Speech

For release on delivery 1:00 PM EST Thursday, February 25, 1982 NEGOTIATING THE PASSAGE Remarks by Paul A. Volcker Chairman, Board of Governors of the Federal Reserve System before the Conference Board New York City February 25, 1982 I am delighted to take part in your Annual Conference on the Financial Outlook. I can imagine what's most immediately on your mind -- like what's the direction of interest rates this afternoon, tomorrow, or next week. But since we have to remain in ignorance on that score, I'd like instead to approach our current economic and financial problems from the other end of the time spectrum -- what kind of an economy would we like to see in the 1980's and beyond, and what are the chances of achieving it. Then we can deal with the question of how to get from here to there -- and to anticipate one conclusion, I believe, through all the current hardships and turmoil, we are in the process of laying the foundation for a much brighter future. In looking to the rest of the decade and beyond, let me make two assumptions: first, that sometime soon recovery does get underway, and second, that that recovery begins in a context of a declining rate of inflation. I'll defend those propositions later, but I think we can accept without debate the further pro- positions that recovery will start from exceptionally high levels of unemployment and excess capacity, and, by past standards, interest rates. There do seem to me strong forces, at work, now and pro- spectively, that should, once the recovery does start, lead to a kind of self-reinforcing process of growth, higher real income and profits, and declining unemployment. In the early stages of recovery, we should benefit from sizable gains in productivity. Even as the rise in nominal wages - 2- slows,those productivity gains will be translated into gains in real wages and real profits, and in turn support further progress toward price stability. As workers and businessmen find moderation in nominal wages is consistent with improvement in real wages, demands for "catch up" wage increases should dissipate, and the favorable experience with inflation can help moderate new wage demands. At the same time, inflation premiums in interest rates should diminish, and the stock market should reflect both better business prospects and lower capitalization rates. Under such circumstances, the long-term bond and mortgage markets could be expected to revive. Those factors alone will help support business investment, which will, of course, also be stimulated by the more favorable tax climate already in place. The new investment, and higher levels of savings, can, in turn, foster the continuing growth in productivity that is the key to keeping the process going -- including a return to price stability. And, in that environment, I expect that management and labor alike would shift their attention back to the fundamentals of production and production techniques, reducing costs and raising productivity. Balance sheets would again begin to reflect the real world instead of inflationary distortions; decisions to consume and invest would more accurately reflect real returns than how to beat inflation. And we might even find ourselves with an excess supply of doomsday literature. -3- Now, I realize that is an idealized picture. But I stubbornly hold to the view that it is not an unreasonable model of how the economy should work, and how it can work. It has much in common with what did happen in the early 1960's, before the Vietnam War and before inflation took hold. As recently as the mid-seventies, we seemed to be getting back on that path -- you will recall both interest rates and the inflation rate declined well into that recovery, before we got off track. There is, of course, always the possibility of shocks and strain from unpredictable directions upsetting the best laid plans -- and we had plenty of those in the past decade. However, while the outlook is hardly assured, recent develop- ments do suggest that we may indeed be approaching or at (conceivably even beyond) a sustainable real price for petroleum. The long and expensive process of adjustment to higher energy prices is now well advanced, and could become less of a drain on both investment resources and labor productivity. In support of more favorable prospects, let me also point out that the bulge of new and inexperienced workers in the 1970's will, in the 1980's, be a more mature, trained, and more productive element in the workforce. Absorbing those people after all, had something to do with the lackluster productivity performance of the 1970's. Similarly, while environmental protection will remain a challenge, some of the most expensive changes have already been made. -4- Still, the kind of vision I have sketched in so summary a way will remain just that -- a vision -- unless our policies are firmly directed to that end. Essential policy elements are already in place, or being put in place. I need not remind you of the lower marginal income tax rates and the variety of tax incentives enacted last year. A start has been made toward bending down the seemingly inexorable upward trend in government spending. Progress in deregulation -- and in enhancing competition -- is underway. It will surprise you not at all for me to insist that, most important of all, we need to follow