably change the future
course of the economy
in 1967, as weII as the appropriate rnix of rnonetary
fiscal policy today.
ñLore
and
-5This type of uncertainty is indeed unfortunate, although uncertainty is
a
basic fact of life. Policy rnakers rnust assurne, on the basis of the best evidence
available, that the econorr|y will behave in a certain fashion over a finite period,
and forrnulate an appropriate policy mix
for that finite period. If econornic
conditions alter unexpectedly during the period of the forecast, what was once
judged to be appropriate policy will becorne inappropriate. The inflexibility and
rigidity of the policy rnix -- particularly the fiscal aspects of that policy -create the crux of the difficulty. \ilhile rnonetary policy can adapt quickly, fiscal
policy cannot. The inflexibility and rigidity of fiscal policy were clearly
dernonstrated during the second half of 1965 and the firS half of 1966, when fiscal
policy was too expansionary while the economy \ /as overheating, and during late
1966, when fiscal policy was inadequately expansionary while the economy was
cooling off. The basic problern of fiscal policy is the inflexibility of the Federal
budget once forrnulated, and the slowness with which
it
can be reforrnulated under
our existing institutional arrangerrlents.
Monetary policy also has its problerns, but they are not the sarne problerns
as those of fiscal policy. Both types of policy reston fallible forecasts, but,
fortunately, rnonetary policy is not rigid and inflexible. To the contrary, it is
extrernely responsive and accomrnodative.
Given the right inforrnation, rnonetary
policy can be adjusted cluickly to changing econornic circurnstances, as attested
by the shift that occurred last Novernber. Although policy rnakers look ahead
as far as the horizon perrnits, policy can be reforrnulated at intervals as short
as the periods between meetings of the Federal Open Market Cornrnittee. This
flexibility is rnuch greater than that of fiscal policy, where the operational lag
rnay be as rnuch as a year and a half , frorn January through the end of the next
rnore
-6-
fiscal yeal^, which is the current planning period for the Federal
budget.
The relative flexibility of the tr'ederal Reserve Systern partly reflects
the fact that it is not comrnitted to a pubtished forecast, and partly the Lact tlrat,
it is an independent agency within, but not of, the Governrnent. 'Within the
Systern, a srnall group of people (FOMC) -- with diverse backgrounds and
interests -- rneets frequently to discuss econornic developrnents and must rnake
a policy decision at each rneeting. Nevertheless, despite tirneliness and flexi-
bility of rnonetary policy, rr,aîy basic questions regarding its effects on the
econorny are
Sill unresolved. The lead-lag relationships of changes in bank
reserves, the lnoney stock, bank credit, and interest rates are not fully under-
stood. For exarnple, tight rnoney in 1966, has had,
uneven effects on various sectors of the economy
and the arnount and tirning of these effects are
in
and
will continue to have,
1967 and perhaps beyond,
unresolved. The uncertaínty
associated with variable tirne lags and irnpacts are problerns that are, of course,
not unique to rnonetary policy. Fiscal policy also has distributed effects on
various sectors of the econorny, and the rnagnitudes of these effectsare not
known. For exarnple, the elirnination of the
October,
L966
7%
investrnent tax credit in
(just at the wrong tirne, as it turned out) has had, and will continue
to have, promoünced effects on the arnount and tirning of plant and equiprnent
expenditures in 1967, the extent of which can only be approxirnated. In addition,
I do not know what the effects of the restoration of the investrnent tax credit will
be
in
1967
-- or in 1968, or beyond.
more
-7Only one thing, based on invariant historical experiences, is really
clear. If the economy overheats later this year, the overheating will be blarned
on rnonetary
policy, no rnatter what fiscal policy rnay be or rnay have been. It
will be said that \/e overreacted to recessionary fears in late
1967, On the other hand, if the econolny were to
for excessively tight money in
1966
sag
1966 and
early
further, we will be blamed
or the fact that we underreacted ín
1967,
independently of the nature of fiscal policy. The rule is: heads, rrronetary
policy loses; tails, fiscal policy wins. Hopefully, in the rernainder of rny talk
I will be able to rise above the perpetual squabble about the respective roles of
rnonetary and fiscal policy, and shed sorne tight on the practical difficulties of
the Federal Reserve Systern as it atternpts to conduct rnonetary policy on the
basis of the inforrnation available. Let us therefore turn to a review of economic
developrnents since the last recession, and the role of public policy in that period.
