Regional President Speech

INFLATION AND HOUSING Remarks of John J. Balles, President Federal Reserve Bank of San Francisco Meeting with Portland Community Leaders and Board of Directors, Portland Branch Federal Reserve Bank of San Francisco Portland Oregon May 1,1980 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Inflation and Housing I'm glad to have the opportunity to visit Portland once again, although I'd much rather be here when the state's leading industry was in better shape than it is today. Later on, I'll discuss the problems of the housing industry — and hence of the forest-products industry but I should emphasize at the outset that those difficulties are related to the overriding problem of inflation. Thus, most of my comments will focus on the steps we must take to overcome that major national problem. But first, let me note one of the good things about meetings such as this, which is the chance it provides our directors to meet with Portland's community leaders for a discussion of matters of common interest. Our directors are an able and diverse group of individuals, and they help in many ways to improve the performance of the Federal Reserve System. The directors at our five offices are concerned with each of the major jobs delegated by Congress to the Federal Reserve. That encompasses the provision of "wholesale" banking services such as coin, currency, and check processing; supervision and regulation of a large share of the nation's banking system; administration of consumer-protection laws; and above all, the development of monetary policy. We are fortunate in the advice we get from them in each of these four areas. Our directors constantly help us improve the level of central-banking services, in the most cost-effective manner. Most of all, they help us improve the workings of monetary policy. As one means of doing so, they provide us with practical first-hand inputs on key developments in various regions of this District and various sectors of business and public life. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 - - Our directors thus help us anticipate changing trends in the economy, by providing insights into consumer and business psychology which serve as checks against our own analyses of economic data. Fundamental Economic Problems At a time like this, we need all the help we can get from our directors -- and indeed from all of you. We must deal with an incipient recession, which ordinarily would suggest the need for a policy of stimulus -- but also deal with a severe inflation, which definitely calls for a policy of restraint. To understand the situation, we must remember that many of our difficulties arise from the fact that economic growth over the past decade depended very heavily on public-sector spending. In particular, massive Federal-spending increases outpaced tax revenues and created red ink on the books for every single year of the decade. Indeed, the combined Federal deficit for the decade, $315 billion, matched the combined total for the entire previous history of the Republic. Inflation was the inevitable result of this prolonged series of deficits, the overly stimulative monetary expansion that sometimes accommodated them, and a series of supply-related shocks from the OPEC nations and elsewhere. Consumer prices practically doubled over the course of the decade, in the worst peacetime inflation in the nation's history. We're paying the price in 1930 of failing to deal more forthrightly with the problems which originated in the 1970's. Recession, or a situation closely resembling recession, is an obvious consequence of the past decade's excesses, and of the stringent policy moves needed to cure those excesses. The recent weakness of production, employment and retail sales, plus a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3 - - five-month-1 ong decline in the leading-indicators index which usually signals cyclical turning points, suggest that the long-, awaited recession may finally be here. In other words, overall business activity may actually decline for several quarters, following the period of sluggish growth which has been evident since last fall. Basic Cause of Inflation I would emphasize, however, that recession is not the basic problem, but rather the consequence of our earlier actions. The basic problem is inflation, and this has been true throughout the past decade and more. Inflation undermined the otherwise commendable record of income and employment growth achieved during the 1970's, when consumer prices doubled within a single decade. Yet if the past year's trend continues, prices would double again within a half-decade alone. Where do we look for the cause of this severe problem? Surging OPEC oil prices are partly responsible, of course, but most of the blame must lie with the Federal budget. This has seriously aggravated the inflation problem during the recent cyclical expansion by generating a massive series of deficits, which then induced a substantial over-expansion of the money supply. Part of the problem was the monetization of debt which resulted from the Federal Reserve's former operating techniques, which sometimes involved a slow adjustment to inflationary pressures because of the Fed's attempt to limit the impact of rising interest rates on private sectors of the economy. This link was broken last October 6, when the Fed shifted from