Speech

For release on delivery 8:30 A ML, E.S.T. February 20, 1985 Statement by Paul A. Volcker Chairman, Board of Governors of the Federal Reserve System before the Committee on Banking, Housing and Urban Affairs U.S. Senate February 20, 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I appreciate this opportunity to appear before you to present the Federal Reserve's monetary policy objectives for 1985. In accordance with the Humphrey-Hawkins Act, the semi- annual report of the Federal Reserve was transmitted to you this morning That report reviews in detail economic develop- 0 ments and monetary policy in 1984, and sets forth for 1985 the plans for policy by the Federal Open Market Committee. This morning I would like to discuss the Committee's decisions and the outlook for the economy in the context of some important unfinished business facing all of us responsible for economic policy. The Economic Setting The familiar objective of monetary policy is to foster sustained economic growth and employment in a context of reasonable price stability. Stated so generally, that objective can hardly be challenged; it indeed encompasses the broad goals of economic stabilization policy generally. Measured in those terms, there is clear reason for satisfaction in the performance of the economy last year. In summary, with real gross national product up by 5-1/2 percent over the year, and by about 12 percent in two years, we have enjoyed the strongest expansion since the Korean War period. On top of the gains in jobs in 1983, employment increased by over 3 million last year. The unemployment rate fell one full percentage point to 7.2 percent at year-end. Real incomes for the average American are up. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -2- P r o s p e c ts for s u s t a i n ed growth and p r o d u c t i v i ty over time rest i m p o r t a n t ly on s u c c e ss in a c h i e v i ng and m a i n t a i n i ng an e n v i r o n m e nt of g r e a t er s t a b i l i ty of prices and f i n a n c i al m a r k e t s. In that light, it is e n c o u r a g i ng t h a t, c o n t r a ry to w i d e s p r e ad e a r l i er e x p e c t a t i o n s, the strong growth of 1984 took place w i t h o ut i n f l a t i on i n c r e a s i ng a p p r e c i a b ly from the s h a r p ly reduced levels of 1982 and 1 9 8 3. S p e c i f i c a l l y, the c o n s u m er price index i n c r e a s ed around 4 p e r c e nt last y e a r, l i t t le c h a n g ed from the p r e v i o us two y e a r s, and p r i c es of most goods (in c o n t r a st to s e r v i c e s) at the w h o l e s a le and retail levels rose by less than t h a t. While the e v i d e n ce is less t a n g i b l e, t h e re are also e n c o u r a g i ng signs that c h r o n ic e x p e c t a t i o ns of future i n f l a t i on have been d a m p e d. The b e h a v i or of actual prices and nominal w a | e s, w h i ch by some m e a s u r es rose more slowly in 1984 than in 1983 d e s p i te e x p a n d i ng d e m a n ds for l a b o r, may in some part r e f l e ct t h o se c h a n g es in a t t i t u d e. B u s i n e s s m en and w o r k e rs no l o n g er seem so p r e o c c u p i ed with a need to a n t i c i p a te i n f l a t i on in t h e ir p r i c i ng and wage d e c i s i o n s. And d e c l i n es in bond y i e l ds after m i d y e ar seemed to r e f l e c t, to some d e g r e e, less fear of f u t u re i n f l a t i o n. To be s u r e, a number of factors that may not be l a s t i ng have helped to hold price i n c r e a s es d o w n. The c o n t i n u i ng a p p r e c i a t i on of the d o l l ar and strong c o m p e t i t i on from i m p o r ts have p l a c ed s t r o ng p r e s s u r es on p r i c es and w a g es in some m a n u f a c t u r i ng and m i n i ng i n d u s t r i e s. W i d e s p r e ad d e c l i n es in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 3 - c o m m o d i ty p r i c es c a n n ot p e r s i st i n d e f i n i t e l y. U n e m p l o y m e nt is still h i g h er than we w o u ld like to s e e. But it is also true that p r o g r e ss a g a i n st i n f l a t i o n, as it is p r o l o n g e d, can p o t e n t i a l ly feed on i t s e lf by e n c o u r a g i ng r e s t r a i n ed price and w a ge b e h a v i o r. As we start 1 9 8 5, the i m m e d i a te e c o n o m ic o u t l o ok a p p e a rs r e a s o n a b ly f a v o r a b le in t h e se r e s p e c t s. P r o j e c t i o ns of Federal Open M a r k et C o m m i t t ee m e m b e rs that I will be r e v i e w i ng later in my t e s t i m o ny b r o a d ly parallel t h o se of the A d m i n i s t r a t i o n, the C o n g r e s s i o n al B u d g et O f f i c e, and many o t h er o b s e r v e r s; e c o n o m ic growth is e x p e c t ed to remain s t r o ng e n o u gh in 1985 to p r o d u ce some f u r t h er d e c l i ne in u n e m p l o y m e n t, with l i t t le if any p i c k up in i n f l a t i o n. But we must not be b e g u i l ed by t h o se t r a n q u il f o r e c a s ts into any false sense of c o m f o rt that all is w e l l. If the e n o r m o us p o t e n t i al of the A m e r i c an e c o n o my for growth and s t a b i l i ty -- not just for 1985 but for the y e a rs beyond - is to b e c o me r e a l i t y, we need a sense of u r g e n c y, not of relaxati on. For one t h i n g, with the general price level still rising in the n e i g h b o r h o od of 4 p e r c e nt a y e ar -- and with p r i c es of s e r v i c es that t o d ay a c c o u nt for so much of the e c o n o my rising more rapidly than that -- we s h o u ld not c o n f u se e v i d e n ce of p r o g r e ss a g a i n st i n f l a t i on with u l t i m a te s u c c e s s. I n d e e d, the more f a v o r a b le p r i ce e x p e c t a t i o ns I noted a few m o m e n ts ago Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 4- could p r o ve f r a g i le -- h i g h ly v u l n e r a b le to any i n d i c a t i o ns that p u b l ic p o l i cy is p r e p a r ed to accept and a c c o m m o d a te to i n f l a t i o n a ry f o r c e s. That must be of p a r t i c u l ar c o n c e rn in the c o n d u ct of m o n e t a ry p o l i c y. P e r h a ps more i m m e d i a t e l y, d e s p i te the s t r e n g th of the overall e x p a n s i o n, some i m p o r t a