ECONOMIC DEVELOPMENTS SINCE 196I
In the long business expansion since early 1961, the econorny has been
characterized by three diSinct periods of econornic growth, with a different mix
of rnonetary and fiscal policy in each period. Between the cyclical trough in
February 1961 and mid-1965, the econorny advanced at a rernarkably wellbalanced and noninflationary pace. Real GNP rose at a high average rate of
about 5.5T0, and the GNP deflator rose at a relatively low average annual rate of
about L.+Vo a yea.r. In an effort to close the gap between the economyrs potential
and actual output, both rnonetary and fiscal policy were expansionary throughout
the period. Around the tirne of the reduction in personal and corporate incorne
ñì.oIe
-8taxes in February I)64, real econornic growth accelerated but without a
noticeable acceleration in prices. The Federal Reserve Systern rnaintained
an accorrrrnodative rnonetary
policy, which provided the rnoney and credit
needed to
support enlarged spending by businesses, consumers, and governrnent.
During each of the next two periods, the rnix of rnonetary and fiscal
policy was less appropriate. Frorn rnid-1965 untit rnid- 1966, the econorny v/as
characterized by excessive aggregate dernand relative to the nationrs capacity
to produce. The results were irnbalances and distortions in various sectors
of the economy, and a general inflationary overheating. In mid-1965, accelerated
defense spending for Vietnam \Mas superirnposed on rapidly rising business
expenditures for fixed plant and equiprnent. Inventory spending also expanded
rapidly, both for defense purposes and other uses. (Parenthetically, as I will
discuss later, our inforrnation on defense spending and inventory investrnent was
highly inadequate at that tirne. ) Operating rates in many lines began to exceed
desired levels, and labor shortages appeared. After years of virtual stability,
unit labor costs began to rise rapidly, profit margins fell, and inflationary
pressrres accelerated. Between the second quarter oî. 1965 and the third quarter
of. L966,
real GNP rose at a satisfactory
deflator increased at a
Z.9To annual
5,5q0 annual
rate, but the GNP price
rate, about twice the increase of the earlier
period.
The surge in econornic activity generated enormous dernands for funds,
which could not be satisfied without an excessive expansion of credit. As
inflationary pressures increased, the Federal Reserve Systern becarne less
accolrrrnodative, the growth of bank credit slackened, and the entire constellation
rnore
-9
of interest rates began to rnove up, The increase in the discount rate Lrorn 4To
to 4-l lZYo in Decernber, 1965, although at fírst highly unpopular, gained
grudging support frorn inforrned quarters when it becarne apparent that the
Adrninistration was not going to ask for an appropriate contracyclical increase
in incorne taxes. The logic *rpporting earlier fiscal rneasures to invigorate
a Iaggíng economy now argued for the reverse fiscal policy, but this was not
to be the case. Despite token fiscal rrì.easures, such as the partial restoration
of previously reduced excise taxes and accelerated incorne tax withholdings'
the rnajor burden of restraint fell on rnonetary policy.
This, as it turned out, had ñlany unfortunate consequences. For exarnple,
as rnonetary policy becarne progressively
to the highest levels in
4O
tighter,
and
interest rates soared
years, savings that normally flow through
nonbank
deposit-type institutions were diverted directly into higher yielding rnoney
rnarket investrnents. Since deposit-type institutions norrnally supply the bulk
of funds for residential construction, the rnortgage rnarket was seriously
squeezed. The result was a sharp decline in housing starts and in residential
construction.
The
third period began in the fall of I966 when it becarne apparent
to
the Federal Reserve that the overheated econoñry was beginning to cool off.
'While prices were
still rising, the pace of the private sector slowed,
and
industrial prod.uction began to level. Moreover, just as econornic activity began
to rnoderate in October, 1966, fiscal policy took a restrictive step with the
suspension of
the
7To
tax credit on business investrnent and accelerated
depreciation allowances. The burden once again was on rnonetary policy, which
rnore
- 10-
turned progressively easier beginning in Novernber. After a short period of
hesitation, bank reserves began to grow rapidly, bank credit expanded sharply,
the rnoney suppty increased, and interest rates declined.
Fiscal policy began to play an appropriate contracyclical role early in
1967, The Adrninistration released funds that had been withheld frorn the
highway prograñt, rnade rnore rnortgage funds available th,rough FNMA, speeded
up veteransr dividend payrnents, and in March called
rnent of the
7To
for irnrnediate reinstate-
ínvestrnent tax credit (which Congress is still considering).