policies that will result in an unwinding of the inflationary process, that monetary policy has a particular role and responsibility in that area, and that we mean to "stick with it." The vision I have for the 1980's is, in important respects simply the mirror image of the 1970's. Then, inflation accelerated to the point where it became the expected norm and fed upon itself. Like walking through a "fun house" at a carnival, the distorting effects on economic behavior reflected back on reality in strange ways -- and it was not much fun. All the lessons we thought we had learned about managing and "fine tuning" the economy no longer seemed to work when markets were distracted by what might happen to prices. We no longer faced a choice between a little more inflation or a little more un- employment -- somehow we ended up with more of both. We became more interested in how to make a capital gain and exploit leverage than how to invest productively an^ maintain an equity cushion. -5- We were more preoccupied with keeping up with inflation than with enhancing the only source of higher real income over time -- productivity. And now, we have found -- if there was ever any doubt -- that breaking a deeply embedded inflationary process is a painful thing. The simple and hard fact is that this country had never in its history -- not since the Continental Dollar -- experienced an inflation so long and so large as from the mid-1960's to the present. To the younger generation, it had become a way of life -- and to some of our older citizens, a kind of betrayal of their retirement planning. The effort to restore stability is justified by one overriding proposition -- that we cannot build a prosperous, healthy economy and meet our social and security responsibilities, on the shifting sands of an unstable dollar. History and experience alike show that inflation cannot be sustained without excessive money creation. As you know, that monetary nourishment to the inflationary process is no longer being provided. In the short-run -- and I realize the short-run may, to those most vulnerable, sometimes seem an eternity -- restraint on monetary growth may intensify pressures on interest rates and credit markets. It's little consolation to those affected -- including so many prudent and hardworking members of our society -- to point out that, without restraint, interest rates would ultimately be still higher and remain there longer -- even though that is close to a certainty. So would - 6- inflation be greater, with even more difficulty ultimately in bringing it to bay. The fact is that we can now point to encouraging signs of real progress in the inflation fight. I realize that some of the evident slowing of the most widely used price indices reflects the more immediate effects of the recession in weak- ening market demand, the pressures of high interest rates on speculative commodity markets, and the current surpluses of oil and grain. Those immediate gains have been achieved partly at the expense of unemployment and savage pressures on profits of many companies. High unemployment and a depressed economy can't be an acceptable base for sustaining the effort to restore price stability. But the gains against inflation we see today need not be temporary -- just another passing episode in the ratcheting-up of inflation. They can become a kind of platform for moderation in pricing policies and wage practices, and for the attention to productivity improvement, we need. That is a process we can see, at least in embryo. As might be expected, at this point the evidence is clearest in those industries in a particularly exposed competitive position because costs and wages have risen disproportionately, and in industries more exposed to the competitive forces of deregulation or imports. But the prospects for new attitudes of restraint spreading seem to me excellent, so long as public policy in general, and monetary policy in particular, remain credibly and demonstrably pointed in the direction of price - 7- stability. That process will be aided as the realization spreads that we will have more room for real growth in the economy as a whole, and better prospects for higher employment, real wages and profits in particular industries, as costs are held in control. Occasionally, in this country or abroad, there have been attempts to formalize that concept in a so-called "incomes policy." Experience with that approach has not been favorable and it is hard to conceive of an apparatus consistent with the complexity and flexibility of our economic system. Possibly we can learn something from the kind of informal "consensus- building" mechanisms that seem to make a contribution to stability in Japan or Germany; our practice of three-year labor bargaining at different times in different industries, in contrast, may well complicate the process of winding down inflation. I don't mean to suggest we can or should transplant wholesale practices unique to the economy and cultural setting of others, and in important ways, we already have more flexible labor markets in this country. But looking to the long years ahead, as unemployment recedes and capacity is more fully utilized, I hope we will be alert to new forms of cooperation and understanding among business and labor that can help in avoiding revival of a price-wage-cost spiral