nt areas of the e c o n o my are u n d er s t r a in and t h e re have been r e c u r r e nt i n t e r n a t i o n al and d o m e s t ic c r e d it p r o b l e m s. T h o se s t r a i ns and p r e s s u r es are a g g r a v a t ed by u n d e r l y i ng i m b a l a n c es t h a t, u n l e ss dealt with e f f e c t i v e l y, will u n d e r c ut the l o n g - t e rm o u t l o o k. One of t h o se i m b a l a n c es was h i g h l i g h t ed by the s l o w d o wn in GNP g r o w th we e x p e r i e n c ed in the t h i rd q u a r t e r. Such a "pause11 is not an unusual f e a t u re of an e x p a n s i on p e r i o d. D e m a nd does not grow s m o o t h l y, and o c c a s i o n al i n v e n t o ry i m b a l a n c es will d e v e l op that r e q u i re p r o d u c t i on a d j u s t m e n t s. What was unusual last summer was that the s l o w i ng of d e m a nd g r o w th was a c c o m p a n i ed by a surge in i m p o r t s, m a g n i f y i ng the e f f e c ts on d o m e s t ic p r o d u c e r s. That summer import s u r ge was r e v e r s ed by y e a r - e n d, but the u n d e r l y i ng trend t o w a rd h i g h er i m p o r ts is c l e a r. Our t r a de d e f i c it i n c r e a s ed to about $110 b i l l i on in 1 9 8 4, far h i g h er than ever b e f o r e, and the e n t i re e x t e r n al c u r r e nt a c c o u nt d e f i c it -- c o u n t i ng both g o o ds and s e r v i c es -- has d e t e r i o r a t ed by about $100 b i l l i on s i n ce 1 9 8 2. The s u s t a i n a b i 1 i ty of that t r e n d, p o l i t i c a l ly as well as e c o n o m i c a l l y, is, to say the l e a s t, q u e s t i o n a b l e. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -5- The rising trade deficit helps account for the failure of a number of important sectors to participate at all fully in the expansion. Agriculture* heavy capital equipment pro- d u c e r s, and the metals industry., all of which face difficult structural problems in any event, are examples. They are further pressed by interest rates that, as you know, remain historically high, both in nominal terms and relative to recent inflation. Looking abroad, growth in many industrial countries remains sluggish amid continuing high levels of u n e m p l o y m e n t, and depreciation of their currencies vis-a-vis the dollar seems to be one factor inhibiting more expansionary policies. Important developing countries are still struggling to restore stability and maintain growth while laboring under heavy debt b u r d e n s. In this interdependent world, these difficulties feed back on our own prospects. It is no coincidence that the record external imbalance and continued high interest rates have been accompanied by large federal budget deficits -- deficits that according to projections of both the Administration and the Congressional Budget Office will only deepen in the years ahead in the absence of decisive corrective action. Government deficits can be relatively benign and even useful in boosting incomes and purchasing power in the slough of recession and when private investment and credit demands are weak. It is also true that our growing volume of imports Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -6- over the last two y e a rs has p r o v i d ed an impetus for growth in o t h er c o u n t r i es when other e x p a n s i o n a ry forces were w e a k. M o r e o v e r, the kind of o b v i o us s q u e e ze on, or " c r o w d i ng out" of, d o m e s t ic h o u s i ng and i n v e s t m e nt that many a n t i c i p a t ed as the e x p a n s i on has d e v e l o p ed has not been a p p a r e n t. We have been able to r e c o n c i le high d e f i c i t s, s h a r p ly rising i m p o r t s, and strong i n v e s t m e nt m a i n ly for one r e a s o n: we have been able to a t t r a ct an e n o r m o us amount of s a v i n gs from abroad to s u p p l e m e nt our own. The net capital i n f l ow a p p r o a c h ed $100 b i l l i on last y e a r, and it will p r o b a b ly need to be still larger this y e a r. D o m e s t ic net s a v i n gs -- by i n d i v i d u a l s, b u s i n e s s e s, and state and local g o v e r n m e n ts -- are running at about $325 b i l l i o n, so the s u p p l e m e nt from a b r o ad adds close to a third to net s a v i n gs g e n e r a t ed i n t e r n a l l y. The net capital i n f l ow was e q u i v a l e nt last y e ar to m o re than half of the budget d e f i c i t. That same inflow of funds has e n c o u r a g ed a yery strong d o l l a r. The strong d o l l a r, in t u r n, c o n t r i b u t es i m p o r t a n t ly to the huge and g r o w i ng t r a de d e f i c i t. Our policy d i l e m ma is simple but p e r h a ps not fully u n d e r s t o o d. We cannot l o g i c a l ly w e l c o me the capital inflow from abroad in one breath and com- plain about the t r a de d e f i c it in the next. They are two sides of the same c o i n. We are m a n a g i ng to f i n a n ce the d e f i c it and m a i n t a in h o u s i ng and i n v e s t m e nt e x p e n d i t u r es with the help of i m p o r t ed Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis c a p i t a l. At the same t i m e, the e x p o r t e r, those c o m p e t i ng with i m p o r t s, and the farmer are being "crowded out.11 Looking ahead, the s t a b i l i ty of our capital and m o n ey m a r k e ts is now d e p e n d e nt as ueyer before on the w i l l i n g n e ss of f o r e i g n e rs to c o n t i n ue to place g r o w i ng a m o u n ts of m o n ey in our m a r k e t s. So far, they have been not only w i l l i ng but eager to do so* But we are in a real sense living on b o r r o w ed m o n ey and t i m e. It is up to all of us to make c o n s t r u c t i ve use of both the money and the t i m e. In e s s e n c e, that is the c h a l l e n ge for all of us -- for m o n e t a ry and fiscal p o l i c y, and for all the other p o l i c i es that can c o n t r i b u te to a p r o d u c t i v e, g r o w i ng e c o n o m y. M o n e t a ry Policy in 1984 As you will r e c a l l, the e c o n o my was e x p a n d i ng p a r t i c u l a r ly rapidly during the early part of 1 9 8 4, and d e m a n ds for money and credit -- and for bank r e s e r v es to support m o n e t a ry growth -• were also s t r o n g. By early s p r i n g, data a v a i l a b le at the t i me showed Ml i n c r e a s i ng at rates well into the upper portion of its range for the y e a r, which t a r g e t ed growth at 4-8 p e r c e n t .