The existence of rnoderating tendencies in the econorny was reconfirrned by the
Federal Reserve Systern in March when reserve requirernents on certain tirne
d.eposits were reduced, and again in
4-LlZTo to 4To, Frorn the
April, when the discount rate was cut frorn
third quarter
of. 1966
to the first quarter of 1967, real
GNP ros e at a sornewhat rnore subdued rate of Z,3lo, but the price deflator
continued to rise at a high annual rate of Z,8o/r, although other rnajor price
indexes showed rnoderating tendencies,
Despite the recently improved rnix of rnonetary and fiscal policy, the
nationts real econornic growth will be srnall ín 1967, judged by recent standards.
Business investment in new plant and equiprnent is edging down, inventory
accurnulation has been reduced, and until recently, consurrrer spending has been
sluggish. The basic question of the rnornent, frorn the point of view of rnonetary
policy, is whether our stance is about right, or whetherwe should ease further
or tighten. 'Whatever policy is adopted, our basic goal rernains the sañle as it
always been -- to achieve balanced noninflationary econornic growth.
rnore
has
-I
LESSONS OT' RECENT EXPERIENCE
In rny brief review of econornic developrnents since the last recession,
I delineated a long period frorn I961 to rnid-I965 when the econoñly enjoyed
steady growth and stable prices, and two short periods, rnid-1965 to rnid-1966,
when growth was satisfactory but prices spurted, and rnid- L966 to the present,
when growth slackened while prices continued to
rise. All of us can take
pride in the record as a whole, but it could have been better, given better
inforrnation, deeper insights, and rnore appropriate rnixes of rnonetary
and
fiscal policy. Let us see what constructive steps should be taken to irnprove
public policy in the future.
First, it is irnperative that we find
and resulting untirneliness of fiscal
budget rnaking process
sorne way of reducing the
inflexibility
policy. Part of the trouble lies in
the
itself" Federal budgets are based on specific, one-
shot forecasts of what the econorny
will be like over the next lB rnonths;
against this background, receipts are estirnated, tax policy planned, and
spending
projected. If the forecast is wrong, as it alrnost always is for
any
I8-rnonth period, estirnates of incorne will be wrong, and spending plans and
tax policy will be inappropriate for econornic stabíLízation and growth. The
difficulty is that Federal programs for spending and taxing take many rnonths
to place in train, gain rnornenturn in the process, and cannot easily be reversed,
once started.
One
practical solution would be to provide for the regular publication
of rewised quarterly budgets, sirnilar to those the Bureau of the Budget will
provide this year to the Joint Econornic Cornrnittee. Another constructive step
rnore
_
\Mould be
IZ_
to develop better understanding and agreernent as to which budget concept
is rnost appropriate for policy planning purposes. The present systern of rnultiple
budgets
is confusing to the layrnan, and lends itself to rnanipulation to show a
surplus -- or a srnall deficit -- in whatever budget happens to be in favor at the
rnornent. As a forrner Chairrnan of the Council of Econornic Advisers recently
pointed out, we are operating in a kind of 'rfiscal fogrrthat could be highly d.angerous.
Fortunately, the President plans soon to establish a bipartisan group to study
budget processes, with a view towards reforrn and irnprovernent.
think also that sorne
\May
I personally
firust be found to provide for speed.ier adjustrnents in the
tax systern to changing econornic conditions. Perhaps an independent agency rnight
be given the power to adjust taxes upward or downward as need.ed. within a srnall
percentage range, subject to review and revision by Congress or the Executive.
Adrnittedly, the practical political difficulties of any such plan are enorrnous,
but the potential econornic benefits are even greater.
Second, rnonetary policy also is in need of some irnprovernent, particularly
in the area- of rneasuring tirne lags
and
irnpact. Frankly, I think rnonetary policy
has been quite good since early 1960, There now seems to be general approval
afilong econornists of the tirneliness and direction, if not the rnagnitudes, of recent
rnonetary policy changes, although there is considerably Iess agreernent, as I
have indicated, on whether we tend to overstay our position. Also, rlany críticíze
us for not designating one particular econornic tirne series as the rnajor rnonetary
variable. Should it be Professor Brunnerrs rrcredit base, rr Professor Friedrnanrs
rrbroadrr money supply,
or the Federal Reservers own brain child,
proxyrr?
lïLo r e
rrthe bank cred.it
-
Frankly, I
I3-
do not know the answer, and doubt that anyone else
practice, the Federal
Open
Market Cornrnittee looks at
tries to account for significant variations in rates of
aLL
does. In
kinds of variablesand
change arnong thern.
Econornetric rnodels have a way of indicating that one or another of a set of
variables is the rnost irnportant variable to be considered, but the selected variable
has a disconcerting way of changing, depending upon the rnodel and tirne period
considered. In part, this probably reflects inherent statistical problerns associated
with econornic rnodel building, for exarnple, the high degree of intercorrelation
between the dependent variables
in the rnodel, serial correlation, incorrect
assurnptions about the distribution of error terrns, and so forth. In part, I suspect
that it also reflects the fact that econornic relationships are too cornplex and interrelated to be representedby any single tirne series, or any single set of variables.