as the recovery is extended. In that connection, there may be lessons to be learned from the current experience in some industries - 8- experimenting with new forms of compensation and labor- management cooperation. Moreover, there are expanding areas of the economy -- particularly health care and some other service sectors -- where normal competitive processes seem to be weak or non- existent in holding down costs. This is obviously neither the time nor place -- nor do I have the competence -- to delve into either the reasons for the relatively high rates of inflation in those areas, or the means of coping with them. I do point to them as areas where the general tools of economic policy need to be supplemented by more specific measures of cost containment as we move ahead. To move from the specific to the general, I must emphasize the key importance of maintaining open, competitive markets. While all of us can point to exceptions, our record in permitting open access from abroad has been reasonably good. In the long run -- and the not so long run -- it is that actual and potential competition that can be the most effective restraint of all on excessive pricing and wages, and the most effective goad to productivity. Internally, the process of reforming the overgrown regu- latory apparatus is equally compelling. We can often make needed regulation more cost effective -- and the Administration is making real progress toward reducing or eliminating those which are simply excessive in terms of the objective sought. And apart - 9- from the direct cost burden, in these past few years we have learned again the invigorating effects on productivity and the restraint on costs that result from more intense competition in some industries where pricing and other terms and conditions of business have been sheltered for years. Maintaining the momentum of regulatory reform is one part of the "vision" of which I have been speaking. Closer to ''home" -- and basic to our economic prospects -- is the conduct of monetary and fiscal policy -- a matter that is, of course, under intense debate now in the halls of Congress. In this debate lies the key to whether, indeed, we can look forward not just to recovery, but even more importantly, to recovery that can be sustained into a long-lived expansion. The temptation, of course, is to reach out for a "quick fix" -- for interest rates, for unemployment, for profits. But relative to earlier recessionary periods, I believe there is understanding that a "quick fix" is not the same as a lasting solution. There is a healthy concern that a recovery could too easily abort if we approach the present difficulties without taking account of the predictable longer-term consequences of policy actions. In the simplest terms, pumping up growth in money and credit today might seem at first sight appealing to speed recovery, but the inflationary consequences could only 1 threaten the longevity of that recovery. In the short run, we could bolster income at the expense of government deficits -- -10- but building in a large structural deficit would be directly counter to the investment and housing needs of a growing economy. Economists, businessmen, and politicians -- even central bankers -- can debate endlessly about the realism of a particular economic or interest rate forecast for the months ahead. And we do, even though simple experience suggests those prognostications have a considerable margin for error. More important -- and I think also considerably clearer -- is the general direction appropriate for monetary and fiscal policy if we want to sustain the recovery over a long period. I did assume, in setting out my vision, that recovery relatively soon was a reasonable expectation. Certainly, negotiating safely the passage from today's recession and apprehension to firmly based recovery is the immediate challenge before us. In that respect, I would remind you that the present situation has some important parallels to earlier recessions, where recovery was fairly prompt and strong. Business in general appears to have made much of the production adjustment necessary to curtail inventories. In fact, production levels rather generally may be below shipments, and if reasonable stability can be maintained in consumption for a time, production [ and incomes should improve, giving rise to further upward momentum. In effect, a cyclical recovery could get under way soon. -11- That prospect in the near term receives strong support from the Federal fiscal position. A great deal of the current $100 billion or so deficit is cyclical in nature, reflecting the reduced revenues and higher expenditures growing out of the recession. At the same time, it provides substantial support to the income and expenditure stream, support that will be reinforced by the second stage of the tax program at mid-year. Of course, the deficit needs to be financed, and financed without excessive money creation. In concept, that should be manageable in a recession period, with private credit demands slackening. In practice, extraordinarily high interest rates and financial market pressures are the most obvious hazard to strong and early recovery. In analyzing that problem, I must emphasize that interest rates reflect not only the current state of the economy and the balance of underlying demand and supply