* At the same t i m e, driven by the f i n a n c i ng needs g e n e r a t ed by rising levels of p r i v a te s p e n d i ng and by the Federal G o v e r n m e n t, *The data in this t e s t i m o ny for the m o n e t a ry a g g r e g a t es reflect recent seasonal and b e n c h m a rk r e v i s i o n s* While the c h a n g es for the y e ar as a w h o le w e re s m a l l, the revised data for Ml for the first half of the y e ar are l o w e r, and the second half h i g h e r, than r e p o r t ed e a r l i e r. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -8- M3 and n o n - f i n a n c i al credit were e x p a n d i ng around or above the upper end of t h e ir l o n g - t e rm r a n g e s. The strong e x p a n s i o n a ry forces in the e c o n o my were re- flected in some limited upward m o v e m e n ts in i n t e r e st rates in F e b r u a ry and M a r c h, and early in the spring the Federal R e s e r ve began to exert some additional r e s t r a i nt on r e s e r v es being s u p p l i ed t h r o u gh open market o p e r a t i o n s. C o n s e q u e n t l y, d e p o s i- tory i n s t i t u t i o ns were forced to rely i n c r e a s i n g ly on b o r r o w i ng at the d i s c o u nt w i n d ow to satisfy d e m a n ds for r e s e r v e s. With credit d e m a n ds and the economy c o n t i n u i ng to e x p a nd s t r o n g l y, and with m a r k e ts c o n c e r n ed about the p o s s i b i l i ty that i n f l a- t i o n a ry forces might reassert t h e m s e l v es as the period of strong e x p a n s i on l e n g t h e n e d, interest rates moved n o t i c e a b ly h i g h er in the s p r i n g. In April the Federal R e s e r ve i n c r e a s ed its d i s c o u nt rate 1/2 of a p e r c e n t a ge point to 9 p e r c e nt to bring this rate into b e t t er a l i g n m e nt with m a r k et rates and to d i s c o u r a ge r e s e r ve a d j u s t m e nt at the d i s c o u nt w i n d o w. In May, a l i q u i d i ty crisis d e v e l o p ed in one of the largest c o m m e r c i al banks in the c o u n t r y, growing out of c o n t i n u i ng c o n c e r ns over w e a k n e s s es in its loan p o r t f o l i o. The Federal R e s e r v e, the F D I C, and the primary s u p e r v i s or of the b a n k, the C o m p t r o l l er of the C u r r e n c y, w o r k ed c l o s e ly t o g e t h er to support the o r d e r ly f u n c t i o n i ng of the i n s t i t u t i on w h i le more p e r m a n e nt r e c a p i t a l i z a t i on and other e l e m e n ts of a l o n g - t e rm s o l u t i on could be d e v e l o p e d. N o n e t h e l e s s, that i n c i d e n t, t o g e t h er with c o n t i n u i ng c o n c e r ns about i n t e r n a t i o n al debt p r o b l e m s, for a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -9- time c o n t r i b u t ed to u n e a s i n e ss in b a n k i ng m a r k e t s, and i n t e r e st rates on s h o r t - t e rm p r i v a te c r e d it i n s t r u m e n ts rose a p p r e c i a b ly a b o ve t h o se on g o v e r n m e nt s e c u r i t i e s ,* D e m a n ds for m o n ey s l a c k e n ed a f t er m i d y e ar as the e c o n o m ic e x p a n s i on s l o w e d. L o n g - t e rm i n t e r e st rates began to drop from the h i g h er l e v e ls r e a c h ed in the s p r i ng as i n f l a t i on c o n c e r ns m o d e r a t e d. With the p r o b l e ms of the C o n t i n e n t al I l l i n o is Bank c o n t a i n ed and p r o g r e ss m a de t o w a rd r e s t r u c t u r i ng the d e b ts of some i m p o r t a nt d e v e l o p i ng c o u n t r i e s, the a b n o r m al i n t e r e st rate s p r e a ds began to n a r r o w, but the m o n ey m a r k e ts as a w h o le r e m a i n ed u n d er some p r e s s u r e. By late A u g u st and S e p t e m b e r, w i th Ml g r o w th m o v i ng t o w a rd the m i d p o i nt of its range and M3 e x p a n s i on s l o w i ng t o w a rd the u p p er end of its r a n g e, and w i th some e v i d e n ce that e c o n o m ic g r o w th had s l o w e d, the Federal R e s e r ve began to ease p r e s s u r es on r e s e r ve p o s i t i o n s. That p r o c e ss c o n t i n u ed t h r o u gh the f a l l, and b o r r o w i ng at the d i s c o u nt w i n d ow fell s t e a d i ly from S e p t e m b er t h r o u gh J a n u a r y. Late in the y e a r, total and n o n b o r r o w ed r e s e r v es began to grow r a p i d l y. S h o r t - t e rm i n t e r e st rates d e c l i n ed b e t w e en 2-1/2 and 3-1/2 p e r c e n t a ge p o i n ts over the last four m o n t hs of the y e a r. R e a c t i ng to t h e se d e c l i n e s, and to dn e x t e nt f a c i l i t a t i ng t h e m, the Federal R e s e r ve in two h a l f - p o i nt steps r e d u c ed the d i s c o u nt rate to 8 p e r c e n t, the lowest level s i n ce 1 9 7 8. ^ A t t a c h m e n ts I & II s u m m a r i ze t h e se and r e l a t ed d e v e l o p m e n t s, and the Federal R e s e r ve r e s p o n s e, m o re f u l l y. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis - 1 0- S e v e r al a d d i t i o n al f a c t o rs i n f l u e n c ed j u d g m e n ts a b o ut the a p p r o p r i a te d e g r ee of e a s i ng of r e s e r ve p o s i t i o ns d u r i ng the f a l l. The d o l l ar r e m a i n ed e x c e p t i o n a l ly s t r o ng in f o r e i gn e x c h a n ge m a r k e t s, p o t e n t i a l ly i n c r e a s i ng p r e s s u r es on some s e c t o rs of the A m e r i c an e c o n o my and a s o u r ce of g r o w i ng c o n c e rn among some of our t r a d i ng p a r t n e rs e x p e r i e n c i ng d e p r e c i a t i ng c u r r e n c i es v i s - a - v is the d o l l a r. At the same t i m e, r e l a t i v e ly f a v o r a b le i n c o m i ng data about p r i c es and w a g es t e n d ed to a l l ay c o n c e r ns about actual and p o t e n t i al i n f l a t i o n a ry p r e s s u r e s. In f a c t, p r i c es of many s e n s i t i ve c o m m o d i t i es w e re f a l l i ng a p p r e- c i a b l y. In t h e se c i r c u m s t a n c e s, r e s e r v es could be p r o v i d ed m o re l i b e r a l l y, and g r o w th in the m o n ey