In any event, the Federal Reserve Systern is keenly aware of the gaps in its
knowledge and
is sincerely trying to fill thern.
As a third step in irnproving public policy in general, we desperately need
to irnprove our inforrnation systern, by obtaining rnore accurate and tirnely statistics,
by irnproving coverage, and by filling sorne of the gaps in our knowledge. Consider,
for exarnple, business inventory investrnent, which plays
a
rnajor role in explaining
cyclical swings in econornic activity generated in the private sector. Publication
of rnonthly statistics on cornbined rnanufacturing and trade inventories now lags
the event by about two rnonths. This rneans that today we know something about
what happened to inventories in February, but subsequent developrnents rernain
shrouded in
rnystery. This is not only bad by itself, but the early releases
inventories are subject to substantiat revision, due chiefly to difficulties in
rnore
on
-
t4-
obtaining reliable inforrnation on rnanufacturing and retail stocks. The sarne
difficulties carry over into the GNP statistics. To illustrate, in January
and
early February, the Federal Open Market Cornrnittee operated on the assurnption
that business inventories had increased by $I4.4 billion in the fourth quarter of
1966, only to learn at the end of February that inventory investrnent had been
$Z Uittion
higher, irnplying a much more severe inventory adjustment later on.
In addition to accura-cy and tirneliness, we need to irnprove the coverage
of our statistics. Consider, for exarnple, the irnportant influence of changes in
liquid asset holdings of businesses and consurners on savings flows, the money
stock, and sources of cornrnercial bank funds.
FTC-SEC estirnates of rrcashrr,
rrIJ.
'We
rely here on quarterly
S. Governrnent securitiesrr, and rrotherrr liquid
assets, rather than on rnore precise and rneaningful categories (now aknost totally
unavailable to us) of such iterns as corporate holdings of Eurodollars, tirne
certificates of deposit, foreign Treasury bills, and so forth, all of great concern
to the rnonetary authorities.
A third rnajor inforrnation problern involves the gaps in our knowledge. A
rnajor irrforrnation gap relates to defense spending. As rnentioned earlier, the
huge and largely unexpected surge
in defense spending that began in late I965
generated far-reaching reactions in the econofiry, the effects of which are still
with us. Undoubtedly, if rnonetary and fiscal policy rnakers had been fully aware
of d.eveloprnents then, steps would have been taken earlier to restráin thern, and
less restraint would have been needed later on. The fact is, however, that key
variables relating to defense spending are alrnost irnpossible to predict, and
irnpossible to obtain even within the various agencies of the Governrnent itself"
rrro
re
_I5_
Unfortunately, these unexpected escalations and de-escalations in defense
spending can do serious harrn to the dornestic econorrly, unless offset by appropriate
public policy. At least, irnportant policy rnaking groups such as the Council of
Econornic Advisers and the Federal Open Market Cornrnittee should be informed,
to the extent possible, of rnajor shifts in defense spending, even if such inforrnation rnust be withheld frorn the public on grounds of national security. If this
type of inforrnation is not available, then steps should be taken to develop it by
the appropriate agencies.
In general, I suspect that the root of the difficulty in obtaining adequate
and tirnely inforrnation goes back to our old bugaboo, the fiscal processesof
the Governrnent itself. Unless and until high-level public officials reeognize
the dangers involved, no departrnent of the Governrnent will receive adequate
appropriations for such rnundane things as data collection or data processing,
which are Ð necessary for efficient policy rnaking. It is inconceivable that the
greatest nation in the world, with a Gross National Product of over $750 billion,
and with Federal Governrnent outlays of over $150
billion a yeat, spends only
$I25 rnillion on its Federal statistical prograrns. Surely, we need to irnprove
the quality and tirneliness of our econornic inforrnation, even if it rneans spending
rnoTe rnoney.
These then, in broad brush, are the elernents needed for a better rnix of
rnonetary and fiscal policy in the future; first, a more flexible fiscal policy,
particularly
a
filore flexible tax policy; second, an irnproved theoretical basis
rrlore
t-
- Ió.
for rnonetary policy;
and
third, better
data
for the policy rnaker in
such
irnportant areas as liquid assets, business inventoriee, and defense spending.
\{'e, of course, also need to improve our econgmic forecasts. This is somethíng
to whích we can all contribute
-- in the universities, in Government,
business.
###
and in
@FedFRASER