Congressional Testimony

FEBERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1982 HEARINGS BEFORE THE COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS UNITED STATES SENATE NINETY-SEVENTH CONGRESS SECOND SESSION ON OVERSIGHT ON THE MIDYEAR MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BAL- ANCED GROWTH ACT OF 1978 JULY 20, 21, AND 27, 1982 Printed for the use of the Committee on Banking, Housing, and Urban Affairs [97-68] U.S. GOVERNMENT PRINTING OFFICE WASHINGTON: 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS JAKE GARN, Utah, Chairman JOHN TOWER, Texas DONALD W. RIEGLE, JR., Michigan JOHN HEINZ, Pennsylvania WILLIAM PROXMIRE, Wisconsin WILLIAM L. ARMSTRONG, Colorado ALAN CRANSTON, California RICHARD G. LUGAR, Indiana PAUL S. SARBANES, Maryland ALFONSE M. D'AMATO, New York CHRISTOPHER J. DODD, Connecticut JOHN H. CHAFEE, Rhode Island ALAN J. DIXON, Illinois HARRISON "JACK" SCHMITT, New Mexico JIM SASSER, Tennessee NICHOLAS F. BRADY, New Jersey M. DANNY WALL, Staff Director ROBERT W. RUSSELL, Minority Staff Director W. LAMAR SMITH, Economist (H) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS TUESDAY, JULY 20, 1982 Pa«e Opening statement of Chairman Garn 1 Opening statements of: Senator Riegle 2 Senator Tower 'S3 Senator Sasser 34 Senator Schmitt 34 WITNESS Paul A. Volcker, Chairman, Board o!' Governors of the Federal Reserve System 4 Monetary and credit targets 6 Blend of monetary and fiscal policy 10 Concluding' comments 11 Midyear monetary policy report to Congress 14 Answers to subsequent written questions of Senator Schmitt 79 Panel discussion: Congress blamed 35 Failure to meet target growth 36 Need for major change in policy mix 38 Flight of money to short-term securities 41 Effect of unregulated money market funds 42 Turned the corner on inflation 44 Ideas to change budget process 46 Poor economy causes large lasting deficits 48 Economic recovery predicted 49 Constitutional amendment 50 Impact of Government borrowing 53 Huge short-term borrowing 53 Administration supportive of present monetary policy 55 Possibilities of lower interest rates 57 Monetary policy counterproductive 58 Amendment for national economic emergencies 60 Small business bankruptcies 63 Interest rates continue to rise 64 Pressure on monetary policy 65 Same debates and arguments 67 Administration to stand pat on economic policy 70 Fed response to sinking economy 72 Record borrowing by the Treasury 74 Cutting taxes 77 Rash of farm foreclosures 78 Investors sitting on short-term money 78 WEDNESDAY, JULY 21, 1982 WITNESSES Murray L. Weidenbaum, Chairman, Council of Economic Advisers 83 Prepared statement 85 Selecting a definition of money 85 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IV Murray L. Weidenbaum, Chairman, Council of Economic Advisers—Contin- ued Prepared statement—Continued Pa»?p Setting and achieving monetary growth targets 89 Variability of money growth 94 Improved monetary control 98 Conclusion 99 Table 1—Composition of M, 87 Figure 1—Income velocity of money 92 Panel discussion: Budget predictions constantly underestimated 100 Serious economic conditions 102 Difficult times are behind us 104 Time is running out 104 Recession bottomed out 106 Trillion dollar debt 107 Reduction of money supply 110 Grant item veto power to the President 112 Targeting interest rates 113 Housing bill vetoed 125 Bailout approach 116 Characterizing Fed's monetary policy 118 Discount rate lowered 119 Foreign economic growth 122 Frustration of politics 126 Letter to Senator Sarbanes regarding the growth of money and its veloc- ity in Germany and Japan compared to the United States 128 Midcourse correction in economic policy 128 Donald E. Maude, Chief Financial Economist and Chairman, Interest Rate Policy Committee, Financial Economic Research Department, Merrill Lynch, Pierce, Fenner & Smith, New York, N.Y 132 Prepared statement 133 The setting 134 Possible reconciliation 135 Monthly changes in M 138 m M Growth 140 2 Monetary policy conduct considerations 141 Remarks 143 Weekly credit market bulletins • 152 Credit Market Digest 158 Serious contradictions 165 M growing above targets 167 2 Eliminate "base drift" 168 Leif H. Olsen, Chairman, Economic Policy Committee, Citibank, N.A., New York, N.Y 169 Prepared statement 170 Panel discussion: Contemporaneous reserve adjustment 176 Federal deficits 177 Balancing the budget 179 Social security problem 181 TUESDAY, JULY 27, 1982 WITNESSES Beryl W. Sprinkel, Under Secretary of the Treasury for Monetary Affairs 183 Views and recommendations 184 Gradual deceleration of money growth 185 Summary of study titled "The Effect of Volatile Money Growth on Inter- est Rates and Economic Activity" 189 Curb excessive Government spending 200 Prepared statement 202 Summary 212 Chart I—Growth in nominal GNP and adjusted monetary growth 214 Chart II—Growth in Mi and the monetary base 215 Chart III—Short-term monetary growth and short-term interest rates 216 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis V Beryl W. Sprinkel, Under Secretary of trie Treasury for Monetary Affairs— Continued Paw Predicting monetary growth 217 Federal Reserve targets 21!) Continuous deficit 219 Good prospects for a recovery 222 Subsequent additional statement on alternative ways to reduce interest rates 224 Steven M. Roberts, Director, Government Affairs, American Express Co 225 Monetary and fiscal policies 225 Recommendations 226 Prepared statement 227 Newspaper article from the Washington Post entitled, "Companies Rushing to Borrow Funds" 247 Testimony of Benjamin M. Friedman, professor of economics, Har- vard University, before the House Committee on Banking, Finance and Urban Affairs 248 Proposal for fiscal responsibility and lower interest rates 262 Proposed joint resolution to reduce total Federal outlays as a share oi' GNP 269 Analysis of the proposed joint resolution 270 Controlling total net credit 271 Comparing M, after 5 years 272 Adjusting prime rates to cost of funds 273 Problem controlling target for Mi 275 Answers to subsequent written questions of Senator Riegle 278 Reprint of paper by Alan Reynolds titled "The Trouble With Monetar- ism" 282 ADDITIONAL MATERIAL RECEIVED FOR THE RECORD Statement by Jack Carlson, vice president and chief economist, National Association of Realtors 306 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1982 TUESDAY, JULY 20, 1982 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, D.C. The committee met at 9:30 a.m. in room 5302 of the Dirksen Senate Office Building, Senator Jake Garn (chairman of the com- mittee) presiding. Present: Senators Garn, Tower, Lugar, Chafee, Schmitt, Brady, Riegle, Proxmire, Cranston, Sarbanes, Dixon, and Sasser. The CHAIRMAN. The Banking Committee will come to order. Chairman Volcker, we are happy to have you with us this morn- ing, to hear your report on monetary policy. I hope that we will be able to have a discussion with members of the Banking Committee that avoids a lot of rhetoric, as we discuss the current condition of the U.S. economy, together with the appropriateness of recent pros- pective monetary policies. To have a constructive discussion, we must not ignore the very real economic challenges that we face. Constructive discussion, however, will also require that we not ignore the equally real prog- ress that has been made since we began our efforts to slow infla- tion and curtail the government's growth rate—less than 19 months ago. Mr. Chairman, in the interest of time—we came to hear you today—and I would put the balance of my comments in the record, and turn to Senator Riegle for any comments that he might have before you begin, and then to Senator Dixon. OPENING STATEMENT OF CHAIRMAN GARN The CHAIRMAN. I hope that we will be able to avoid rhetoric this morning as we discuss the current condition of the U.S. economy together with the appropriateness of recent and prospective mone- tary policy. To have a constructive discussion, we must not ignore the very real economic challenges we face. A constructive discus- sion, however, will also require that we will also require that we not ignore the equally real progress that has been made since we began our efforts to slow inflation and curtail government's growth rate less than 19 months ago. Certainly, our greatest success has been in combatting what was acknowledged to be our country's No. 1 economic problem when Ronald Reagan was elected President. During the 6 months prior to his inauguration, consumer prices rose at a 10.3-percent annual (i) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis rate. Over the last 6 months, consumer prices have risen at an annual rate of only 3.7 percent. By holding firm to a commitment to gradually slow the mone- tary aggregates' growth rate, the Federal Reserve has played a cen- tral role in the successful fight against inflation. With inflation down, our greatest current challenge is to hasten a decline in interest rates so that the job-creating potential of our economy can be released. Today I applaud the Federal Reserve's commitment to removing money-growth volatility as a contributor to high rates, as evidenced by your decision to try to use contemporaneous reserve accounting to improve your short-term control over the aggregates. Nevertheless, I remain convinced that it is the Congress that is primarily to blame for the failure of interest rates to decline as quickly as inflation. The first budget resolution which we recently passed calls for steadily declining Federal deficit in the years ahead: $104 billion in fiscal year 1983; $84 billion in fiscal year 1984; and $60 billion in fiscal year 1985. But of the $281 billion in spending cuts that will be necessary over the next 3 years to achieve these declining deficits, only $27 billion—less than 10 percent—have been reconciled or enacted into law. Is it any wonder that the financial markets have remained skep- tical—as evidenced by the stickiness of interest rates—of Congress ability to make the budget cuts called for in the budget resolution? Still, I began this statement with a call for a constructive discus- sion, one that acknowledges accomplishments as well as remaining problems. In this spirit, we must acknowledge that an important start has been made toward lowering interest rates. In the 4 years before Ronald Reagan began charting a new eco- nomic future, rates rose steadily. From an average of only 4.4 per- cent in December 1976, the yield on 3-month Treasury bills rose to: 6.1 percent in December 1977; 9.1 percent in December 1978; 12.1 percent in December 1979; and 15.7 percent in December 1980. Yesterday that rate had come back down to just over 11 percent. Similarly, while the prime rate has not declined nearly enough, it is down substantially from the 21.5 percent Ronald Reagan inherit- ed. From much of what you hear and read today, you might think rates were up—instead of down—from where they were 19 months ago. In conclusion, I again call for a discussion that does not fail to confront problems head-on and also does not fail to give credit where credit is due. OPENING STATEMENT OF SENATOR RIEGLE Senator RIEGLE. Thank you, Mr. Chairman. Mr. Volcker, it's good to have you back before the committee today. As I have had the chance to talk with leading financial and eco- nomic people across the country, business people, labor people, and citizens at the grassroots level, it's clear from everything I am hearing that the economy is in very, very serious trouble. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis If I were to try to assess the bottom line, of what I'm hearing from this cross-section of opinion in the country, it is that the coun- try now, economically, seems to be on a disaster course, unless major changes are made, unless the Federal deficits come down, and come down substantially, unless the interest rates come down, and come down substantially and stay down for a period of time; that unless these things are done, we are going to find ourselves in a situation where unemployment will go higher, the rate of bank- ruptcies—which is running at 550 firms a week—would likely go higher. We've got a number of interest rate-sensitive sectors of the econ- omy in terrible difficulty. Certainly the savings and loan industry is in that situation. Agriculture and farming are increasingly in that situation. The auto industry is at less than 50 percent of ca- pacity operation. The steel industry is running at about 40 percent of capacity. The construction and the real estate industries are dev- astated. The headline today, on the front of the business section of the Washington Post, indicates that housing starts declined 15.3 per- cent from May—and we're now facing the worst year for housing in the United States since World War II. Capital investment plans have dropped off. If we consider all of this information, it shows that we are really in extremely serious trouble. The question is: How are we going to change this? What is the Fed doing to change it? What are you saying in your conversations with the President? What is his response to you? Are we going to be able to get these rates down? Are they going to come down soon? Will they come down enough to make a difference? And if not, then what is our contingency plan? If we stay on this course and the damage and the destruction and the hardship continue to accumulate, then the question is: How do we propose to treat those problems, which are mounting every day, in every place that we look? We have over 10.5 million people out of work in the country; and that does not count another IVfe million that are no longer included in the statistics because they have lost their unemployment bene- fits. So, the situation is really at a desperate point. I'm going to be very interested to hear both your assessment of the seriousness of the problem and how you feel that the Fed and the rest of us can change these policies and improve the picture as it now appears. The CHAIRMAN. Senator Brady, do you have any comments you wish to make? Senator BRADY. No comments, thank you, Mr. Chairman. The CHAIRMAN. Senator Dixon. Senator DIXON. Mr. Chairman, I will make my statement after the witness has concluded. The CHAIRMAN. Chairman Volcker, it is yours. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis STATEMENT OF PAUL A. VOLCKER, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. VOLCKER. Mr. Chairman, I am pleased to have this opportu- nity once again to discuss monetary policy with you, within the context of recent and prospective economic developments. As usual on these occasions, you have the Board of Governors' Humphrey-Hawkins report before you. This morning I want to en- large upon some aspects of that report and amplify as fully as I can my thinking with respect to the period ahead. In assessing the current economic situation, I believe the com- ments I made 5 months ago remain relevant. Without repeating that analysis in detail, I would emphasize that we stand at an im- portant crossroads for the economy and economic policy. In these past 2 years, we have traveled a considerable way toward reversing the inflationary trend of the previous decade or more. I would recall to you that, by the late 1970's, that trend had shown every sign of feeding upon itself and tending to accelerate to the point where it threatened to undermine the foundations of our economy. Dealing with inflation was accepted as a top national pri- ority, and, as events developed, that task fell almost entirely to monetary policy. In the best of circumstances, changing entrenched patterns of in- flationary behavior and expectations—in financial markets, in the practices of business and financial institutions, and in labor negoti- ations—is a difficult and potentially painful process. Those, con- sciously or not, who have come to bet on rising prices and the ready availability of relatively cheap credit to mask the risks of rising costs, poor productivity, aggressive lending, or overextended financial positions, have found themselves in a particularly diffi- cult position. The pressures on financial markets and interest rates have been aggravated by concern's over prospective huge volumes of Treasury financing, and by the need of some businesses to borrow at a time of a severe squeeze on profits. Lags in the adjustment of nominal wages and other costs to the prospects for sharply reduced inflation are perhaps inevitable, but have the effect of prolonging the pres- sure on profits—and indirectly on financial markets and employ- ment. Remaining doubts and skepticism that public policy will carry through on the effort to restore stability also affect interest rates, perhaps most particularly in the longer term markets. In fact, the evidence now seems to me strong that the inflation- ary tide has turned in a fundamental way. In stating that, I do not rely entirely on the exceptionally favorable consumer and producer price data thus far this year, when the recorded rates of price in- crease, at annual rates, declined to SMj and 2V2 percent, respective- ly. That apparent improvement was magnified by some factors likely to prove temporary, including, of course, the intensity of the recession; those price indexes are likely to appear somewhat less favorable in the second half of the year. What seems to me more important for the longer run is that the trend of underlying costs and nominal wages has begun to move Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis lower, and that trend should be sustainable as the economy recov- ers upward momentum. While less easy to identify—labor produc- tivity typically does poorly during periods of business decline— there are encouraging signs that both management and workers are giving more intense attention to the effort to improve produc- tivity. That effort should pay off in a period of business expansion, helping to hold down costs and encouraging a revival of profits, set- ting the stage for the sustained growth in real income we want. I am acutely aware that these gains against inflation have been achieved in a context of serious recession. Millions of workers are unemployed, many businesses are hard pressed to maintain profit- ability, and business bankruptcies are at a postwar high. While it is true that some of the hardship can reasonably be traced to mistakes in management or personal judgment, including presumptions that inflation would continue, large areas of the country and sectors of the economy have been swept up in more generalized difficulty. Our financial system has great strength and resiliency, but particular points of strain have been evident. Quite obviously, a successful program to deal with inflation, with productivity, and with the other economic and social problems we face cannot be built on a crumbling foundation of continuing reces- sion. As you know, there have been some indications—most broadly reflected in the rough stability of the real GNP in the second quar- ter and small increases in the leading indicators—that the down- ward adjustments may be drawing to a close. The tax reduction ef- fective July 1, higher social security payments, rising defense spending and orders, and the reductions in inventory already achieved, all tend to support the generally held view among econo- mists that some recovery is likely in the second half of the year. I am also conscious of the fact that the leveling off of the GNP has masked continuing weakness in important sectors of the econo- my. In its early stages, the prospective recovery must be led largely by consumer spending. But to be sustained over time, and to sup- port continuing growth in productivity and living standards, more investment will be necessary. At present, as you know, business investment is moving lower. House building has remained at depressed levels; despite some small gains in starts during the spring, the cyclical strength normal in that industry in the early stages of recovery is lacking. Exports have been adversely affected by the relative strength of the dollar in exchange markets. I must also emphasize that the current problems of the Ameri- can economy have strong parallels abroad. Governments around the world have faced, in greater or lesser degree, both inflationary and fiscal problems. As they have come to grips with those prob- lems, growth has been slow or nonexistent, and the recessionary tendencies in various countries have fed back, one on another. In sum, we are in a situation that obviously warrants concern, but also has great opportunities. Those opportunities lie in major part in achieving lasting progress—in pinning down and extending what has already been achieved—toward price stability. In doing so, we will be laying the base for sustaining recovery over many years ahead, and for much lower interest rates, even as the econo- my grows. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 Conversely, to fail in that task now, when so much headway has been made, could only greatly complicate the problems of the econ- omy over time. I find it difficult to suggest when and how a credi- ble attack could be renewed on inflation should we neglect complet- ing the job now. Certainly the doubts and skepticism about our ca- pacity to deal with inflation—which now seems to be yielding— would be amplified, with unfortunate consequences for financial markets and ultimately for the economy. I am certain that many of the questions, concerns, and dangers in your mind lie in the short run—and that those in good part re- volve around the pressures in financial markets. Can we look for- ward to lower interest rates to support the expansion in invest- ment and housing as the recovery takes hold? Is there, in fact, enough liquidity in the economy to support expansion—but not so much that inflation is reignited? Will, in fact, the economy follow the recovery path so widely forecast in coming months? These are the' questions that we in the Federal Reserve must deal with in setting monetary policy. As we approach these policy decisions, we are particularly conscious of the fact that monetary policy, however important, is only one instrument of economic policy. Success in reaching our common objective of a strong and prosperous economy depends upon more than appropriate mone- tary policies, and I will touch this morning on what seems to me appropriately complementary policies in the public and private sec- tors. THE MONETARY TARGETS Five months ago, in presenting our monetary and credit targets for 1982, I noted some unusual factors could be at work tending to increase the desire of individuals and businesses to hold assets in the relatively liquid forms encompassed in the various definitions of money. Partly for that reason—and recognizing that the conven- tional base for the Mi target of the fourth quarter of 1981 was rela- tively low—I indicated that the Federal Open Market Committee contemplated growth toward the upper ends of the specified ranges. Given the bulge early in the year in Mi, the committee also contemplated that that particular measure of money might for some months remain above a straight line projection of the target- ed range from the fourth quarter of 1981 to the fourth quarter of 1982. As events developed, Mi and M both remained somewhat above 2 straight line paths until very recently. M and bank credit have re- 3 mained generally within the indicated range, although close to the upper ends. See table I. Taking the latest full month of June, Mi grew 5.6 percent from the base period and M 9.4 percent, close to 2 the top of the ranges. To the second quarter as a whole, the growth was higher, at 6.8 and 9.7 percent, respectively. Looked at on a year-over-year basis, which appropriately tends to average through volatile monthly and quarterly figures, Mi during the first half of 1982 averaged about 43A percent above the first half of 1981, after accounting for NOW account shifts early last year. On the same basis, M and M grew by 9.7 and 10.5 percent, respectively, a rate z 3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis of growth distinctly faster than the nominal GNP over the same interval. In conducting policy during this period, the committee was sensi- tive to indications that the desire of individuals and others for li- quidity was unusually high, apparently reflecting concerns and un- certainties about the business and financial situation. One reflec- tion of that may be found in unusually large declines in velocity over the period—that is, the ratio of measures of money to the gross national product. Mi velocity—particularly for periods as short as 3 to 6 months—is historically volatile. A cyclical tendency to slow, relative to its upward trend, during recessions is common. But an actual decline for two consecutive quarters, as happened late in 1981 and the first quarter of 1982, is rather unusual. The magnitude of the decline during the first quarter was larger than in any quarter of the entire postwar period. Moreover, declines in velocity of this magnitude and duration are often accompanied by, and are related to, reduced short-term interest rates. Those interest rate levels during the first half of 1982 were distinctly lower than during much of 1980 and 1981, but they rose above the levels reached in the closing months of last year. More direct evidence of the desire for liquidity or precautionary balances affecting Mi can be found in the behavior of NOW ac- counts. As you know, NOW accounts are a relatively new instru- ment, and we have no experience of behavior over the course of a full business cycle. We do know that NOW accounts are essentially confined to individuals, their turnover relative to demand accounts is relatively low, and, from the standpoint of the owner, they have some of the characteristics of savings deposits, including a similar- ly low interest rate but easy access on demand. We also know the great bulk of the increase in Mi during the early part of the year— almost 90 percent of the rise from the fourth quarter of 1981 to the second quarter of 1982—was concentrated in NOW accounts, even though only about one-fifth of total Mi is held in that form. In con- trast to the steep downward trend in low-interest savings accounts in recent years, savings account holdings have stabilized or even increased in 1982, suggesting the importance of a high degree of li- quidity to many individuals in allocating their funds. A similar tendency to hold more savings deposits has been observed in earlier recessions. I would add that the financial and liquidity positions of the household sector of the economy, as measured by conventional liquid asset and debt ratios, has improved during the recession period. Relative to income, debt repayment burdens have declined to the lowest level since 1976. Trends among business firms are clearly mixed. While many individual firms are under strong pres- sure, some rise in liquid asset holdings for the corporate sector as a whole appears to be developing. The gap between internal cash flow—that is, retained earnings and depreciation allowances—and spending for plant, equipment, and inventory has also been at a historically low level, suggesting that a portion of recent business credit demands is designed to bolster liquidity. But, for many years business liquidity ratios have tended to decline, and balance sheet ratios have reflected more dependence on short-term debt. In that perspective, any recent gains in liquidity appear small. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis In the light of the evidence of the desire to hold more NOW ac- counts and other liquid balances for precautionary rather than transaction purposes during the months of recession, strong efforts to reduce further the growth rate of the monetary aggregates ap- peared inappropriate. Such an effort would have required more pressure on bank reserve positions—and presumably more pres- sures on the money markets and interest rates in the short run. At the same time, an unrestrained buildup of money and liquidity clearly would have been inconsistent with the effort to sustain progress against inflation, both because liquidity demands could shift quickly and because our policy intentions could easily have been misconstrued. Periods of velocity decline over a quarter or two are typically followed by periods of relatively rapid increase. Those increases tend to be particularly large during cyclical recov- eries. Indeed, velocity appears to have risen slightly during the second quarter, and the growth in NOW accounts has slowed. Judgments on these seemingly technical considerations inevita- bly take on considerable importance in the target-setting process because the economic and financial consequences—including the consequences for interest rates—of a particular Mi or M increase 2 are dependent on the demand for money. Over longer periods, a certain stability in velocity trends can be observed, but there is a noticeable cyclical pattern. Taking account of those normal histori- cal relationships, the various targets established at the beginning of the year were calculated to be consistent with economic recovery in a context of declining inflation. That remains our judgment today. Inflation has, in fact, receded more rapidly than anticipated at the start of the year potentially leaving more room for real growth. On that basis, the targets established early in the year still appeared broadly appropriate, and the Federal Open Market Com- mittee decided at its recent meeting not to change them at this time. However, the committee also felt, in the light of developments during the first half, that growth around the top of those ranges would be fully acceptable. Moreover—and I would emphasize this— growth somewhat above the targeted ranges would be tolerated for a time in circumstances in which it appeared that precautionary or liquidity motivations, during a period of economic uncertainty and turbulence, were leading to stronger than anticipated demands for money. We will look to a variety of factors in reaching that judgment, including such technical factors as the behavior of different compo- nents in the money supply, the growth of credit, the behavior of banking and financial markets, and, more broadly, the behavior of velocity and interest rates. I believe it is timely for me to add that, in these circumstances, the Federal Reserve should not be expected to respond, and does not plan to respond, strongly to various bulges—or for that matter valleys—in monetary growth that seem likely to be temporary. As we have emphasized in the past, the data are subject to a good deal of statistical noise in any circumstances, and at times when de- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 mands for money and liquidity may be exceptionally volatile, more than usual caution is necessary in responding to blips.1 We, of course, have a concrete instance at hand of a relatively large—and widely anticipated—jump in Mi in the first week of July—possibly influenced to some degree by larger social security payments just before a long weekend. Following as it did a succes- sion of money supply declines, that increase brought the most recent level for Mi barely above the June average, and it is not of concern to us. It is in this context, and in view of recent declines in short-term market interest rates, that the Federal Reserve yesterday reduced the basic discount rate from 12 to \\l/z percent. In looking ahead to 1983, the Open Market Committee agreed that a decision at this time would—even more obviously than usual—need to be reviewed at the start of the year in light of all the evidence as to the behavior of velocity or money and liquidity demand during the current year. Apart from the cyclical influences now at work, the possibility will need to be evaluated of a more lasting change in the trend of velocity. The persistent rise in velocity during the past 20 years has been accompanied by rising inflation and interest rates—both factors that encourage economization of cash balances. In addition, techno- logical change in banking—spurred in considerable part by the availability of computers—has made it technically feasible to do more and more business on a proportionately smaller cash base. With incentives strong to minimize holdings of cash balances that bear no or low interest rates, and given the technical feasibility to do so, turnover of demand deposits has reached an annual rate of more than 300, quadruple the rate 10 years ago. Technological change is continuing, and changes in regulation and bank practices are likely to permit still more economization of Mi-type balances. However, lower rates of interest and inflation should moderate in- centives to exploit that technology fully. In those conditions, veloc- ity growth could slow, or conceivably at some point stop; To conclude that the trend has, in fact, changed would clearly be premature, but it is a matter we will want to evaluate carefully as time passes. For now, the committee felt that the existing targets should be tentatively retained for next year. Since we expect to be around the top end of the ranges this year, those tentative targets would, of course, be fully consistent with somewhat slower growth in the monetary aggregates in 1983. Such a target would be appro- priate on the assumption of a more or less normal, cyclical rise in velocity. With inflation declining, the tentative targets would appear consistent with, and should support, continuing recovery at a moderate pace. 1 In that connection, a number of observers have noted that the first month of a calendar quarter—most noticeably in January and April—sometimes shows an extraordinarily large in- crease in M,—amplified by the common practice of multiplying the actual change by 12 to show an annual rate. Those bulges, more typically than not, are partially washed out by slower than normal growth the following month. The standard seasonal adjustment techniques we use to smooth out monthly money supply variations—indeed, any standard techniques—may, in fact, be incapable of keeping up with rapidly changing patterns of financial behavior, as they affect seasonal patterns. A note attached to this statement sets forth some work in process developing new seasonal adjustment techniques. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 BLEND OF MONETARY AND FISCAL POLICY The Congress, in adopting a budget resolution contemplating cuts in expenditures and some new revenues, also called upon the Fed- eral Reserve to "reevaluate its monetary targets in order to assure that they are fully complementary to a new and more restrained fiscal policy." I can report that members of the committee wel- comed the determination of the Congress to achieve greater fiscal restraint, and I want particularly to recognize the leadership of members of the Budget Committees and others in achieving that result. In most difficult circumstances, progress is being made toward reducing the huge potential gap between receipts and ex- penditures. But I would be less than candid if I did not also report a strong sense that considerably more remains to be done to bring the deficit under control as the economy expands. The fiscal situa- tion, as we appraise it, continues to carry the implicit threat of crowding out business investment and housing as the economy grows—a process that would involve interest rates substantially higher than would otherwise be the case. For the more immediate future, we recognized that the need remains to convert the inten- tions expressed in the budget resolution into concrete legislative action. In commenting on the budget, I would distinguish sharply be- tween the cyclical and structural deficit—that is, the portion of the deficit reflecting an imbalance between receipts and expenditures even in a satisfactorily growing economy with declining inflation. To the extent the deficit turns out to be larger than contemplated entirely because of a shortfall in economic growth, that add on would not be a source of so much concern. But the hard fact re- mains that, if the objectives of the budget resolution are fully reached, the deficit would be about as large in fiscal 1983 as this year, even as the economy expands at a rate of 4 to 5 percent a year and inflation—and thus inflation-generated revenues—re- mains higher than members of the Open Market Committee now expect. In considering the question posed by the budget resolution, the Open Market Committee felt that full success in the budgetary effort should itself be a factor contributing to lower interest rates and reduced strains in financial markets. It would thus assist im- portantly in the common effort to reduce inflationary pressures in the context of a growing economy. By relieving concern about future financing volume and inflationary expectations, I believe, as a practial matter, a credibly firmer budget posture might permit a degree of greater flexibility in the actual short-term execution of monetary policy without arousing inflationary fears. Specifically, market anxiety that shortrun increases in the Ms might presage continuing monetization of the debt could be ameliorated. But any gains in these respects will, of course, be dependent on firmness in implementing the intentions set forth in the resolution and on en- couraging confidence among borrowers and investors that the effort will be sustained and reinforced in coming years. Taking account of all these considerations, the committee did not feel that the budgetary effort, important as it is, would in itself ap- propriately justify still greater growth in the monetary aggregates Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 over time than I have anticipated. Indeed, excessive monetary growth—and perceptions thereof—would undercut any benefits from the budgetary effort with respect to inflationary expectations. We believe fiscal restraint should be viewed more as an important complement to appropriately disciplined monetary policy than as a substitute. CONCLUDING COMMENTS In an ideal world, less exclusive reliance on monetary policy to deal with inflation would no doubt have eased the strains and high interest rates that plague the economy and financial markets today. To the extent the fiscal process can now be brought more fully to bear on the problem, the better off we will be—the more assurance we will have that interest rates will decline and keep de- clining during the period of recovery, and that we will be able to support the increases in investment and housing essential to healthy, sustained recovery. Efforts in the private sector—to in- crease productivity, to reduce costs, and to avoid inflationary and job-threatening wage increases—are also vital, even though the connection between the actions of individual firms and workers and the performance of the economy may not always be self-evi- dent to the decisionmakers. We know progress is being made in these areas, and more progress will hasten full and strong expan- sion. But we also know that we do not live in an ideal world. There is strong resistance to changing patterns of behavior and expectations ingrained over years of inflation. The slower the progress on the budget, the more industry and labor build in cost increases in anti- cipationg of inflation or Government acts to protect markets or impede competition, the more highly speculative financing is un- dertaken, the greater the threat that available supplies of money and credit will be exhausted in financing rising prices instead of new jobs and growth. Those in vulnerable, competitive positions are most likely to feel the impact first and hardest, but unfortu- nately the difficulties spread over the economic landscape. The hard fact remains that we cannot escape those dilemmas by a decision to give up the fight on inflation—by declaring the battle won before it is. Such an approach would be transparently clear— not just to you and me— but to the investors, the businessmen, and the workers, who would, once again, find their suspicions con- firmed that they had better prepare to live with inflation and try to keep ahead of it. The reactions in financial markets and other sectors of the economy would, in the end, aggravate our problems, not eliminate them. It would strike me as the cruelest blow of all to the millions who have felt the pain of recession directly to sug- gest, in effect, it was all in vain. I recognize months of recession and high interest rates have con- tributed to a sense of uncertainty. Businesses have postponed in- vestment plans. Financial pressures have exposed lax practices and stretched balance-sheet positions in some institutions—financial as well as nonfinancial. The earnings position of the thrift industry remains poor. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 But none of those problems can be dealt with successfully by reinflation or by a lack of individual discipline. It is precisely that environment that contributed so much to the current difficulties. In contrast, we are now seeing new attitudes of cost containment and productivity growth—and ultimately our industry will be in a more robust competitive position. Millions are benefiting from less rapid price increases—or acutally lower prices—at their shopping centers and elsewhere. Consumer spending appears to be moving ahead and inventory reductions help set the stage for production increases. Those are developments that should help recovery get firmly un- derway. The process of disinflation has enough momentum to be sustained during the early stages of recovery—and that success can breed further success as concerns about inflation recede. As recov- ery starts, the cash flow of business should improve. And, more confidence should encourage greater willingness among investors to purchase longer debt maturities. Those factors should, in turn, work toward reducing interest rates, and sustaining them at lower levels, encouraging in turn the revival of investment and housing we want. I have indicated the Federal Reserve is sensitive to the special liquidity pressures that could develop during the current period of uncertainty. Moreover, the basic solidity of our financial system is back- stopped by a strong structure of governmental institutions precise- ly designed to cope with the secondary effects of isolated failures. The recent problems related largely to the speculative activities of a few highly leveraged firms can and will be contained. And over time, an appropriate sense of prudence in taking risks will serve us well. We have been through—we are in—a trying period. But too much has been accomplished not to move ahead and complete the job of laying the groundwork for a much stronger economy. As we look forward, not just to the next few months but to long years, the rewards will be great: In renewed stability, in growth, and in higher employment and standards of living. That vision will not be accomplished by monetary policy alone. But we mean to do our part. [Additional material received from the Federal Reserve Board follows:] TABLE I.