supply m o re a c t i v e ly s u p p o r t ed w i t h o ut p r o v i d i ng a basis for a d e s t r u c t i ve rise in i n f l a t i on e x p e c t a t i o n s. The fall in i n t e r e st rates and the m o re g e n e r o us p r o v i s i on of r e s e r v es in the c o n t e xt of some i n c r e a s es in e c o n o m ic a c t i v i ty led to a r a t h er s t r o ng revival of Ml and M2 g r o w th a r o u nd y e a r- end, b r i n g i ng both a g g r e g a t es r e l a t i v e ly c l o se to the m i d - p o i n ts of t h e ir r e s p e c t i ve r a n g e s. As m o n e t a ry and c r e d it g r o w th c o n t i n u ed at a r e l a t i v e ly rapid pace into J a n u a r y, the e a s i ng p r o c e ss came to an end. U n l i ke the p a t t e rn d u r i ng much of 1982 and 1 9 8 3, when Ml grew m o re r a p i d ly than nominal 6NP (that is "velocity11 s l o w e d ), the i n c o me v e l o c i ty of Ml rose 4 p e r c e nt last y e a r. That is b r o a d ly in line with c y c l i c al e x p e r i e n ce in the p a s t, t a k i ng Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -11- into account both the pattern of interest rate m o v e m e n ts and income g r o w t h. M2 velocity also i n c r e a s e d, rising around 1-1/2 percent f o l l o w i ng two y e a r ly d e c l i n e s. These d e v e l o p m e n ts p r o v i de some support for the view that v e l o c i ty trends over t i m e, as well as cyclical c h a n g es for these a g g r e g a t e s, may be r e t u r n i ng to p a t t e r ns more along the lines of e a r l i er e x p e r i e n c e. In c o n t r a s t, in 19 82 and 1 9 8 3, during a period of rapid t r a n s i t i on to d e r e g u l a t i on of deposit interest rates and substantial e c o n o m ic u n c e r t a i n t y, those e a r l i er p a t t e r ns had been d i s r u p t ed and v e l o c i ty had decli ned appreci ably. The rise in M3 and credit during 1984 e x c e e d ed e x p e c t a- tions at the start of the y e a r, and both m e a s u r es e x c e e d ed by a c o n s i d e r a b le m a r g in the upper limits of their ranges over the y e ar as a w h o l e. In fact, credit i n c r e a s ed at its most rapid pace over the entire post-Wo rid War II period, both in a b s o l u te terms and r e l a t i ve to nominal GNP. Debt growth of this m a g n i t u de would appear to be much faster than c o n s i s t e nt with the long-run health of our e c o n o my and financial system. It reflects to some degree the i m b a l a n c es in our economy I emphasi zed earli er . For e x a m p l e, the budget deficit led to e x p a n s i on of federal debt of 16 p e r c e n t, an u n p r e c e d e n t ed rate of growth in the second y e ar of a b u s i n e ss c y c l e. The growth of the debt of n o n - f e d e r al s e c t o r s, at nearly 13 p e r c e n t, also was Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -12- high relative to past experience. A portion of this growth in private debt -- perhaps around 1-1/2 percentage points - can be attributed to a huge volume of mergers, leveraged buyouts, and stock repurchases by businesses which had the effect of substituting debt for equity. Despite some sizable sales of new stock, non-financial corporations on balance retired about $70 billion of stock last year. Whatever the circumstances and justification for the particular companies involved, a financial structure that tends toward more debt (and shorter debt) relative to equity becomes more vulnerable over time. More cash flow must be dedicated to debt servicing, exposure to short-run increases in interest rates is magnified, and cushions against adverse economic or financial developments are reduced, These are factors that prudent lending institutions should take into account in evaluating new credits, and reports suggest that some banks did in fact review their policies toward mergers and leveraged buyout financing as the year wore on. While the effect cannot be isolated, the rapid growth of debt relative to 6NP may also reflect the fact that domestic spending increased appreciably faster than domestic production, which is what the 6NP measures. A new machine, for instance, will require financing, whether purchased at home or abroad, and sharply increasing amounts of capital equipment have in fact been imported. As I indicated earlier, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -13- directly or indirectly, that financing may be supplied from abroad, alleviating the pressures on our market. But the debt burden inevitably rests with the borrower. Monetary Policy in 1985 At its meeting last week the FOMC agreed to some small changes in some of the ranges for the monetary and debt aggregates tentatively set out last July. The modifications are in response to analysis of information now available and do not represent any change in policy intentions. As shown on the attached table, for Ml, the Committee reaffirmed the lower tentative range it adopted last July of 4 to 7 percent growth from the fourth quarter of 1984 to the fourth quarter of 1985. M2 is targeted to grow between 6 and 9 percent, the same range as used in 1984. The upper end of that range was increased by 1/2 percent from the tentative range for 1985 set in July. That small adjustment reflects a technical judgment -- based on assessment of recent developments -- that M2 could expand more in line with income growth this year, in keeping with the historic record of little trend growth in its velocity. The upper end of the new M3 range of 6 - 9 1/2 percent was also set 1/2 percent higher than tentatively agreed in July. The associated monitoring range for credit was set at 9 to 12 percent, a percentage point above the 1984 range. Adjustments in both target ranges still contemplate a consider- able slowing in these two aggregates from what actually occurred Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -14- in 1984. Even so, credit growth, fueled in part by the budget deficit, is expected to be quite strong, significantly exceeding the rate of expansion of 6NP for the third consecutive year. The Committee does not anticipate that growth of debt within the targeted range would necessarily pose significant new risks for the economy or the financial system in the year immediately