an interest-rate operating technique to direct control of growth in bank reserves, and hence in the money supply. The aim since that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 _ - time has been to slow the growth of the money supply to a point where it will be consistent with price stability. But we're still experiencing the results of that earlier problem. Moreover, much of the run-up in inflation expectations early this year could be traced to the belief that our budgetmakers had lost control of that engine of inflation. The fears about a runaway budget surfaced before the ink was dry on the January document, when it became apparent that Federal spending would not be as "lean and austere" as projected a year ago. For fiscal 1980, the original budget document forecast a $40-bi 11 ion deficit -- 44 percent larger than last year's deficit. For fiscal 1981, continued deficit financing seemed inevitable, even in the face of about $50 billion in tax increases -- either from the social-security tax, the windfall-profits tax, or inflation-related boosts in personal-tax revenues. Inflation and Crowding-out Now, substantial budget deficits can be defended in deep recession periods, because they support aggregate business activity at times when other credit demands are weak. But that condition hasn't existed in any of the last several years of essentially full employment. Instead, heavy deficit financing has led to intense pressure on credit markets and to greater inflation, by inducing an excessive monetary expansion -- understandably, because the Federal Reserve tended to lag in restricting credit availability to the private sector. As a result, interest rates have come under sustained upward pressure, and higher interest rates have "crowded out" many private borrowers from the money and capital markets, because they could not pay what the Treasury could pay for funds. Over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 5 - - time, this has helped cause a greater portion of aggregate savings to go to the public sector, and thus has led to less productive investment and to a decline in the nation's real-growth potential. The "crowding out" argument was widely discussed -- and also frequently ignored -- in the mid-19701s . But now we're face-to-face with the truth of that thesis. At a time of tight Federal Reserve monetary policy, and of a continued high level of private credit demands, the Federal government's borrowing demands have been rising rather than declining, with severe consequences for the markets. Much of the Federal borrowing pressure comes from Federal entities which are classified "off budget," but which are still financed by the U.S. Treasury, such as the group of credit agencies operating under the wing of the Federal Financing Bank. Other pressures come from privately- owned but government-sponsored enterprises, primarily those operating in the mortgage market. In any event, total Federal and federally-assisted credit demands could reach $95 billion or even more in calendar 1980. In other words, the Federal government and its agencies could pre-empt almost one-fourth of all credit demands, compared to less than a one-sixth share during the first half of the 1970' s . Thus, none of us should be surprised at the stratospheric level of interest rates which results when money growth is obviously slowing, and when the Federal government is taking a larger share of available funds. These considerations indicate why the drive for a truly balanced budget is at the heart of our anti-inflation struggle. It may be difficult to reach that goal in light of the need for real increases in defense Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis spending, but that simply means that stiff cutbacks elsewhere are essential if we are ever to reduce the government sector's excessive demands on the nation's resources. The Administration has made a good start by reopening the books on the 1981 budget, and proposing a $16 1/2-billion surplus rather than a $16-bill ion deficit. Yet most of that shift represents a sharp increase in revenues rather than spending cutbacks -- and for that matter, there is no certainty that Congress will approve the proposed budget- balancing measures. Finally, and most importantly, little has been done to date to cut Federal spending and a likely deficit of $37 to $43 billion in the current fiscal year. Despite recent signs of recession, the problem of rampant inflation and sky-high interest rates is still our major concern. I would argue that the government could make a greater contribution to the anti-inflation fight by restricting spending rather than by boosting revenues. Our elected representatives in Congress should take the lead here. First, they must overhaul the legislative process itself -- especially considering that, in 1979, Congress passed three times as many bills that contributed to inflation as did the reverse, according to a recent study by the National Association of Business Economists. Again, Congress would do well to follow-up on the Congressional Budget Office's list of 58 areas of possible budget cutbacks -- including, for example, the modification of indexing requirements for soci al-securi ty benefits and other Federal programs, which could yield $70 billion in savings over a five-year period. (Almost $40 billion of that total could be saved by granting social-security