forces in the financial markets, but expectations and anticipations of the future. One dimension of those expectations revolves around monetary policy -- will there be enough money to meet potential financing requirements and support expansion? That is, of course, a question faced directly by the Federal Open Market Committee in its deliberations. In setting our monetary and credit targets last month, we concluded that those targets would be consistent with recovery beginning before very long. But I would also acknowledge that, by design, they are a -12- "tight fit," in the sense they presume, and are designed to encourage, further reductions in the rate of inflation. A second factor in expectations revolves around prospects for inflation, which in turn bears upon "inflation" and "uncertainty" premiums in the bond market today. While the relationship between inflation and interest rates historically is not so close in the short run as some popular commentary would suggest, there is validity to the view that, over time, the trend of interest rates -- particularly long-term rates -- should reflect in substantial part inflation and inflationary expectations. Given reasonable confidence in the success of an anti-inflation program, today's bond market would appear to offer extraordinary investment opportunities. I am well aware of the residue of skepticism, uncertainty, and even cynicism born out of the experience of the past decade and more. Policy will need to be credible -- and credibility needs to be earned by persistence and performance. In all our planning, we believe that disciplined money and credit growth will have to continue as a central part of the effort to wind down inflation. A third element of expectations impacting on interest rates is the prospective fiscal position of the government. The Administration, the Congressional Budget Office, and others have all emphasized that, without any action to change existing budgetary programs (that is, the "current services budget"), deficits in coming fiscal years could reach $150 billion and more. Such deficits, whether measured in absolute terms, in relation to -13- GNP, or relative to our savings potential, would be historically high. They would be so even after assuming steady and sizable increases in production, employment, and income; in other words, the prospective deficits, unlike the current deficit would largely be of a structural, not a cyclical, character. There is a psychological dimension, in the sense that concern over the possibility of such large deficits itself leads to fear of inflation, whether as a result of debt monetization or otherwise. Perhaps more important, in an environment of limited money expansion and rising private demands for credit, large deficits would seem to threaten continued congestion in financial markets, with strongly adverse consequences for other potential borrowers. In such a climate, there would indeed be room to doubt whether the kind of self-sustaining recovery and the self-reinforcing disinflation I have been talking about could proceed at all smoothly. The Administration -- and I believe the Congress -- is alert to these dangers. The President, as you know, has proposed very substantial measures to reduce the prospective deficits for fiscal year 1983 and thereafter. He has, correctly in my judgment, emphasized priority for spending cuts in achieving a reduced deficit. Measures of the magnitude the Administration has proposed would obviously go a long way toward relieving the potential fiscal burden on financial markets. The challenge now is for the Congress to respond, and 1 would myself welcome even larger cuts to provide -14- a greater margin of safety, given the uncertainties surrounding the underlying trend in spending or revenues, in interest rates, in the inflation rate and savings -- areas where any projection must have a margin for error. It is in the light of this situation that I have urged measures to deal effectively and firmly with the budgetary problem we face for future years. What is at stake is not only the longer term outlook -- the reality of the vision I set before you today -- but the prospects for early and strong recovery in the months more immediately ahead. The important thing here -- and I cannot emphasize this enough -- is to get the economic and financial conditions in place that will support the kind of economic performance that we want, and can achieve, over the years ahead. Important measures to that end have been taken over the past year. One key continuing condition is a restrained but supportive monetary policy; another is a better fiscal outlook. The fact is that I can only be encouraged by the greater understanding of the nature of our problems, and by the distance we have traveled in putting appropriate policies in place. The remaining challenge before us all is clear. With an appropriate response, we will be a long ways toward negotiating the passage to that brighter vision that I see ahead. •k -k -k -k -Jc -k -k

Paul A. Volcker (1982, February 24). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19820225_volcker

@misc{wtfs_speech_19820225_volcker,
  author = {Paul A. Volcker},
  title = {Speech},
  year = {1982},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19820225_volcker},
  note = {Retrieved via When the Fed Speaks corpus}
}