ahead. However, a healthy financial structure will in time require more restraint on borrowing relative to the economic growth that, in the last analysis, provides the wherewithal to service the debt. One continuing problem in that respect is the extent to which the current tax structure tends to favor debt rather than equity financing, a point addressed in the Administration's reform proposals. The ranges for growth in money and credit are expected by FOMC members and non-voting Reserve Bank Presidents to support another year of satisfactory economic expansion without an acceleration of inflation. Forecasts of real GNP growth centered around rates of 3-1/2 to 4 percent from the fourth quarter of 1984 to the fourth quarter of 1985 -- rates antici- pated to be sufficient to reduce the unemployment rate to around 6-3/4 to 7 percent by year-end. Inflation, as measured by the GNP deflator, was expected most frequently to be in a range of 3-1/2 to 4 percent over the year, about the same rate as prevailed in 1984.* *These projections, now regularly set out in our Humphrey- Hawkins Reports, should not be interpreted as indicating "targets11 for real growth or inflation in the short or longer run. As discussed in Attachment III, the Committee does not target a specific long-range growth path for the economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -15- In view of the necessarily tenuous nature of any judgment about the outlook for exchange rates, FOMC members in preparing their projections assumed that the dollar would fluctuate in a range encompassing its level of recent months. They also assumed that the federal budget deficit would be reduced sig- nificantly in fiscal 1986 relative to base line projections, a development that would help damp both interest rate and infla- tionary expectations. Obviously, those assumptions suggest some of the important risks inherent in the outlook. As I indicated in discussing 1984 developments, we enter- ed 1985 with the various monetary aggregates growing relatively rapidly. The targets for this year take, as usual, the actual average for the fourth quarter of the previous year as a start- ing point (or "base11). Consequently, we are starting the year with the levels of the aggregates above the target ranges as they have been conventionally illustrated -- that is by so- called "cones" starting at a point late the previous year and widening through the current year. (See Charts I to IV) 0 That conventional and widely used "picture" is essentially arbitrary. Interpreted rigidly (and wrongly), the narrowness of a cone in the early part of the year -- literally narrower than some weekly fluctuations in the money supply -- would attach policy importance to levels or movements in the various aggregates that in fact have no significance. We have sometimes considered, and others have suggested, a better "pictorial" approach would be to illustrate the targets Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -16- by a different (but also necessarily arbitrary) convention -• parallel lines drawn back from the outer bounds of the specified fourth quarter target ranges to the base period, as shown in the charts attached. The target range is then portrayed as maintaining the same width throughout the year. The current levels of the aggregates, as you can see on the charts, are within such parallel lines.* As a matter of economics and policy, rather than graphics, the Committee is not disturbed by the present level of Ml and M2 relative to its intentions for the year. It contemplates that, as the year progresses, growth will slow consistent with the target ranges. Consistent with that approach, as I indicated earlier, the progressive process of easing reserve positions undertaken in the latter part of 1984 ended. The provision of reserves through open market operations is currently being conducted a bit more cautiously to guard against inadvertent "overshoots11 in supplying reserves. Any further change in approach will, as always, depend upon assessments of the trend of monetary growth in the period ahead, evaluated in the context of the flow of information on the economy, on prices, and on domestic credit and exchange markets. The annual target ranges for Ml and M2 assume that trends in velocity are returning to a more normal and predictable ^Attachment IV addresses the different but related questions of the appropriate "base" used in setting and illustrating targeted growth ranges. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -17- pattern. However, there is some analysis that suggests the trend of velocity over time may be a little lower than the trend of 3 percent or so characteristic of much of the postwar period when interest rates were trending higher. Should devel- opments during 1985 tend to confirm that somewhat lower velocity growth, and provided that inflationary pressures remain subdued, the Committee anticipates that those aggregates might end the year in the upper part of their ranges. The lower part of the Ml range would be consistent with greater cyclical growth in velocity than now thought likely. As usual, these ranges will be reviewed at mid-year, in accordance with Humphrey-Hawkins Act procedures. The Challenge Ahead The approach toward monetary policy that I have outlined for 1985 is designed to promote, as best we can, our common objectives of sustained growth and stability. We can build on the strong progress of 1983 and 1984. There is forward momentum in the economy. The public at large seems to sense a greater degree of control over inflation than for many a year -- and I sense some chance of further progress toward price stability this year even as the economy grows. Happily, despite the strength of the economic advance and the financing of a huge deficit, interest rates are today little above those of two years ago. The threats of financial dislocation growing out of the debt problems of much of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -18- developing world, or from more purely domestic financial pres- sures, have been well contained. Points of strain will, with- out doubt, require continuing attention this year. But, in the context of a healthy economy, they are capable of