recipients an 85-percent adjustment instead of a 100-percent adjustment for increases in the consumer price index, which is logical because of the CPI's Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7 - - tendency to overstate the actual inflation rate.) Such cutbacks are politically difficult to enforce, of course, but they are also essential to our long-term economic health. Inflation and Monetary Policy Monetary policy meanwhile has a crucial role to play in restoring price stability, especially in view of the fact that excess money creation helped create the problem, in the wake of the excess credit demands generated by Federal deficit financing and other forces. Over the 1975-79 business expansion, the M-1B measure of the money supply grew at more than a 7-percent annual rate — faster than in the 1970-74 period, and almost twice as fast as in the less inflationary period of the 1960's. The M-1B measure, incidentally, consists primarily of currency plus demand and other check-type deposits. The Federal Reserve, recognizing that price stability requires a progressive reduction in money-supply growth, moved aggressively last October 6 to enforce its tight-money policy decisions. In particular, it placed more emphasis on controlling money-supply growth, and placed less emphasis on minimizing short-term fluctuations in interest rates. The early returns are quite heartening. In the six-month period prior to October 6, the M-1B money supply increased at more than a 10-percent rate; in the subsequent six months, the estimated growth rate averaged roughly 6 percent -- which means that at present we are within the 4-to- 6 1/2 percent range set by the Fed for 1980. Moreover, according to Chairman Volcker's recent testimony to Congress, the Fed's desired target Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis growth rate for this measure in 1980 is the midpoint of the 4-to-6 1/2 percent range, implying further deceleration of monetary growth. We're already seeing some results from this policy of monetary discipline, with inflation expectations being squeezed out of the economy, and with interest rates falling sharply from the stratospheric highs reached in the late- winter months. In the past month and a half, for example, Treasury-bill rates have dropped about 5 percentage points, and corporate-bond rates have fallen about 1 1/2 percentage points. The most heartening recent development in this area was the passage a month ago of legislation which should provide a permanent source of strength to the nation's monetary policy. The legislation goes by the tongue-twisting title of "The Depository Institutions Deregulation and Monetary Contro'1 Act of 1980," and despite being almost overlooked in the media, it represents the most important piece of financial legislation of the past generation. It helps to solve the problem of declining Federal Reserve membership, by reducing the cost of reserve requi rements for member banks. It helps to support equity and to improve monetary control, by extending reserve requirements to all depository institutions with transactions accounts (check-type accounts) and non-personal time deposits. And it helps to promote greater competition in financial markets, primarily by phasing out deposit interest-rate ceilings and by broadening the asset and payments powers of banks and thrift institutions. The new legislation makes a number of basic structural changes, and in the process, it increases the effectiveness of monetary policy in confronting the inflation problem. The measures taken on March 14 represent yet another segment of the overall anti-inflation program, with the Federal Reserve broadening its Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 - - policy of restraint, as a means of spreading the impact of its policies more evenly throughout the credit markets. The consumer-credit restraint program for many lenders and retailers was designed to diminish excess credit demands arising from unsecured loans, but not to discourage worthwhile loans where collateral is involved, such as auto, home-appliance and home- improvement loans. The voluntary credit-restraint program for banks was designed so that banks would limit themselves to productive loans--especially those for farmers, small businesses and home-builders--while avoiding acquisition loans and those involving speculation in commodities and inventories. Yet despite this increased attention to lending policy, the Fed will continue to base its credit-restraint program mainly on its control of rnoney-supply growth. Tn_e_ Housing Problem Now, what are the implications for Oregon of all these developments? Despite the state's increasingly diversified economy, Oregon still suffers when scarce and high-cost mortgage money cut into national housing demand, and hence into forest-products demand. The nation's home-building sector, which had held up relatively well throughout most of sluggish 1979, has now experienced a 45-percent drop in housing starts since last fall, and worse seems to be in store. Many analysts expect starts this year to fall below a 1.0-million annual rate -- only one-half the average of the 1977-78 period. And according to the president of the National Association of Home Builders, the housing decline has the same meaning for the national economy as four Chrysler bankruptcies. To understand this situation better, we should realize that the nation's housing industry has just completed a very productive decade. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 - - The industry produced 17.8 million housing units during the 1970's, or 24 percent more than in the preceding decade. Also, the financial markets supplied more than $284 billion for home financing in the period, so that the home-mortgage share of total credit flows grew from an average of 19 percent in the 1960's to a 20 1/2-percent share in the 1970's. However, that financing record was achieved only with the help of government-sponsored institutions, which financed almost one-fourth of all home mortgages over the entire decade, and almost one-third of the total last year. This year has been considerably different, with mortgage-financing institutions suffering a crunch similar to that of 1974. Many such institutions are in trouble because of the mismatch between the high rates that they currently pay on short-term sources of funds, and the low rates they earn on long-term mortgages made perhaps years ago. In the second half of 1979, for example, the typical savings-and-1 oan association faced a 7.7-percent average cost of funds -- only about one percentage point below the average yield on its loan portfolio. The situation obviously has worsened in more recent months, and some individual thrifts are now in difficult circumstances. Over the long run, these problems should be overcome with the help of the new legislation which I mentioned a minute ago. Disintermediation -- the outflow of deposit funds into market instruments during high-interest- rate periods -- should no longer be a danger as interest-rate ceilings are phased out over the next half-dozen years. The thrifts should be helped also by several other features of the new law -- which, among other things, permits thrifts to offer check-like NOW accounts and pre-empts state usury Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 - - ceilings on mortgage loans. Another favorable move is the Federal Home Loan Bank Board's recent approval of a new kind of home-mortgage loan with an interest rate subject to change every three to five years, but with certain protections to the borrower over the 30-year life of the loan. In the more immediate future, the housing industry should benefit from the increasing sluggishness of business activity and from the Federal Reserve's success in squeezing speculative excesses out of the economy. These developments are now freeing up resources for this cyclical industry, as evidenced by recent sharp declines in interest rates. But we cannot maintain a high and stable level of housing activity without bringing inflation under control -- unless we want to make the industry a complete ward of the Federal government. Admittedly, inflation at times has artificially stimulated the industry, by holding out the promise to buyers of large capital gains on their home purchases. But inflation has also forced many buyers out of the market by generating an upsurge in home prices and in mortgage interest rates. Altogether, a lasting improvement in the industry's situation -- and in Oregon's prospects — depends on a favorable resolution of the nation's fight against inflation, because high and rising mortgage rates basically reflect high and rising inflation rates. Concluding Remarks To sum up, my remarks today suggest that strong measures are needed to overcome the new outburst of inflation which has undermined the economy so badly in recent months. The Administration has taken an unprecedented step by re-opening the books on its 1981 budget document only a month and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 - - a half after sending it to Congress, with the intention of ending the inflation stimulus created by continued massive Federal deficits. But as I've suggested, much more remains to be done along that line, with increased emphasis on spending cutbacks rather than tax boosts. The Federal Reserve meanwhile has broadened its policy of restraint, as a means of spreading the impact of its anti-inflation policy more evenly throughout the credit markets. Still, these measures must be considered secondary to the Fed's basic policy of controlling money-supply growth. That policy has begun to show some success in reducing speculative excesses and inflation expectations, as evidenced by recent declines in interest rates. But unfortunately, we cannot expect such an approach to yield immediate results on the price front. History shows that there is an unavoidable lag between the imposition of a program of monetary restraint and the eventual return of price stability. (For example, the inflation rate was cut in half following the 1974 tight-money period, but it took two years' time to accomplish that task.) In any case, it is imperative that we continue to follow this basic cure for inflation, with the steady application of disciplined monetary and fiscal policies. # # # Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

John J. Balles (1980, April 30). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19800501_john_j_balles

@misc{wtfs_regional_speeche_19800501_john_j_balles,
  author = {John J. Balles},
  title = {Regional President Speech},
  year = {1980},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19800501_john_j_balles},
  note = {Retrieved via When the Fed Speaks corpus}
}