resolu- ti on # By encouraging appropriate growth in money and credit, in discharging our supervisory responsibilities, in performing when necessary the essential functions of lender of last resort, and in our general surveillance of the financial system, the Federal Reserve can help build on that progress. We aim to do so. But it is equally important to understand clearly what monetary policy and the Federal Reserve cannot do. The progress against inflation, the strength of the dollar and the competition from abroad, and some margins (if diminish- ing) of capacity and manpower have provided a certain degree of flexibility in the conduct of monetary policy. But that limited flexibility would be abused at our collective peril. Credibility in the effort to deal with inflation is a precious thing. The lesson here and abroad, now and through history, is that, once a sense of price stability is lost, it can be restored only with pain and suffering. The Federal Reserve can theoretically run the modern equivalent of the printing press -- we can create more money. But more money is not the same as correcting the gross imbalance Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -19- between our ability to generate real savings and the demands for those savings posed by housing, by investment and by the federal deficit. To create money beyond that needed to sustain orderly growth would be to invite renewed inflation -- damaging incen- tives to save in the process. In contrast, to encourage savings from income would be to provide more of the real resources we need for future growth -- and it would help spur productivity and reduce price pressures in the process. If that route isn't open to us -- and as a practical matter we probably can't do much right now to change ingrained savings behavior -- then the only constructive alternative is to attack the problem from the other side of the ledger by reducing the federal deficit. For the time being, capital from abroad has been readily available to close the growing gap between our domestic savings and the demands upon them, moderating pressures on interest rates. Indeed, the money attracted partly by perceptions of our strength has come so freely we have an exceptionally strong dollar. But that same strong dollar contributes to a massive trade deficit that strains key sectors of industry and our agriculture, aggravating structural problems. No doubt bad monetary policy could drive the dollar down -- a monetary policy that aroused inflationary expecta- tions, undermined confidence, and drove away foreign capital. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -20- But then, how would we finance our investment and our budget deficit? Nor is the process of money creation adapted to relieving particular sectoral strains within our economy. We can and will, in our administration of the discount window and in our actions as lender of last resort, protect the essential finan- cial fabric by supporting credit-worthy depository institutions faced with extraordinary needs. But the evident problems of particular sectors, in the last analysis, will yield only to measures that support their efficiency and broaden their markets. That in itself is a large agenda, for government and those involved alike. And the process will be much easier if we at the same time address the basic imbalance between our capacity to save and our need to invest and to finance the government that I have emphasized today. Conclusion I fully appreciate the difficulties of the decisions before you as you collectively approach those excruciating budgetary choices. As you do so, I know that you are aware of the priority that progressive reduction of the deficit deserves. That, indeed, would provide the most fundamental kind of reassurance that growth can be sustained in an envi- ronment of greater stability. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis -21- For our part, in the conduct of monetary policy, we in the Federal Reserve will be sensitive to both the opportunities and the dangers before us. We believe the approach I have out- lined with respect to the monetary targets and our implementa- tion of policy sensibly reflects and balances the concerns I am sure we share. ******* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 1 M1 Target Ranges and Actual Billions of dollars 600 7% 580 560 Actual M1 / y 540 i I i 520 O ND J F M A MJ J A S O ND J F M A M J J A S O ND 1983 1984 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 2 M2 Target Ranges and Actual Billions of dollars 2600 g 9%' H 2550 2500 H2450 -H2400 H 2350 I I I I I I I I I I I I I 1 I I J F M A MJ J A S O ND O N D J F M A M J J A S O ND 1983 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 3 M3 Target Ranges and Actual Billions of dollars 3300 91/2% 3200 3100 3000 2900 6% 2800 2700 I I 1 I I I I J I 2600 O ND J F M A MJ J A S O ND J F M A M JJ A S O ND 1983 1984 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chart 4 Debt Monitoring Ranges and Actual Billions of dollars 6800 12% 6600 6400 6200 6000 Actual Debt 5800 \ 8% 5600 5400 5200 I I I 1 1 I I 8 I 1 1 I J I 5000 O N D J F M A M J J A S O ND J F M A M J J A S O ND 1983 1984 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment I The Implications for Monetary Pojjcy of the Near Failure of the Continental Illinois Bank The condition of the Continental Illinois Bank -- the seventh largest in the United States at the beginning of 1984 -- had been a matter of concern to regulatory authorities and market participants for some time, particularly after the failure of the Penn Square Bank in the middle of 1982 brought to light large loan losses and weaknesses in credit policy. Continuing profit and loan problems culminated in rumors of possible impending failure and a liquidity crisis in May 1984, involving withdrawal or failure to renew billions of dollars of deposits in the bank over a few days. The FDIC, the Federal Reserve, and the Comptroller of the Currency, with the cooperation of a group of major banks, de- veloped arrangements to provide temporary capital and liquidity support pending more permanent solutions and reorganization. The Federal Reserve -- acting as lender of last resort -- pro- vided large amounts of funds through the discount window to maintain the bank's liquidity. That lending rose irregularly from around $3 billion during most of May to a peak of more than $7 billion in August. During the autumn the amount of outstanding loans declined to much reduced levels. Provision of funds through the discount window has the effect of expanding total bank reserves, and unless otherwise offset, the lending to the bank would have had the effect of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1-2 expanding the money supply well beyond targeted ranges* To maintain consistency of reserve provision with FOMC intentions, essentially equivalent amounts of reserves were absorbed by open market operations. While the large borrowings necessarily involved some added technical difficulties and uncertainties in the conduct of open market operations, the Committee was able to achieve its reserve objectives. At the same time, however, the liquidity crisis of Continental Illinois Bank, particularly in an environment in which international debt and other credit problems were attract- ing attention, generated concern about possible threats to the stability of other financial institutions. As a result, inter- est rates on banking liabilities rose appreciably relative to interest rates on Treasury securities during the spring. More cautious funding and lending policies by a number of banks appeared to have some effect on maintaining short-term interest rates at higher levels than might otherwise have been the case. The extraordinary concerns in the marketplace dissipated as the year wore on, reflecting some sense of progress in deal- ing with both the international debt situation and points of domestic financial strain. Strong liquidity pressures at one of the largest savings and loan organizations during the late summer and fall, requiring sizable liquidity support by the Federal Home Loan Bank System, had lesser effects on market attitudes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 1-3 The e x p e r i e n ce of 1 9 8 4, t o g e t h er with s u p e r v i s o ry e f f o r ts and the strong c o n t i n u i ng p r e s s u r es on some s e c t o rs of the e c o n o my have u n d e r s c o r ed for d e p o s i t o ry i n s t i t u t i o ns the i m p o r t a n ce of a d e q u a te capital and p r u d e nt lending p o l i c i e s, and o t h er means of a s s e s s i ng and c o n t r o l l i ng risk. S u b s t a n t i al e f f o r ts have been made by many of the larger b a n k i ng o r g a n i z a t i o ns to in- c r e a se capital ratios and to review credit s t a n d a r d s. In t i m e, in the e n v i r o n m e nt of a growing e c o n o m y, t h e se e f f o r ts should be r e f l e c t ed in s t r o n g er i n s t i t u t i o ns and a r e i n f o r c ed b a n k i ng s y s t e m. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment II The International Debt Situation in 1984 At times during 1984, concerns about the external debt problems of key borrowing countries continued to be an impor- tant factor affecting attitudes in financial markets. As the year began, markets had substantial doubts about the viability of the Brazilian adjustment program, the programs of the new Venezuelan and Argentine governments were unknown, and there was some sense of weariness among the borrowing countries and their creditors. Tensions were aggravated by increases in dollar interest rates in the spring and early summer. Subsequently, concerns in financial markets receded some- what as interest rates moved lower, clear progress was recorded in narrowing some countries1 external imbalances, and plans for long-term debt restructuring were developed for some of the 1argest borrowers. The improvements in external accounts in Mexico and Venezuela in Latin America, and in Yugoslavia and Hungary in Eastern Europe, produced current account surpluses last year. Brazil's current account deficit was essentially eliminated, and a number of other countries had reduced deficits. This progress was faciliated in many cases by significant increases in exports, particularly to the United States, and in most cases was accompanied by a recovery -- or at least a slower rate of decline -- of imports. Such developments, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11-2 coupled with continued moderate capital inflows, contributed to sizable increases in the international reserves of many of these countries and to the prospects of reduced demands for extraordi- nary external financing in the future. At the same time, most of those countries managed to achieve domestic growth. Against this background, several of the major borrowing countries were able to move on to a second phase in their adjustment and financing programs. One important iniative, when warranted by progress in adjustment, has been planning for longer-term or multi-year restructuring of outstanding debts on terms that reflect stronger creditworthiness and permit plann- ing on a more assured basis for the future. Such arrangements have been agreed in principle between the commercial banks and Mexico and Venezuela; serious negotiations have begun with Brazil and Yugoslavia; and the financing package prepared for Argentina contains some longer-term elements. However, it is also evident from developments in 1984 and the first months of 1985 that the process of adjustment which began in 1982 is far from complete, particularly on the internal side. Financial markets will remain sensitive to indications of progress or the lack thereof. Cooperation among borrowing countries, commercial banks, multilateral institutions, and creditor countries will continue to be required. The need for imaginative and constructive solutions to the problems faced by individual countries is not over. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment III Targeting Real Growth Questions sometimes arise as to whether the Committee's forecasts for real GNP growth or prices are in the nature of short-run targets toward which the Federal Reserve "fine tunes" policy, or whether the Committee has preconceptions about just how rapidly the economy can and should grow over the medium or longer run. The answer to those questions is no. Monetary policy is, of course, broadly directed toward sustaining the growth process in a non-inflationary environment. But the Committee as a group has no preconceived notion as to just how rapid growth can or should be over a particular period of time, with- out straining our resources or giving rise to price pressures and imbalances that would make it ultimately unsustainable. Our capacity for growth over time depends on such vari- ables as the trends in productivity, in the labor force, in incentives to save and invest, and in other factors over which monetary policy has essentially no direct or long-run influence, There are other policies, public and private, quite outside the purview of monetary policy that will influence both our growth potential and actual growth paths over time. There are debates in and outside the Federal Reserve as to some of these factors that affect economic growth, but annual monetary targets and operational decisions do not, and need not, rest on such assump- tions for the long run. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis III-2 For i n s t a n c e, the C o m m i t t ee would p r e s u m a b ly w e l c o me f a s t er growth than p r e d i c t ed for 1985 if that proved c o n s i s t e nt with m o d e r a t i ng i n f l a t i o n a ry f o r c e s, and indeed, less i n f l a t i on than a n t i c i p a t ed would tend to e n c o u r a ge g r e a t er g r o w t h, con- sistent with our m o n e t a ry t a r g e t s. Indeed, the r e l a t i o n s h ip b e t w e en money and e c o n o m ic growth at any point in time is s u f f i c i e n t ly loose that many other factors bear upon actual p e r f o r m a n c e. In sum, p o l i c i es are p e r i o d i c a l ly r e a s s e s s ed in light of i n c o m i ng i n f o r m a t i on about p r i c e s, o u t p u t, e x c h a n ge rates and other v a r i a b l es b e a r i ng on our growth potential and p r o s p e c ts for i n f l a t i o n. In p r a c t i ce there is s u f f i c i e nt f l e x i b i l i ty in our t a r g e t i ng p r o c e d u r es to a c c o m m o d a te i n f o r m a t i on that might suggest g r e a t er or lesser growth potential over t i m e. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment IV The Base for Monetary Target Ranges Some questions have been raised concerning the "base" used by the Open Market Committee in deciding on targets for the monetary and credit aggregates for the calendar year. Consistent with the Humphrey-Hawkins Act p r o c e d u r e s, the Committee's target ranges are specified each February as a range of growth from the fourth quarter of the previous calendar year to the fourth quarter of the current calendar year. The convention that is usually used, is that the beginn- ing point -- or "base" from which growth is measured -- is taken to be the fourth quarter average growth of a particular monetary or credit aggregate. Other "bases" could be used -• and occasionally have been used -- if the conventional base period is seriously distorted, by institutional change or otherwi se. During its recent meeting the Committee, as it has from time to time, discussed the issue of the desirability of choos- ing a base for 1985 for one or more of the aggregates other than the conventional one. It concluded that none of the fourth quarter averages for the targeted aggregates were dis- torted in a manner that strongly suggested the desirability of departing from the usual convention, and that such a departure might indeed confuse communication of the Committee's inten- tions. It also noted that the average level of both Ml and M2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IV-2 during the fourth quarter of 1984 was reasonably close to the mid-point of the previous year's range, an alternative base suggested by some, M3 and credit rd.n significantly above the 1984 ranges. Rebasing those aggregates at the mid-point of the 1984 ranges would thus have implied a wrenching adjustment in the levels of those aggregates, a result that would be contrary to the Committee's intentions. Essentially, such a change would have implied a substantial tightening to bring the growth of those aggregates into the new ranges, or, alternatively, a specification of ranges of growth for 1985 that would have been extraordinarily high and quite out of keeping with 1onger range intentions. More broadly, a decision to regularly target growth from the mid-point of a previous year's range would seem to imply the continuing validity of a judgment made a year earlier that the mid-point of a previous range is in some sense a uniquely "correct" level of a monetary aggregate. The Committee does not share such a conviction. Instead, it believes that the appropriate trend of each aggregate needs to be judged in the light of evidence as to velocity changes and other factors as they emerge over time. In setting targets for any year, the Committee is, of course, aware of the base level of the aggregate. Adjustments in the new target ranges themselves, or in the conduct of policy within those ranges, can take account of any modest distortions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IV-3 in the base,. Such considerations are reflected in the discus si on of policy in the testimony. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Growth Ranges for the Aggregates for 1984 in Comparison with Actual Growth (QIV to QIV) Percent Increases Actual Ranges Growth Ml 4 to 8 5.2 M2 6 to 9 7.7 M3 6 to 9 10.5 Domestic Nonfinancial Debt 8 to 11 13.4 Growth Ranges for the Aggregates Adopted for 1985 in Comparison with Tentative Ranges and Those for 1984 (QIV to QIV) Percent Increases Adopted Ranges Tentati ve Ranges for 1985 Ranges for 1 985 Set in M id-1984 for 1984 Ml 4 to 7 4 to 7 4 to 8 M2 6 to 9 6 to 8-1/2 6 to 9 n M3 6 to 9-1 6 to 9 6 to 9 Domesti c Non - fi nancial Debt 9 to 12 8 to 11 8 to 11 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1985, February 19). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19850220_volcker

@misc{wtfs_speech_19850220_volcker,
  author = {Paul A. Volcker},
  title = {Speech},
  year = {1985},
  month = {Feb},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19850220_volcker},
  note = {Retrieved via When the Fed Speaks corpus}
}