—TARGETED AND ACTUAL GROWTH OF MONEY AND BANK CREDIT [Percent changes, at seasonally adjusted annual rates] Actual growth Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 APPENDIX—ALTERNATIVE SEASONAL ADJUSTMENT PROCEDURE For some time the Federal Reserve has been investigating ways to improve its procedures for seasonal adjustment, particularly as they apply to the monetary ag- gregates. In June of last year, a group of prominent outside experts, asked by the Board to examine seasonal adjustment techniques, submitted their recommenda- tions.1 The committee suggested, among other things, that the Board's staff develop seasonal factor estimates from a model-based procedure as an alternative to the widely used X-ll technique that provides the basis for the current seasonal adjust- ment procedure,^ and release the results. The Board staff has been developing a procedure using statistical models tailored to each individual series.n The table on the last page compares monthly and quar- terly average growth rates for the current Mi series with those of an alternative series from the model-based approach. Differences in seasonal adjustment techniques do not change the trend in mone- tary growth, but, as may be seen in the table, they do alter month-to-month growth rates owing to differing estimates of the distribution over time of the seasonal com- ponent in money behavior. Shortrun money growth is variable under both the alter- native and current techniques of seasonal adjustment, illustrating the inherently- large "noise" component of the series. However, the redistribution of the seasonal component under the alternative technique does on average tend to moderate month-to-rnonth changes somewhat. The Board will continue to publish seasonally adjusted estimates for Mi on both current and alternative bases at least until the annual review of seasonal factors in 1988. A detailed description of the alternative method will be available shortly. GROWTH RATES OF M, USING CURRENT1 AND ALTERNATIVE2 SEASONAL ADJUSTMENT PROCEDURES 1981 1982 ' See Committee of Experts on Seasonal Adjustment Techniques, Seasonal Adjustment of the Monetary Aggregates (Board of Governors of the Federal Reserve System, October 1981). 2 The current seasonal adjustment technique has most recently been summarized in the de- scription to the mimeograph release of historical money stock data dated March 1982. Detailed descriptions of the X-ll program and variants can be obtained from technical paper No. 15 of the U.S. Department of Commerce (revised February I9B7i and from the report to the Board cited in footnote 1. -1 The model-based seasonal adjustment procedures currently under review by the Board staff use methods based on the well-developed theory of statistical regression and time series model- ing. These approaches allow development of seasonal factors that are more sensitive than the current Factors to unique characteristics of each series, including, for example, fixed and evolv- ing seasonal patterns, trading day effects, within-month seasonal variations, holiday effects, out- lier adjustments, special events adjustments (such as the 1980 credit controls experience), and serially correlated noise components. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 GROWTH RATES OF Mi USING CURRENT' AND ALTERNATIVEa SEASONAL ADJUSTMENT PROCEDURES—Continued [Monthly ai'e'iige percenl annual rates] June.. 16 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM—MIDYEAR MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, Washington. D.C., July JO, W8J. The PRESIDENT OF THE SENATE, The SPEAKER OF THE HOUSE OF REPRESENTATIVES, Washington. D.C. The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, PAUL A. VOLCKER, Chairman. SECTION l: THE PERFORMANCE OF THE ECONOMY IN THE FIRST HALF OF 1982 The contraction in economic activity that began in mid-1981 continued into the first half of 1982, although at a diminished pace. Declines in production and employ- ment slowed, while sales of automobiles improved. Real GNP fell at a 4 percent annual rate between the third quarter of 1981 and the first quarter of 1982. With output declining, the margin of unused plant capacity widened and the unemploy- ment rate rose to a postwar record. By mid-1982, however, the recession seemed to be drawing to a close. Inventory positions had improved substantially, homebuilding was beginning to revive, and consumer spending appeared to be rising. Nonetheless, there were signs of increased weakness in business investment. Although final demands apparently fell during the second quarter, the rate of inventory liquidation slowed, and on balance, real GNP apparently changed little. If, in fact, this spring or early summer is deter- mined to have been the cyclical trough, both the depth and duration of the decline in activity will have been about the same as in other postwar recessions. The progress in reducing inflation that began during 1981 continued in the first half of 1982. The greatest improvement was in prices of food and energy—which benefited from favorable supply conditions—but increases in price measures that ex- clude these volatile items also have slowed markedly. Moreover, increases in em- ployment costs, which carry forward the momentum of inflation, have diminished considerably. Not only have wage increases eased for union workers in hardpressed industries as a result of contract concessions, but wage and fringe benefit increases also have slowed for non-union and white-collar workers in a broad range of indus- tries. In addition there has been increasing use of negotiated work-rule changes as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 well as other efforts by business to enhance productivity and trim costs. At the same time, purchasing power has been rising; real compensation per hour increased 1 percent during 1981 and rose at about a 3 percent annual rate over the first half of 1982. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 Industrial Production Index, 1967= 100 150 140 130 1978 1980 1982 Real GNP Change from end of previous period, annual rale, percent 1972 Dollars nr HI H2 HI 1978 1980 1982 Gross Business Product Prices Change (com end ol previous period, annual rate, percent Fixed-weighted Index H1 H2 Ml 1978 1980 1982 Note Dala lor 19S2 H1 are partially estimated by the FRB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 Interest rates As the recession developed in the autumn of 1981, short-term interest rates moved down substantially. However, part of this decline was retraced at the turn of the year as the demand for money bulged and reserve positions tightened. After the middle of the first quarter, short-term rates fluctuated but generally trended down- ward, as money—particularly the narrow measure, Mi—grew slowly on average and the weakness in economic activity continued. In mid-July, short-term rates were dis- tinctly below the peak levels reached in 1980 and 1981. Nonetheless, short-term rates were still quite high relative to the rate of inflation. Long-term interest rates also remained high during the first half of 1982. In part, this reflected doubts by market participants that the improved price performance would be sustained over the longer run. This skepticism was related to the fact that, during the past two decades, episodes of reduced inflation have been short-lived, fol- lowed by reacceleration to even faster rates of price increase. High long-term rates also have been fostered by the prospect of huge deficits in the federal budget even as the economy recovers. Fears of deepening deficits have affected expectations of future credit market pressures, and perhaps also have sustained inflation expecta- tions. The resolution on the 1983 fiscal year budget that was adopted by the Con- gress represents a beginning effort to deal with the prospect of widening deficits; and the passage of implementing legislation should work in the direction of reduc- ing market pressures on interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 Interest Rates Percent — 6 1978 1980 1982 Funds Raised by Private Nonfinancial Sectors Seasonally adjusted, annual rate, billions of dollars 300 200 1980 1982 Federal Government Borrowing Seasonally ad|usted, annual rate, billions of dollars Combined Deficit Financed by the Public 120 80 40 1978 1980 1982 Note Data for 19B2 H1 are partially estimated by the FHB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 Domestic credit flows Aggregate credit flows to private non-financial borrowers increased somewhat in the first half of 1982 from the reduced pace in the second half of 1981, according to very preliminary estimates. Business borrowing rose while households reduced fur- ther their use of credit. Borrowing by the federal government increased sharply in late 1981, after the 5 percent cut in personal income tax rates, and remained near the new higher level during the first half of 1982 on a seasonally adjusted basis. Reflecting uncertainties about the future economic and financial environment, both lenders and borrowers have shown a strong preference for short-term instruments. Much of the slackening in credit flows to nonfinancial sectors in the last part of 1981 was accounted for by households, particularly by household mortgage borrow- ing. Since then, mortgage credit flows have picked up slightly. The advance was en- couraged in part by the gradual decline in mortgage rates from the peaks of last fall. In addition, households have made widespread use of adjustable-rate mortgages and "creative" financing techniques—including relatively short-term loans made by sellers at below-market interest rates and builder "buy-downs." About two-fifths of all conventional mortgage loans closed recently were adjustable-rate instruments, and nearly three-fourths of existing home transactions reportedly involved some sort of creative financing. Business borrowing dropped sharply during the last quarter of 1981, primarily re- flecting reduced inventory financing needs. However, credit use by nonfinancial cor- porations rose significantly in the first half of 1982, despite a further drop in capital expenditures. The high level of bond rates has discouraged corporations from issu- ing long-term debt, and a relatively large share of business borrowing this year has been accomplished in short-term markets—at banks and through sales of commer- cial paper. The persistently large volume of business borrowing suggests an accumu- lation of liquid assets as well as an intensification of financial pressures on at least some firms. Signs of corporate stress continue to mount, including increasing num- bers of dividend reductions or suspensions, a rising fraction of business loans at commercial banks with interest or principal past due, and relatively frequent down- gradings of credit ratings. After raising a record volume of funds in U.S. credit markets in 1981, the federal government continued to borrow at an extraordinary pace during the first half of 1982, as receipts (national income and product accounts basis) fell while expendi- tures continued to rise. Owing to the second phase of the tax cut that went into effect on July 1 and the effects on tax revenues of the recession and reduced infla- tion, federal credit demands will expand further in the period ahead. Consumption Personal consumption expenditures (adjusted for inflation) fell sharply in the fourth quarter of 1981, but turned up early in 1982 and apparently strengthened further during the second quarter. The weakness in consumer outlays during the fourth quarter was concentrated in the auto sector, as total sales fell to an annual rate of 7.4 million units—the lowest quarterly figure in more than a decade—and sales of domestic models plummeted to a 5.1 million unit rate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 Real Income and Consumption Change Irom end ol previous period, annual rate, percent [T|] Real Disposable Personal Income P~] Real Personal Consumption Expenditures HI H2 M1 1978 1980 1982 Real Business Fixed Investment Change from end of previous period, annual rate, percent Producers' Durable Equipment Structures ' 20 10 H1 H2 H1 1978 1980 1982 Total Private Housing Starts Millions ot units 2.0 1.5 1.0 1978 1980 1982 Note; Data for 1 962 HI are partially estimated by trie FAB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 Price rebates and other sales promotion programs during the early months of 1982 provided a fillip to auto demand, and sales climbed to an 8.1 million unit rate. Auto markets remained firm into the spring, boosted in part by various purchase incentives. But as has generally occurred when major promotions have ended, auto purchases fell sharply in June. Outside the auto sector, retail sales at most types of stores were up significantly for the second quarter as a whole. Even purchases at furniture and appliance outlets, which had been on a downtrend since last autumn, increased during the spring. Real after-tax income has continued to edge up, despite the sharp drop in output during the recession. The advance reflects not only typical cyclical increases in transfer payments but also the reduction in personal income tax rates on October 1. Households initially saved a sizable proportion of the tax cut, boosting the personal saving rate from SVi percent in mid-1981—about equal to the average of the late 1970s and early 1980s—to 6,1 percent in the fourth quarter of 1981. During early 1982, however, consumers increased spending, partly to take advantage of price markdowns for autos and apparel, and the saving rate fell. Business investment As typically occurs during a recession, the contraction in business fixed invest- ment has lagged behind the decline in overall activity. Indeed, even though real GNP dropped substantially during the first quarter of 1982, real spending for fixed business capital actually rose a bit. An especially buoyant element of the invest- ment sector has been outlays for nonfarm buildings—most notably, commercial office buildings, for which appropriations and contracts often are set a year or more in advance. In contrast to investment in structures, business spending for new equipment showed little advance during 1981 and weakened considerably in the first half of 1982. Excluding business purchases of new cars, which also were buoyed by rebate programs, real investment in producers' durable equipment fell at a 2 percent annual rate in the first quarter. The decline evidently accelerated in the second quarter. In April and May, shipments of nondefense capital goods, which account for about 80 percent of the spending on producers' durable equipment, averaged nearly 3 percent below the first-quarter level in nominal terms. Moreover, sales of heavy trucks dropped during the second quarter to a level more than 20 percent below the already depressed first-quarter average. Businesses liquidated inventories at a rapid rate during late 1981 and in the first half of 1982. The adjustment of stocks followed a sizable buildup during the summer and autumn of last year that accompanied the contraction of sales. The most promi- nent inventory overhang by the end of 1981 was in the automobile sector as sales fell precipitously. However, with a combination of production cutbacks and sales promotions, the days' supply of unsold cars on dealers lots had improved consider- ably by spring. Manufacturers and non-auto retailers also found their inventories rising rapidly last autumn. Since then, manufacturers as a whole have liquidated the accumula- tion that occurred during 1981, although some problem areas still exist—particular- ly in primary metals. Stocks held by non-auto retailers have been brought down from their cyclical peak, but they remain above pre-recession levels. Residential construction Housing activity thus far in 1982 has picked up somewhat from the depressed level in late 1981. Housing starts during the first five months of 1982 were up 10 percent on average from the fourth quarter of 1981, The improvement in homebuild- ing has been supported by strong underlying demand for housing services in most markets and by the continued adaptation of real estate market participants to non- traditional financing techniques that facilitate transactions. The turnaround in housing activity has not occurred in all areas of the country. In the south, home sales increased sharply in the first part of 1982, and housing starts rose 25 percent from the fourth quarter of 1981. In contrast, housing starts declined further, on average, during the first five months of 1982 in both the west and the industrial north central states. Government Federal government purchases of goods and services, measured in constant dol- lars, declined over the first half of 1982. The decrease occurred entirely in the non- defense area, primarily reflecting a sharp drop in the rate of inventory accumula- tion by the Commodity Credit Corporation during the spring quarter. Purchases by the Commodity Credit Corporation had reached record levels during the previous two quarters owing to last summer's large harvests and weak farm prices. Other Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 nondefense outlays fell slightly over the first half of the year as a result of cuts in employment and other expenditures under many programs. Real defense spending apparently rose over the First half of the year, and the backlog of unfilled orders grew further. The federal deficit on a national income and product account basis widened from $100 billion at the end of 1981 to about $130 billion during the spring of this year. Much of this increase in the deficit reflects the effects of the recession on federal expenditures and receipts. At the state and local goverment level, real purchases of goods and services fell further over the first half of 1982 after having declined 2 percent during 1981. Most of the weakness this year has been in construction outlays as employment levels have stabilized after large reductions in the federally funded CETA program led to sizable layoffs last year. The declines in state and local government activity in part reflect fiscal strains associated with the withdrawal of federal support for many ac- tivities and the effects of cyclically sluggish income growth on tax receipts. Because of the serious revenue problems, several states have increased sales taxes and excise taxes on gasoline and alcohol. International payments and trade The weighted-average value of the dollar, after declining about 10 percent from its peak last August, began to strengthen sharply again around the beginning of the year and since then has appreciated nearly 15 percent on balance. The appreciation of the dollar has been associated to a considerable extent with the declining infla- tion rate in the United States and the rise in dollar interest rates relative to yields on assets denominated in foreign currencies.. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 Foreign Exchange Value of the U.S. Dollar Index, March 1973 = 100 — 110 — 100 — 90 — 80 1978 1980 T982 Current Account Balance Annual rate, billions o( dollars 10 20 1978 1980 1982 Note Dala for 1982 H1 are partially estimalea Oy the FRB Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 Reflecting the effects of the strengthening dollar, as well as the slowing of eco- nomic growth abroad, real exports of goods and services have been decreasing since the beginning of 1981. The volume of imports other than oil, which rose fairly stead- ily throughout last year, dropped sharply in the first half of 1982, owing to the weakness of aggregate demand—especially for inventories—in the United States. In addition, both the volume and price of imported oil fell during the first half of the year. The current account, which was in surplus for 1981 as a whole, recorded an- other surplus in the first half of this year as the value of imports fell more than the value of exports. Labor markets Employment has declined by nearly IVa million since the peak reached in mid- 1981. As usually happens during a cyclical contraction, the largest job losses have been in durable goods manufacturing industries—such as autos, steel, and machin- ery—as well as at construction sites. The job losses in manufacturing and construc- tion during this recession follow a limited recovery from the 1980 recession; as a result, employment levels in these industries are more than 10 percent below their 1979 highs. In addition, declines in aggregate demand have tempered the pace of hiring at service industries and trade establishments over the past year. As often happens near a business cycle trough, employment fell faster than output in early 1982 and labor productivity showed a small advance after declining sharply during the last half of 1981. Since mid-1981 there has been a 21/* percentage point rise in the overall unem- ployment rate to a postwar record high of 9 Vz percent. The effects of the recession have been most severe in the durable goods and construction industries, and the burden of rising unemployment has been relatively heavy on adult men, who tend to be more concentrated in these industries. At the same time, joblessness among young and inexperienced workers remains extremely high; hardest hit have been black male teenagers who experienced an unemployment rate of nearly 60 percent in June 1982. Reflecting the persistent slack in labor markets, most indicators of labor supply also show a significant weakening. For example, the number of discouraged work- ers—that is, persons who report that they want work but are not looking for jobs because they believe they cannot find any—has increased by nearly half a million over the past year, continuing an upward trend that began before the 1980 reces- sion. In addition, the labor force participation rate—the proportion of the working- age population that is employed or actively seeking jobs—has been essentially flat for the last two years after rising about one-half percentage point annually between 1975 and 1979. Prices and labor costs A slowing in the pace of inflation, which was evident during 1981, continued through the first half of this year. During the first five months of 1982 (the latest data available), the consumer price index increased at an annual rate of 3.5 percent, sharply lower than the 8.9 percent rise during 1981. Much of the improvement was in energy and food prices as well as in the volatile CPI measure of homeownership costs. But even excluding these items, the annual rate of increase in consumer prices has slowed to 5Va percent this year compared with a 9J/2 percent rise last year. The moderation of price increases also was evident at the producer level. Prices of capital equipment have increased at a 4V percent annual rate thus far 4 this year—well below the 9'A percent pace of 1981. In addition, the decline in raw materials prices, which occurred throughout last year, has continued in the first half of 1982. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Consumer Prices Change from end Of previous period, annual rate, percenl Excluding Food, Energy, and Horneownership 15 10 Dec to May 1976 1930 1982 Gasoline Prices Dollars per gallon 1.50 1.00 .50 1978 1980 1982 Hourly Earnings Index Change from end of previous period, annual rate, percent H1 H2 H1 1978 1980 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Gasoline prices at the retail level, which had remained virtually flat over the second half of 1981, fell substantially during the first four months of 1982. Slack domestic demand and an overhang of stocks on world petroleum markets precipitat- ed the decline in prices. However, gasoline prices began to rise again in May in re- flection of rising consumption, reduced stocks, and lower production schedules by major crude oil suppliers. The rate of increase in employment costs decelerated considerably during the first half of 1982. The index of average hourly earnings, a measure of wage trends for production and nonsupervisory personnel, rose at a ti'/4 percent annual rate over the first half of this year, compared with an increase of 8'A percent during 1981. Part of the slowing was due to early negotiation of expiring contracts and renegotiation of existing contracts in a number of major industries. These wage concessions are ex- pected to relieve cost pressures and to enhance the competitive position of firms in these industries. Increases in fringe benefits, which generally have risen faster than wages over the years, also are being scaled back. Because wage demands, not to mention direct escalator provisions, are responsive to price performance, the prog- ress made in reducing the rate of inflation should contribute to further moderation in labor cost pressures. SECTION 2: THE GKOWTH OF MONEY AND CREDIT IN THE FIRST HALF OF 1982 The annual targets for the monetary aggregates announced in February were chosen to be consistent with continued restraint on the growth of money and credit in order to exert sustained downward pressure on inllation. At the same time, these targets were expected to result in sufficient money growth to support an upturn in economic activity. Measured from the fourth quarter of 1981 to the fourth quarter of 1982, the growth ranges for the aggregates adopted by the Federal Open Market Committee (FOMCl were as follows: for M>, 2Va to f>Va percent; for M, ti to 9 per- 2 cent; and for M, fi'/a to 9'/a percent. The corresponding range specified by the FOMC for bank c ;i redit was 6 to 9 percent.l When the FOMC was deliberating on its annual targets in February, the Commit- tee was aware that Mi already had risen well above its average level in the fourth quarter of 1981, In light of the financial and economic backdrop against which the bulge in Mi had occurred, the Committee believed it likely that there had been an upsurge in the public's demand Cor liquidity. It also seemed probable that this strengthening of money demand would unwind in the months ahead. Thus, under these circumstances and given the relatively low base for the M! range for 1982, it did not appear appropriate to seek an abrupt return to the annual target range, and the FOMC indicated its willingness to permit Mi to remain above the range for a while. At the same time, the FOMC agreed that the expansion in M, for the year as a whole might appropriately be in the upper part of its range, particularly if availa- ble evidence suggested the persistence of unusual desires for liquidity that had to be accommodated to avoid undue financial stringency. In setting the annual target for Ma, the FOMC indicated that Mj growth for the year as a whole probably would be in the upper part of its annual range and might slightly exceed the upper limit. The Committee anticipated that demands for the assets included in M might be enhanced by new tax incentives such as the broad- 2 ened eligibility for IRA/Keogh accounts, or by further deregulation of deposit rates. The Committee expected that M growth again would be influenced importantly by 5 the pattern of business financing and, in particular, by the degree to which borrow- ing would be focused in markets for short-term credit. As anticipated—and consistent with the FOMC's short-run targets—the surge in M, growth in December and January was followed by appreciably slower growth. After January, M, increased at an annual rate of only 1'4 percent on average, and the level of Mi in June was only slightly above the upper end of the Committee's annual growth range. From the fourth quarter of 1981 to June, Mi increased at a 5.6 percent annual rate. M growth so far this year also has run a bit above the 2 FOMC's annual range; from the fourth quarter of 1981 through June, M^ increased on average at a 9.4 percent annual rate. From a somewhat longer perspective, Mi has increased at a 4.7 percent annual rate, measuring growth from the first half of 1981 to the first half of 1982 and abstracting from the shift into NOW accounts in 11*81; and M has grown at. a 9.7 percent annual rate on a half-year over half-year 2 basis. 1 Because of the authorization of international banking facilities iIBF's) on Dec. .'!, 11181. the bank credit data starting in December litHl are not comparable with earlier data. The target for bank credit was put in terms of annualized growth measured from the average of December 1!)81 and January !f)S2 to the average level in the fourth quarter of 1982 so that the shift of assets to IBF's that occurred at the turn of the year would not have a major impact on the pattern of growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 Ranges and Actual Monetary Growth M1 Billions ot dollars Range adopted by FOMC for Annual Rates of Growth 1981 04 to 1982 Q4 1981 Q4 to June 5.6 Percent 1981 04 to 1982 Q2 6.8 Percent 1981 H1 to 1962 H1 450 4 7 Percent' 1981 1982 M2 Billions of dollars Range adopted by FOMC lor Annual Rates of Growth 1981 Q4 to 1982 Q4 I960 1981 04 to June 9.4 Percent 1981 Q4 to 1982 O2 9.7 Percent 1900 1981 H1 to 1962 H1 9.7 Percent 185O 1800 lp -LL. 1981 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 Although Mi growth has been moderate on balance thus far this year, that growth has considerably exceeded the pace of increase in nominal GNP. Indeed, the first-quarter decline in the income velocity of Mi—that is, GNP divided by M,—was extraordinarily sharp. Similarly, the velocity of the broader aggregates has been un- usually weak. Given the persistence of high interest rates, this pattern of velocity behavior suggests a heightened demand for M, and M? over the first half. The unusual demand for M has been focused on its NOW account component. t Following the nationwide authorization of NOW accounts at the beginning of 1981, the growth of such deposits surged. When the aggregate targets were reviewed this past February, a variety of evidence indicated that the major shift from convention- al checking and savings accounts into NOW accounts was over; in particular, the rate at which new accounts were being opened had dropped off considerably. As a result of that shift, however, NOW accounts and other interest-bearing checkable deposits had grown to account for almost 20 percent of M, by the beginning of 1982. Subsequently, it has become increasingly apparent that Mi is more sensitive to changes in the public's desire to hold highly liquid assets. Mi is intended to be a measure of money balances held primarily for transaction purposes. However, in contrast to the other major components of Mi—currency and conventional checking accounts—NOW accounts also have some characteristics of traditional savings accounts. Apparently reflecting precautionary motives to a con- siderable degree, NOW accounts and other interest-bearing checkable deposits grew surprisingly rapidly in the fourth quarter of last year and the first quarter of this year. Although growth in this component has slowed recently, its growth from the fourth quarter of last year to June has been 80 percent at an annual rate. The other components of M, increased at an annual rate of less than 1 percent over this same period. Looking at the components of M not also included in M,, the so-called nontran- 3 saction components, these items grew at a 10% percent annual rate from the fourth quarter to June. General purpose and broker/dealer money market mutual funds were an especially strong component of M, increasing at almost a 30 percent 2 annual rate this year. Compared with last year, however, when the assets of such money funds more than doubled, this year's increase represents a sharp decelera- tion. Perhaps the most surprising development affecting M has been the behavior of 2 conventional savings deposits. After declining in each of the past four years—falling 16 percent last year—savings deposits have increased at about a 4 percent annual rate thus far this year. This turnaround in savings deposit flows, taken together with the strong increase in NOW accounts and the still substantial growth in money funds, suggests that stronger preferences to hold safe and highly liquid fi- nancial assets in the current recessionary environment are bolstering the demand for M as well as M,. 2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 Ranges and Actual Monetary Growth dollars Annual Rates of Growth '981 O4 to June 9.7 Percent 2300 1981 O4 to 1982 Q2 9.8 Percent 1981 H1 to 1982 H1 10 5 Percent — 2200 1982 Bank Credit Billions of dollars Range adopted by FOMC tor Annual Rates ot Growth Dec 1981-Jan 1982 to 1982 Q4 1982 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 M increased at a 9.7 annual rate from the fourth quarter of 1981 to June, just 3 above the upper end of the FOMC's annual growth target. Early in the year, M 3 growth was relatively moderate as a strong rise in large denomination CDs was offset by declines in term RPs and in money market mutual, funds restricted to in- stitutional investors. During the second quarter, however, M showed a larger in- 3 crease; the weakness in its term RP and money fund components subsided and heavy issuance of large CDs continued. With growth of "core deposits" relatively weak on average, commercial banks borrowed heavily in the form of large CDs to fund the increase in their loans and investments. Commercial bank credit grew at an 8.3 percent annual rate over the first half of the year, in the upper part of the FOMC's range for 1982. Bank loans have in- creased on average at about a 9Va percent annual rate, with loans to nonfinancial businesses expanding at a 14 percent annual rate. In past economic downturns, busi- ness loan demand at banks has tended to weaken, but consistently high long-term interest rates in the current recession have induced corporations to meet the great bulk of their external financing needs through short-term borrowing. Real estate loans have increased at a 7'A percent annual rate this year, somewhat slower than the growth in each of the past two years. Consumer loans outstanding during the first half of the year have grown at the same sluggish pace of 3 percent experienced last year. The investment portfolios of banks have expanded at about a 5 percent annual rate, with the rate of increase in U.S. government obligations about twice as large as the growth in holdings of other types of securities. SECTION 3: THE FEDERAL RESERVE'S OBJECTIVES FOR GROWTH OF MONEY AND CREDIT There is a clear need today to promote higher levels of production and employ- ment in our economy. The objective of Federal Reserve policy is to create an envi- ronment conducive to sustained recovery in business activity while maintaining the financial discipline needed to restore reasonable price stability. The experience of the past two decades has amply demonstrated the destructive impact of inflation on economic performance. Because inflation cannot persist without excessive monetary expansion, appropriately restrained growth of money and credit over the longer run is critical to achieving lasting prosperity. The policy of firm restraint on monetary growth has contributed importantly to the recent progress toward reducing inflation. But when inflationary cost trends remain entrenched, the process of slowing monetary growth can entail economic and financial stresses, especially when so much of the burden of dealing with infla- tion rests on monetary policy. These strains—reflected in reduced profits, liquidity problems, and balance-sheet pressures—place particular hardships on industries that depend heavily on credit markets such as construction, business equipment, and consumer durables. Unfortunately, these stresses cannot be easily remedied through accelerated money growth. The immediate effect of encouraging faster growth in money might be lower interest rates, especially in short-term markets. In time, however, the at- tempt to drive interest rates lower through a substantial reacceleration of money growth would founder, for the result would be to embed inflation and expectations of inflation even more deeply into the nation's economic system. It would mean that this recession was another wasted, painful episode instead of a transition to a sus- tained improvement in the economic environment. The present and prospective pressures on financial markets urgently need to be eased not by relaxing discipline on money growth, but by the adoption of policies that will ensure a lower and de- clining federal deficit. Moreover, a return to financial health will require the adop- tion of more prudent credit practices on the part of private borrowers and lenders alike. In reviewing its targets for 1982 and setting tentative targets for 1983, the FOMC had as its basic objective the maintenance of the longer-range thrust of monetary discipline in order to reduce inflation further, while providing sufficient money growth to accommodate exceptional liquidity pressures and support a sustainable re- covery in economic activity. At the same time, the Committee recognized that regu- latory actions or changes in the public's financial behavior might alter the implica- tions of any quantitative monetary goals in ways that cannot be fully predicted. In light of all these considerations, the Committee concluded that a change in the previously announced targets was not warranted at this time. Because of the tend- ency for the demand for money to run strong on average in the first half, and also responding to the congressional budget resolution, careful consideration was given to the question of whether some raising of the targets was in order. However, the available evidence did not suggest that a large increase in the ranges was justified, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 31 and a small change in the ranges would have represented a degree of "fine tuning" that appeared inconsistent with the degree of uncertainty surrounding the precise relationship of money to other economic variables at this time. However, the Com- mittee concluded, based on current evidence, that growth this year around the top of the ranges for the various aggregates would be acceptable. The Committee also agreed that possible shifts in the demand for liquidity in cur- rent economic circumstances might require more than ordinary elements of flexibil- ity and judgment in assessing appropriate needs for money in the months ahead. In the near term, measured growth of the aggregates may be affected by the income tax reductions that occurred on July 1, by cost-of-living increases in social security benefits, and by the ongoing difficulties of accurately accounting for seasonal move- ments in the money stock. But more fundamentally, it is unclear to what degree businesses and households may continue to wish to hold unusually large precaution- ary liquid balances. To the extent the evidence suggests that relatively strong pre- cautionary demands for money persist, growth of the aggregates somewhat above their targeted ranges would be tolerated for a time and still would be consistent with the FOMC's general policy thrust. Looking ahead to 1983 and beyond, the FOMC remains committed to restraining money growth in order to achieve sustained noninflationary economic expansion. At this point, the FOMC feels that the ranges now in effect can appropriately remain as preliminary targets for 1983. Because monetary aggregates in 1982 more likely than not will be close to the upper ends of their ranges, or perhaps even somewhat above them, the preliminary 1983 targets would be fully consistent with a reduction in the actual growth of money in 1983. In light of the unusual uncertainty surrounding the economic, financial, and budgetary outlook, the FOMC stressed the tentative nature of its 1983 targets. On the one hand, postwar cyclical experience strongly suggests that some reversal of this year's unusual shift in the asset-holding preferences of the public could be ex- pected; with economic activity on an upward trend, any lingering precautionary mo- tives for holding liquid balances should begin to fade, thus contributing to a rapid rise in the velocity of money. Moreover, regulatory actions by the Depository Insti- tutions Deregulation Committee that increase the competitive appeal of deposit in- struments—as well as the more widespread use of innovative cash management techniques, such as "sweep" accounts—also could reduce the demand for money rel- ative to income and interest rates. On the other hand, factors exist that should in- crease the attractiveness of holding cash balances. The long upward trend in the velocity of money since the 1950s took place in an environment of rising inflation and higher nominal interest rates—developments that provide incentives for econo- mizing on money holdings. As these incentives recede, it is possible that the attrac- tiveness of cash holdings will be enhanced and that more money will be held rela- tive to the level of business activity. SECTION 4: THE OUTLOOK FOR THE ECONOMY The economy at midyear appears to have leveled off after sizable declines last fall and winter. Consumption has strengthened with retail sales up significantly in the second quarter. New and existing home sales have continued to fluctuate at de- pressed levels, but housing starts nonetheless have edged up. In the business sector, substantial progress has been made in working off excess inventories, and the rate of liquidation appears to have declined. On the negative side, however, plant and equipment spending, which typically lags an upturn in overall activity, is still de- pressed. And the trend in export demand continues to be a drag on the economy, reflecting the dollar's strength and weak economic activity abroad. An evaluation of the balance of economic forces indicates that an upturn in eco- nomic activity is highly likely in the second half of 1982. Monetary growth along the lines targeted by the FOMC should accommodate this expansion in real GNP, given the increases in velocity that typically occur early in a cyclical recovery and absent an appreciable resurgence of inflation. The 10 percent cut in income tax rates that went into effect July 1 is boosting disposable personal income and should reinforce the growth in consumer spending. Given the improved inventory situation, any siz- able increase in consumer spending should, in turn, be reflected in new orders and a pickup in production. Another element supporting growth in real GNP will be the continuing rise in defense spending and the associated private investment outlays needed for the production of defense equipment. At least during the initial phase, the expansion is likely to be more heavily con- centrated in consumer spending than in past business cycles, as current pressures in financial markets and liquidity strains may inhibit the recovery in investment ac- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 tivity. With mortgage interest rates high, residential construction does not seern likely to contribute to the cyclical recovery to the extent that is has in the past. Likewise, the high level of corporate bond rates, and the cumulative deterioration in corporate balance sheets resulting from reliance in recent years on short-term bor- rowing, may restrain capital spending, especially given the considerable margin of unutilized capacity that now exists. The excellent price performance so far this year has been helped by slack demand and by exceptionally favorable energy and food supply developments. For that reason, the recorded rate of inflation may be. higher in the second half. However, prospects appear excellent for continuing the downtrend in the underlying rate of inflation. As noted earlier, significant progress has been made in slowing the rise in labor compensation, and improvements in underlying cost pressures should continue over the balance of the year. Unit labor costs also are likely to be held down by a cyclical rebound in productivity growth as output recovers. Moreover, lower infla- tion will contribute to smaller cost-of-living wage adjustments, which will moderate cost pressures further. The Federal Reserve's objectives for money growth through the end of 198,1 are designed to be consistent with continuing recovery in economic activity. A critical factor influencing, the composition and strength of the expansion will be the extent to which pressures in financial markets moderate. This, in turn, depends important- ly on the progress made in further reducing inflationary pressures. A marked de- crease in inflation would take pressure off financial markets in two ways. First, slower inflation will lead to a reduced growth in transaction demands for money, given any particular level of real activity. It follows that a given target for money growth can be achieved with less pressure on interest rates and accordingly less re- straint on real activity, the greater is the reduction in inflation. Second, further progress in curbing inflation will help lower long-term interest rates by reducing the inflation premium contained in nominal interest rates. The welcome relief in inflation seen recently apparently is assumed by many to represent a cyclical rather than a sustained drop in inflation. But the longer that improved price performance is maintained, the greater will be the confidence that a decisive downtrend in infla- tion is being achieved. Such a change should be reflected in lower long-term interest rates and stronger activity in the interest-sensitive sectors of the economy. Another crucial influence on financial markets and thus on the nature of the ex- pansion in 1983 will be the federal budgetary decisions that are made in coming months. The budget resolution that was recently passed by the House and Senate is a constructive first step in reducing budget deficits as the economy recovers. Howev- er, much remains to be done in appropriation and revenue legislation to implement this resolution. How the budgetary process unfolds will be an important factor in determining future credit demands by the federal government and thus the extent to which deficits will preempt the net savings generated by the private economy. A strong program of budget restraint \vou(d minimize pressures in financial markets and thereby enhance the prospects for a more vigorous recovery in homebuilding, business fixed investment, and other credit-dependent sectors. In assessing the economic outlook, the individual members of the FOMC have for- mulated projections for several key measures of economic performance that fall gen- erally within the ranges in the table below. In addition to the monetary aggregate objectives discussed earlier, these projections assume that the federal budget will be put on a course that over time will result in significant reductions in the federal deficit. ECONOMIC PROJECTIONS OF FOMC MEMBERS Actua Changes, 4th quarter to 4tti quarter, percent: Nominal GNP . .. RealGNP GNP deflator level in the 4th quartet, percent- Unemployment rate Revised administration forecasts for the economy were not available at the time of the Committee's deliberation. Our understanding, however, is that the adminis- tration's midyear budgetary review will be presented within the framework of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 economic assumptions used in the first budget resolution. For the remainder of 1982, those assumptions imply somewhat more rapid recovery than the range now thought most likely by members of the FOMC, but would be consistent with the monetary targets outlined in this report on the assumption of growth in velocity characteristic of the early stages of a number of past recoveries. Looking further ahead, the Committee members, like the administration and the Congress, foresee continued economic expansion in 1983, but currently anticipate a less rapid rate of price increase and somewhat slower real growth than the assumptions underlying the budget. The monetary targets tentatively set for 1983, which will be reviewed early next year, would imply, under the budgetary assumptions, relatively high growth in velocity. The CHAIRMAN. Thank you very much, Mr. Chairman. Since you started your testimony we have had additional Sena- tors come in, and although I would like to proceed with the ques- tioning I would ask if any members who have joined us since Chairman Volcker started his testimony would like to take just 2 minutes for any sort of an opening statement. If not, we will proceed with the question period. Senator Sarbanes, do you have any opening comments? Senator SARBANES. I'll wait until after the questioning period. The CHAIRMAN. Senator Tower. Senator TOWER, Mr. Chairman, I have an opening statement I'd like to file for the record. The CHAIRMAN. All right, it will be filed for the record. OPENING STATEMENT OF SENATOR TOWER Senator TOWER. Mr. Chairman, I would like to congratulate you for the courage you have shown since assuming your office. In my view, this Government and the American people owe you far more than we understand or will acknowledge. In the face of skyrocketing Government spending, you and your fellow Governors have been the only component of government willing to do what is right rather than what is politically popular. We have all watched as you struggled with the effects of spiral- ing, and seemingly permanent, inflation. We have seen how this in- flation perverted traditional monetary policy theory to the point where both increases and decreases in the money stock meant higher interest rates. We have seen your courageous movement from interest rate targeting to monetary aggregate targeting, just at the time when institutional changes made all of the old defini- tions of money obsolete. We have seen you move from very volatile monetary growth to the recent period of relative stability. Most im- portantly, Mr. Chairman, we have seen you exercise the courage to wring the inflation, which is at the bottom of all of this, out of our economy. In doing all of this, you resisted enormous political pressures, and thank God you did. In my view, it is only your independence which gives you the necessary freedom to avert the overwhelming pressures to which Congress is so susceptible. I shudder to think what condition this economy would be in today if we managed monetary policy with the same dispassionate skill with which we manage fiscal policy. The CHAIRMAN. Senator Sasser. Senator SASSER. Mr. Chairman, I'll submit my statement for the record. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 OPENING STATEMENT OF SENATOR SASSER Senator SASSER, Chairman Volcker, before I ask you some ques- tions for the record let me be very frank with you. I regard the Federal Reserve Board's monetary policy as a chief cause of our current economic problems. High interest rates and tight money are crushing the life out of our economy. High interest rates have devestated the housing industry, We are only building one-half the houses we need every year to house a growing and changing population. High interest rates have crucified the small businessman. Business failures totaled just over 17,000 last year. This year we will witness 22,000 small business failures—a level that exceeds that recorded in 1933. High interest rates are slamming the brakes on our economic growth. We are using only 70.8 percent of our manufacturing capacity, and real gross national product in 1982 may be no higher than the real gross national product recorded in 1979, the year in which the Federal Reserve Board's monetary policies went into effect. Indeed, in your report to the committee you note that the con- traction in our economy that began in 1981 is continuing through 1982. And your whole report gives little indication that the Federal Reserve Board is prepared to adopt a new monetary policy that will stimulate economic growth. It is my contention that the Federal Reserve Board's monetary policies are leading us to the brink of economic chaos. I have expressed serious reservations about the Board's interest rate policies ever since they were adopted in 1979. I expressed these reservations to President Carter, and I have, on several occasions, offered legislation that would revise the Board's tight money policies. Chairman Volcker, the independence of the Federal Reserve Board does not give it the right to wreak havoc with the American economy. The Board has a legal, and I would argue, a moral obligation to help the economy grow. The Board has failed to meet this obligation by almost any rea- sonable standard. The economic carnage caused by the Board's high interest rate policies must stop. The Board must, either voluntarily or by congressional direction, revise its monetary policies to permit greater monetary growth that will bring interest rates down and make credit more afforda- ble to American consumers and American businessmen. The CHAIRMAN. Thank you very much. Mr. Schmitt. OPENING STATEMENT OF SENATOR SCHMITT Senator SCHMITT. Mr. Chairman, when you get to the questions, I hope I will have that opportunity. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 Mr. Chairman, I just wanted to welcome you once again to the committee and tell you, since we last spoke, I like many others have had to reevaluate my analysis of the economy. I must say I was one of those at the first of the year that felt if we held inflation down significantly from where it had been in 1979 and 1980 before the new economic policies were put into place, that we would see an easing of interest rates. Clearly, the feel the investor has of 13 percent inflation is still there. The deficits are still there and greater; there is, I think, some concern that money growth might be too high for a recession- ary period, and it just doesn't seem that anything is going to act— anything structural is going to act to reduce these interest rates. And I think in that context the actions of both the financial com- munity and the Fed yesterday are welcome. Now how many points that will milk out of the interest rates, I don't know, but there does seem to be this inherent problem that the investor still remembers inflation, and is afraid to loan his money at less than 13, 14. or 15 percent, The Federal Government is moving toward demanding 50 percent of the credit available in this country, business demand is still on the horizon when a recovery comes in—and we can have continually built into our tax code disincentives to save. That's one of my main concerns about the current tax bill before the Senate. It does nothing to increase the pool of capital available for invest- ment, but in fact goes the other direction. Mr. Chairman, I appreciate having that opportunity for a brief opening statement, and I'll reserve the rest of my comments for questions. The CHAIRMAN. Thank you, Senator. Mr, Chairman, as you well know, you received a lot of criticism over the last couple of years, and some of it from me, and particu- larly on the calls many, many times—virtually every time you have appeared—to do away with weekly reporting of money supply data and also to go to contemporaneous reserve accounting rather than lagged accounting. So having done something about both problems, I think you should be publicly complimented for announcing that you are going to use contemporaneous reserve accounting and also the decision of the Fed since we last met to move to not reporting weekly adjusted money supply data. CONGRESS BLAMED Nevertheless, I remain convinced that it is the Congress that is primarily to blame for the failure of interest rates to decline as quickly as inflation. The first budget resolution which we recently passed calls for a steadily declining Federal deficit in the years ahead: $104 billion in 1983; $84 billion in 1984; $60 billion in 1985. But of the $281 billion in spending cuts over the next 3 years that will be necessary to achieve these declining deficits, only $27 billion, less than 10 percent, have been reconciled or enacted into law. My point is simply that regardless of what you do with the dis- count rate or changes in how you account and handle the money Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 supply of this country, it seems to me it is still up to Congress to put up or shut up. Is it any wonder that the financial markets have remained skep- tical—as evidenced by the stickiness of interest rates—of Congress ability to make budget cuts called for in the budget resolution. So I hope that Congress will not just pass a budget resolution then, in the individual appropriations process, not reconcile that budget. We need to send the proper signals to the market. Mr. Chairman, recently there's been much talk of credit controls. As you know, this committee and the Congress let the authority for credit controls expire on June 30. But there has been additional talk and bills introduced in the House and Senate to not only revive credit control authority but to expand the scope of the Credit Control Act. You were Chairman when President Carter invoked the act in the spring of 1980, requiring the Federal Reserve to impose credit controls. Could you explain for the committee what you learned from that experience in the spring of 1980? Mr. VOLCKER. I think one thing we learned, Mr. Chairman, is that because of psychological effects or influences that are not en- tirely predictable—at least they weren't predictable to us—you sometimes get results that are out of proportion to the action taken. In early 1980, when we introduced some rather mild controls or restraints on a limited portion of consumer credit, we found, as that message was interpreted in the country, that nobody wanted to spend for a month or two, certainly not to spend on credit—to exaggerate a bit to make the point—and we had a larger impact than the action was designed to produce at that time. I think it is illustrative of the difficulties of adopting an ap- proach of that kind for which you don't have, by the nature of things, much experience. The effects that you get are not entirely predictable in those circumstances. The CHAIRMAN. Well, I'm one who does not want to renew those credit controls. I think we have plenty of evidence—not only in the spring of 1980—that they are counterproductive. We can go back to Tricky Dicky's phase 1, 2, 3, and 4, and so on, that simply did not work. And I see no reason whatsoever to reenact the Credit Control Act. FAILURE TO MEET TARGET GROWTH The Federal Reserve continues to be criticized for failure to meet announced targets for growth in Mi, M , and M , and in bank 2 3 credit. Obviously a major source of the problem is that you do not have direct control over these aggregates. Why not announce targets for an aggregate over which you do have more direct controls, such as bank reserves or the monetary base? Don't you think this might increase the credibility of the Fed in the financial markets? Mr. VOLCKER. I don't know whether it would increase or decrease the credibility, but I don't think that's an appropriate target for the Federal Reserve. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 As to meeting the targets that we do have, there can be two sources, I suppose, of difficulty, if that's the right word. One is the problem of meeting the targets themselves. Are the tools adequate to meet the target in a technical way? The other is whether conditions have changed in a way that may make it inap- propriate to meet a target precisely at a particular point in time. I would think the first half of this year had some of the charac- teristics, at least, of the latter situation, where demands for liquid- ity for precautionary balances, as we judged it, were particulary strong. As conditions developed, taking account of economic devel- opments, taking account of interest rates and other factors, it seemed to us inappropriate—not that we couldn't have done it, but that it was inappropriate—to take a still stronger measure to re- strict the growth of money and credit under the conditions that prevailed. So I think we always have to interpret the meaning of these tar- gets in the light of circumstances as they develop. The meaning of the target is that it sets a presumption—and a strong presump- tion—that you want to operate in that framework. There may be circumstances in which, taking account of all developments, it's ap- propriate to allow a little leeway. I myself think the monetary base tends to be more of a lagging indicator than a leading indicator, and I don't think it would bring us better results than looking at what's happening in Mi and the other aggregates. The CHAIRMAN. Another criticism of monetary policy is that the aggregates that you target are too narrow and ignore major sources of credit in our economy, such as commercial paper. Why not target a broad aggregate, such as total credit? Mr. VOLCKER. As you know, we target a number of aggregates now, and there's been some discussion recently of looking at broad- er forms of credit aggregates than we include formally. I think targets are relevant economic variables, and we do and should look at them. We have not been convinced that as a formal targeting mechanism they offer a substantial improvement, but we continue to look at that issue, and I haven't got any preconceived notions on that score. We haven't seen that that would add much. But I think it's relevant as a magnitude to look at and to observe in connection with the other targets. One difficulty with credit—a technical point—is that some of that data is not as up-to-date as looking at the other side of the balance sheet which is essentially what we do in looking at the monetary targets. The CHAIRMAN. Episodes such as the recent Drysdale Govern- ment securities problem and the failure of the Penn Square Na- tional Bank in Oklahoma cause the Fed to inject liquidity into the economy through the discount window. What impact does this have on your ability to implement mone- tary policy and you completely offset the discount window loans through sales of securities in the open market? Mr. VOLCKER. The first point I would make is that those inci- dents have not required any substantial injection of liquidity through the discount window. If they had, in connection with the fundamental role of the central bank as lender of last resort—lend- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis ing to those that are caught up in the secondary repercussions of an incident of that sort—if that became necessary, the first as- sumption, I suppose, would be that that would be offset by sales of securities from the portfolio so that it does not necessarily mean that we would deviate from reserve objectives or from monetary ob- jectives. You could conceive of situations in which you might want to pro- vide some additional liquidity to the economy as a whole, and then you would handle it somewhat differently. But increased use of the discount window in reaction, to that kind of event has not been at all significant. If it were significant, it could be offset by open market sales. The CHAIRMAN. Thank you, Mr. Chairman. Senator Riegle. Senator RIEGLE. Chairman Volcker, I want to try to set the stage here for some responses from you by making some observations as quickly as I can. At the outset I recounted several measures of the damage that's been done to the economy in terms of the high un- employment, the shutdown of the economy, the tremendous damage that's been done to any number of interest-rate sensitive sectors of the economy. I believe that we have a desperate situation on our hands. That's confirmed by conversations that I've had the last 4 or 5 weeks with the heads of most of the major banks and financial institutions, and a number of large corporations in this country. NEED FOR MAJOR CHANGE IN POLICY MIX They all to a person feel that the economy is in desperately seri- ous trouble and there is requirement for a major change in the policy mix. At the same time there's really no sign that change in the policy mix is coming any time soon or that the key decision centers—the President and perhaps at the Fed as well—have a sense that a change is needed. I can tell you as a member of the Senate Budget Committee that my "own estimates for the deficit—if we stay with the current fiscal plan—will be in excess of $130 billion for next year, in the range of $200 billion for 1984, and a range of $300 billion for 1985. I don't see how our economy can function if we stay on that path. As a matter of fact from everything I can see, the President, who is the most important player in this discussion, is at peace with these deficits—as a matter of fact, he came in with a budget that asked for even higher deficits. I think the high interest rates that we have now are just ripping the guts out of this economy, and you can see it everywhere you look: From the financial institutions across to the housing sector into the industrial base, into agriculture. There really is no part of the economy that has not now been affected and damaged—and I think in many cases permanently—by this high interest rate policy. So there is a need—a desperate need—for a change in the policy mix, and yet there's no sign of any change in sight. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 Now the Congress, according to Senator Baker, is targeting to ad- journ on October 2. We have about 45 working days left here, if one takes out the weekends and the planned recesses. The window is closing on this session of Congress. Once the Con- gress shuts down, we're not going to be back into the new Congress until late in January. You take out the Lincoln day recess in Feb- ruary, and it's going to be the beginning of the second quarter of next year before the Congress will be in a position to act in a major way, if we miss the opportunity to make a major change in the eco- nomic policy mix at this time. And I'm greatly concerned that we're missing that opportunity; I'm concerned the administration is missing it, I think the Con- gress is missing it, and it appears to be the Fed as well is missing it. The lowering of the discount rate yesterday I think shows a small shift in your own policy, but it is a very small change and it comes very late in the game, and there's no way of really measur- ing whether or not this will have any appreciable effect on this larger set of problems. I think you ought to be more outspoken in your appeals publicly and your appeals privately to the President, in your appeals to the Congress and within the business community. It's possible from your vantage point that you can have as much to do with helping to create a sense of urgency about a need now for a change in the policy mix as anybody. And I believe if it doesn't happen, you're going to find yourself, and the Fed is going to find itself, more and more compelled to have to act unilaterally. Because if we see more bank failures, we will see more panic, we will see more people moving into more liquid assets and into short-term Government securities. I've talked with heads of major investment companies in the United States who are changing their own personal financial plans because of their apprehension about the future of the economy. The thing that worries me now is that we may find ourselves in period when we're not going to be able to act readily as a Federal Government to change policy because of the shutdown that occurs as we come into an election year of this kind. And I think that we can find ourselves at some point facing some kind of panic—some kind of financial panic—and possibly even a genuine fear that a depression could develop. We have Canada in shambles on our northern border; we've got Mexico in shambles on our southern border; we've got nonperform- ing loans by major banks all around the world and across the United States. And my question to you is that if this comes, if we miss this very small opportunity that's left for a major change in the policy mix— and I'm talking about a substantial reduction in deficits and a sub- stantial change in monetary policy and a big reduction in interest rates that would come within a matter of weeks—if we fail to get that done collectively, are you prepared to act unilaterally at the Fed, should we find ourselves in a kind of growing panic situation. Will you move then? Will you either increase the monetary tar- gets or will you bring down the discount rate further, if in fact you find yourself alone out there with the situation worsening and the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 President not connected to the problem and the Congress not even in session? Mr. VOLCKER. I'll make a couple of comments on your comments, Senator. I yield to no one in my concern about the budget, and I think that I've made that plain through the months. I'm not quite as pes- simistic as the figures that you cited for the out-years on the budget. I do think that we collectively, in a sense, missed a great oppor- tunity this spring to more forcefully and dramatically, through some process of consensus, take more forceful action on those out- years. As you point out, there is relatively little time left in this congressional session, and you've got your work cut out for you in implementing the budget resolution that was passed. I very much look forward to your coming back for the further large bites that I think are necessary in the budgetary situation—after November. But I try to be realistic, and I don't know if there's anything hugely dramatic, beyond what is incorporated in that budget reso- lution, that can be done within the next month or two. I recognize your concerns about the economy and about the fi- nancial system, but let me say that I don't share those, to the extent that you have cited them. I think that we are clearly in a difficult period. We are still facing the damages, as you put it. In my mind, they are the dam- ages of handling the long episode of inflation and turning that around. But I think that we are laying a strong foundation for the economy. If some of these contingencies of which you speak arose— I don't believe they are going to arise—I think we can be sure the Federal Reserve is well aware of its responsibilities as lender of last resort and provider of liquidity to the economy. Senator RIEGLE. How much effect do you think the lowering of the discount rate, of half a point yesterday, is going to have? And over what time period? Mr. VOLCKER. I wouldn't isolate that particular move. Senator RIEGLE. Let me try and isolate it. I realize that there are a lot of other factors—but just that particular move—what do you think it, by itself, might accomplish? Obviously you decided to take it for a reason. Mr. VOLCKER. We took it in the light of rather sharp reductions in short-term interest rates that had already taken place in the market; so, to some extent, you can consider that a move of aline- ment to changes that had already taken place. You can ask why the other changes took place. We had the money supply in pretty good control. Banks have been under less reserve pressure in recent weeks. The economy appears to be in a fairly level phase. There are a variety of factors. I think the budg- etary progress, limited as it is, helps, relative to the situation of not having had that progress. A variety of factors have entered in, and the discount rate change is one part of that complex. I think that it does tend to anchor the reduction in short-term rates that took place. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 FLIGHT OF MONEY TO SHORT-TERM SECURITIES Senator RIEGLE. Do you see any movement out of people holding long-term securities and short-term securities? Do you see a flight of money into shorter and shorter term securities? Mr. VOLCKER. I think for some months, as my statement sug- gests, we have seen evidence of a desire for liquidity; and that is part of that phenomenon. Senator RIEGLE. What does that mean? What do you interpret that to mean, the fact that there is this rush toward liquidity? Mr. VOLCKER. I think it means several things. This is partly in the realm of speculation. We have a variety of evidence, survey evidence and other kinds of evidence. It is not atypical during a recession to have a desire for more liquidity. This time, more than in some past recessions, some of it may re- flect uncertainty about interest rates themselves. Of course, we have had a high level of short-term interest rates, so it's been at- tractive, just on sheer financial grounds, so to speak, to park money in liquid assets. Senator RIEGLE. If we don't get long-term rates down, if we don't see some willingness of people to finance long-term investments— whether it's for houses, factories, or whatever it might be—how are we actually going to get an economic recovery going? If everybody is moving in the direction of short-term instru- ments, then how could we possibly get things moving again? Mr. VOLCKER. I think it's possible to do so. As I indicated, I think the recovery in the near term is going to be fed largely by consum- er spending, which isn't so dependent upon long-term borrowing— probably not dependent upon long-term borrowing at all. I fully agree with you. We would be in a much better position, much happier position, if long-term rates were lower. When you emphasize long-term rates, I think that it is, in a sense, illustrative of the policy problem; this is, we can't control long-term rates and they're going to depend upon the decisions of those in the market- place and their having enough confidence to go out and buy longer term securities. That is one reason why I think that it's so terribly important, if we're interested in getting interest rates down—and particularly long-term rates down—that we carry through on deal- ing with inflation. That's the thing that will really spook the market in terms of making an investment for the long term. The investor is making a bet for 10, 20, or 30 years, depending on the security; he's going to be looking at the chances for stability—or for greater stability—than we have had over that length of time in recent years. Senator RIEGLE. My time is up. I will have more to say later. But it seems to me that we have not made much progress on that front. Mr. VOLCKER. We have not so far, I agree. The CHAIRMAN. Senator Tower. Senator TOWER. Thank you, Mr. Chairman. Chairman Volcker, I want to congratulate you on having the courage to do what you perceive to be right, rather than what may be politically popular. And although I may be inclined to disagree with you from time to time myself, I hope that we will never be in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 a position where we feel tempted to threaten the independence of the Federal Reserve Board. I think it's been the only agency of Government that has, regard- less of political fallout, proceeded to do what it felt to be necessary. I can't help but be reminded that you and I are both products of the London School of Economics. I rather fancy, every time you make a pronouncement on fiscal or monetary policy, that Lord Keynes and Harold Lasky start turning in their graves. Mr. Chairman, many analysts suggest that we have, in effect, two credit markets, that interest rates are affected by different fac- tors. For example, they suggest that the long-term rates are stay- ing high because of expectations of future inflation, very large defi- cits, or both; while short-term rates are high because of supply and demand forces—that is to say, business and Treasury loan demand is greater than the supply of credit. Do you agree with that analysis? Mr. VOLCKER. I certainly agree that you would expect long-term rates to be affected more by the expectational factors, and short- term rates probably more immediately by the quantitative magni- tudes involved as opposed to the psychology, although the distinc- tion is not a clean one. EFFECT OF UNREGULATED MONEY MARKET FUNDS Senator TOWER. Mr. Chairman, to what extent to you believe that the availability of unregulated money market funds contrib- utes to the continuation of high interest rates? Mr. VOLCKER. I would not, I think, put a lot of importance on un- regulated money market funds in and of themselves. I do think that the move toward deregulation in the financial world generally, including banks—and the money market funds are one manifestation of that—means that the restraint that used to come out in a rationing of credit in the market now comes out virtually entirely in interest rates. That has probably meant a higher level of interest rates in these past few years than you would have had with the different institutional arrangements that we had in the 1950's and the 1960's and the early 1970's. To put it badly, now when money is restrained, banks don't stop making loans, they just raise the rates until the borrowers are squeezed out. In the good old days—if they were good old days; people didn't like them much when they existed—when there tended to be pres- sure on the money market, the banks and financial institutions were, to some extent, rationed out themselves; interest rates would push up against the ceiling rates, and they would slow down in making loans. They raised interest rates, too, but not as far, be- cause some of the restraint came through by way of a rationing process rather than from interest rates alone. I think this whole thrust—of which money markets are merely one part—has resulted in a type of money market in which interest rates are more volatile and higher, at least during the restrictive phase of policy, than they otherwise would be. Senator TOWER. This morning, in the Washington Post, Allen Sinai suggests that the lowering of the discount rate will be of no Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 help before the fourth quarter. He says, in effect, that this quarter is already lost. Dp you agree with him? And specifically, what result were you hoping to achieve as a result of this action? Mr. VOLCKER. I don't agree that the third quarter is lost, for whatever reason. We're trying to conduct a policy which continues the progress on inflation, but also leaves room for recovery. We have no desire to have interest rates any higher than they need be. As I indicated, I think that the discount rate move was a reflection, to a considerable extent, of declines in market rates that had al- ready occurred, and has the effect of anchoring those for the time being to some degree. Senator TOWER. Mr. Chairman, we are due to mark up a bill in the near future that, among other things, is designed to give some assistance to the thrift industry. In your view, will providing thrift institutions with banklike asset powers enable them to- solve their problems before it's too late for a number of individual institutions? Mr. VOLCKER. I don't think that providing new powers—more particularly, commercial loan powers—at this point in time is going to have much relevance to their near-term problems. I think that has to be viewed in the context of the direction that you would like that industry to go in over a period of time. I don't see it as any saving measure for the immediate future, in terms of the present squeeze. In fact, there are some dangers in going into a new business rapidly, in the hopes of increasing income; you've had some examples recently of banks being a little overambitious in that area and getting into trouble. Senator TOWER. Are you saying, then, that nothing can be done to alleviate the immediate problem? Mr. VOLCKER. No. I simply was referring to that particular por- tion of the bill. The legislation you are considering has measures in it that are directly relevant to the immediate problem. In the capi- tal infusion area and the so-called "Regulators Bill" the consider- ations are very directly relevant and important for the current problems in the thrift industry. I think they are very important, given the current problems that we have in that area. Senator TOWER. Are you worried about the safety of the financial industry right now? Mr. VOLCKER. No. I think that the financial system in this coun- try is a strong one. As I indicated in my statement, we have an elaborate system, with the Federal Reserve, the FDIC, and so on designed to backstop that system. I am not concerned about the system in general. There are obviously points of particular strain, in that financial institutions are feeling the effects of the recession, in some cases. We have been through periods of this sort before—most recently, in the mid-1970's—but I think that the system has great resiliency and strength, and great support when and if it's necessary, from the governmental institutions. Senator TOWER. Thank you, Mr. Chairman. My time is up now. The CHAIRMAN. My policy has normally been to recognize Sena- tors on the basis of when they came in, rather than seniority. But we have had enough come in and go out that I'm not quite sure Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 who came in when. So, unless there are some objections from the committee, I will simply stick to the seniority system and go to Senator Proxmire. But if anyone remembers when they came in and ahead of whom, we can go back to the normal practice. Senator PROXMIRE. Mr. Chairman, I certainly would not object. [Laughter.] Chairman Volcker, as you know, I have been an enthusiastic sup- porter of yours and your policies—and I still am. And I do think, as others have indicated, that the problem is that we have had an ir- responsible fiscal policy that has gotten out of control. And you have a very, very painful and difficult job. On the other hand, I think that we ought to recognize that, when you started this new policy in October 1979, of concentrating on money supply, a prime purpose of that was to get inflation under control. And I think with all the other problems in the economy— and they are great—the inflation picture has improved, and has improved sharply. Last month was an abberration, but over the last 6 months, there is no question that inflation is much better than it was. As you know, that big philosopher, George Santana, used to say "fa- naticism is redoubling your efforts when you've lost sight of your objective." I think that maybe the Federal Reserve Board is a little guilty of that kind of Santana-defined fanaticism. Here, as I say, inflation is under control. You are not adjusting— as I understand it, you are not adjusting your money supply tar- gets' ranges; they are still very conservative. And when we consid- er what causes inflation—inflation, as I understand it, and most of us agree, is caused when demand puts pressure on limited produc- tion facilities. Now we have a situation where, in our big industries, our credit- sensitive industries, we are operating far, far below capacity. There is enormous surplus manpower. It seems to me that the latest report, only a week or so ago, indicated that for the first time in years we are operating below 70 percent of capacity; the auto- mobile industry, below 50 percent of capacity; the homebuilding in- dustry, even lower than that. And if we do increase the availability of credit, it would seem to me that there is no way that that would be inflationary, even if the increase in availability of credit were quite substantial. So, how would you address that general notion, that inflation has improved greatly and it is time that we do ease up, to some extent, on the availability of credit in a credit-starved economy? TURNED THE CORNER ON INFLATION Mr. VOLCKER. I do think we have turned the corner on inflation, but I don't think the problem is over. Of course, I would not agree that we have lost sight of our objectives at all. Let me review the targets. In particular, based upon all recent historical experience, it is our judgment that the targets as they are—and note that I have said we find it quite acceptable to come in around the high end of those targets—should allow room and be fully consistent with the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 kind of recovery that most economists have been predicting in the second half of this year. That does assume that velocity will be more or less normal; it doesn't have to be particularly on the high side for a period of busi- ness recovery. What evidence do we have, other than looking at the historical record, in making that kind of a judgment? I have noted that we do think there are some potentially and actually unusual characteris- tics that may require some more liquidity and have required more liquidity in the first half of the year than an absolutely literal in- terpretation of some of the targets indicated. If we found that to be the case in the second half of the year, and there was clear evi- dence of that, I have indicated we would be willing to run above the targets for a period of time. But now we come to the other side of the dilemma. I agree with you that, as I indicated, a lot of progress has been made on infla- tion. I agree with you that considering economic conditions, there is every reason to believe that that progress on inflation can con- tinue during a period of business recovery, certainly as far ahead as we want to look now. That's all on the favorable side. But in connection with the dis- cussion with Senator Riegle earlier, look at long-term rates, for in- stance. To the extent that they are important and a key to sustain- ing recovery, I don't think we are going to do ourselves or anybody else a favor with respect to long-term rates if we convey the im- pression or the actuality that we were no longer worried about in- flation. I think it would be counterproductive in terms of impact precisely on those interest rates that are so significant to business and the housing area. Senator PROXMIRE. I certainly wouldn't argue that you ought to forget about inflation. It's certainly a serious and potential prob- lem. But the difficulty is our deficits are so colossal, the Federal Government is borrowing so much—you know the figures—the early 1970's the Federal Government took $1 out of $6 of new credit, last year took $2 in new credit, next year it will take close to $3 out of $6 in new credits, crowding the industries like auto- mobiles and homebuilding and so forth, so that they just don't have credit available without paying very, very high rates. It seems to me the realistic way to meet that would be to find some way of making more credit available one way or the other. Senator Lugar had one kind of proposal for the housing industry. I supported that, and I think you opposed it, as did the administra- tion. It may have been defective, but some way, it seems to me, we have to work out an economic system to put our people to work when obviously that idleness accomplishes nothing. It hurts our growth, our efficiency, and we just have to find some way to over- come that. And part of it is high interest rates. Mr. VOLCKER. I think you put your finger on the problem. You identified the Federal budget as being part of the problem and, in effect, seem to be asking if you can cure that through monetary policy. We can't cure the Federal budget through monetary policy. Now, it's a matter of judgment as to what is excessive money growth; I fully agree that issue should and can be debated. But we can't cure the basic problem resulting from the percentage of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 credit market availabilities absorbed by the Federal budget by cre- ating an excessive amount of money and credit in total, because then we would come back to the inflation side of the dilemma. That would have an adverse impact on interest rates, rather than a favorable impact on interest rates. IDEAS TO CHANGE BUDGET PROCESS Senator PROXMIRE. Let me ask you for some advice that you can give us, then. Other Chairmen of the Federal Reserve haven't been reluctant to give us that kind of advice. In fact, as long as I can remember, every Fed Chairman has indicated to this committee that the Fed can't fight inflation alone. Federal spending must be constrained. We now have facing us the largest deficits in our his- tory. The budget process has not convinced anyone that interest rates can decline. In fact, some observers have said the budget process doesn't work; it needs reform; we need an amendment to the Constitution. If you could change the budget process, what would you do? Would you put a cap on Federal spending? Would you make the budget a multiyear process, require a two-thirds vote on budget res- olutions? How would you restrain them? Mr. VOLCKER. I can give you some tentative ideas on that, anyway. As I observe the budget process in recent years, I think there is something to be said for making it a multiyear process— making it, let's say, a 2-year time perspective. It appears that you are continuously in the budget process now, and I wonder whether it wouldn't be better to try to set out a framework for a couple of years instead of for 1 year. You might get a better result. As far as other' changes are concerned, I have been hesitant, to say the least, about the particular structure of the balanced budget amendment that's being considered by the Congress. Senator PROXMIRE. You favor that or oppose it? Mr. VOLCKER. I have great sympathy for its objectives, but I have considerable difficulty with the particular form of the amendment. Senator PROXMIRE. If you were a Senator, would you vote for it? Mr. VOLCKER. If I had my druthers—and I was about to suggest this—I think there is a bias in the system toward deficits and toward more spending than the collective will would really suggest is appropriate; it may not be a bad idea therefore to require, as you were suggesting, more than a majority vote for spending of any sort, whether or not it depended upon a particular phase of the budget at a particular time. This is a very sensitive area. I think you could probably improve the budgetary process if the President had an item veto. Senator PROXMIRE. You don't want to answer the question as to whether you oppose a balanced budget? Mr. VOLCKER. If I could vote on one of the other proposals, I would prefer to. Senator PROXMIRE. Do you think we should support a constitu- tional amendment balancing the budget or not, requiring by amendment of the Constitution? Mr. VOLCKER. I would like to move toward balancing the budget, but I am not sure I would support that particular amendment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 Senator PROXMIRE. I will mark you down as not exactly sure. Mr. VOLCKER. As I said at one point, I am for it with reserva- tions, and maybe against it with reservations. I applaud the spirit that's behind it, but I do have some reservations about that partic- ular mechanism. Senator PROXMIRE. Would you agree with Senator Riegle that you are leaning no? Mr. VOLCKER. I think that's probably accurate in this. [Laughter.] Senator PROXMIRE. My time is up. The CHAIRMAN. Senator Lugar. Senator LUGAR. Chairman Volcker, in the past you have ex- plored the problem of inflation, and among other points you have made is that it's very difficult to break through various flaws, rigi- dities in our economy; that inflation may be a process in which var- ious groups have the power to enforce prices and to enforce wage levels, and as a matter of fact, as we have noted even recently, some things that have been going well in inflation—the regrouping of OPEC, at least temporarily. We had a spurt in the inflationary side on the energy, based on 1 month. In short, even though the policy of Fed, maybe of the whole Fed- eral Government, has been to break the back of inflation, to what extent are these rigidities that were a part of the picture 1 year, 2, or 3 years ago still there and to what extent can we have any confi- dence that we are not likely to have very substantial inflation due to the fact that people want to maintain their claims and are able to do so politically? Mr. VOLCKER. I think you put your finger on the heart of the problem. We have one tool of policy which works in a rather crude kind of way against those rigidities and claims of which you speak. I think there has been some success, but the cost is much higher than is necessary because of those rigidities and claims. I would hope that out of this experience and the fact that those who are in a most exposed position are not always the ones who are hurt most immediately, we will find a different climate and a more satisfactory situation in that respect. But it's been a very long-term problem. It's the kind of problem which is addressed by so-called incomes policies. The way we have gone about that in the past in this country has not been terribly successful, probably damaging on balance. That's generally been my view of the experience in other countries. At the same time, there is a lot of hard experience that is poten- tially relevant to us. There are some countries that do this job better, reflecting a kind of social consensus, I suppose, as well as some institutional arrangements that don't exist in this country. Whether it's a process of annual wage bargaining across the board, where all the parties take some account of how their particular claims fit into the national need; whether it's a different climate within particular countries as to labor-management relationships, with implicit contracts with respect to employment as well as wages; I think all of those things are relevant, and I would hope we could learn from some of that foreign experience over a period of time. But that's a long-range matter. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 LARGE LASTING DEFICITS Senator LUGAR. Let me ask a question that calls for general counsel. I am disturbed by the fact that I think many of the rigidi- ties are still there, and you may feel they may still be there, too. We try to influence things so they become more fluid, but what if we have a situation in which we still have very strong collective bargaining arrangements, pricing policies, that may not have real- ism with regard to actual markets for goods and services, and I wonder if, coupled with this, we have a situation of deficits that we discuss today and we all condemn these, and really part of the problem is congressional inability to stop the spending. The greater part is simply that the economy is working so poorly, that the rev- enues coming in mean that if we're going to have very large defi- cits for a long time, largely because people do not make enough money as individuals or as corporations, the whole tax base is simply insufficient. So given even minimum requirements of social security and defense situation and the Government, even at a mini- mum we have continued to have very, very large deficits because the economy just didn't work. For example, if automobiles are still in a decline, the housing sit- uation is more of a disaster this month, steel clearly is still headed down, agricultural implements already down and getting worse, farm income not very promising except in the livestock area, clear- ly not in the grain side; there are just no signals on the horizon that look toward greater income, and this probably means greater deficits, not because people were irresponsible, necessarily, in econ- omy—just because the economy doesn't work. Now, on the one hand you would point out we can't give up the inflation fight, and I would agree with that, but I wonder if compa- nies and labor unions and various groups in our society are just to- tally unresponsive to the reality of what we face, and as a result, continue to accept more and more unemployment and economic disaster lamenting the political situation, while in fact the signals just don't get out. Mr. VOLCKER. If that were literally true, we'd have an impossible problem. I think your statement is too extreme. I share your very great concern about these rigidities and claims. But obviously, people do respond, and we are seeing perhaps a greater response than might have been expected. I think that is one reason why it is important that we remain in a posture of concern about inflation, because nobody is going to give up those claims if they think things are going to be aggravated by inflation and that Government policy is going to yield in those respects. I wouldn't be quite as pessimistic as you are in that respect, or at least as your statement was. As far as the budget is concerned, I think you have a difficult enough problem in substance, but in communicating and in analyz- ing the situation, as I've indicated in my statement, I would dis- count very heavily that portion of the deficit which arises purely from poor economic performance. You're quite right, obviously; the economy isn't expanding. You're not going to get the revenues normal in an expanding economy, and when you analyze the budget situation at any particular point in time, I think you've got to take account of that, but the deficit simply doesn't mean the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 same thing if it is generated out of poor economic performance as it does if it appears in a growing, rising economy. I think the budgetary resolution, the budgetary deliberations, at- tempted to handle that problem, more or less correctly, by assum- ing we were going to have a satisfactory period of economic growth during a time the budget was rising, then looking at the deficit as it would be in a satisfactory economic environment. I think that is the appropriate way to approach the deficit problem. My only problem, looking at the deficit in that light, is that, even If everything went just right, according to the budget resolution— and Congress did everything it needs to, and those estimates were right, and those administrative actions indicated in the budgetary resolution actually produced every dollar that they were assumed to produce—you would still end up with as big a deficit next year as you have this year, assuming that you don't have the complica- tion that you referred to. Senator LUGAR. Doesn't that imply that the successful game plan all along would have to have been one of dynamic growth? There was no way for us to pay our bills without very substantial econom- ic growth in the country, and that there is nothing at least that I can see in that whole budgetary picture, nor in the monetary policy of the Fed, that is likely to cause that degree of investment activity to leap forward. In other words, we're all assuming that this is a natural consequence. What goes down must come up; but why? Is there anything out there right now that leads one to be- lieve that investments are going to be made as opposed to money parked at high interest rates? RECOVERY PREDICTED Mr. VOLCKER. When you speak of leaping forward, I don't know what quantitative magnitudes you have in mind. I don't think it's a process of leaping forward, but certainly it is one of progressing. I think there are a lot of things out there that can produce an eco- nomic recovery. Business investment is not one of those in the period immediately ahead; I think business investment is weak and the economy is going to rise in the next few quarters, in my opin- ion, because consumption will be increasing, defense spending will be increasing, defense ordering will be increasing, and because we have had a very substantial inventory liquidation. Inventories are notoriously difficult to pick in terms of timing and magnitude, but it seems to me we should not expect to have inventory liquidation at the rate of speed that has been occurring for much longer. That turnaround in the inventory picture alone can support an advance in economic activity for some period of time. What we would hope would happen, of course, is that as we get into 1983, the business investment picture begins to turn around, and the housing picture turns around so we have continuing sup- port for economic expansion from those very important sectors of the economy. It's better than nothing, but we don't want to have an expansion that's resting on consumption, or even inventory be- havior, indefinitely. That's not a very healthy kind of expansion. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 Senator LUGAR. You are confident that, if not automatic factors, at least substantial factors are likely to lead to consumers buying, the inventory situation turning around. Do you think this is a suffi- cient enough phenomenon that it cures itself without direct politi- cal action or some economic plan? Mr. VOLCKER. Yes, I think that is the prospect. That doesn't mean a very strong recovery in its early stages. It means a some- what unbalanced recovery in its early stages. But there are indica- tions of rising consumption; there were indications in the second quarter; the June figure was not good, but the April and May fig- ures showed sizable increases. Of course, we had a tax cut effective on July 1. We have a large Government deficit that is pumping out purchasing power. I think there is hard analysis that suggests there is reason to expect for- ward movement on the economy. Senator LUGAR. Thank you. The CHAIRMAN. Senator Cranston. CONSTITUTIONAL AMENDMENT Senator CRANSTON. Mr. Chairman, could you spell out your con- cerns about the form of the constitutional amendment that is pend- ing on balancing the budget? Mr. VOLCKER. I testified on this some months ago and looked very carefully at the Senate report and other discussions. As I said, I very much sympathize with the objective, but you asked me about the form. There, questions arise as to what happens when you have a situation where, let's say, there is an indication of lack of balance in the budget and you can't get a 60-percent vote to pass the unbal- anced budget, because you have an impasse among those who say "What do you do about it?" In the analysis of the amendment that I saw it was quite clear that it wasn't the intent of the authors to give the President any additional power to do anything about that. There was discussion about whether the Supreme Court would then step in and demand action, and it was quite clear in the report that the authors of the amendment didn't think that was a very good idea. The Supreme Court shouldn't get into this thorny, political area. It was left, es- sentially, as I read it—overstating it a bit—that the forces of public opinion would require that the Congress somehow reconcile the dis- crepancy. How successfully would that process work out in a situation in which—and this is conceivable, anyway—you have strongly held views on both sides of the issue in a narrowly divided Congress? Would you go for a 60-percent vote and have an unbalanced budget? How would you collect a majority to cut back particular areas? There seem to me difficulties of such a process. There were also questions, which I have no particular expertise on, as to how the spending could be accomplished through the back door or pushed off on the States and local governments. The objective is admirable. My question is whether there are not better ways to achieve the objective. Senator CRANSTON. There is a substantial question about wheth- er or not the courts would not be drawn into the budget process in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 ways that would threaten the separation of powers. There is a widespread feeling, I believe, that there would be ways to get around the amendment, that ingenious accounting suggestions could be provided and that therefore it could be rather meaning- less, could raise false hopes, and would therefore rather demean the Constitution processes. Mr. VOLCKER. Let me say—I am repeating myself, and I apolo- gize—that if you accept the basic analysis which was put very deci- sively in that Senate report—that there are institutional and politi- cal factors in today's world that push you into more unbalanced budgets than anybody would think is desirable—then I think there is something to be said about changing the constitutional processes to counter that bias that seems to exist. It is a question of how to do it. Senator CRANSTON. It certainly is a question about how to do it. There are faults in the proposed amendment that could be correct- ed. Whether or not they can be on the Senate floor I do not know. One of my concerns about enshrining a mandate for a balanced budget in the Constitution is the relationship between outlays, re- ceipts, and economic assumptions, including monetary policy, ag- gregates and ranges of growth, which go into attempting to put to- gether a balanced budget. In my view, one of the prime factors in the gross underestimating of the magnitude of deficits by this ad- ministration, by prior administrations, lies in the original assump- tions about monetary policies used by OMB which turned out to be far removed from reality. So, I would like your comments on the relationship of monetary policy assumptions to the so-called unexpected deficits that appear year after year in the budget. Do you feel, in other words, that an inability to predict what the monetary policy was going to be was one of the factors that led to an inability to project what the budget was going to turn out to be and what the deficit would be accurately? Mr. VOLCKER. You can make a very general statement that there are difficulties in economic forecasting, whether it's about mone- tary policy or anything else, that are going to affect the particular numbers in the budget as they emerge. I don't think there is any bias. I am not aware of any reason why there should be in predict- ing monetary policy explicitly that would lead to a bias in the budgetary results in one direction or another over a period of time. One of the difficulties, of course, always in the budgetary process is projecting the economic environment that will exist. As Senator Lugar was emphasizing, the revenue outcome obviously, and to a lesser extent the expenditure outcome, depends on the level of eco- nomic activity. That can work in either direction. The budgetary problem that an amendment ought to be aimed at is that in good years, bad years, indifferent years the bias toward deficits seems to exist. I might say, I don't see it as the purpose of an amendment to enshrine a particular economic theory in the Constitution, but rather to deal with what seems to be a kind of political bias that operates in an environment—with whatever par- ticular theory you are operating under at the time. Senator CRANSTON. That may be part of the purpose, but the actual effect of the proposed amendment in its present form is to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 fix one economic theory in the Constitution, the theory that a bal- anced budget is advisable under all circumstances and a provision limiting the growth of Government in a very severe way by tying it to national income without defining what national income is. Mr. VOLCKER. That is why, I suppose, in a kind of conceptual way, that bias probably exists in good years, bad years, whether the budget happens to be balanced in some particular year or not. If you have got a chronic problem of too easy spending, in some sense, then deal with that directly rather than only in years when you have an unbalanced budget. Senator CRANSTON. In relationship to the question I was asking you about, projecting what is going to happen, would you see any problem in requiring the President and the Congress, both to pro- pose a statement of outlays and receipts through a constitutional amendment in order to come up with one that is in balance, would you see any problem in requiring the President to state the mone- tary policy which is assumed to underpin the balanced budget statement just so you have some idea of what to expect and upon what the balanced budget was based in terms of monetary policy? Mr. VOLCKER. I think I am skeptical of enshrining that kind of thought in law, let alone in the Constitution. You have got a prob- lem, a kind of threshold problem, of how you measure monetary policy; we struggle with that all the time. But what is the meaning of these particular monetary aggregates over time? That is a very definite question when you are in a world of shifting technology and a shifting financial environment. Even in a particular period of time as this year, I think we have to evaluate the meaning of growth in any particular aggregate, or all of them together, in the light of changed circumstances during the year, and I don't know how you would reduce that to a statistic at the beginning of the year. We do it as carefully as we can, of course, in setting these tar- gets; but if everybody were, in effect, putting forward a different number, you would have even more problems, I suspect, in making intelligent judgments during the year. Senator CRANSTON. Your response would seem to underscore the great difficulty, at the beginning of a year or even before a year is begun, to predict what is going to happen to the economy and what the effects of that will be on the budget. Mr. VOLCKER. I agree with that. Senator CRANSTON. You have met in recent days with Mr. Meese and Mr. Baker and other people in the White House. Did their views on the state of the economy and what monetary policy should be have any impact on the decision made now to reduce the discount rate? Mr. VOLCKER. No, I don't think that decision was affected by any conversations that I have had with members of the administration. I have continuing conversations with members of the administra- tion whether or not we are changing the discount rate. Senator CRANSTON. Are you at liberty to tell us anything about the views that they have been expressing concern about Fed policy, its impact on the economy? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 Mr. VOLCKER. I think it is no great secret to say that they, like everyone else, share concern about the economy, interest rates, and the whole surrounding set of issues. Senator CRANSTON. Well, they are naturally concerned, but are they specifically concerned about the effect of Fed policy, as pres- ently pursued, on interest rates and, hence, on the economy? Mr. VOLCKER. I don't know exactly what you have in mind, but in terms of particular criticisms or very specific suggestions, no. Senator CRANSTON. They have not made any suggestions for any particular changes in the Fed policies? Mr. VOLCKER. No. IMPACT OF GOVERNMENT BORROWING Senator CRANSTON. Can I ask one more question? My time is up. What do you think will be the impact on interest rates when the Government proceeds to borrow some $50 billion or a somewhat similar sum because of the size of the impending deficit? Mr. VOLCKER. If you borrow $50 billion, or whatever the figure, in the next few months, interest rates will be higher than they oth- erwise would be. But I would be hopeful that we can get through this period with declining rates. If anything, interest rates are ex- traordinarily high to start with. The economy is soft. Private credit demands could well decline during this period, and they have not been particularly high. There have been a lot of credit demands on the banking system, and they are very visible; there is a certain amount of pressure in the bank- ing system because so much of the business credit demands are short term and focused on the banking system. But, fortunately, private credit demands in total are not so high at the moment, for obvious reasons; the economy is soft. I don't think that Treasury financing job, large as it is, in the near term presents an insuperable obstacle to lower interest rates during this period, but it sure doesn't help. Senator CRANSTON. Thank you very much. The CHAIRMAN. Senator Brady. Senator BRADY. Chairman Volcker, I would like to go back to Senator Lugar's line of questioning, which was generally aimed, I think, at how does the economy start going again. I have a concern that we are in kind of a gridlock with respect to interest rates, where we have all sorts of intersecting forces that sort of met at a corner, and I don't quite see how we are going to get out of it. HUGE SHORT-TERM BORROWING One new phenomenon, and I would like to get your feeling on it, is that after the 1974 recession the additions to short-term credit were limited. I think in 1975 and 1976 the flow of funds charts would indicate that there wasn't a great deal of short-term borrow- ing. Now we are in a recession in 1981 and 1982, and you have almost the reverse phenomenon, which is huge borrowing in short- term markets. I am sure you have thought about this, and I wondered whether you have any feeling as to what would alleviate that new phenom- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 enon. Why does the phenomenon exist now when it didn't exist in 1974? Mr. VOLCKER. I think there has been some tendency for borrow- ing to take place either to maintain or improve liquidity positions in a period when profits obviously have been reduced. The compli- cating factor is that businesses generally have had a trend toward depleted liquidity positions, not just in the last 6 months, but in the last 20 years, quite literally, and all during the 1970's. They went into this recession with liquidity positions affected en- tirely apart from this recession, liquidity positions that were al- ready well depleted, balance sheets that were strained relative to earlier periods, with less equity, more short-term debts. Then they get squeezed by the recession and they have to maintain liquidity. There is a lot of concern about liquidity positions, and so, I expect, some anticipatory borrowing. There are some indications that the corporate sector as a whole is showing increased liquidity. If the economy turns around, and as the economy turns around, you ought to get some increased cash flow from profits. And, as confidence returns, you could see less demand for business credit for a time and, perhaps particularly, demand less concentrated on the short-term market to the extent the long-term markets open up at all. You used the figure of speech gridlock, and I think that is appro- priate in some respects, because demand is concentrated in the short-term market, as the long-term market has not been very in- viting. Short-term rates have remained high, and that helps to keep the long-term rates up; and with long-term rates up, people borrow short, which tends to keep the short-term rates up. But gridlocks can be broken; this is taking longer than most people expected, but the favorable factor in the outlook is, indeed, that inflation is coming down. I think inflationary expectations are changing, and that, in a fundamental way, sooner or later, is going to contribute to breaking that gridlock. Senator BRADY. If you had to guess where the gridlock might be broken, where would you think it was going to be? Mr. VOLCKER. I am not going to guess precisely. Maybe we see something of that happening now, but I don't want to make a pre- cise forecast. Senator BRADY. With regard to the two markets that Senator Tower was referring to, the short-term market and long-term market, to what degree is the Fed's ability to help—and be imagi- native—blocked off by the fact that fiscal policy has produced such huge deficits? I think we have generally agreed that an important reason for high interest rates in the long-term sector is high defi- cits and the expected return to inflation. Mr. VOLCKER. To a substantial extent that does block it. It is ob- viously not within our control. Senator BRADY. So that your ability to do too much which wouldn't be regarded as monetizing the debt is blocked off by the fact that fiscal policy really hasn't left you with the options that you would have if that policy were restrained? Mr. VOLCKER. That is correct. Senator BRADY. I don't have any further questions. The CHAIRMAN. Senator Sarbanes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 Senator SARBANES. Thank you, Mr. Chairman. Chairman Volcker, the paper in the last few days has the head- line "With Elections, Fed Chairman Gets the Lunch Touch." I think we'd be interested to know what the lunch touch was and what it was you were getting at those lunches. Mr. VOLCKER. Perhaps that gives the wrong impression. Perhaps I should say I paid for the lunches. [Laughter.] Senator SARBANES. That puts the conflict-of-interest question at rest, perhaps, but it still doesn't address the question of the sub- stance of policy. Mr. VOLCKER. The point I'm making is that I have conversations with the relevant officials of the administration from time to time. In particular, I met with Mr. Meese some time ago—quite a few weeks ago. I happened to meet with Mr. Baker much more recent- ly, and I meet with the Secretary of the Treasury very frequently. These are just things that are done Senator SARBANES. Would you say that the policy the Federal Re- serve is pursuing in the monetary area is the policy which the ad- ministration wishes it to pursue, that the Federal Reserve and the administration are consonant on monetary policy? ADMINISTRATION SUPPORTIVE OF PRESENT MONETARY POLICY Mr. VOLCKER. I am, as I said before, not aware of any real prob- lems in that respect. I think they have generally been supportive of what we're trying to do and the general way we go about it. But I guess you had better address the question to them Senator SARBANES. No; I'm interested in knowing your perspec- tive of their view of your policy. I take it from your answer that your perspective is that they, in fact, support the policy which you are pursuing; is that correct? Mr. VOLCKER. In general terms, that's certainly my impression; yes. Senator SARBANES. When you testified in front of the JEC in June, you said that you and the President had discussed interest rates a couple of months earlier. Was that the last time you met and discussed interest rates and monetary policy with the President? Mr. VOLCKER. Yes. Senator SARBANES. You have not met with him since last Febru- ary? Mr. VOLCKER. Correct. Senator SARBANES. Mr. Chairman, I want to say, in the strongest terms, that I think there's a quality of "Nero fiddling while Rome is burning" about this entire discussion. You have used such phrases this morning as "encouraging signs," "upward momentum," "situation has great opportunities." It seems to me the one reference in your statement that is pretty close to being in touch with reality is where you talk about the crumbling economic foundations of a continuing recession. Unem- ployment is at the highest level it's been since before World War II, now at 9V2 percent; business bankruptcies are at an all-time high, since before World War II. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 We are confronting an economic situation in which this talk about "upward momentum" and "when the recovery takes place" is really not consonant with conditions in the real world. I'd like to know why you seem to regard lower interest rates as giving up the fight on inflation? Mr. VOLCKER. I don't regard lower interest rates as giving up the fight on inflation. I would regard it as giving up the fight on infla- tion if we had an unrestrained growth in money and credit, and that probably wouldn't produce the lower interest rates. To put it the other way around, I think lower interest rates would be a sign of success and confidence in the fight on inflation if they came about in the right way. Senator SARBANES. We're getting back a little bit to Senator Brady's question about how to break the gridlock. You keep referring to the budget problem, and I take it that problem, as you see it, is large deficits, particularly projected into future years when there are favorable assumptions being made about the state of the economy; is that correct? Mr. VOLCKER. Correct. Senator SARBANES. Do you concede that the high interest rates have helped to provoke the downturn which we are experiencing, and the increase in unemployment from 7.2 percent to 9.5 percent? Mr. VOLCKER. In a direct sense, yes. But I don't think that's the whole story. You have to ask why they're so high. Senator SARBANES. The interest-sensitive sectors of the economy, housing and autos are depressed. Housing starts are now below sea- sonally adjusted rates of a million units. Housing, which we have always counted upon to some extent to lead us out of a recession, is in a deep depression. It's my calculation that this increase in the unemployment rate from 7.2 percent to 9.5 percent represents an addition of between $60 and $70 billion to the Federal deficit. Do you differ in any marked way with that calculation? Mr. VOLCKER. Certainly the weak economy contributes to deficits. I don't know about your particular calculation, but the recession has a substantial impact, which I think, to a degree, you should ab- stract from in your budgetary decisions, as I indicated earlier. Senator SARBANES. The higher interest rates also increase the carrying charge on the Federal debt, is that not correct, and there- by also contribute to an enlargement of the deficit? Mr. VOLCKER. In a direct sense, yes. Senator SARBANES. In fact, Walter Heller, in a column not very long ago, said "the Reagan mix of ultra-easy fiscal policy with ultra-tight monetary policy boosts both interest rates and the Fed- eral debt and thus will cost the Treasury an additional $40 billion or so per year. How long can the country endure current economic conditions without a fundamental loss to the Nation's productive base and to its social fabric, to which jobs and housing are essential? Mr. VOLCKER. I don't know the answer to that question. My ex- pectation is, of course, that the economy will begin showing some recovery. Senator SARBANES. You've been telling us that for a long time. I don't want to drag out your past statements. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 Mr. VOLCKER. I think you can drag out my past statements and find I've been very consistent in saying that I expected some level- ing of the economy in the second quarter. Senator SARBANES. Some leveling? Do you call the highest unem- ployment since World War II as some leveling? Mr. VOLCKER. Yes; some leveling in the second quarter, and I ex- pected some recovery in the second half of the year. That remains my expectation. I didn't say it was satisfactory. I say, technically, it does not appear that the gross national product declined in the second quarter. I'd rather see that than see a decline. POSSIBILITIES OF LOWER INTEREST RATES Senator SARBANES. Let me ask you this question. If lower inter- est rates would have given us more economic activity, avoided the rise to 9.5 percent unemployment, held down the carrying charge on the Federal debt, and therefore represented potentially, let's say, a contribution of $75 billion toward the deficit, then why wouldn't a policy of the Fed for lower interest rates—and I'm not talking about opening the floodgates, but about interest rates at a level that would permit something approximating normal activity in the interest-sensitive sectors—have been a major contribution to moving the economy forward, a major and responsible contribution, without reigniting inflation? After all, the inflation you're concerned about you tied to the deficit. And the deficit is related to the high interest rates which have provoked the economic downturn. Mr. VOLCKER. I think the trouble with that line of questioning, Senator Sarbanes, is that it assumes we have some magic wand we could wave to produce a lower level of interest rates without all those other side effects that you have just assumed away. I haven't got all those powers. Senator SARBANES. Do you have the power to lead us toward lower interest rates? Mr. VOLCKER. Not regardless of economic conditions, no. Senator SARBANES. And what is the relationship that you see in terms of inflation with lower interest rates at a time when the economy is working so far below capacity, as it is today? Mr. VOLCKER. I'm not sure I understand the question. Senator SARBANES. Suppose we had interest rates today at, let's say, 12 or 13 percent. Now, how would that contribute to inflation? It would seem to me that that would contribute to economic ac- tivity that would help to lower the deficit, bring down the carrying charge. The deficit would be lower. Mr. VOLCKER. I don't know what interest rates you are referring to. Some interest rates are below 12 or 13 percent. Some are above. Senator SARBANES. That's not much comfort for the people in homebuilding and other sectors. Mr. VOLCKER. I agree it's not much comfort to them. Senator SARBANES. What's going to happen to them? Mr. VOLCKER. You assume I can say interest rates are going to be 8 percent or wherever you want them, and that nothing else is Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 going to happen, and that's going to be a wonderful thing for the economy, If I could just dictate that interest rates are going to be 8 per- cent, without any adverse effects, that the money supply is going to be on target, and that the deficits are going to be fine, I would go do it. I haven't got that kind of power. Senator SARBANES. Is there a relationship between the money supply and the interest rates? Mr. VOLCKEE. A complex relationship. Senator SARBANES. Do you control the money supply? Do you care to accept that proposition? Mr. VOLCKER. We certainly influence the money supply. Senator SARBANES. For years, the Fed focused on the interest rates, which are, after all, the variable that the people in the econ- omy have to work with. You departed from that a few years back. I don't see that that departure has enabled us to develop a policy to keep the economy moving on some reasonable track. Mr. VOLCKER. I think we have made a lot of progress in some di- rections, and we have had very heavy costs in the short run. Senator SARBANES. I'm not ignoring the problem of inflation, but I think any economic policy that does not address both the problem of inflation and the problem of full employment is a failure. It's got to address both of those issues. We now have a situation where we have the highest unemploy- ment since before World War II. And in some States, the figures, of course, are double digit. Now, there are people, who see everything they've done over a lifetime being lost, both workers and business- men. COUNTERPRODUCTIVE And I don't see that the policy of the Fed and the administra- tion—because, as I understand your opening comments, your policy is in harness or in tandem with the policy which the administra- tion wishes you to pursue is anything but counterproductive. It is helping to compound the very situation which you say you are con- cerned about. You talk about the size of the Federal deficits, and yet we can trace, albeit in a complex way, a good part of those deficits to a monetary policy which has helped to promote the economic down- turn. Mr. VOLCKER. Obviously, I don't agree with that analysis. I have indicated that that part of the deficit that can be attributed direct- ly to subpar economic performance should be analyzed in a differ- ent way. I do agree with your basic comment that economic policy in gen- eral and monetary policy in particular has to be concerned with all the characteristics of our economy. Where I guess I disagree, as a practical matter, is that we can instantaneously achieve all those things. Let me point out that the kind of problems you described for the American economy, which are very real, are absolutely endemic among other industrialized countries. You can take practically any Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis country in the Western world today and find that unemployment is at the highest level in the postwar period. Senator RIEGLE. What's the prime rate in Japan—interest prime rate? I think it's 5% percent. Mr. VOLCKER. I don't know what the prime rate is in Japan. In- terest rates are much lower. Japan has the best economic perform- ance of any of these countries. They have a very low inflation rate. But even Japan, relative to its performance, has not been growing very healthily; it's not growing at all now. Senator SARBANES. They're all related. I keep getting notes. My time is up. They re all related to the high interest rates in this country. Was not that a subject on the agenda at the Versailles Confer- ence? Mr. VOLCKER. Yes; but I think it's oversimplified to trace all the problems in the world to particular interest rates in the United States. Senator SARBANES. I'm not trying to do that, Mr. Chairman. I recognize the complexity of the problem. But the point I'm trying to make is that your presentation, as you continually give it to the committee, seems to posit that any move to lower interest rates is giving up the fight on inflation, but that is, first, not accu- rate and, second, sends the wrong message to the country. It's my contention that we could move toward lower interest rates in a reasonable fashion. Again, I'm not talking about opening the floodgates, but moving toward lower interest rates without ig- niting inflation, helping to restore activity to the economy and, in fact, making a contribution both to the fight against unemploy- ment and to the fight against inflation. Mr. VOLCKER. To the extent that's possible, maybe we aren't in any disagreement. I agree with you. My only disagreement is whether one can force that development regardless of whatever else is happening with respect to monetary growth, credit growth, the economy in general. I just can't force that. I agree it would be very desirable to have that happen, and I think it can happen. Senator SARBANES. We have got to move in that direction. I don't think it's adequate to talk about hopeful signs and say the situation offers great opportunties at the same time that you can concede that there is a crumbling foundation of continuing re- cession. The CHAIRMAN, Senator Dixon. Senator DIXON. Thank you, Mr. Chairman. Mr. Chairman, I'd like to switch gears with you for a minute and then come back to the economic question. First of all, I want to say I was delighted to hear your expression of support for a line item veto power for the Chief Executive. I would like to tell you that immediately prior to our Fourth of July break, on the occasion of the second veto of the urgent supple- mental by the President, I made a statement in the Senate support- ing the line item veto and said I'd introduce a constitutional amendment on that line. And I expect to offer an amendment to the budget-balancing amendment giving the President that power. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reser9v7e-6 5B6a n0k- o8f2 S t. L5ouis 60 In my State, the Governor has a line item veto power, with a right to override in both legislating bodies by a constitutional ma- jority and save millions of dollars there. I think it would have a very, very good impact upon the budget- balancing capability of the Congress at the present. So, I thank you for your remark. Mr. VOLCKER. I didn't realize you introduced that amendment. I congratulate you. Senator DIXON. One other thing I'd like to pursue with you in connection with what Senator Cranston discussed with you is the question of the amendment that will be before us again when we leave the tax bill. As you know, in section 3 of that amendment, the three-fifths majority can be waived upon the declaration of a war. AMENDMENT FOE NATIONAL ECONOMIC EMERGENCIES I am going to offer an amendment that would extend that power to national economic emergencies. And I wondered if you would express your view on the impor- tance of having that waiver power when we encounter either very serious recessions or depressions, as we have in the past? Mr. VOLCKER. I certainly understand what you're after. I suppose in those conditions you'd get the 60-percent majority anyway. I would support the substance of what you are saying. I don't know whether you mean you would leave that up to a Presidential decla- ration or what. Senator DIXON. It would be necessary to have an enactment by the Congress and signature by the President, so it would be a joint effort of both. Mr. VOLCKER. I appreciate what you're after. I'm a little cautious about getting into detail on a piece of legislation that I haven't seen and analyzed more completely. Senator DIXON. Mr. Chairman, I'd like to pursue a little bit what my friends from Indiana, New Jersey, Maryland, and others have pursued with you here, and that is the question of the basic policy that you have adopted at the Fed. Early on, after your remarks, I made a note on my first page, "more of the same." I don't mean that critically, but would you say it is a fair analysis that you have come to this committee essentially during my short tenure here, telling us pretty much the same things, advocating pretty much the same policies both by the Congress and by the Fed, as the ap- propriate solution to our problems. Is that a substantially true statement? Mr. VOLCKER. Yes. Senator DIXON, Basically, a monetary policy that you have pur- sued in the past, one that you have indicated to us again in your statement today, one you perceive to be the solution to our prob- lem. But I would want to ask you whether, in fact, the evidence is not to the effect that so far that policy has not worked in the coun- try. Mr. VOLCKER. I think the evidence is that it's extremely difficult to turn around in terms of inflation. I think those difficulties mul- tiply when so much of the burden falls on monetary policy. I think Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 those are very substantial problems, but I don't conclude from that that I know of a better policy, because I think we've got to deal with these problems, using the tools that are at hand. Senator DIXON. If I might pursue that for a moment with you, Mr. Chairman, sometimes I think I hear from you and others in this committee and here on the Hill different things and sense of perception here of a different world than I find when I go back to my home State of Illinois—I was back there this past weekend— unemployment is 11.3 percent. Housing starts in my State were down the most in the country, down 77 percent last year under the prior year, which was a terrible year. I spoke in Rock Island County this weekend, 26,000 people are unemployed, looking for work and want to work in Rock Island County. The automobile in- dustry is decimated. Every one of my thrifts is against the wall and coming here, telling me they're hanging by their fingernails. I'm asking whether in that circumstance our policy can be described as adequate, and I pursue that by saying this: others have alluded to the fact, my friend from Wisconsin has, and others, to the fact that before October 1979, we also targeted interest rates. There were some other things in your policy that, at least in the perception of people I know, now appear to be rational policies applied to a given set of circumstances. I ask you whether you have ever considered that policy, once again given the very serious times we've had. Mr. VOLCKER. Let me describe the policy we had before October 1979. We also were targeting the money supply then. We put more weight on very short-term interest rates as an instrument to achieving this same target that we are now aiming at. I'm describ- ing a difference in mechanism to achieve the same target, not a dif- ference in targets. The operational variable, so to speak, has changed; we now much more importantly target reserves rather than trying to influence the Federal funds rate from week to week. The previous policy did not necessarily dictate that given the same monetary targets you would have had lower interest rates. We would have aimed at the Federal funds rate as the variable in the short run, but we might have had to go to a very high rate to achieve the same control over the monetary target. I think it's fair to say the difference between that technique and the present technique is that we had more short-run stability in in- terest rates, at least in the short-term rates, under the old tech- nique, but I don't think it said anything about the level of the in- terest rate. Senator DIXON. But the very nature of the stability of those in- terest rates in my view had a lot to do with the continuation of that stability. One of the things I see in the very high long-term rates is the fear of future inflation and other adverse experiences that'a keeping that market so high, when under ordinary circum- stances, real interest rates, over and above the inflation rate, would be 2 or 3 percent. Now it's substantially more than that over the inflation rate. It just seems to me, and I don't mean to be overcritical of what I consider to be your tenacity and coolness under fire, but it does seem to me that the point is that in the past those policies have produced a better result for the economic commmunity. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 Mr. VOLCKER. One of the reasons we changed—there were a vari- ety of reasons—is that the decade before 1979 had been character- ized by rising inflation and progressively poorer economic perform- ance, I might say, over time. We had higher unemployment at the end of that decade than we did at the beginning. We had a lower productivity trend and higher inflation. By the end of the decade, the threat clearly was that the inflation rate would accelerate and economic performance would continue to deteriorate. The change in approach was designed to make the point and to implement the point that the monetary aggregates would be brought under appro- priate control and that the inflationary tide would be turned. With respect to that particular objective, I think there's been a good deal of success. We've also run into a real problem in the economy while these changes are taking place. Senator DIXON. Could I make this point, Mr. Chairman, that I would concede, as every member will, the results with respect to inflation from your stated policy, but I have to say to you that we have had deficits in all but 1 year in the last two decades. To the best of my recollection, the deficits have been there. I can tell you this, however, these are the worst economic times we've had in my adult lifetime. So there has to be some reexamination of some of the policies that we are following around here, if we're going to turn this thing around. It at least seems to me that we ought to look back to what we did before, if it was a better result. Mr. VOLCKER. Obviously, I agree with you that policies ought to be reexamined, and I do not think our total mix of policies is ideal, to say the least. We are only dealing with one aspect of policy now, monetary policy. When you talk about changes in policies, presum- ably, you talk about the whole framework of policy. We have fiscal problems. I am personally very sensitive to the kind of problems Senator Lugar raised, which I don't think anybody is working on very much, but over time should be. They are a very difficult, intractable set of problems, and when I look to a longer run, I think they have to be an important compo- nent of a successful economic policy that, indeed, reconciles stabil- ity with growth. I think we can get that out of our present policies, but it will take longer and yield much more distress than would otherwise be necessary. Senator DIXON. Then let me ask this final question. Again pursu- ing the question of that policy with reference to targeting interest rates as have been done prior to October 1979 and reverting one more time to a classic example of a really troubled industry, thrifts, which I suppose in my State are in more difficult circum- stances than many others. It came to my attention the other day, for example, that right now the Federal National Mortgage Associ- ation is earning about 10 percent on its portfolio, but is paying over 11 percent for its capital. I want to ask you, given the circum- stances, how much longer that kind of an industry can tolerate these rates before something dramatic happens in this country that is destructive to our market? Mr. VOLCKER. I have no quarrel with the proposition that we would be much better off if interest rates were lower. The only Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 question is how to get them there and keep them there. I have no quarrel with that proposition at all. Senator DIXON. I thank you. The CHAIRMAN. Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. SMALL BUSINESS BANKRUPTCIES Mr. Chairman, we've had a lot of discussion here today of esoter- ic economic theory, but the simple truth is that small business is being crushed in this country. In my native State of Tennessee, small business is being snuffed out of existence by high interest rates. I recently contacted the administrative officer of the bank- ruptcy courts in my State, and I was absolutely flabbergasted by these statistics. In the first quarter of 1981, there were 395 business bankruptcy filings in my State. In the first quarter of 1982, there were 701 business bankruptcy filings. That's a 77-percent increase in busi- ness bankruptcy filings from the first quarter of 1981 to the first quarter of 1982. Now I contend, as my small business constitutents have con- firmed, that their businesses have failed or are on the verge of fail- ing largely as a result of high interest rates. They are paying 18 to 20 percent to borrow money for capital, and small business just simply cannot last or last very long in that sort of environment. Now my question to you is this: What does the Federal Reserve Board intend to do to ease the interest rate burdens on small busi- ness, or are you just going to stand by at the Fed and watch this rising tide of bankruptcies go on and more and more small business people go under? Can you give us some hope, Mr. Chairman? A lot of these people are living on hope. Mr. VOLCKER. I certainly can give you the hope and the expecta- tion that interest rates will move lower over time. I think the fun- damentals point in that direction. No one would be happier than I to see interest rates move lower, but we come back to the old ques- tion of how can that be done within the scope of the tools available to monetary policy, not only getting them lower, but getting them to stay lower. We come back to these same old questions of gridlock or problems that have looked quite intractable. I think, in fact, they are going to prove tractable, and what's going to make it all possible is a sense of progress on inflation and continuing progress on that front to lay the basic groundwork. Senator SASSER. Let's talk about that just a moment, Mr. Chair- man. Now we have today the highest real interest rates, that is, inter- est rates corrected for inflation, that we have had in this century- Just looking at some numbers here, in October 1979, we embarked upon a new monetary policy under your leadership. At that time in 1979, the prime rate was roughly 12 percent; the GNP deflator was 8.5; and we were running real interest rates of 4.1 percent. By 1980, the prime rate was up to 15 percent; the GNP deflator was 9 percent; and the real interest rate was 6.3 percent. In 1981, the prime rate jumped to 18.8 percent, with the GNP deflator at 9.2, meaning real interest rates were at 9.7, almost 10 percent. And in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 1982, with inflation coming down—no doubt about that—the prime rate's at 16 percent, the GNP deflator at 3.5 percent and real inter- est rates at 12.6 percent. INTEREST RATES CONTINUE TO RISE Now my question is this: if our policy is to try to drive down in- flation with high interest rates, it appears to me, Mr. Chairman, there's been some success in that regard. Now why are interest rates continuing to go up, and why do we have real interest rates at the highest point in this century? What's the answer to that? Mr. VOLCKER. Interest rates, real interest rates are very difficult to measure. Let me make a preliminary comment. It's hard to measure what the precise inflation rate is, and real interest rates really depend on a determination of what expected inflation is, rather than on any rate you can measure directly. The prime interest rate is extraordinarily high historically, rela- tive to market rates at the moment. You would not get a different picture in character, but you would get a different picture in the extremes that you cite if you used an interest rate other than the prime rate. Having said all those things, real interest rates are certainly rel- atively high. I don't think it's true that they're the highest they've been in the century, but that's besides the point. They are very high; there's no question about that by any reasonable Senator SASSER. You wouldn't agree that they're the highest they've been since 1900 in real terms. Mr. VOLCKER. If you make a mechanical comparison between in- terest rates and the inflation rate, you'll find a few episodes when they were higher. They weren't very happy periods in economic history, so I won't pursue that point further, but such rates are not totally unprecedented. They're very high; there's no dispute about that fact. You come back to the question of why, how do you get them down, what's responsible for it? Going back to late 1979, early 1980, we begin to look at that period, I guess, with a little nostalgia. It wasn't a very nostalgic period to live through. The inflation rate was accelerating, everyone was scared to death about what was happening to the economy—and rightfully—and about inflation. Senator SASSER. They're not very sanguine about what's happen- ing to the economy now, Mr. VOLCKER. I agree with that, which is indicative of the fact that we've got a problem. It was not born yesterday, but developed over a considerable period of time. Again, it conies back to the question of what approaches can we best adopt to deal with that? I have described what we try to do with monetary policy. I have indi- cated that we are sensitive to the liquidity needs of the economy. Unfortunately, we have just one tool of economic policy, and we are dealing with an accumulation of problems over a period of time. I can only tell you what I think is best, even in explicit terms, for getting interest rates down and, as I keep emphasizing, not just getting them down for a month or two but sustaining a lower level, in terms of the tools we have at our command. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 Is it a happy situation? No, I'd much rather see interest rates lower, and I would be delighted to see them decline as rapidly as they can, consistent with what I think is necessary to keep them at a lower level. Senator SASSER. The disturbing thing to me, Mr. Chairman, is that when we embarked—I say, "we," the Federal Reserve Board embarked on this course in 1979—I remember vividly your telling us in the Budget Committee in the spring of 1980 that high interest rates were a product of inflation, and that they would drive infla- tion down. Some of us were unconvinced at that time; in fact, I've never thought that you can combat inflation strictly with monetary policy. We now find that inflation is coming down considerably. I had some statistics here earlier that indicated that the GNP defla- tor for the first quarter of 1982 is 3.5 percent; down dramatically, yet we still find our interest rate figures high and our real interest rate figures high. We see that inflation is coming down, but interest rates aren't coming down. And we see our economy in very, very serious diffi- culty now. Comparing this recession of 1981 and 1982—and I'll yield to you in just a moment—comparing the recession of 1981-82 to the recession of 1973-75, which was a very deep and a very severe recession, we find that in the recession of 1981-82 corporate profits are off 30 percent, as compared to only 23 percent in the previous recession. We find there are 2 million more people unem- ployed in this recession than there were in the 1973-75 recession, and we find mortgage delinquency rates are up almost 20 percent. All of this is occurring. Inflation is coming down, but interest rates in real terms are at one of the highest levels, I think we'll agree, in the century. Mr. VOLCKER. One of the highest. Senator SASSER. That clearly indicates to me that something is wrong with this policy that we are pursuing. And if we don't re- verse it, Mr. Chairman, I have some very grave fears that we're going to be in desperate straits, if we're not already. Mr. VOLCKER. Again, I think I have to answer the Senator by saying that I'm sure there can be, and should be, improvements in economic policy in general. I think that some degree of difficulty in this present situation was inevitable as a transitional matter. But if you asked me whether it could have been handled better through a different combination of policies, I would certainly agree with you. PRESSURE ON MONETARY POLICY Indeed, I think too much of the burden was put on monetary policy, which helps account for the high interest rates. Senator SASSER. No doubt. Mr. VOLCKER. There is no question that when monetary policy carries the full thrust of reversing an inflationary situation, you are likely to have more pressures, strains, higher interest rates than would otherwise be the case. That's not the world that I made or that the Federal Reserve made; that's the world that we live in. Anything that could be done in any other area to help out, I would welcome. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 I do think that this pressure on monetary policy is partly respon- sible for what you observe with respect to interest rates. Where I may differ with you is whether interest rates should follow a sub- stantially different course, given the environment in which we have to work. Senator SASSER. One final question, Mr. Chairman. My time is up and I will be very brief. Recently, U.S. News and World Report stated—quoting David Stockman—that the administration endorsed the Federal Reserve's tight money policy. Mr. Stockman said of the Board's monetary policy—and I quote—"We endorsed it, we urged it, and we have supported it." Well, almost contemporaneous with that, on Good Morning, America the Secretary of the Treasury, Mr. Regan, stated—and I quote him—"High interest rates have brought this economy right to its knees." And he indicated he directed the Treasury Depart- ment to study various alternatives that the administration might pursue, to lower interest rates or otherwise curb the independence of the Federal Reserve Board. Now, in your mind, Mr. Chairman, where does the administra- tion stand on this monetary policy? Is David Stockman right? Have they endorsed it? Have they urged it? Do they support it? Or is the Secretary of the Treasury correct, in being critical of it and directing studies to try to lower interest rates and perhaps even do something about the independence of the Federal Reserve board? Mr. VOLCKER. As I indicated earlier, in response to Senator Sar- banes, my perception is that they've been generally supportive of the thrust of monetary policy. Senator SASSER. So, Mr. Stockman is closer on the mark when he says "we have supported," than the Secretary of the Treasury is when he says he's critical of it? Mr. VOLCKER. I suppose those are questions that have to be di- rected specifically to them. Senator SASSER. Thank you, Mr. Chairman. Senator BRADY. Mr. Chairman, I think I have 1 more minute. Might I ask one more question? The CHAIRMAN. You quit 2 minutes early on your last round. Senator BRADY. Thank you. Mr. Chairman, I think that I heard you say no one would be hap- pier than you to get lower interest rates. Is it, therefore, a further conclusion that it's the way you get them that is your Mr. VOLCKER. At issue, yes. Senator BRADY. It seems to me that it's worthwhile noting that you are Chairman of the Fed, and not economic dictator; you only have certain tools to work with—three, I believe: operations of the Federal Open Market Committee, the discount window, and reserve requirements. Any pushing or aggressive actions in those three areas are going to return us to where we were in 1978 and 1979. As I have heard you speak this morning, it seems to me that lower interest rates are your goal; if you could mandate them, fine. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 But your feeling is that you don't have any such tools before you? Mr. VOLCKER. If I could mandate them, and have all these other happy things happen with no adverse effects, I would mandate them this morning. Senator BRADY. Let me ask you one more question, then: When you put into place the policy, in 1979, that is now in place, what would have happened if you had not done that? Mr. VOLCKER. What we were dealing with, fundamentally, was accelerating inflation. We let that go and get out of hand; even now, we would be in much more serious economic difficulties had we not dealt with it. You can argue about the particular technique, but that fundamental need to deal with and turn around an accel- erating inflation seems to me unambiguous, otherwise we would have been left in much more serious economic circumstances, over a much longer period of time. Senator BRADY. How would it have manifested itself? Mr. VOLCKER. Among other things, it would have manifested itself in still more serious problems in financial markets and in higher interest rates. Senator BRADY. Were we headed toward the economies in South America, where you have rates of inflation Mr. VOLCKER. I don't want to be overly dramatic, but we were certainly going in that direction. We were a long ways from there, but that's the way things start. The longer it lasts, the more it ac- celerates, the harder it is to deal with. Let me just make a point I try to make with practically every audience: never before in the history of this country have we had an inflation of the size and duration that we have had since 1965. I think that left a very great imprint on people's minds, their behav- ior, their attitudes, their willingness to buy long-term securities, and the way they look at interest rates. All those things grew out of the unparalleled inflationary episode that we had in this coun- try. Senator BRADY. I think that it's worth noting—one more observa- tion is that we have in this country the only long-term bond market in the world, I believe that is correct? Mr. VOLCKER. That's right. And that has been, and is, threat- ened. Senator BRADY. Thank you. SAME DEBATES AND ARGUMENTS The CHAIRMAN. Mr. Chairman, I would like to use my last period of time to express some great frustration, as I have listened to these hearings today, and also sadness. And the reason I say this is that I never seem to hear much different. I've sat on these hear- ings, now, for 8 years. It's almost like picking up the newspaper in Salt Lake City. It's been 8 years since I was mayor there, but yet, I pick up the newspaper out there and read about the present mayor and the struggles of the city council; and the news is the same, they are having the same debates and the same arguments over and over again. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 After 8 years on this committee, I see the positions shift, but not too much different is going on. Today we have here a great effort—not only here, but across the country, and on the floor of the Senate, and all the committee meetings—there is a great effort for Congress to pass the buck; not just one party, but both parties—to you. You are one of the favorite topics of speeches by Congressmen and Senators of both parties, all over this country: If we could just get Paul Volcker to do some- thing, all this would go away. Never much talk about fiscal policy; never much talk about our role in it. And the second target is Ronald Reagan. I realize his program has been in effect since last October. You are No. 1; he's No. 2. "The two of you have destroyed the economy in the last year and a half," without any regard to histori- cal significance of a trillion-dollar debt that was built up before either one of you were around, of refunding one-third of that debt, of $340, $350 billion a year—just ignoring the arithmetic complete- ^This isn't a partisan statement I'm making, because you were here when Jimmy Carter was President. And my side was sitting here, asking the same kinds of questions that you've heard today: "Have you been having lunch with Jimmy Carter?" "Does Jimmy Carter agree with your policies?" All we've done is change the roles and the parties. That's where my frustration and sadness come in, because what we've heard today is true, from everyone. This economy is sick; it's very sick. And we're switching roles, regardless of which party we belong to, to try and assess blame on the Fed and whoever the in- cumbent President is, and ignoring our role. That's why I'm so frustrated. Congress seems to be getting away with that year after year. Every year I've been here, they get away with it and push it off on someone else. You can loosen up your money policy tomorrow. Interest rates will probably go up, in my opinion. Or we can do away with the third year of the tax cut. We can cut billions out of the military. We can do all sorts of things. Everything you've heard from every- body, particularly those running for office, Republican or Demo- crat, who want to find somebody else to blame for these horrible conditions they're having to explain at home. It seems to me that we've got to get away from that and start looking at the arithmetic. And I'm speaking specifically of long- term interest rates. I simply know of no actions that you can take, no actions that this President can take, because we can bitch and moan about high deficits and everything else, and there's a fact that no one can dispute. And that is: That no President has ever spent a dime not appropriated by the Congress of the United States. Not George Washington, Abraham Lincoln, Harry Truman, Jimmy Carter, Ronald Reagan, or anybody else. So, if we really don't like these budget deficits, why don't we just shut up and do something about it. Congress is the only one, under the Constitution, that can appro- priate money. If we don't like a $100 billion deficit, we can do something about it—and no one else. The President can recom- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 mend, he can plead, he can threaten, he can veto, he can twist arms; but it is a fact that only Congress can appropriate money. So we're involved in so much rhetoric about these deficits, trying to push it off on you or someone else. That doesn't mean that I agree with all of your policies. I don't; you know that and every- body else does. But it is internal within our budget process to solve this interest rate problem, particularly in the long term, because nobody is going to be fool enough to loan money over a long period of time, at reasonable interest rates—I'm not talking about short term. You can have some influence over short-term rates. But if they sit there and see half a trillion deficits in the out years because we're so gutless that we won't even talk about social security and veterans' pensions and Federal civil service retire- ment and the entitlements programs that are automatically in- dexed and growing at an incredible rate, we're not going to solve that problem and interest rates won't come down. We can make any of these critics Chairman of the Fed tomorrow. I would like to make some of them Chairman, and put the whole thing on them. And I bet you they would be up here saying, "Hey, I don't have that much power." [Laughter.] "Good heavens. I can't do anything about that." I just want to make the point. I'm not trying to blame anybody. I've got seven kids. I would like somebody to tell me how they're going to buy a house, what we're going to do about this long-term market. This President can't do anything about it. You can't do anything about that long-term market. Only we. When we have the courage to say to the American people, "Yes, we have got to talk about slowing the growth of social security, not cut anybody." I was talking to a pressman the other day, in Atlanta. He just didn't seem to understand. So I said, "OK. I can't seem to get through to you that no one is talking about eliminating anyone from social security. No one is talking about dismantling. No one is talking about reducing anybody's pension from their present levels. But we must talk about making that system solvent, and we must talk about slowing the increase." So, I said, "What if you just demanded of your boss that you were the greatest living media reporter the world had ever had, and you wanted a $10,000 raise. And your boss said, 'boy, you really have done a fantastic job and I'm going to give you a $6,000 raise; that's all I can afford within my budget.' " "So you run home to your wife and you say, 'That lousy boss of mine just cut our pay by $4,000 a year.' " Now, that's what we re hearing. No one in this town is talking about cutting anybody's social security, but until we talk about slowing the growth of those entitlements programs, you can bal- ance the 1983 budget tomorrow, and I think everybody would be still surprised. They would say, "Why are long-term mortgage rates still so high?" Because we haven't scratched the surface of the bud- gets in 1990 and 1995. A 30-year mortgage is the year 2012. We're worried about a 1983 budget—which we should. It's too big. The deficit is too large. But this Congress has not yet faced up to those out years. And interest Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 rates will not come down, and the American people better learn where the problem of long-term interest rates is. It isn't in the Fed. It isn't in this administration, in the Carter administration, or any other place. It lies with the people who have the power of the purse strings, and nobody else. The Constitution says so. We've got the power to do something about it. And until we do, the wrath lies on this body—the Senate and the House, on both Re- publicans and Democrats—who ought to be penalized in this elec- tion in November if they haven't got the guts to address these issues and do something about them. That's hardly a question period. It was a speech. But it was in- tended that way because, like I say, the bottom line with me is: How do my seven kids grow up in this country and buy a house? Right now they couldn't possibly even hope to buy one. Senator Riegle. Senator RIEGLE. Senator Garn, that's a tough speech to follow right now. I appreciate and share many of the frustrations that you expressed, but I want to try to nail down where we are going from here with Chairman Volcker, because I think we are moving into a period of extraordinarily high risk to the economy. I think we are into a period in which I think the jeopardy is rising, as we last saw just before the Great Depression, and I think what is required here is to steer a course, a change in course that can take us through these difficulties and bring us through without a far worse finan- cial collapse than we've already seen. And we do have a financial collapse occurring now. You can measure it, as many members of this committee have today, by unemployment, depression in the housing industry. In my State today, in Michigan, the unemployment rate is 15 percent. That does not count 125,000 workers who have been unem- ployed so long they are no longer included in the unemployment numbers. In my State we have had unemployment above 10 per- cent for 32 consecutive months. Every day my phone is ringing from business people across the State of Michigan, from large cor- porations down to the smallest businesses, telling me they can't survive another month, another 2 months. They are filing for bank- ruptcy, they are going into chapter 11. Everywhere I look, that is what I see. It isn't just Michigan; it is true across this country, and I've been across this country in the last 30 days talking with people in different places, and this is what I am finding. I don't sense that there is a recognition yet within the Fed of the magnitude of this problem, and despite the good personal relation- ship that you and I have and which I want to maintain, I don't sense in your remarks today that you perhaps comprehend the magnitude of the human suffering and the devastation that's going on at the foundation of this economy, that I am not sure we are going to be able to correct, or if we do, it may well take us decades to do it. ADMINISTRATION TO STAND PAT ON ECONOMIC POLICY I think we are about to move into a period of free fall on the economy. What people are not paying attention to is the Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 Government, for all practical purposes, is about to shutdown for 6 months. That's what's happening. As a matter of fact, in the U.S. News and World Report of yesterday, which is pretty well tuned into the White House, what they say here on page 11, they say: The President will stand pat on economic policy for the rest of the year. Reagan won't be turned around, even though the oft touted just around the corner recovery is looking more and more elusive. Political realism is the key. There is not much the President can do between now and election time to give the ailing economy a quick fix. White House game plan is to tough it out, insist Reaganomics will work, and hope things will perk up soon enough to prevent heavy losses in Congress this fall. The last thing Reagan wants to be accused of is Carterism, being wishy-washy on major issues. Reagan's advisors argue his steadfastness is a virtue, shifting gears would send bad signals to financial markets and voters, I think this is probably accurate. They don't intend to make any change, any mid-course correction in the policy; nor fight to try to bring the deficits down. It can't be done in this country without the President participating. The President is the single most important leadership figure in this country. That is why he is paid $200,000 a year to do the job. He can't sit up in the bleachers and complain about the problems and not participate directly. However, we've not had that kind of direct participation and the Congress itself has not responded. The deficits are out of control, and I don't know of any economist in the country today that believes the deficit estimates in the first budget resolution, which is nonbinding that reported that deficit of $104 billion next year. Deficit estimates range way beyond that point, and they are clearly much higher than we can tolerate. But the problem is that once we shutdown here, there are no emergen- cy powers in place today that anybody can operate. If we find the economy worsening, the Credit Control Act has just expired. You, in effect, said there is very little that you can do. The President, for his part, not only doesn't want to do anything at this point, but it's not clear what emergency powers he has to use in the period of time that the Congress is not even in session, can't even meet short of an emergency joint session of the Congress. And people like Henry Kaufman and Wosinauer, who have great re- spect in the financial markets, as you well know, are predicting that interest rates are about to go back up. You may have a mo- mentary drop in interest rates, partly driven by the reduction in the discount rates yesterday, but their expectation, which is widely shared in the financial markets and amongst financial experts across the country, is between now and the end of the year the in- terest rates are as apt or more apt to be going higher, maybe not to 20 percent but certainly back up to 16.5 or 17 or 18, and as Senator Sasser points out, there are small business people in this country who are not borrowing at 16.5 percent—they are borrowing at 18, 19, and 20 and they are going down the drain. You talk about the other Western economies. I look at Japan; the prime rate in Japan is 5.75 percent. Their people are working. Our people want to go back to work and they have a right to go back to work. But I think what everybody is failing to see here is that we are about to go into a period of maximum risk and jeop- ardy in this economy where, if things do get much worse, if inter- est rates do go higher, we could find the financial structure and ev- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 erything else put in jeopardy beyond anything we have seen since the 1930's. We are seeing bank failures. We are seeing a quiet run on finan- cial institutions. We are seeing people move out of long-term secu- rities into short-term securities, and basically what everybody says is, "Sorry, we can't do anything about it." And in effect, that's what you're saying today. You are saying your hands are tied, there is not much you can do. What I am saying to you is that if that is the attitude everybody is going to take, if the Fed is going to take that view, the Presi- dent's going to take that view, the Congress—and it is divided; one party controls one body of the Congress, the other party controls the other—if the best that we can say collectively is, "Sorry, we really can't do anything about this problem," then that's a pretty sorry admission of the failure on our part to respond to an emer- gency. That's what we have on our hands. I just want to conclude by saying this: I've talked to the top fi- nancial officers of the major banks in this country at major finan- cial institutions, every single day, and I have for the last 30 days straight. They share this view. This is their view, this is what they're saying. This is what they're saying in the private conversa- tions. And so this is not just a question of one person's opinion or someone else's. There is great alarm, great fear about where we are heading unless we change this policy mix. Everything that I see here indicates that everybody is prepared to stay on the course we're on, and I see that as posing unacceptable dangers to this country. I am prepared to go with you and I'm prepared to give people on both sides of the aisle, hopefully, to go as a group to see the Presi- dent, to see his economic advisors, to meet with a bipartisan group of leaders in Congress, to meet with whoever has to be met with so that we can reach a collective decision, a bipartisan decision to take action now before this window closes, because once this ses- sion of Congress ends, we are going to be locked on course. I had the head of one of the top banks of this country say to me a week ago, he said, "This economy is right on the edge." I said, "Is it going to go over the edge or come away from it?" He says, "I don't know." He says, "I think it's as apt to go over the edge as it is to come away from it." That's the situation we're facing today, and yet there is no plan here. And my question is this: If things do worsen, if things do worsen and we see the unemployment rate go up another percent- age point or two, we see the bankruptcy rate continue to climb, we see interest rates start to go back up again, what will the Fed do at that point? FED RESPONSE TO SINKING ECONOMY Mr. VOLCKER. You asked the question—I was about to volunteer the response. I certainly understand the sense of frustration that Senator Garn expressed. I understand the concerns you expressed. Let me say as clearly as I can that I don't share your concern Senator RIEGLE. You don't need to share it. If it happens, what response will the Fed make? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 Mr. VOLCKER. You say we can't do anything. I say we haven't got any wand to wave to get interest rates down in current circum- stances and keep them down. In the kind of situation that you're calling up here, obviously we have powers to increase the liquidity of the economy, to respond and protect the banking system and other financial institutions, and we would exercise those powers— there shouldn't be any doubt about it—if that kind of scenario threatened to develop. Senator RIEGLE. So it would be your plan, if we find the economy continuing to sink, if interest rates start to go back up again, that it would be the Fed's intention to use whatever powers it has if it finds us moving into a greater emergency than we have at the present time, you are prepared to respond? You are prepared to take whatever unilateral actions are necessary to see that there is adequate liquidity in the economy? Mr. VOLCKER. Yes. If we face that kind of situation, which I don't expect to face, we would obviously use our powers. Senator RIEGLE. And what exactly would that involve? What would you be able to do at that point? How would you be able to bring the rates down sharply and quickly? I am serious. I am inter- ested in knowing what the mechanical response would be in that case. Mr. VOLCKER. What we can do is provide more liquidity to the economy. Senator RIEGLE. How would you do that? That's what I'm asking. Mr. VOLCKER. Through our ordinary tools of policy: Using open market operations, the discount window, depending upon what was necessary and desirable. Senator RIEGLE. If interest rates go back to 17, 17.5 percent before this year is out, would it be your intention to respond in this fashion? Mr. VOLCKER. It would depend upon the whole context of the sit- uation. You just can't pick out one variable and ask me how I would respond. You are positing the threat of a national emergen- cy, of an emerging depression or something like that. I don't expect those things to happen, but obviously we would respond if they did. Senator RIEGLE. Do you think the economy could take interest rates of 17.5 percent sometime between now and the end of the year, or higher? Mr. VOLCKER. It would depend upon what else is happening. Senator RIEGLE. We know what else is happening. We see the state of things at the present time. Do you think this system can take that kind of high interest rate stress at this point? Mr. VOLCKER. At this point I certainly would not like to see that, but we're not talking about this point in time. Senator RIEGLE. I can't find anybody today who is in the finan- cial institution world, who is looking at the balance sheet and in- terest statements of hundreds of thousands of other companies, who feels that this country can sustain that at this point. My hope would be if we find that developing, that you will act. And if the President remains serene and detached from this problem, if the Congress demonstrates an incapacity to respond to it, and in fact it may even be out of session when it develops, I hope you will re- spond. I'hope you won't wait. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Mr. VOLCKER. We would respond with all the powers which we have, if we thought the basic institutional structure and the basic economic structure were threatened, within the limitations of what we can do. The CHAIRMAN. Senator Proxmire. Senator PROXMIRE. Mr. Chairman, I'll be quite brief. You issued today the midyear monetary policy report to Congress pursuant to Full Employment Balanced Growth Act of 1978. Right after page 13 you have a graph showing the ranges of actual mone- tary growth. I am asking this because I want to—it seems to me this indicates what you are going to do, in all likelihood, because as I understand you to have said this morning, you don't intend to depart from the monetary targets that you have set. Mr. VOLCKER. We expect to be around the upper end of them. We indicated, if special liquidity problems arise, we are prepared to go above that. Senator PROXMIRE. As I look at these charts, Mi and M , you just 2 came back to M barely, in the latest figure. On M you are still a u 2 little bit above the M target. As you come to the midrange, that 2 would be 4 percent for Mi and 7.5 percent for M . That would be a 3 restriction. You've just said you expect to be in the upper area, so that you would continue with what I think all of us would have to define as a restrained, conservative monetary policy. You would expect to do that for the rest of the year; is that correct? Mr. VOLCKER. Relatively restrained. We said we might be around the upper end of the ranges. Senator PROXMIRE. The same thing would be true on the table following page 15 with respect to M and bank credit? 3 Mr. VOLCKER. Yes; let me point out, as I did in my statement, that with that kind of growth in the monetary aggregates, histori- cal experience would suggest there is quite a lot of room for real growth in the economy at the current rate of inflation. RECORD BORROWING BY THE TREASURY Senator PROXMIRE. I don't want to hash over what we've already been through, because I don't want to take up that much of your time. As I tried to point out, the Federal Government is going to absorb a very large part of the available money supply. There is going to be record borrowing, isn't that true, by the Treasury, the rest of this year and next year, way, way beyond anything we've had before? Mr. VOLCKER. Yes, but these are not measures of the total supply of credit in the economy. These are measures of the money supply. The total supply of credit is of a much larger magnitude than these numbers. Senator PROXMIRE. That would be reflected, to some extent, in the chart in your statement where you say bank credit (see p. 12). Mr. VOLCKER. A part of it would be. The Government doesn't borrow very much from the banks. Actually, the banks don't hold very many Government securities these days, and these would be consistent with the figure for credit expansion that would allow for a very large volume of Treasury financing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 Interest rates are higher than they otherwise would be because of that volume of financing. But, certainly, based upon any analytic relationships we can develop, this kind of growth in money would be accompanied by growth in credit that is consistent with econom- ic recovery in the latter part of the year. If that's not the case, if there are extraordinary liquidity demands that impact on these numbers, I indicated a note of reservation or modification. Senator PROXMIRE. The reason I have trouble with that is over the past year or two, the private economy has not been able to borrow much because interest rates are so terribly high, and in the next 6 months or a year the Federal Government is going to borrow more. The available supply of credit would not seem to be increased, and therefore it would seem to me it is pretty clear that any objective analysis would suggest we are going to continue to have high interest rates and restrained economic activity for the next 6 months or year. I just can't see any room for recovery. Mr. VOLCKER. I disagree with that analysis. Our analysis would suggest, on the contrary, that this kind of monetary growth, based on historical experience, would be consistent with recovery. On M , 2 for instance, the arithmetic is simple; in recent years it has been expanding about as fast as the nominal GNP. In the past three quarters it's expanded faster than the nominal GNP. What you would expect, following a period of that sort where these monetary aggregates have, in fact, expanded faster than you might have expected, given what's going on in the economy, is that that would be followed by a period where they are expanding rela- tively slowly relative to the economy. I'm Senator PROXMIRE. But the nominal GNP has been stagnant, the inflation hasn't been that much and the growth in the economy has been stagnant. Mr. VOLCKER. The nominal GNP has been stagnant, and the technical manifestation of that, consistent with these targets, is that velocity has been low. Experience suggests following a period of low velocity you have a period of higher than average velocities. That's what we're assuming will happen. If that doesn't happen, this would obviously be called into question. The CHAIRMAN. Do you feel your monetary policy would accom- modate that increase, substantial increase in nominal GNP? Mr. VOLCKER. Yes. Senator PROXMIRE. Thank you, Mr. Chairman. The CHAIRMAN. Senator Brady, do you have additional questions? May I apologize for placing you after Senator Riegle, but you're so far away, hidden behind the cameras, that I simply missed you. Senator BRADY. Thank you, Chairman Garn. I will only add to what Senator Riegle says about talking to people all across the United States, which I have done myself in the last month or so, only I have come to a different conclusion from my colleague. I got very little comment about what the Feder- al Reserve is doing and what Chairman Volcker is doing. I got a lot of comment on the subject that Senator Garn has put forward, which is what are you guys in the Senate doing with regard to fiscal policy? What about the size of the deficit? So I think the con- cern is there about where we're going in this country, what the level of economic activity is. But the people that I talk to don't lay Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 the blame on the Chairman of the Fed or the Federal Reserve System. They lay it right smack where I think it probably belongs, which is on the Congress of the United States. So I would only add that to what we have already heard this morning. I think we do have—Chairman Garn, you put your finger on it. There is a great sense in this body of ours—let me just point up, having been here for such a short period of time, is that some- body's made a mistake and since we don't make mistakes, some- body else must be making them. And I think the case is more nearly the case that you cited this morning; that we simply have to have more of a fiscal restraint on this body. The CHAIRMAN. Might I just say, I share both yours and Senator Riegle's concerns. You know, we do—Congress does have time. We have yet, in either body, to look at an appropriations bill, so we can't cop out on that, that we are going to be out of session. We've got 13 regular appropriations bills to attempt to implement the budget resolution. As meager and unsatisfactory as that budget res- olution is, I have doubts about the Congress ability to adhere to it. But we've got time. We've got all the rest of July and August and September. We might even not have to have a Labor Day recess. We've got time to put up or shut up on the 1983 budget, because we have yet to address a single appropriations bill. Senator RIEGLE. Excuse me. Would you yield, Senator Brady, just for comment? Apart from how one assigns the responsibility for events up until the present time, or even in terms of how we break the gridlock at this point, in terms of the various players playing their roles, and so forth, leaving that aside in terms of the urgency of the moment, the need to break the gridlock and to take the fun- damental actions to get us on a different course that can bring rates down, bring down the deficit, and so forth; I don't know whether you're getting the same sense of urgency on that point that I am getting, but I find that to be universal. It's up and down the scale from people at the top of gigantic financial institutions down to the person running a store on the street corner. Senator BRADY. I do get that same sense of urgency. I think there is a great feeling throughout the land that things are not right, something has to be done, and maybe even a feeling that the Congress does not understand that. Having come from the private world just recently, I would say people underestimate their Congress in the sense of what their sit- uation is. I think at least the Senators I've talked to do understand the problem, that that urgency is out there. T would only say to my colleague from Michigan that in breaking the gridlock, we could strike a mighty blow by doing the thing that Senator Garn has talked about, by taking the next appropriation bill that conies through—I do not know what it is going to be, but acting responsi- bly toward it and give the people of this country the idea that we are going to face the problems there. My problem talking about monetary policy, is that I do not think it addresses the problem. I think the problem is in the area we talked about, the unlocking the gridlock, for you to have to unlock it at the short end of the market or the long end of the market. I think it is very hard to unlock at the short end of the market right Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 now, and the key is to take an absolutely clear step on fiscal policy. It does not have to continue forever. I think one of the things we have in Congress is we take a step in one direction, everybody says we're going to continue doing that for the next 15 years. We could make some steps in the next 6 months and see how it works, and turn around and go the other way again, after we get through. So to me, you've got to start some- where, and I would start with the area of fiscal policy because I think the chairman of the Fed is absolutely boxed right now. The CHAIRMAN. Senator Sasser. Senator SASSER. Thank you, Mr. Chairman. Mr. Volcker, I take it from what you have said earlier that you do not think we can fight inflation just with monetary policy either, do you? Mr. VOLCKER. I think it is much better if we do not just rely on monetary policy. In theory, you can just use monetary policy, but it makes things much more difficult. Senator SASSER. We would be in a better position, I assume, if we had a match of monetary and fiscal policy operating in tandem? Mr. VOLCKER. Yes. CUTTING TAXES Senator SASSER. I recall your coming before the Senate Budget Committee in 1980 and advising us at that time that we should not go forward with our plans to cut taxes. There was some discussion at that time in 1980 by a number of Members of the Senate; more specifically, Senator Bentsen and others, about cutting taxes. As I recall your testimony in response to questions before the Budget Committee, you advised us against that at that time. Mr. Chairman, did you give the same advice to the President and this administration when they embarked upon their expansive fiscal policy of cutting taxes? Did you discourage them from doing that? Mr. VOLCKER. Certainly in terms of the magnitude of the pro- gram, yes. It all depended upon how much we were to be able to cut expenditures obviously, and I had some skepticism he would be successful in cutting expenditures enough. Senator SASSER. I would say your skepticism about whether or not this Congress could cut some $750 billion in expenditures over a 3 Vz- or 4-year period was well founded. But I make this point, I think to illustrate that perhaps there is more responsibility here than some of my colleagues are giving us credit for. We turned away from the tax cut in 1980 because we were advised by you and others that that would not be responsible, and yet we then saw the tax cut coming in 1981. Let me ask you this: Do you think this tax bill that is before the Senate now, which will raise some $91 billion in revenues—does that go far enough in raising the revenues that are needed to at- tempt to do something about the deficit, or should we go forward and give consideration to deferring the third year of the tax cut? Mr. VOLCKER. What I think I said consistently is that I would welcome and urge further cuts in the deficit, preferably on the spending side. If you can't do it on the spending side, do it on the tax side, but preferably cuts would come on the spending side. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 Senator SASSER. One final question, Mr. Chairman. We have had a lot of discussion here today about problems that are being occa- sioned by the economy and economic policy that we are presently pursuing, and some of my colleagues, I suspect myself included, appear to be somewhat emotional on some of these issues. But we are back home every weekend talking to the people and seeing what the consequences of this policy have amounted to. And, it is pretty sad to see—I referred a moment ago to the prob- lems of the small business community—we have got over 85,000 farmers in my State. Most of them are small farmers. Most of them are family farmers. They are in a situation now where the interest costs for most of them—the interest costs are exceeding their actual farm profits. The Department of Agriculture is telling us that their Farmers Home Administration loans—and most of them have borrowed money from Farmers Home Administration—they are telling us that their delinquency rates are between one-third and 50 percent. RASH OF FARM FORECLOSURES Now, we are on the verge, Mr. Chairman, of a rash of farm fore- closures in this country like we haven't seen since 1931 and 1932. And this is particularly sad to see because when these farms go under it is a whole family generally losing everything they have got, everything they have worked for for a long period of time. Now, can't the Federal Reserve Board give these people some relief? Why can't we ease up on the reserve requirements of those banks lending to the agricultural sector, who have a large part of their lending in the agricultural sector? This is nothing new. Even Arthur Burns did this, and nobody ever accused Dr. Burns of being a Santa Glaus. He did it in the 1970's, early 1970's, in response, as I recall, to very serious prob- lems then. Why can't we have a dual rate of interest perhaps for these in- terest-sensitive sectors of our economy like farmers, like small busi- ness people? Maybe we could wring the inflation out of our econo- my with our monetary policy and at the same time not destroy these people who are so vulnerable, have no protection really against this type of monetary policy. What is wrong with that? Mr. VOLCKER. I have a great deal of sympathy for the human problems that you describe. I go home occasionally, too. I don't recall the particular incident that you are referring to, some spe- cial policy we had in 1980 where we provided some special assist- ance to agricultural banks. INVESTORS SITTING ON SHORT-TERM MONEY I think if you analyze the situation now you will find the typical bank in agricultural areas is quite liquid. The problem is not that those banks don't have money. The problem is, in many cases, they would prefer to lend it at the high interest rates that they can get in the Federal funds market or other markets rather than lending it to the farmer for a period of time at low interest rates. You come back to the interest rate problem and, particularly, the willingness to lend for a long period of time at low interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7!* This drives me back to the basic problem that we are dealing with: How do you give that banker— or whoever is lending the banker money — the confidence to be willing to commit money for a long period of time at a low interest rate? You know, you are not going to do it by reducing his reserve re- quirement so he has a little more liquidity than he has now. Why isn't he going to take that money and send it where he is sending it now rather than lend it to that farmer at a low interest rate? The underlying problem is how can we create conditions in which confidence returns, particularly in the long-term market? A number of you today have emphasized the fact many investors are sitting on a lot of short-terrn money. How can we encourage them to lengthen their maturities, extend that credit at lower rates of interest for a long period of time? I think you come back to this question of confidence and all that bears upon it in terms of the inflation outlook, the interest rate outlook, the budgetary situation, and all the rest. It goes back and bears on our policy to the extent that there is some confidence that the Federal Reserve itself is going to continue to keep inflation under control. If you don't have that kind of confidence that some- body is going to do it, that the value of the currency is going to be maintained, you are not going to have a climate in which lenders will want to lend for a period of time to the very people you are talking about or to the big companies or to anybody else. That is what we have to fight to get in the interests of those very people that you and I are concerned about. Senator SASSER. The problem we have got, Mr. Chairman, is those very people that I am concerned about and which you profess to be concerned about aren't going to be around economically by the time this policy runs its full course. The problem is that the overwhelming majority of them are not going to be able to last out this year, or certainly not through the spring, at least in the agri- cultural sector of the economy in my State. That is the problem. That is their short-terrn problem. Mr, VOLCKER. I hope and believe that is not true in terms of the magnitude of the problem, but the problem is very serious. I don't contest that at all. Senator SASSER. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Sasser. Mr. Chairman, we appreciate your patience today; and, if you haven't proven any- thing else to this committee, you have proven you have great sit- ting power to stay for 3 hours and 10 minutes. We thank you very much, and the committee is adjourned. [Whereupon, at 12:40 p.m., the hearing was adjourned.] [Additional material received for the record follows:] BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM, Washington, D.C., August 17, JMJ. Hon. HARRISON SCHMITT, U.S. Senate, , D.C. DEAR SENATOR SCHMITT: Thank you for your letter of July 21. I am pleased to furnish you with responses to the written questions you submitted in connection with the hearing held on -July 20. I have also furnished a copy of these responses to the Senate Banking Committee for inclusion in the record of the hearing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 Please let me know if I can be of further assistance. Sincerely, PAUL A. VOLCKKR, Chairman. Enclosures. Question 1. It has been suggested that the demand for credit for corporate merg- ers and acquisitions has helped to keep interest rates high. Would you comment on this please? Answer. I don't think the demands for credit to finance corporate mergers and acquisitions have been a significant factor behind the high level of interest rates. In general, such transactions involve simply a transfer of ownership of shares in an existing enterprise. They buyer borrows to pay the shareholders of the firm being absorbed, in the process creating a demand for funds. However, the shareholders then must do something with the funds they've received, and the reinvestment of those monies provides funds to the market. In economic terminology, such a trans- action gives rise to no net demand for savings—that is, there is no diversion of cur- rent income for consumption to investment. Although "imperfections" in the capital markets might lead to some frictional or transitory impacts on interest rates and credit availability for other borrowers, the overall effect of merger activity should not be substantial and does not appear to have been. I might note that the publicity attending some of the merger transactions has left people with a somewhat distorted idea of the quantitative dimensions of the credit flows involved. Figures on the huge lines of credit arranged, sometimes involving competitive efforts by more than one firm to acquire another, have greatly overstat- ed the actual amounts of credit ultimately taken down. Those sums have not bulked large at all in the bank loan totals, for example. Question '2. There has been recent, discussion of the possibility of a wave of unex- pected major corporate failures occurring sometime late this year—or next. What is your view with regard to this possibility? Answer. I'm sure you can appreciate the difficulty of forecasting the unexpected. The fact is that we have seen to date some sizable corporate failures. I don't think these were in all respects "unexpected," for securities analysts and others who have tracked developments in individual firms closely knew that there were significant problems brewing for some time. Clearly, there are a good many firms today experi- encing considerable stress—struggling with various combinations of weak sales, de- pressed cash flows, and large interest burdens. I would hope that the upturn in eco- nomic activity we are anticipating and the current trend of moderation in interest rates will result in improved profitability and an alleviation of these financial strains. One cannot rule out the possibility of some additional significant business fail- ures, however, either among firms now widely recognized as being in serious trouble or among other firms whose difficulties may not yet have attracted widespread at- tention. I certainly do not take this matter lightly, and people in the Federal Re- serve are constantly monitoring developments so that if any failures do occur we are able to assess the situation quickly and take action when necessary to prevent any generalized liquidity probems that might lead to broad economic dislocation. We are mindful of the System's fundamental mission as the lender of last resort, and our commitment to maintaining adequate liquidity in the economy helps to lower the risk of a damaging "wave" of large business failures, Question 3. As you know, the Japanese deficit as a percentage of GNP is substan- tially larger than that of the United States. Yet their interest rates are lower. It is generally suggested that the Japanese rate of personal saving—close to 21 percent of disposable income—allows the Japanese to finance their debt at tower rates. The Japanese Government permits up to $52,000 in principal to generate tax free income. But in this country we have tended to look at only the demand for credit— particularly that of government—ignoring our national rate of saving as a compo- nent in the solution to our interest rate problem. In your opinion, would the Con- gress be well advised to consider expanding the incentive to save as a means of get- ting interest rates down and keeping them there? More specifically, should the Congress attempt to create specific incentives de- signed to raise our nation's rate of savings to the K percent level which prevailed in the early 1970's? Answer. The tax reduction passed iast year contained in it several measures tbat work to enhance the incentives to save rather than consume. The lowering of mar- ginal tax rates for individuals and the accelerated depreciation provisions certainly stand out in this regard, I think these broad measures are likely to be more effec- tive in raising the overall proportion of resources devoted to saving and investment Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 than are many specific savings incentives, which frequently can be expected to do little more than shift the form of savings and which tend to be cost-ineffective from the standpoint of lost tax revenues. The matter of tax revenues raises an important point—namely, that large govern- ment deficits work counter to a desire to lower interest rates or to enhance private capital formation. Federal deficits absorb private savings, so that movement toward budgetary balance is an integral part of a meaningful effort to improve the finan- cial climate. One final note: it probably is not wise to focus on any particular magic number of a goal for saving. The optima] level of saving for an economy is not readily deter- mined, and it may be most important simply to create the kind of general economic environment and tax climate that does not tilt the scale of incentives against saving. Moreover, it is really not appropriate to focus solely on the personal saving rate. Households are important contributors to the pool of savings, but so too are businesses, the government potentially, and foreigners. This is just one of many rea- sons why international comparisons of saving behavior must be performed with a considerable degree of caution; financial structures differ considerably from country to country. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1982 WEDNESDAY, JULY 21, 1982 U.S. SENATE, COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Washington, D.C. The committee met at 10 a.m. in room 5302 of the Dirksen Senate Office Building; Senator Jake Garn, chairman of the com- mittee, presiding. Present: Senators Garn, Riegle, Sarbanes and Dixon. The CHAIRMAN. The hearing will come to order. We continue today with the second day of hearings on the con- duct of monetary policy. We do not have our first witness here yet; however, in a year and a half, this committee has started on time. It will continue to start on time, even when we don't have wit- nesses here. The chairman will be on time. So now that we have started and kept the record perfect, we will hold until Mr. Weidenbaum arrives. [Brief recess.] The CHAIRMAN. Mr. Weidenbaum, the committee has already started, although I was the only one here. I understand that you were in the building on time. Mr. WEIDENBAUM. Yes, sir. The CHAIRMAN. We'll be happy to hear your testimony at this time. STATEMENT OF MURRAY L. WEIDENBAUM, CHAIRMAN, COUNCIL OF ECONOMIC ADVISERS Mr. WEIDENBAUM. I have prepared a fairly technical presenta- tion this morning. Before I present it, I would like to highlight a few key points. First, the Federal Reserve's monetary policy has been the key to the successful unwinding of inflation that we have witnessed during the past year and a half. Second, the administration and the Fed have been, and continue to be, on the same wavelength during this entire period; that is, we consistently agree that slowing down what had been an unsustaina- bly rapid growth in the money supply is basic to achieving a less inflationary economy. And three, there are many technical problems that arise in the conduct of monetary policy. My prepared testimony deals mainly with those technical problems, but in the context that I have just sketched out. That is, I present the following analysis from the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 viewpoint of strong and continuing support for the efforts of the Federal Reserve in dealing with the serious problem of curtailing inflation in a careful and responsible way. I am pleased, of course, to appear before your committee to dis- cuss the current conduct and performance of monetary policy. [The complete statement follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 Statement of Murray L. Weidenbaum, Chairman Council of Economic Advisers Mr. Chairman and Members of the Committeei I am pleased to appear before your Committee to discuss the current conduct and performance of monetary policy. During this period of painfully high interest rates, it is appropriate that we intensively scrutinize both the objectives and the implementation of the Federal Reserve's monetary targets and its monetary control procedures. Let me begin by underscoring the point that the Administration and the Federal Reserve agree on the basic dimensions of monetary policy. Both, the Administration and the Fed believe that a gradual reduction in the growth of the money supply is the best policy for achieving price stability. This reduction is best accomplished when the Fed enjoys independence from the routine pressures of the political process, and understands unequivocally that its primary mandate is to attain and maintain price stability. Selecting a Definition of Money The Federal Reserve can eliminate inflation most rapidly and least painfully if it concentrates on announcing an appropriate target for money growth and then achieving that growth as closely as possible. A key' decision in this process is choosing the specific definition of money for which growth is to be targeted. Selecting a particular definition of money to target is not a simple task. As is true of almost all economic data, the proper statistical definition of money is at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 times less clear than we would like. In recent years new types of financial assets have been created, such as money market mutual funds, and the characteristics and usage of old assets have changed. For example, with the invention of the NOW account in 1971, an asset appearing in our statistics as a savings account became checkable. The evolutionary character of our monetary system means that the definition of money shall not remain static for the purposes of monetary policy. The Federal Reserve should and does revise its definitions of money as changes in our monetary system occur. It did this most recently in 1980 when it began to include NOW accounts along with demand deposits and currency in its definition of M-l. Table 1 shows the changing composition of M-l over the last several years. While currency has remained a stable 27 to 28 percent of the money supply, demand deposits have declined from 69 percent of M-l at the beginning of 1979 to 53 percent in early 1982. Meanwhile, NOW accounts and other checkable deposits have risen rapidly from 4 percent to almost 20 percent- during the same period. Economic theory suggests and the data confirm a predictable relationship between the growth rate of money and the future growth rate of total spending and income in the economy. This relationship is remarkably stable when examined over periods long enough to average out Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 Table 1 COMPOSITION OF til (In Percent) Other Checkable Quarter Deposits 1979 i 1 27.1 68.9 4.1 1979:2 27.0 68.3 4.7 1979:3 27,0 67.9 5.1 1979:4 27,3 67.5 5.2 1930:1 27.4 67.0 5.6 1980 .-2 28.2 65.8 6.0 1980:3 27.9 65.4 6.6 1980:4 27.8 64.9 7.3 1981:1 27.8 58.8 13.4 1981:2 27.7 55.9 16.4 1981:3 28.0 54.S 17.1 1981 i4 27.9 54.0 18.0 1982:1 52,6 19.6 Source: Board of Governors of the f Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis transitory disturbances and statistical noise. The relationship between money growth and nominal GNP does not necessarily hold closely on a quarter-to-quarter basis, however, since money growth tends to affect income only after a lag that tends to toe somewhat irregular and unpredictable. Of the alternative definitions of money, the growth of M-l demonstrates the highest statistical correlation with the growth of nominal income. It is sometimes suggested, though, that more broadly defined measures of money may show a stronger relationship with spending and income than M-l. If so, they would provide a more appropriate focus for monetary policy. Several more comprehensive definitions of money are available. For example, H-2 includes various liquid assets, such as savings accounts and money market funds, that are relatively close substitutes for currency and checking accounts. However, statistical tests comparing M-l and M-2 suggest that changes in M-l provide a more reliable indicator of changes in national income. A four-quarter moving average of M-l growth captures almost all of the changes of a four-quarter moving average of nominal GNP growth; a moving average of M-2 does not perform as well. Given this evidence, I believe that it is best to continue to place primary emphasis on Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 controlling the rate of growth of M-l, while watching the other monetary measures for signs of unexpected developments. Setting^ and Achieving J^Ojie^aj^Growth_Tg.rget^B Since 1975 the Federal Reserve has announced annual targets for monetary growth. These targets are expressed in terms of a range, with two to three percentage points between the high and the low ends. For 1982, the Fed's target for M-l growth is between 2-1/2 and 5-1/2 percent. Over the last six years the Fed has frequently failed to hold M-l within its target ranges. In 1981 and the first few months of 1982 the Fed first undershot and then significantly overshot its targets. Published minutes of Federal Open Market Committee meeting show that the Fed's trading desk in New York was often given instructions to aim M-l growth in a direction substantially away from the mid-point of the annual target range. While the Fed admittedly faces technical problems in pinpointing month-to-month monetary growth precisely, it is capable of exercising greater year-to-year control than it has achieved to date. Frequently, the Fed has stated that its primary reason for adhering only loosely to it M-l targets in previous years was its desire to achieve other objectives as well. Before October 1979 great weight was given to short-run stability in the federal funds rate, and the Fed Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 was unwilling to adjust the federal funds rate rapidly enough to hit the announced monetary targets. In the second half of last year considerable weight was given to the target range for M-2. At other times, other variables have assumed importance. Although the Fed1s desire to achieve simultaneous targets for numerous variables is understandable, I believe it is generally an error to allow those objectives to sidetrack the goal of meeting H-l targets. Nominal income growth has continued to demonstrate a more stable relationship to the growth of M-l than to any of the other monetary aggregates. This is true despite the proliferation of financial innovations and new forms of checking accounts. In the absence of compelling evidence that the relationships between M-l and other economic variables are changing, the M-l target range provides sufficient leeway to adjust M-l growth up or down to reflect short run developments such as higher or lower than expected growth in M-2. The rationale moat frequently cited for the Fed missing its H-l targets over the last several years is that the growth of velocity is changing. The velocity of money, or its rate of turnover, can in fact complicate the relationship between money and income. Fluctuations in the velocity of money affect national income in the same manner as do fluctuations in the supply of money. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Fortunately for policy makers, the underlying growth of M-l velocity has proven remarkably constant and predictable for the last several decades. Velocity growth has averaged about 2 percent a year since the begining of 1981, a figure which is close to the average growth of 3 percent from 1959 to 1981. Quarterly velocity changes have varied widely throughout the recent past, and particularly in the last 18 months, as a partial consequence of volatile money growth. But the observed path of velocity growth becomes far smoother as the measured intervals are lengthened. Most movements from a long-run 3 percent growth trend disappear when the growth rate of M-l velocity is measured year-to-year as shown in Figure 1. Admittedly, there is no inherent reason why the growth rate of M-l velocity should remain constant indefinitely. There are presently forces at work which may affect velocity growth trends, although in different directions. On the one hand, the increasing popularity of money market funds, which are included in M-2, have probably tended to increase the growth of M-l velocity. On the other hand, the decline of inflation and the spread of interest-bearing transactions accounts have probably tended to decrease the growth of M-l velocity. At present, there is no indication that one of these two forces is dominating the other and thus systematically shifting the trend of M-l velocity growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis INCOME VELOCITY OF MONEY SEASONAUV ADJUSTED. QUARTERLY RATIO SCALE, TURNOVER RATE rtr\— 12 - 1.2 1.0 1960 1965 1970 1975 1980 19BS Source: Hoard u£ Governors oE the Federal Reserve System Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 The relative predictability of velocity is convenient in that it allows the Federal Reserve to rely on a fairly stable relationship between the growth of money and the growth of nominal income. Unless and until a long-term shift in the money velocity trend becomes apparent, the Federal Reserve should follow a path of stable M-l growth. As recovery proceeds, announced reductions in both targeted and realized money growth are essential to minimizing the costs of permanently eliminating inflation. Unannounced and unanticipated reductions in money growth will depress output and employment until wages and prices adjust to the lower level of nominal income consistent with lower money growth. Conversely, sudden and unexpected increases in money growth will rekindle fears that the Fed is not truly committed to reducing inflation. It is clear that inflationary expectations are adjusted only as the actual course of monetary policy proves consistent with policy objectives. The credibility of the Fed, like the credibility of anyone else, is enhanced when it achieves what it says it is planning to achieve. For the Federal Reserve, this requires establishing money growth targets which are consistent with a sustained decrease in the rate of inflation, and then adhering to those targets. The more success the Fed enjoys in meeting its targets, the less time it will take Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis before the public is convinced of the Fed's credibility, and the more rapidly wa9es and prices will adjust to noninflationary monetary policies. Variability^ of MqneyGjrowth So far 1 have emphasised the need for the Federal Reserve to concentrate on M-J as its principal monetary target variable, and to meet its annual targets for growth in M-l. I would also like to discuss the importance of the Fed's achieving smooth, monetary growth within a given year. Due to uncertainty about the Fed's future actions, public expectations about future rates of monetary growth, and hence future inflation, have become more volatile in recent years as current money growth has become more volatile. This is understandable, since it is difficult to determine whether a deviation of money growth from a targeted growth path represents a temporary discrepancy or a fundamental change in the growth trend of money. Statistical tests applied to past data suggest that the best guide to future monetary growth levels is primarily the growth rate for the most recent period. Given this historical regularity/ the marXet may not necessarily believe that current Federal Reserve policy does indeed involve a distinct break with its previous Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 policies, and that the Fed will in fact correct current deviations from targeted growth rates at some future point in time. Consequently, when money growth strays above the target range, even temporarily, long term interest rates rise as both higher money growth and inflation are expected in the future. Thus, at least in the current monetary environment, unanticipated changes in short-run money growth tend to destabilize interest rates across the maturity spectrum, and not just short rates. If the Fed could achieve more precise control over money growth, that would lessen capital market fears that departures of money growth from target may indicate a beginning of a new trend. Also, fluctuations in longer-term interest rates would prove much smaller. The justification given most frequently for temporary shifts in money growth by the Fed is that unstable demand for money requires fluctuations in the money supply. Without shifts in money growth, it is hypothesized, short-terra changes in the demand for money would result in large and sudden swings in interest rates. This argument is essentially identical to the assertion that short-term variability in velocity justifies shifts in money growth. The problem with attempting to control the money supply in accord with perceived short-term shifts in money demand ia that, while achievable in theory, it proves Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 counterproductive in practice. It is usually difficult to determine at any point in time whether an apparent shift in the demand for money is due to a change in the demand for money relative to the pace of economic activity, or due to a change in the level of economic activity itself. If economic activity is decreasing, lowering money growth will only serve to worsen an economic slowdown. Conversely, raising money growth when economic activity is picking up will aggravate the inflationary consequences of rapid economic expansion. Past attempts by the Federal Reserve to offset hypothesized shifts in money demand and to control interest rates have led to variations in money growth which have exacerbated previous business cycles. An excessive focus on shifts in the short-term demand for money and their effects on interest rates have caused both money growth and inflation to accelerate. This was certainly true in the years between 1965 and 1980. Even if temporary shifts in the demand for money were easily identified, which they are not, the Fed would be well advised to ignore them. We can infer from velocity growth data — which in part reflect shifts in money demand -- that deviations from trend tend to reverse themselves within a year. Insofar as variations in money growth are used to smooth interest rate paths, only rates on debt instruments of very short maturities — probably less than six months — would be significantly affected. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 Moreover, in the current environment, variability in interest rates on long-term maturities, such as mortgage rates and various bond rates, is actually likely to be increased rathet than decreased, as changes in money growth lead to changes in the market's forecast of future inflation. In short, the gains from offsetting temporary disturbances in money demand are small, transitory, and problematical. The costs in terras of destabilizing expectations and higher long-term interest rates are significant and clear. Economists who are skeptical of the importance of lowering volatility point out that a number of countries which enjoy relatively low inflation rates, such as Germany and Switzerland, have more variable monetary growth than the United States. This observation is interesting, but it is also misleading. The United States has experienced increasing monetary growth on average over thg last 15 years, and is trying to reverse that trend. West Germany has experienced nearly constant money growth, on average, since 1960, and in Switzerland money growth has actually declined. As a consequence of their prudent monetary policies in the past, the German and Swiss central banks enjoy the confidence of the public. They can afford to allow considerable month-to-month variability in money growth without generating high and volatile inflationary expectations. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 In contrast, the United States Government -- no matter how sincere the anti-inflationary efforts of the Federal Reserve, the Administration, and the Congress — must convince people that its behavior in the future will differ significantly from the past. The legacy of previous monetary expansion seriously constrains our monetary authorities/ who face the unenviable task of establishing the degree of credibility enjoyed by their German and Swiss counterparts. Improved.Monetary Control The major departures of money growth from targeted trends on a quarter-to-quarter basis that we have seen in recent years are by no means inevitable. The Federal Reserve is technically capable of achieving fairly smooth M-l growth, measured over periods of several months rather than week to week. According to a 1981 Federal Reserve study on monetary control procedures, the growth rate of M-l from quarter to quarter need not deviate on average more than plus or minus one percentage point from target, at annualized rates. Attaining this degree of precision would result in a substantial improvement over current performance. I am pleased to note that changes in Federal Reserve procedures are occurring which should improve the controllability of money growth in the future. The recent Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 decision of the Federal Reserve to adopt contemporaneous reserve accounting should allow the Fed's open market operations to have a more immediate effect on total bank reserves and M-l. Also, the phasing in of more uniform reserve requirements for different forms of bank accounts, as required by the Monetary Control Act of 1980, should u.2lp to reduce random fluctuations in money growth. Improved control of the money supply remains within the Federal Reserve* s grasp. A reduction in the fluctuations in money growth might result in more variable interest rates on loans of very short maturity. But tbe change would help to stabilise the longer-term interest rates that matter most for investment decisions and general economic performance. Conclusion We have learned over the last several years that reducing inflation, while essential for a strong economy, entails large but temporary costs in the form of lower employment and dampened economic activity. The challenge for the Federal Reserve, as well as for the Administration and the Congress, is to achieve price stability while minimizing the toll that must be paid for it. Monetary policy has played a critical role in achieving the substantial reduction in inflation that we have experienced over the last year-and-a-nal£. The Federal Reserve, by adhering to the current direction of its policies in a predictable and reliable fashion, can play an essential part in demonstrating that stable prices and healthy economic growth are both compatible and mutually reinforcing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 100 Mr. WEIDENBAUM. Thank you, Mr. Chairman, for your forebear- ance. The CHAIRMAN. Thank you, Mr. Weidenbaum. Yesterday we had a very long session with Chairman Volcker and as I sat and lis- tened to not only the testimony, but the questions from both Re- publicans and Democrats, I made the comment, Murray, that noth- ing much seemed to change. Some of the roles reversed. Yesterday, the minority was valiantly trying to make certain what you've said in your testimony, that, in general, the adminis- tration agrees with Fed policy. And I can remember when the Chairman came here and we Republicans were trying to make sure that we, for political reasons, that Carter and Chairman Volcker were in lock-step going down. And I listened to all of these figures and all of this detailed eco- nomic philosophy and, I don't know, I'm to the point where I wonder if it even means anything, because there was no disagree- ment among members of this panel yesterday, Republican or Democrat, about the problems of high interest rates and high un- employment and the crisis that this economy is in. BUDGET PREDICTIONS CONSTANTLY UNDERESTIMATED But after 8 years of sitting on this panel and listening to econo- mists, and you know how I feel about you personally—so I don't mean this personally at all—what does it all mean? Everybody's wrong. We come in and we hear all these figures and we have all of these predictions, and they're meaningless because they never corne true. Do our economists have crystal balls? I mean, it's just absolutely amazing. In 8 years here I've seen administrations—and this one is doing what every other one has done—making projections that simply don't fit into the world of reality. You would think we would learn from hindsight because no budget presentation by a President, an administration, either Republican or Democrat, or from Congress, or from the Congressional Budget Office, from anybody, since I have been here, has come anywhere close to what actually hap- pened. And they've all been underestimates, without exception. Every single time every year. Now do we ever get smart? Does anybody get smart? Economists? Republicans? Democrats? Presidents? People are out there suffering, Murray. And we hold these hear- ings and we talk about these things, and the reason I sit here and sometimes don't even particularly listen, is because 6 months from now, nobody's going to be right. They never have been before. I'm just asking a very practical question: Isn't it possible for people to have a little commonsense and say, nobody's predictions have been right, at least while I've been in politics. Why don't we try and be a little realistic and look at past history for making pro- jections? But I don't think that anybody has a right to criticize anybody else and say, this administration's estimates are off. I can go through what Congress has done in the last couple of years. We haven't come close. Nobody—Alice Rivlin isn't close to hers. She's supposed to be in- dependent of anybody and just advise. I haven't found a set of fig- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 101 ures on this economy or any budget year that have been anywhere close to the reality of what has actually taken place. Mr. WEIDENBAUM. Mr. Chairman, the short answer to your point is, yes. As you often do, you've hit the nail on the head. The record for specific monthly and quarterly forecasts of the economics pro- fession is not very good. The CHAIRMAN. How about yearly? Mr. WEIDENBAUM. Much better. The CHAIRMAN. Not much. Mr. WEIDENBAUM. Over the years, the standard private forecasts, as reported in blue chip indicators, have been quite close to the mark. I don't want to give them a commercial, but let's just say a wrapup of what 30 or 40 major private forecasters are saying. In our case, in February 1981, we forecasted the year. We said that real growth would be 1.1. It turned out to be 2 percent. We said that inflation would be, the CPI would be 11.1. It was a shade under that. Frankly, I think as general guides, that was useful. But there's something more basic. And that's why I'm so pleased that this is a hearing focusing on monetary policy. I think you don't need pin- point accuracy in forecasting. The CHAIRMAN. Murray, what I'm talking about has nothing to do with pinpoint. The administration—well, let's go back to all of them, the most current one—remember the $45 billion deficit? Mr. WEIDENBAUM. Now I don't take credit for The CHAIRMAN. Remember some of us were sitting down there and saying, hey, hey, hey, and you believe in the tooth fairy, too. But they persisted. And I sat and served in a Congress that in June of 1980 passed the first concurrent budget resolution; I mean, not estimates, passed it and said, we're going to have a $200 million surplus. And by August, it was a $27 billion deficit. By the time we got to January and February, it was a $70 billion deficit. I mean, we're not missing by a little bit. These aren't fine. I mean, they're just gross. It has nothing to do with partisan politics. If you're the out-party, you criticize; if you're the in, it's all right and you try and cover it up. But it knows no party bounds, no po- litical philosophy. Just the grossest of errors on the budget over and over and over again. Who's kidding who? Those people are out there suffering. They don't even know what M> is. They could care less. They know they're unemployed. They know they're paying 16V2, 17 percent interest, and we're playing games with numbers that are always wrong. Mr. WEIDENBAUM. There's something basic here, Mr. Chairman, and that is the kind of monetary policy that we have developed not only doesn't depend on forecasts, but I think, objectively, has worked. Let me give you just three dates, and they're not chosen at random, frankly: January 1977; January 1981, and today. January 1977, the prime interest rate was 7 percent. January, 1981, the prime was 21 percent. Today, it's 16 percent. And I'm not saying that from a partisan basis because I'm not going to relate that to who was in office, but what was the policy during that period. During the more recent period, the policy has been to slow down the growth of the money supply. During the previous period, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 102 policies were quite different than that. I think, visibly, embarking on the policy of monetary restraint has succeeded, more slowly than you and I would like it, of course, and more slowly than we expected, frankly. But it has succeeded in bringing down interest rates. And it didn't require an economic forecast; it required the adoption of the appropriate monetary policy, which, of course, is the whole thrust of my statement. And I maintain that the basic reason not only that we've gotten this progress on interest rates, but the very substantial progress on inflation, is the monetary policy that has been followed in the past year and a half. The CHAIRMAN. Well, relatively speaking, the reduction from 21l/g to 16Va percent interest is good, although they used to put people in jail for charging 16 percent interest. It's known as usury. I never thought I would live long enough to pray every night for a 12-percent prime and think people were giving money away at 12. Well, my point was simply one of frustration and without regard to political party or economic philosophy of various economists. I think our track record on forecasting and trying to manage the monetary and fiscal policy of this country is so poor, that I wonder about the science of economics, the practicalities of at least not being able to learn from past experience. Now I admit, some of the estimates that I'm talking about lie solely in the political field, in administrations and in this Congress, who, for political purposes, I guess, exaggerate one way or another. Mr. WEIDENBAUM. Well, a wiser man than I has said that eco- nomic forecasting is neither an art, nor a science; it's a hazard and one not covered by OSHA. The CHAIRMAN. Senator Riegle? SERIOUS ECONOMIC CONDITIONS Senator RIEGLE. Chairman Weidenbaum, we did have a long ses- sion yesterday with Chairman Volcker, And I must tell you, both from the vantage point of my State of Michigan, which is the hard- est hit State by the recession and the economic conditions, and all across the country, all 50 States, that we have a desperately serious economic situation on our hands. All the major indicators right now bear that out: Unemploy- ment—we've got 10V2 million people out of work across the coun- try, and at least another million and a half that aren't counted in the statistics any more because they've been unemployed for so long, as well as estimates of maybe another 5 million that are sub- stantially underemployed. We've got business failures right now running at an all-time record rate since the Depression. We're Losing 550 a week. We're losing one every 20 minutes around the clock, 7 days a week, and many of them good, solid businesses, well- managed businesses. They're being ground down by the high inter- est rates and the general conditions of recession. We've got financial institutions failing. We've got virtually every S. & L. in the country in trouble, and many in very desperate seri- ous trouble. We've got the auto industry below 50 percent of capac- ity, the steel industry running at about 40 percent of capacity. We've got a depression in the housing and construction industry. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 103 We've got agriculture in deep trouble in many areas of the country. We have a bona-fide interest rate crisis. And we can talk about the half-point drop in the discount rate and the fact that the prime has dropped to 16 percent. But I have to agree with the Chairman: 16 percent is really no consolation in terms of the problem we face today, and most small businesses can't borrow at 16 percent. They're borrowing at 2, 3 points above prime, if they can get the money. So we've got an urgent situation on our hands. In this week's issue of U.S. News & World Report, it says as fol- lows on page 11. And they seem to have a pretty good reading on the thinking in the White House. They lead with this statement: The President will stand pat on economic policy for the rest of the year. Reagan won't be turned around, even though the oft touted "just around the corner" recov- ery is looking more and more elusive. Political realism is the key. There's not much the President can do between now and the election time to give the ailing economy a quick fix. The White House game plan is to tough it out, insist Reagartomics will work, and hope that things perk up soon to prevent heavy losses in Congress this fall. The last thing that Reagan wants is to be accused of "Carterism," being wishy- washy on major issues. Reagan's advisers argue that this steadfastness is a virtue; shifting gears would send bad signals. And it goes on in that vein. I hope that's wrong. Mr. WEIDENBAUM. It is. I'd be glad to explain. The CHAIRMAN. I hope you're prepared not to stand pat on eco- nomic policy. You know, you're a person who brought a reputation into this job because of your fine service over many years as an economist, as a professor, as a person of stature and standing in your own right. And I find it hard to imagine that we can let the conditions that go on that we're seeing today without someone like you blowing the whistle on this and saying that the policy mix needs to change. The deficit next year, I believe, as a member of the Budget Com- mittee, will exceed $130 billion. I think we'll be lucky to hit $130 billion because spending is out of control. Defense spending has gone wild. There are so many sacred cows in the budget that haven't been touched that you could put a list from here to the end of the room. 1 think the deficits in the out-years, 1984 and 1985, will be in the $200 and possibly even as high as $300 billion range. And let me tell you something. As I talk to bankers across the country, people on Wall Street, heads of major corporations—that's what they be- lieve. That's what their economists are telling them. That's the basis upon which they're making their plans. And capital investment plans right now, as you know, have fallen literally to a record low. We are not seeing the supply-side spurt that was supposed to take place at this time. So in light of this, my question to you is this. The President seems to be disconnected from these realities. What he says in his public statements does not show a recognition of the seriousness of this problem. I don't know what his thinking is, but I find it incon- ceivable that you would not see these problems. I just have too much confidence in your own ability, in your own professional strength to see that we have an urgent situation on our hands, and I would want to believe that you were fighting in every way to try to change it, to change the policy mix, to bring the deficits down, to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 104 fight to get a lowering of interest rates now before we see a broad- er collapse in the economy. So my question is: Are you making that kind of an effort? What is going to happen? Can we have any hope that we'll see a change in policy between now and the end of the year? Or are we just going to be in this state of paralysis on economic policy while more and more damage and hardship and suffering in this country takes place? DIFFICULT TIMES ARE BEHIND US Mr. WEIDENBAUM. I'd like to answer that this way. In the second quarter of 1982, real economic growth equalled 1.7 percent. That is the first positive sign of an expanding economy that we've had since the middle of last year. So I think it is quite clear that the worst of the difficult times that you so accurately described are behind us. I can assure you that the President not only is intimately aware of the economic situation. I briefed him as recently as yesterday afternoon in the Oval Office. But he cares deeply and is convinced that his program, as fully carried out, will restore the health of the American economy, with high levels of employment and economic growth and low inflation. Very frankly, those budget deficits that you referred to are deeply worrisome. They are much, much larger than I would like to see. I have said repeatedly, in public, as well as in private, for months now, that I think we need to see the budget deficit decline from its peak in this recession year of fiscal 1982. It's going to take a lot more budget cutting up on this side of Pennsylvania Avenue to achieve that objective. I think there are too many sacred cows in the Federal budget. I don't limit them to any one department. Specifically, I'd start, in alphabetical order, appropriately enough, with the Agriculture De- partment. There are sacred cows there, but I would include every department, military and civilian, in the further budget restraint that is necessary in order to get those deficits down because I do believe that the high interest rates—and again, I've been saying that consistently—the high interest rates are the key barrier to a strong recovery. TIME RUNNING OUT Senator RIEGLE. Let me make a suggestion to you because I'm afraid what's happening here is we're running out of time. We're running out of time both in terms of the economy and the structur- al strength and damage that's being done, and also, we're running out of time in this session of Congress. We have about 45 working days left between now and an October 2 adjournment. The CHAIRMAN. Forty-four. We had 45 yesterday. Senator RIEGLE. Forty-four days. [Laughter.] Mr. WEIDENBAUM. Republicans are always pretty sharp on num- bers. [Laughter.] Senator RIEGLE. Howard Baker has announced that we will ad- journ, his target date is October 2. So that gives us very little time; the window is closing on this session of Congress. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 105 Once the Congress goes out of session, there's also been an indi- cation by the leadership that they would prefer not to see a post- election session. So who knows whether there will be one or wheth- er anything can be accomplished. But then the new Congress will not come in until late in January and with the startup time in get- ting organized, setting up new committees in the House and Senate, and so forth, and you've got a situation where the Jeffer- son, Jackson, the Lincoln day recess is in February—it will be really the first part of the second quarter of next year before the Government as a whole is able to deal with the economic policy problem or with the whole fiscal monetary mix issue. And so we're about to go into a period where, for about 6, 7 or 8 months, it's going to be very difficult for our Government as a whole to function. Even the President, if he wanted to act unilater- ally, with the Credit Control Act just expired—I mean there are limits Mr. WEIDENBAUM, Thankfully. Senator RIEGLE, Well, that may be your view. Mr. WEIDENBAUM. It is. Senator RIEGLE. And the time may come when you wish you had those powers. Let's hope now. In any event, if the President wanted to act unilaterally, he's quite limited and constrained with respect to economic policy ini- tiatives. He would need the Congress, especially if we're going to do something about spending, if we're going to do something about the fiscal side of things. So in light of that, in light of the jeopardy that the economy is now in and with the window closing on this session of Congress, I'd like to make this suggestion to you. I think it would be very con- structive if the President were to decide to take hold of this eco- nomic problem in his own hands directly in this form—that he would convene a kind of emergency budget summit meeting and invite the leaders of the Congress from both parties to meet with him, with him running the meeting, maybe at Camp David, some setting such as that. Invite Paul Volcker and the members of the Fed to come to such a meeting. And the meeting might go on for 2 or 3 weeks, for as long as it might take to work out a bipartisan agreement on major budget reductions for 1983, 1984, and 1985. Then we could come back and legislate the program into place so that the financial markets and capital investment decisionmakers across this country could count on it, so that, in turn, we could get a monetary policy response that would substantially reduce inter- est rates now. Not to 16 percent and with 16, maybe going back to 18 or 20 between now and the end of the year, as Henry Kauffman and some others are predicting may happen, but to give us a cer- tain reduction in interest rate so that we could start to see the economy move and people go back to work. If we could get just 1 percent of the unemployed people, 1 per- centage point of our 9 ¥2 percentage points of unemployed people back to work, we could reduce the deficit by $30 billion. Frankly, I don't see any way that we're going to tackle this prob- lem on the scale that it needs to be tackled unless the President himself were to lead that process directly and invite the rest of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 106 key players on a bipartisan basis to take part in such a piece of work. There has been no such meeting. The "Gang of 17" that met for weeks and weeks and weeks, the only time that the President or Tip O'Neill, either one, participated was in the last meeting, which was really window dressing after it was clear that the whole proc- ess had failed. We need to start again. Would you be willing to support that idea and present that idea to the President? RECESSION BOTTOMED OUT Mr. WEIDENBAUM. I'll be glad to transmit your suggestion, Sena- tor. But it strikes me, very frankly, on the basis of my knowledge of recent American economic history that usually, crash efforts do just that. If they don't crash, they come in far too late, way after the economy has turned. And it strikes me, when I look at the economy, clearly, we have bottomed out of the recession. The econ- omy is beginning to turn up. I look at a table of interest rates—I'll be glad to submit it for the record—at every maturity, from the Federal funds rate, Treasury bills, prime rate, 3-year money, 30-year bonds, municipal bonds, in- terest rates across the spectrum are coming down. In other words Senator RIEGLE. What about unemployment? Mr. WEIDENBAUM. Unemployment has stabilized. Senator RIEGLE. Isn't it rising? Aren't we likely to see a rise in unemployment? Mr. WEIDENBAUM. It was 9.5 percent the last 2 months. It some- times lags behind the upturn in the economy. Senator RIEGLE. Is it rising or is it staying steady or is it drop- ping? Mr. WEIDENBAUM. My point is that the crash efforts don't come onstream promptly enough to deal with today's problems. When they come onstream, they exacerbate Senator RIEGLE. The bottom line is that unemployment is rising. Mr. WEIDENBAUM. If I may. They exacerbate the inflationary pressures during the upturn, which upturn is already Senator RIEGLE. How about housing starts? Are they up? How about auto sales? Mr. WEIDENBAUM. They have hit bottom. Senator RIEGLE. They hit bottom? Mr. WEIDENBAUM. If you look at the trend of housing starts, they hit bottom sometime late last fall. They are still at a very low rate and will take a further decline in mortgage rates. Senator RIEGLE. You must not have seen the article in yester- day's Post, the fact that they had just dropped again. Auto sales just dropped, Mr. WEIDENBAUM. The monthly decline Senator RIEGLE. Bankruptcies are still rising. Unemployment is still rising. You say we're turning up. What are the measures of the fact that we're turning up? Mr. WEIDENBAUM. The total level of economic activity, after you boil out the. inflation, has risen in the last 3 months. Has it risen Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 107 rapidly? Of course not. Do we expect that it will rise more rapidly in the coming quarters? Yes. The tax cut effect of July 1 is an im- portant incentive for spurring this economy. But, very frankly, if we learn from the lessons of the past, the stop-and-go policies don't work. You talk about a crisis in interest rates. Frankly, I question that. With the prime rate at 16 percent, what did you call the interest rate situation when the prime rate was 211/2 percent in early January 1981? Was it a prisis then? Senator RIEGLE. You know, in Japan today, the prime rate is 5% percent. Mr. WEIDENBAUM. Yes. Senator RIEGLE. And they have a lot more of their people at work than we do. Mr. WEIDENBAUM. And I think if the budget deficits were small- er, if Congress had appropriated less spending over the years, we'd have lower inflation in this country. Senator RIEGLE. Murray, this administration came in and asked for bigger budget deficits than we've passed, bigger ones. If we passed the budget you brought to us, we would have deficits larger than the ones I'm talking about. Mr. WEIDENBAUM. I'm not here to defend the budget deficit. Senator RIEGLE. I mean, that is really, I think, just Mr. WEIDENBAUM. I didn't mean to be partisan. Senator RIEGLE. It isn't a question of being partisan; it's a ques- tion of being honest about it. You folks came in here asking for bigger budget deficits than that. That's the fact. Now you come around with the constitutional amendment on a balanced budget, which somebody has described as a "figleaf'—an entirely accurate characterization. You can't come in here and ask for a budget with deficits that go up to $200 billion and beyond and turn around in the same breath—I'm speaking now of the adminis- tration—and say you're for balanced budgets and you're for fiscal restraint. That's a total contradiction. Mr. WEIDENBAUM. It's news to me that we've asked for deficits in that category. Senator RIEGLE. Pardon? Mr. WEIDENBAUM. It's news to me, frankly; I'm not aware that we've ever asked for estimated deficits in that category. Senator SARBANES. Would the Senator yield? Senator RIEGLE. Yes, my time is up. The CHAIRMAN. In just a moment. It's your time. His time is up and I will turn to you, Senator Sarbanes, Senator SARBANES. Thank you, Mr. Chairman. TRILLION-DOLLAR DEBT The CHAIRMAN. Let me just make one quick comment, Don, and I don't want to prolong this at all. I don't like the administration's budget request. But you simply can't constantly try to blame it there, either, and ignore the fact that before this President ever came, without regard to previous Presidents, parties, or Congresses, there was a trillion-dollar debt with a carrying cost of over $100 billion, from whoever was here in either party or any President. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 108 Now that simply cannot be ignored. It didn't make any differ- ence who was inaugurated in January 1981. There were certain in- herited problems from the past that have driven some very large problems, particularly decisions because people thought in previous administrations that interest rates would come down. They started refunding the national debt. All I'm asking is forget Republicans and Democrats. I'm getting sick of it, absolutely sick and tired of people going for partisan ad- vantage. I'm not saying you are. I'm just saying, in general. I'm trying to say it's happened since January or it was all Franklin Roosevelt's fault or somebody else's. Who cares? Who cares? When are we going to face up to the fact that we've got a trillion-dollar debt that Congress, with both Re- publicans and Democrats in it, has been on a wild spending spree for years. And there is a trillion-dollar debt and there is interest of $120 billion a year. There are vested interests, with everybody's ox to be gored and they want to cut somebody else's but not theirs. And until we come to that agreement and quit playing games, whether it's the administration, Ronald Reagan, this Congress, Paul Volcker, we're going to be back here next year. We can have more Democrats in the House. We can elect a Democratic Presi- dent in 1984 and nothing's going to change except the people will suffer until we quit playing partisan games and trying to assess blame and wake up to the arithmetic—the arithmetic of what has been built up over a long period of time. Senator Sarbanes? Senator SARBANES. Mr. Chairman, well ahead of any discussion of playing partisan games is the question of whether you're going to get the truth and the facts. Chairman Weidenbaum, I listened to your response to Senator Riegle. What did the administration estimate that the deficit would be when it submitted the budget to the Congress this year? Mr. WEIDENBAUM. For fiscal 1983? Senator SARBANES. Yes. Mr. WEIDENBAUM. Approximately $103 billion. I do this from memory, you can appreciate. Senator SARBANES. It was under $100 billion, wasn't it? Senator DIXON. I think originally $97 Vfe billion. The CHAIRMAN. $96 billion. Senator SARBANES. You were very careful to have it under $100 billion, weren't you? Mr. WEIDENBAUM. I'm not sure of the meaning of that. Senator SARBANES. Then it was examined and everyone agreed that it was in the range of $160 billion to $180 billion, isn't that correct, including the President himself? Mr. WEIDENBAUM. You're referring to estimates in the absence of any budget cuts or revenue increases? Senator SARBANES. I'm referring to an accurate estimate of what you submitted. Mr. WEIDENBAUM. I don't associate—of course, I defer to the Budget Director on these matters—but I don't associate Senator SARBANES. The CEA is a professional organization, sup- posedly. I spent a good year of my life working for Walter Heller when he was the chairman. I know the enormous pride within the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 109 organization in its professionalism. I think there's serious question now that that professionalism has been compromised. On Friday, the 2d of July Mr. WEIDENBAUM. I object to that, Senator. Senator SARBANES. I'll give you the basis of that assertion. On Friday, the 2d of July, the New York Times carried an article con- cerning the resignation of Jerry L. Jordan, a member of your Coun- cil. Mr. WEIDENBAUM, That's right. Senator SARBANES. In that article, it says, and I quote: Mr. Jordan was known to have had some problems with the Administration's budget forecasts for 1982 through 1985, which formed the basis for the President's original budget proposal for the Fiscal Year 1983. He was one of the first economic officials in the Administration to acknowledge that the revised mid-year forecast which was issued in mid-July, 1981, just before the President's tax bill was consid- ered in Congress, was not properly done and would have shown a worsening deficit picture if it had been. What's your comment on that? Mr. WEIDENBAUM. I never heard those statements. I read that hearsay in the paper. But it's quite clear that as the economy un- folded, as Congress acted on the tax program and on the spending proposals, that the deficit was going to be larger than originally es- timated. There was no question about that as the year progressed. The question, of course, and this goes back to the chairman's opening discussion, was the ability to pinpoint those numbers. It's quite clear that enacting fewer budget cuts and more tax increases than had been assumed in the estimates would have reduced the deficit. Senator SARBANES. Are you now engaged in an exchange with the chairman of the Joint Economic Committee, Congressman Reuss, with respect to working papers of the CEA, which show that the forecasts were much more pessimistic than what was stated in public? Mr. WEIDENBAUM. The short answer is no, because, one, these were not working papers of the CEA. But two, what Mr. Reuss is referring to is the quarterly breakdowns, which add up to the pub- lished annual numbers. By the way, ever since March, 1981, in public testimony, I point- ed out the likelihood of one or more quarters of negative growth last year. Senator SARBANES. Chairman Reuss said: The Administration concealed from the American public information it had that Administration policies would produce a full-scale recession. At the same time this information was available, the American public was being told that we were on the verge of recovery and sustained growth. Mr. WEIDENBAUM. I guess he wasn't paying attention to rny testi- mony before his committee when I said Senator SARBANES. I think he was paying attention to your testi- mony. Mr. WEIDENBAUM. Excuse me? Senator SARBANES. I think he was paying attention. Mr. WEIDENBAUM. Well, in March, 1981, and in many subsequent public statements to his committee and other committees, I said Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis no that we had a soft, soggy economy at the time and that I wondered about the prospects of one or more quarters of decline. Senator SARBANES. Mr. Chairman, I remember very, very vividly a session before the Joint Economic Committee and what I per- ceived to be the acute embarrassment of Professor Jordan with re- spect to the testimony which the Council had" submitted and that, I think, is supported by this Times article which I just quoted. Let me ask you this question. We asked Chairman Volcker yes- terday whether he thought he was pursuing the monetary policy which the administration wished him to pursue? He said, well, he thought so, but we would have to ask the ad- ministration about that. I did pursue with him the question of whether it was, at least, his perception that he was pursuing a policy which you wished him to pursue? And he said, yes, that was the case. So at least that's the perception he has, that he's on track with you. And I take it that your testimony here this morning is to the effect that, indeed, the Federal Reserve is on track with the admin- istration with respect to the monetary policy which it is pursuing. Is that correct? Mr. WEIDENBAUM. Approximately. I use somewhat similar, al- though not identical, language to the effect that we're on the same wavelength. We consistently supported their policy of slowing down the growth of the money supply. I tried to word that, frankly, consistent with my awareness of the independence of the Federal Reserve, that it is their decision and their determination, of course. Senator SARBANES. Is it your assertion that West Germany has not had any money growth since 1960? Mr. WEIDENBAUM. No, that's not what I said. West Germany has experienced nearly constant money growth. In other words, the money growth, quite clearly, has been maintained. It hasn't fluctu- ated as sharply. Senator SARBANES. In other words, there's been money growth. Mr. WEIDENBAUM. Of course. Senator SARBANES. At what rate? Mr. WEIDENBAUM. I don't specify in my statement. Senator SARBANES. Could you tell us that? Mr, WEIDENBAUM. I'll be glad to supply that for the record (see p. 123). Senator SARBANES. You don't have that in mind? Mr. WEIDENBAUM. At my fingertips? No, sir. REDUCTION OF MONEY SUPPLY Senator SARBANES. Now, is it your view that there should be a reduction in the growth of the money supply in this country? Mr. WEIDENBAUM. From the level that obtained a year and a half ago? Oh, yes, sir, a reduction in the growth rate of the money supply. For example, the second half of 1980, which I think is the appropriate base Senator SARBANES. No, I'm asking whether at the moment, do you think that the next step forward would be to reduce the growth in the money supply? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ill Mr. WEIDENBAUM. In the very short-term, I think that it's appro- priate for the Fed to aim at the top end of the target range, as Chairman Volcker stated yesterday. Senator SARBANES. Well, what are the factors that you consider in trying to determine how the money supply should move? Mr. WEIDENBAUM. A variety. First of all, the Fed sets those target rates and we have consistently supported them because they're consistent with our projections. Senator SARBANES. Well, what should they consider? What is it that you should consider when you set the target rate? Mr. WEIDENBAUM. I wouldn't presume to instruct the Federal Re- serve on how to set the target ranges. What we did do Senator SARBANES, I'm not asking you to do that. I'm just asking you what are the factors that you should be looking at in reaching a judgment on what the target rate should be? Mr. WEIDENBAUM. Target rate—the target range as opposed to the movement within the range in a given point in time. Senator SARBANES. You have to make some judgment whether they're doing a good job or not. What are the factors you look at in making that judgment? Mr. WEIDENBAUM. First of all, in the February 1981 white paper, we stated the objective of reducing the growth rate of the money supply between 1980 and 1986 by about one-half. And therefore, the reductions in the targets that the Fed has announced since then are consistent. Senator SARBANES. Well, what is your premise as to how an econ- omy will function? If an economy is expanding, is there need to have a growth in the money supply to accommodate expansion? Mr. WEIDENBAUM. Oh, of course. The serious question is how rap- idly, because Senator SARBANES. The West Germans have been expanding their money supply, haven't they? Mr, WEIDENBAUM. Of course. Growth in the money supply is what we're talking about. But we've seen, unfortunately, when that growth is too rapid, it only exacerbates, it only feeds the infla- tionary pressures. Senator SARBANES. So you think that the growth in the money supply should be cut by half; is that correct? Mr. WEIDENBAUM. Between 1980 and 1986. That's the target we set in our economic white paper in 1981. Senator SARBANES. What is your assumption about what's going to happen to the growth of the economy between 1980 and 1986? Mr. WEIDENBAUM. We assumed in the white paper long-term growth, significant long-term growth, brought about in good meas- ure by a series of tax cuts. Senator SARBANES. Assuming Mr. WEIDENBAUM. If I may attempt to answer the remainder of your question, Senator, in terms of where the Fed should aim, I think it's apparent that the second half, for about 6 months in 1981, approximately April to October, the money supply hardly grew at all. And therefore, I think it's not surprising at all Senator SARBANES. Were you supportive of that? Mr. WEIDENBAUM. In retrospect, I think that that was too slow. Senator SARBANES. Were you critical of it at the time? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 112 Mr. WEIDENBAUM. In my informal meetings with the Chairman of the Federal Reserve, I did give my advice. Senator SARBANES. Were your public statements at the time sup- portive of the Fed's policy? Mr. WEIDENBAUM. The policy, you appreciate, Senator, was to attain the growth targets. The practice was sometimes different. From time to time, frankly, I needled them and said I wish their aim would improve in achieving their policies. Senator SARBANES. You needled them, where? Mr. WEIDENBAUM. In various public statements, testimony. Senator SARBANES. You did needle them in public statements? Mr. WEIDENBAUM. In fact, I'd say we endorsed the target. Their policy is embodied in the targets. I noticed that sometimes they are above the targets, sometimes they're below the targets. I don't mean this critically, but I wish their aim would improve and I'm sure they do, too. Senator SARBANES. That's some needle. Well, my time has ex- pired. The CHAIRMAN. Senator Dixon? GRANT ITEM VETO POWER TO THE PRESIDENT Senator DIXON. Chairman Weidenbaum, you said in your testi- mony that you would like to see more fiscal restraint by the Con- gress. Yesterday, when Chairman Volcker was here, he expressed the view that one of the best things that the Congress could do would be to grant item veto power to the President. We have that power in my State with the Governor and it has achieved remarkable financial savings in my State. I believe that 43 of the 50 States actually give the Chief Executive an item veto power. Do you support that concept? Mr. WEIDENBAUM. I cannot speak for the administration on that budget matter, but personally, as a long-term student of the budget, I think it's a fine idea. Senator DIXON. Your testimony, I think it can be fairly said, Mr. Chairman, is basically an endorsement of the general policies of the Fed. Would that be a fair characterization? Mr. WEIDENBAUM. That's right. Yes, sir. Senator DIXON. And you've indicated in there that the policy of the Fed, which this year targets money growth of 2]/2 to 5Vz per- cent, if I recall correctly, is acceptable to you. I believe you've indi- cated, or at least implied here, that you felt the high side of the target range would be a more acceptable policy for the Fed, in your view. Mr. WEIDENBAUM. Well, what I really was doing was comment- ing on Paul Volcker's testimony here before your committee yester- day, where he indicated that the Federal Reserve would be aiming primarily to operate at the top end of the range and indicated cir- cumstances in which they might occasionally go above it. And it strikes me that that is appropriate for the circumstances. Senator DIXON. That would be your view as Chairman of the President's Council of Economic Advisers, that that target range, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 113 the high side of it, at least, would be acceptable, from your stand- point. Mr. WEIDENBAUM. Under those circumstances, yes. Senator DIXON. And that was basically the policy last year. Mr. WEIDENBAUM. Well, no. Last year, the policy was to operate within the range, and as I pointed out to Senator Sarbanes, for 6 months, they operated without any growth. And then the growth was quite rapid from about November on. And the whole thrust of my statement that I prepared for your committee is that I think we'd have a healthier economy if the Fed could achieve a more stable growth. And I've gone into the technical details as to how to try to achieve that more stable growth pattern. Senator DIXON. But essentially, the policy of the Fed, in the time that I've been here and the time of this administration, has been a monetary growth in the target area indicated here, and that has been the stable policy of the Fed throughout this administration's tenure to date; would that not be a fair statement? Mr. WEIDENBAUM. Our position has been consistent in terms of supporting the Federal Reserve in its policy of slowing down the growth of the money supply and we've consistently supported the specific targets that they independently set. Senator DIXON. I characterized the presentation of Chairman Volcker yesterday as more of the same. And I would say that that is the policy he has represented to us as the policy of the Fed. Would that be your view? Mr. WEIDENBAUM. I need to distinguish between policy and prac- tice because, in practice Senator DIXON. I'm talking about the target ranges, not the vari- ations. Mr. WEIDENBAUM. Well, you see, last year, the Fed, the year as a whole undershot the target range. They came in below the bottom end of the target range. Senator DIXON. You'd like to see them on the high side this year? Mr. WEIDENBAUM. Having undershot last year, I think it's appro- priate to be on the high side thus year, especially with the slow re- covery that's underway. But as a long-term matter, I think they ought to operate within their target. TARGETING INTEREST RATES Senator DIXON. How do you feel about targeting interest rates, looking at interest rate as well as monetary supply, as was done prior to October 1979? What's your view on that policy? Mr. WEIDENBAUM. Very negative. Senator DIXON. You think that's a mistake? Mr. WEIDENBAUM. Yes, sir. That was the key to the inflation that we've been suffering from and that we have tried so painfully to unwind. It sounds attractive, I know, but we found that it doesn't work. Senator DIXON. Basically, your opinion is that you endorse the 2M> to 5Va percent target range in monetary growth of the Fed. You oppose the idea of targeting interest rates, as had been done up until October 1979. And taking into account the variables that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 114 might occur between the bottom and the high side of that range, you find that acceptable policy. Mr. WEIDENBAUM. Yes, sir. Senator DIXON. Well, then, I guess my question would be, given the fact of the terrible economic experience in the country that we're all aware of right now—for instance, I'm a graduate of your fine university, Washington University, September 1949. In my entire adult career, in employment, owning businesses, needing to meet a payroll, making a profit sometimes, experiencing a loss other times, there's never been an economic situation in this coun- try in my adult lifetime, in my view, as severe as the one that we have right now. So I guess my question would be: What, then, does it take for the Fed to make some kind of a response to the economic situation in the country other than what you find acceptable in the policy they apply right now to respond to interest rates, the dramatic unem- ployment situation, and the economic experience in the country? Mr. WEIDENBAUM. First of all, I don't think that the Federal Re- serve is the only game in town, so to speak. Senator DIXON. I can see that, Mr. WEIDENBAUM. A while ago, we were discussing the Federal budget, and I don't mean this in either a partisan fashion or Con- gress versus the administration, because I think, in the course of many administrations, Republican and Democratic, Congress and the executive branch have developed a stream of Government spending which I think is too high, which has been growing too rapidly; and that I think dealing with that, slowing down the growth of Government spending, which is not part of the Fed's re- sponsibility, is a very integral part of economic policy in our coun- try. For example, if the deficit were half the size that it is today, I think that this economy would be in a lot better shape. Interest rates would be lower. Senator DIXON. Do you really think on the basis of your experi- ence—and I grant you all of your fine reputation. I think well of you, personally—do you really believe that the recession in this country has bottomed out? Is that your statement to this commit- tee at this point in time, in July 1982, that this recession has bot- tomed out? Mr. WEIDENBAUM. Yes. In fact Senator DIXON. Things are going to get better from here on in? Prosperity is just around the corner? Mr, WEIDENBAUM. I didn't quite say that. Senator DIXON. You have said that, I think, here. Prosperity is just around the corner. Mr. WEIDENBAUM. There's an old forecasting rule: If you ever make a good forecast, never let them forget it. In late March of 1982, I stated in a speech in, I guess, New York City, that I thought the economy had hit bottom. Well, we've now learned as of 10 a.m. this morning that for the period of April through June, the econo- my did grow, a modest 1.7 percent in real terms, after boiling out the effects of inflation. Senator DIXON, Mr. Chairman, you know, you're familiar with the St. Louis area. That's why I can visit with you this way. I just Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 115 saw some unemployment statistics. For instance, in my hometown of Belleville, a beautiful, lovely city, as you know. Many live in my town and work in St. Louis. Unemployment is 16*/2 percent. They were talking about all the cities around, and I want you to listen to this because you know the area. Granite City, over 20 percent. That's a steel town. You'd under- stand that. East St. Louis, lOVb percent. Now you and I know that in East St. Louis, 40 percent of the people probably don't have work. You know why the figure is lOVb percent? They don't count them any more. They've been out of work under this administra- tion so long, they don't even count them any more. Now the statistics—we have 11.3 percent unemployment in my State. Bankruptcies there in the first quarter of this year were higher than in the first quarter of 1933. I go home every weekend. I listen to you and to other witnesses, men whom I respect, whose reputations are excellent, hearing on the Hill about what a wonderful situation things are right now and everything's getting better. The recession has bottomed out. And I go back home and nobody tells me that on Main Street, Somebody's wrong in this country, Mr. WEIDENBAUM. I share your view that if that is the posted un- employment rate for East St. Louis, it's far too low. The reality is much more severe. And it's been true a long, long time, to every- one's misfortune. Nevertheless, the Midwest, our region of the country, as a fact, has been much harder hit than many other regions of the country. Senator DIXON. But could I—I know my time's just about up, Mr. Chairman. Let me say this in conclusion. Not too long ago our dis- tinguished chairman and Mr. Lugar, the distinguished senior Sena- tor from Indiana, two men who I think would share a reputation as strong supporters of the President, at the top of the list with anyone whom you might suggest in the Congress of the United States Mr. WEIDENBAUM. Indeed. I agree with that. HOUSING BILL VETOED Senator DIXON. Men who are friend to the President and his in- terests, had a bill to respond to the housing needs in our country. Housing starts in my State dropped last year 77 percent. And the year before was a lousy year. It would have employed 650,000 people in this country to put carpenters, plumbers, bricklayers, masons, and others to work. I can understand the philosophical differences of the President with that idea, but he vetoed it. And I come to hearings here and I hear my friend, Mr. Volcker, say that we're going to stick to the game plan we've had for 2 years, more of the same, and you en- dorse it and say it's fine, maybe get on the high side instead of the low side or the target ranges. And I don't see anybody suggesting a thing to do about what's happening in the country. When I spoke in Rock Island this last Sunday and spoke to people there and found out that 26,000 people who want to work in Rock Island can't get work, and they want it, I would like to know Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 116 how in the world things are going to get better if all we do is have meetings and say things are going to be OK if we stick to the plan? Mr. WEIDENBAUM. Senator, I think that we need to learn from past experience. The sad experience of the past is something like the Lugar bill, when it gets enacted—I recommended a veto, I make no bones about that—comes onstream far too late. But in this environment, I think legislation like that would only push in- terest rates up further. Senator DJXON. Well, I hope it came far too late, Mr. Chairman. I respect you. I hope your opinion is right. But I don't see things changing in the country. I don't want to suggest a banana before we've got a banana. But I don't see things getting better in the country. I respect your opinion, but if they're not getting better in the country and we don't do anything here, next year we'll be talk- ing, but it will be too late. BAILOUT APPROACH Mr. WEIDENBAUM. I do believe that the answer is not for Con- gress to take the kinds of actions that will increase the deficit be- cause if there is any part of the economy that will be hardest hit by a further increase in interest rates, it's the housing industry. I think that's why you found parts of the housing industry support- ing the President's veto. They realize that if we shifted to the bail- out approach, to well-intentioned programs to spend more Federal money to specific sectors of the economy, which increase the deficit and increase pressure on interest rates, we would hit hardest those sectors of the economy that we're trying to help the most. Senator DIXON. I thank you and it's nice to see you again. Mr. WEIDENBAUM. Thank you, sir. The CHAIRMAN. Mr. Chairman, let me just make a comment on the so-called Lugar bill. If you or the President or anyone else want to disagree with the philosophy, and I normally would, too, except sometimes you have to get the ox out of the mire. The thing that bothers me is that when that was referred to as a bailout bill in terms of cost, without regard to the structure or how it should be done, because besides being chairman of the Banking Committee, I also happen to be chairman of the HUD Independent Agencies Appropriations Subcommittee. And there are some facts that ought to be known. President Carter requested 225,000 units of subsidized housing. President Reagan requested 175,000 units of subsidized housing. That subcomittee cut it to 150,000 and did the President 25,000 better, as did this authorizing committee. Then in December, we cut it to 143,000 additional cuts; 52' per- cent of all of the recisions in the 1981 budget came out of that sub- committee. In 1982, 82 percent came out of that subcommittee. When the urgent, urgent, urgent March supplemental came up, that didn't pass until last week. And in that bill, the bill came over from the House—every other single subcommittee of the Senate, the Senate Appropriations Committee added money to that bill, except one—the HUD Independent Agencies Subcommittee, which took an additional $6.9 billion out, which made the total bill, which made all the other subcommittees whole so that we could say the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 117 Senate had a bill that was lower in total cost than the House sup- plemental. So we had to take more than all—well, they all added. Not more than they took. They took none. The Lugar, not as compromised in the conference, but out of committee, added $1 billion back in, leaving only a net reduction of $5.9 billion. Those are facts, not opinions, to justify mine or Senator Lugar's position. Simply flatout facts. So if people want to oppose it on phi- losophy and say it's too late, we shouldn't have done it, all of that, OK. But it is totally unfair to call it a bailout. And people would come up to me on the floor and say, Jake, Dick, I would support your bill if you found me a billion-dollar offset. Billion-dollar offset? We had a $6.9 billion offset just in that bill. And 52 percent of the rescission in 1981 and 82 percent in 1982. Now I would suggest my subcommittee has done its share and it was not fair at any point along the line, for whatever other reasons you wanted to veto that bill, to say that the Lugar bill was a budget buster and a bailout. That simply is not the truth. Mr. WEIDENBAUM. Mr. Chairman, I'm ready, willing, and most anxious to state that if every other subcommittee bit the bullet the way your subcommittee did, this country, as well as the budget, would be in far better shape than it is today. I can only add, and that needs to be underscored, I don't think the public realizes the contributions of your subcommittee. The CHAIRMAN. I'm not looking for compliments. I'm just trying to refute that this was a bailout bill to add $l/s billion back in, $1 billion and then $Vfc billion when it came out of the conference committee. You characterized it as one of the budget-buster types of bills. Mr. WEIDENBAUM. Well, from where I sit, almost every bill is a budget buster because of those triple-digit deficits. In good con- science, I can report that every time there is an issue, I have urged the President to recommend less spending rather than more spend- ing on every single department, every single agency, where the issue has arisen. The CHAIRMAN. Well, my only point is I would suggest more pressure on some of the other subcommittees. Mr. WEIDENBAUM. Amen. The CHAIRMAN. And let them do their share of the budget cut- ting as well, rather than lumping it in one particular area. I would hope that we can finish with one more round because we do have two additional witnesses. So I will not take any more of my time because we do have two distinguished witnesses that I would not like to run short of time. Senator Riegle? Senator RIEGLE. I'll try to move as quickly as I can in light of that, Mr, Chairman. You make a good point. David Stockman is quoted in the U.S. News & World Report for July 19—you may have seen this interview. And this is the ques- tion that is posed by the magazine and here is his response: Question: Do you give Reagonomics credit for the Federal Re- serve Board's tight money policy? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 118 Stockman's answer: "We endorsed it. We urged it. We have sup- ported it." Is that accurate? Mr. WEIDENBAUM. I'd let Dave Stockman speak for himself. Senator RIEGLE. Well, he's speaking for the administration. CHARACTERIZING FED'S MONETARY POLICY Mr. WEIDENBAUM. He's the Budget Director. I've never called the Fed's policy tight. I've called it restraint because if you look at the growth of the money supply in 1982, today, it certainly isn't tight. Senator RIEGLE. Well, how would you characterize it? He is saying here that in terms of the Federal Reserve's monetary policy, "We endorsed it. We urged it. We have supported it." Is that an accurate statement? Mr, WEIDENBAUM. The policy. But I describe the policy not as one of tight money, but as one of restraint. Senator RIEGLE. I'm not sure it matters how one characterizes that. Ten people might have different views. But the fact of the matter is that Federal Reserve policy, however one describes it Mr. WEIDENBAUM. Policy. Senator RIEGLE [continuing]. He says that the administration en- dorsed it, urged it, and supported it. Is that an accurate statement? Mr. WEIDENBAUM. Yes, but remember, the key word is "policy." That isn't to endorse each and every move that the independent Federal Reserve has made. Senator RIEGLE. So you're not challenging his statement here. Mr. WEIDENBAUM. My policy is to explain my position and to let my colleagues explain theirs. Senator RIEGLE. Now earlier you said in your quote—I missed the actual quote, that "prosperity is just around the corner." Did you, in fact, say that today? Mr. WEIDENBAUM. Not guilty. [Laughter.] Senator RIEGLE. OK; Let me tell you what I did hear with my ears from your lips, and that is you said that the economy is turn- ing up. That you did say. Mr. WEIDENBAUM. Yes, sir. Senator RIEGLE. OK; Now that is an important statement be- cause you're the President's chief economic adviser. You're coming here in a series of important hearings. That is news. If it is your view and the view now of the administration that, in fact, the econ- omy is "turning up," turning up, which is your phrase, that is a significant statement. And is that what you really mean to say? Mr. WEIDENBAUM. Oh, yes, but it's not news because I state an opinion. It's news because at 10 a.m., the Department of Commerce released the official numbers on the GNP for the second quarter of 1982. They estimate an increase in real GNP for the second quarter of 1.7 percent. Senator RIEGLE. I don't want to get into that in any great detail. Mr. WEIDENBAUM. That's an upturn. Senator RIEGLE. I understand. But you and I both know that the Commerce Department, when they make these estimates, often has to adjust them. They also produced an estimate on housing starts. They had to go back and change that. They had to scale it back. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 119 They have on a number of others as well. It may well be that this will prove to be what the true performance was, and perhaps it won't. Maybe they'll have to adjust. They made a series of adjust- ments. In fact, it's become more common in the last year to have to make major adjustments than it is to leave the numbers stand as is. I don't know whether that's the case here or not. Mr. WEIDENBAUM. You're right. Senator RIEGLE. So I don't know. I hope that the numbers are right. I know the unemployment data. If anything, when unem- ployment experts across the country look at it, they feel it's under- stated for a variety of reasons. Partly seasonal facts, partly the fact that we don't, in the numbers, count people who have been unem- ployed and exhausted their unemployment benefits. In Michigan, for example, just to give you an idea, in our State, we have had unemployment—this is an important fact—above 10 percent for 32 consecutive months—32 consecutive months. If you can imagine what that would do in terms of devastating an area. We happen to be the eighth largest State, so I'm not talking about a small neck of the woods—this is increasingly a pervasive national problem. I don't want to rehash what we said before, but you've got a number of other critical measurements like unemployment, like housing starts, like business failures, where the news is getting worse. Unemployment is rising. Business failures are rising. Li- quidity problems among businesses are rising. Farm foreclosures are rising. The problem of the thrift industry is getting worse. So there is a wealth of data there. Now you may not see it. You may not value it as highly. Mr. WEIDENBAUM. Oh, I monitor those statistics. Senator RIEGLE. But they don't go away. And this preliminary es- timate of second quarter growth by the Commerce Department doesn't in any way address these enormous crisis-scale problems in the interest rate sensitive sectors of the economy. And that's, of course, what we're here to talk about today, is monetary policy. DISCOUNT RATE LOWERED Now I think the Fed, when they just lowered the discount rate yesterday by half a point, I think would have done better had they lowered it by a full point. I think we're at a stage now in the eco- nomic situation where we still need the other kind of meeting led by the President that I spoke about—a real serious budget meeting to get the deficits down and get a corresponding change in the monetary policy that would bring interest rates down. But without that taking place, which I would much prefer to see, if the Fed is going to have to act without any direct help from the administration at this point leading this kind of process, which should involve members of both parties, would you support them taking the discount rate down, say, a full point rather than a half point? Mr. WEIDENBAUM. I have tried to avoid being put into the posi- tion of seeming to give public instructions or even private instruc- tions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 120 Senator RIEGLE. I'm not asking you to instruct them, I want your professional opinion as to whether or not a full point drop in the discount rate would be good medicine, given the overall mix of eco- nomic facts today, or would it not? I mean, would you feel that you would say that it would be? Mr. WEIDENBAUM. Well, you appreciate, I look upon interest rates more as as result than a cause. So if the cause of high inter- est rates Senator RIEGLE. We're not talking about high interest. We're talking about the discount rate, which is the Fed rate. Mr. WEIDENBAUM, It reflects the reality that market interest rates have been coming down in recent weeks. I think that's the key reason we saw a drop in the discount. Senator RIEGLE. Well, would you have been upset if they had dropped it a full point? Mr. WEIDENBAUM. Not at all. Senator RIEGLE. So you could certainly accept and feel good about a full point drop? Mr. WEIDENBAUM. Well, I've tried to avoid taking any position on the specific administrative actions of the Fed, I do think that the kind of monetary policy that Paul Volcker described in his testimo- ny yesterday will get us declines in the interest rates. Senator RIEGLE. I want to extend another invitation. I made a suggestion earlier. This is in the form of an invitation. I think it would be healthy and constructive if the President and yourself and the other economic advisers would come out into the country into some of the centers of high unemployment, and I would list Detroit, really, at the top of the list, because it's Mr. WEIDENBAUM. I've just come back from several days in St. Louis, which is suffering, as Senator Dixon pointed out. Senator RIEGLE. Let me tell you what my idea is here. I think it would be helpful to the President and to the administrative eco- nomic policy people, yourself and the others, if you were to come into some of the major cities where we have massive unemploy- ment and spend several hours talking informally with unemployed workers, with business people who either have just lost their busi- nesses or are about to—any number that you can find and talk to—many of them, by the way, who were ardent supporters of the President in 1980. So you would not be playing with a stacked deck in talking to these folks. But they are coming to me in increasing numbers, just as Sena- tor Dixon said they are in Illinois and across the country, because they are in desperate straits. They cannot survive. They are being ground down and destroyed day by day. I think the President and those of you who are his chief economic advisers owe it to your- selves, and I think you owe it to the country, to the people who are caught in this situation, to sit down in a series of meetings and to discuss this firsthand, to get a feel for it. I'm not talking about some kind of a show business thing or a rigged thing. I think it's better if the press is kept out, so it doesn't become a media extravaganza. I think it would be very construc- tive if 20 or 30 unemployed workers would have a chance to talk directly to the President, just talk with him, just be able to explain what it is they're facing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 121 I don't sense that that is happening. I follow quite closely what goes on and I don't get the feeling that the President has had any series of meetings with groups of unemployed workers or business- es that are on the verge of bankruptcy or business people who have just lost their businesses. I think it would be constructive for the country, for the economic policy process, and for these people if you could start to do that. And I'd like to ask you to come to Michigan. I will play whatever helpful part I can in identifying people like this or meeting places where this could go on. But I think you owe it to the country to do this. Mr. WEIDENBAUM. Senator, I've just been back for a few days in St. Louis, which was anything but a media event, where I spoke to many people at every stage of the happiness spectrum, from owners.of growth industries to people out of work, to people whose companies were in trouble, to students who were looking for jobs, to students who found jobs. And I think that that is useful. And there's been absolutely no shortage of groups coming into the White House, meeting with the President, the Vice President, members of the Cabinet, with the senior staff. Senator RIEGLE. Have you invited in a group of unemployed workers? Has there been that kind of meeting? Mr. WEIDENBAUM. Per se, not to my knowledge. Have there been representatives of groups that have suffered high unemployment, such as blacks and Hispanics? Yes, many. Have there been meet- ings with businesses, small as well as large, especially those who are suffering from the high interest rates? Innumerable. Senator RIEGLE. Well, Mr. Weidenbaum, we've got 10 */2 million people out of work in the country. That is a conservative estimate. Those are the official Government figures. Can't we get some of those people, the ones who are bearing the brunt of what's happen- ing today, can't we give them an opportunity to sit down in a seri- ous, working discussion with the President? Mr. WEIDENBAUM. As an economist, I'll have to ask you the ques- tion: And what do we ask them? Having been unemployed—not re- cently—I understand how many of them are suffering and suffer- ing deeply. But the serious question is: How can you reduce unem- ployment, how can you restore a healthy economy, without getting back into the escalating double-digit inflation Senator RIEGLE. Well, I think Mr. WEIDENBAUM [continuing]. And very frankly, I think Senator RIEGLE. Let me tell you something. It isn't sufficient. It isn't sufficient to say there is no way. I mean, if you believe that, you shouldn't stay in this job another minute. Obviously, there is a way. There have been suggestions offered. A budget meeting of the type that I suggested earlier that could really do something about the deficits and, in turn, monetary policy. There are any number of ideas. You folks are standing pat. That's the problem. Mr. WEIDENBAUM. On the contrary. First of all, we have encour- aged the Congress, and the ball is in your court, if I state that cor- rectly. You are currently acting on the budget right now, which is appropriate, which is proper. I wish you well in terms of cutting the budget more rather than less. Senator RIEGLE. My time is up. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 122 Mr. WEIDENBAUM. I don't see the need for conferences, but the will to cut spending. The CHAIRMAN. Senator Sarbanes? Senator SARBANES. Mr, Weidenbaum, in response to Senator Garn's comment that every bill is a budget-buster, is that true of bills that cut the revenue base? Mr. WEIDENBAUM. I had in mind on the spending side, but I must agree that the short answer to your question is yes. Senator SARBANES. I think that's an important point to make, don't you? Mr. WEIDENBAUM. As an economist, I couldn't have given you any other answer. FOREIGN ECONOMIC GROWTH Senator SARBANES. Are there countries which you think have done a better job with their economy in the decade of the 1970's— West Germany, for example, or Japan? Mr. WEIDENBAUM. Yes. Senator SARBANES. You think they have done a better job? Mr. WEIDENBAUM. I haven't made a formal comparison to offer the committee. But in terms of their record on inflation and on growth, yes, we don't lead the parade. We didn't lead the parade over the 1970's. Senator SARBANES. What, then, is your comment on the fact that the annual average trend growth rate in the money supply, 1970 to 1980, in West Germany was 9J/2 percent, Japan, 13.4 percent, and the United States, 6.1 percent? How do those figures, and the comment you just made about the effective performance of those two economies, square with your as- sertion earlier that we need to cut the growth rate of money in this country? Mr. WEIDENBAUM. In my paper, 1 discuss the technical subject of velocity in great detail. My understanding is that velocity of the money supply in this country has been much more rapid than the velocity in Japan or in West Germany. Senator SARBANES. Are you asserting that as a fact? Mr. WEIDENBAUM. That is my understanding. My staff experts have informed me of this. I'll be glad to give you the details for the record. [The following information was subsequently supplied for the record:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 123 , THE CHAIRMAN OF THE COUNCIL OF ECONOMIC ADVISERS WASHINGTON July 29, 1982 Honorable Paul S. Sarbanes Committee on .Banking, Housing and Urban Affairs United States Senate Washington, D. C. 20510 Dear Senator Sarbanes: This letter supplies the information requested at the hearings of the Senate Banking Committee on July 21 regarding the growth of money and its velocity in Germany and Japan compared to the United States. I was asXed to square my assertion that money growth in the United States needs to be cut with the fact that during the 1970s U.S. money growth was actually lower than in Germany and Japan, where economic performance was better. Actually, as shown in the attached table, the economic performance of these three countries over the entire decade of the 1970s was not very different. However, in the last half of the decade the inflation performance of Germany and Japan improved compared to that of the United States, For the decade as a whole, both inflation and real growth were somewhat higher in the United States than in Germany, but lower than in Japan. The United States experienced about the same growth of nominal GNP as these countries in the 1970s, despite lower Ml growth, because the growth of Ml velocity was substantially greater in the United States. A mare highly developed financial system, combined, with restrictions on interest, payments on Ml balances, prompted the public to economize on its holdings of Ml over time, creating an annual growth of Ml velocity in the United States of 3.6 percent in the 1970s. In contrast/ Ml velocity actually fell in both Germany and Japan. The effect of money growth on inflation is clearly illustrated when the first and second halves of the 1970s are compared. Annual Ml growth in Germany was cut'by an average 1.9 percentage points in the last half of the decade, with a resulting decline in the annual average inflation rate of 2.7 percentage points. Japan reduced its annual Ml growth by 11 percentage points on average, producing a 5.6 percentage point decline in the annual inflation rate. However, annual average Ml growth in the United States rose by .9 of a percentage point, and the resulting increase in inflation was ,7 of a percentage point, on average. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 124 Thus, in the latter half of the decade the German «wd Japanese record on inflation improved compared to our own. Paradoxically, U.S. money growth was lower than in Germany and Japan, but our inflation rate was higher. The reason for this is that the growth in the income velocity of Ml continued to be significantly higher in the United states. U.S. money growth must therefore be cut even more in comparison with these countries if we are to achieve a comparable degree of price stability, I would,, also like to point oat that, despite the reduction in Ml growth 'in Germany and Japan, the growth of real GNP improved in both countries. Over a period of several years a reduction in money growth only affects inflation, and any temporary effects on output and employment disappear. Over the long run, the rate of growth of real GNP is determined by the growth of labor and capital, and their productivity -=- not by the expansion in Ml. Sincerely, /s/ MLW Murray L. Keienbaum Federal Reserve Bank of St. Louis 1970-1980 {Percent Change United States West Germany at Annual Rates) Growth of Ml 6,6 9.2 Growth of Ml Velocity 3,6 -1.0 Growth of Prices 6.8 5.2 Growth of Real GNP 3.2 2.8 1970-1975 United States West Germany^ Growth of HI 6.2 10.2 Growth of Ml Velocity 3,1 -1.4 Growth of Prices 6.5 6.6 Growth of Real GNP 2.6 2.1 1975-1980 United States West.Jj errna ny Growth of Ml 7.1 8.3 Growth of Ml Velocity 4.0 -0,7 Growth of Prices 7.2 3,9 Growth of Real GNP 3.7 3.6 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 125 Senator SARBANES. I'd like to have those. In addition, also, if that is the case, to what do you attribute the difference in the velocity rates? Mr, WEIDENBAUM. I have to confess that I have not made any study of velocity in Japan or West Germany, but I'll be very pleased to amplify Senator SARBANES. Well, I also ought to make the further com- ment that the table I'm looking at indicates that the money growth rates in other countries were above those of West Germany and closer to those of Japan than they were to those of the United States. We, apparently, are an exception to the experience in all of these other countries. Mr. WEIDENBAUM. Many of these other countries have had seri- ous inflationary problems. The reason I compared West Germany and Switzerland is that these have been good examples Senator SARBANES. But your point on West Germany was simply that they had been able to hold to a constant growth rate; not that they weren't—they may well be growing faster than we're growing, as these figures would indicate. Mr. WEIDENBAUM. But the very notion Senator SARBANES. The implication of your statement was, as I understood it, that we had allowed the money supply here to grow more than they have. That's, in fact, not the case. Mr. WEIDENBAUM. More volatile and more rapid, so more unpre- dictable. Senator SARBANES. Well, it may be more unpredictable; it's not greater in terms of the percentages, as these figures I've just given to you would indicate. Mr, WEIDENBAUM. Well, that shows the problem that faces mone- tary policy in the United States, because over the years, it has Senator SARBANES. Now do you think that the high interest rates have contributed to the economic downturn? Mr. WEIDENBAUM. Yes. Senator SARBANES. You do? Now you posited the deficit as the problem that we're trying to deal with, and I recognize that prob- lem. Hasn't the economic downturn brought about a significant in- crease in the deficit? Mr. WEIDENBAUM. Oh, by all means, yes. Senator SARBANES. So the high interest rates, which ostensibly are up there to check inflation, are in fact contributing to enlarg- ing the deficit, which in turn heightens apprehension about this deficit and therefore, keeps interest rates high. Mr. WEIDENBAUM. Of course. But we've never advocated the high interest rates; we've advocated policies to bring down the interest rates. Senator SARBANES. Now in response to Senator Riegle's question about the Japanese economy, its unemployment and its prime rate, isn't it also true that the Japanese deficit as a percentage of their economy is larger than ours? Mr. WEIDENBAUM. Yes, and so is their savings rate. Senator SARBANES. And how about in West Germany? The same thing? Mr. WEIDENBAUM. Yes, the savings rate and the deficits are both higher. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 126 Senator SARBANES. Are you familiar with the story in this morn- ing's Washington Post on the Commerce Department, the an- nounced revisions in personal income statistics stretching back to 1977? Mr. WEIDENBAUM. I glanced at the story. I am generally aware of the revision that the Commerce Department has been making, yes. Senator SARBANES. And what was the thrust of that revision? Mr. WEIDENBAUM. The personal savings rate was a little higher than had been reported. Senator SARBANES. Yes. I just want to quote this article. It says: The changes wipe out part of the sharp declines in the personal savings rate ex- pressed as a percentage of disposable personal income that appeared in Government statistics beginning in 1977. And it goes on to say that the supposed sharp drop in the savings rate was the premise on which the economic policy of the supply side theorists was developed, but it now turns out that that was a faulty premise. Mr. WEIDENBAUM. As I always have tried to describe the situa- tion, the supply of saving in this Nation in recent decades has not been adequate to finance the type of rising investment which is necessary for rapid economic growth. And I see no reason to change that position. Senator SARBANES. Thank you, Mr. Chairman. FRUSTRATION OF POLITICS The CHAIRMAN. Thank you. Mr. Chairman, I suppose I finish your portion of the hearing where I started: with the same amount of frustration of politics as usual without regard to political parties in this town. Again, as with Paul Volcker yesterday, I can remem- ber the line of questioning from my colleagues on the Democratic side in making sure that we tied the administration to Volcker, and the only difference 2 years ago in 1980, before the election, it was Republicans on this side who were trying to tie Paul Volcker and Jimmy Carter together. And Chairman Schultz of the Council of Economic Advisers, the same line of questioning you've been get- ting today came from our side. So I'm not assessing any blame to anyone. I guess—I don't know—I have a great sense of frustration that we can't maybe get out of our traditional roles in a two-party system and forget it for a while and see what we can all do together. The criticisms about errors in estimates of this Administration are factual. They have been. It's for everybody to see. We start out with a budget estimate deficit of $45 billion. A lot of us felt it wasn't realistic and it shouldn't have been stated. As I say, it's been true the entire time I've been here, by both Republican and Democratic administrations, who, I guess, the tendency is always to try and present the most positive viewpoint rather than being to- tally realistic because you worry about the political consequences. That is not peculiar to one party or another. They've both been guilty of it. And the ones who have made the greatest errors of all in estimation of budgets—not in just estimates—since I've been here in the Congress in our appropriations process. Year after year, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 127 we always seem to be suddenly surprised that we're spending a lot more money than we intended to at the beginning of the year. So I just, again, express my frustration with the unbelievable problem abounding in this country and maybe I'm terribly naive and it's impossible for people elected to public office to forget what their party labels are, who happens to be the opposite, and say, hey, let's try and do something about it. But we appreciate your testimony. Senator SARBANES. Mr. Chairman, I'd like to make one observa- tion on that comment. The criticism on this side of Chairman Volcker and of the Chairman of the Council and of the President in the previous administration was as sharp as it has been with re- spect to these witnesses. And if there's been any difference with re- spect to how things have worked, I think it has been a diminution of a comparable approach on the part of the other side of the aisle. I think we were very sharp. I think a review of the transcripts during that period will demonstrate that. And I think that Chair- man Volcker was taken to task as much, if not more so, in the pre- vious administration by the Members on this side as he's been taken to task in this one. The CHAIRMAN. Paul, there are a lot of Republicans who, from the very beginning, have not only been very critical of Volcker with this administration, but we have resolutions from both sides of the aisle before this committee for very structural changes in the Fed. Senator SARBANES. We were also critical of the President for his economic policies, Mr. Chairman. The CHAIRMAN. Well, and there's a lot of criticism from our side, too. Senator SARBANES. I'm looking for it. The CHAIRMAN. We're big boys and I think you—well, I have sat here and totally agreed with you on the inaccuracy of the esti- mates. But the point of it is, let's not kid ourselves, we can sit here and try and defend one side or another. There is plenty of blame for both sides and there is politics as usual going on throughout the entire Congress. I've seen it happen over and over again. But certainly, Paul, there are always exceptions to that and I would agree with you: Members on both sides who do not partici- pate in that. No doubt about it, But I saw people who were for the Panama Canal Treaty when Gerald Ford was President working on it and Republicans for it, Democrats against it. When Jimmy Carter proposed it, we had a certain number on both sides who just switched and suddenly, because Carter was proposing it, we shouldn't ratify the Panama Canal Treaty and others who went the other way. That's a fact of political life and there are always exceptions to people on both sides of the aisle on this committee and the Con- gress who do not participate that way. I just feel that right now, the country is in such dire financial straits, that we ought to be able, a lot more on both sides ought to be able to rise above that. Senator SARBANES. Mr. Chairman, I would agree with that, and on that point, I would simply make the observation on the Panama Canal treaties that I note that President Reagan made so much of it in 1976 in his primary campaign against Gerald Ford and so Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 128 much of it in 1980 in his presidential campaign against Jimmy Carter, and yet has not uttered one word about the treaty since he took office and has reaped all the benefits which flow to the Nation from those treaties. That's a good example, I think, of the kind of attitude you're talking about. I wish we had more of it. The CHAIRMAN. But there are some people who are realistic enough to recognize that once something has been passed and rati- fied by two-thirds of the Senate, that it wouldn't serve much pur- pose, with all of these other problems, to yell and scream about it. Senator SARBANES. Well, it wasn't recognized in 1980, after ratifi- cation had already happened. But it was recognized once the re- sponsibilities of office came down upon the administration. I must say, to the administration's credit, that they have recognized the benefits of those treaties and why they protect our national inter- est. We have not heard one word about them, not a single word. The CHAIRMAN. Well, but there are some of us who still think that it was a lousy treaty, and yet, I haven't made a speech on it for 2 years. There are other more important things to deal with. That's past history. Senator Riegle wanted to make a final comment. Senator RIEGLE. Mr. Chairman, I'd just like to make one parting comment to you, and that is this, I think the economy is in very serious trouble. I think, because of the continuing high interest rates, we have a genuine crisis in the interest-sensitive sectors of the economy. I think it is worsening rather than getting better. MIDCOURSE CORRECTION I believe we need a major adjustment in the economic policy, a midcourse correction, as has been described by many. And I think we need it now, right now. Not 6 months from now, 3 months from now, or at any other time. And I think the chance to do it is rapid- ly diminishing. I speak now in terms of the administration leading the process which has to involve people on a bipartisan basis. And I urge you to monitor things very carefully because you have to be the person, more so than anybody else, that blows the whistle for the Presi- dent. If a bad situation is developing where there is a need for an intervention to change the policy mix, incorporating the efforts of the Congress, you have to be the person to blow that whistle. And if you miss that—you know, I like you well enough that I don't want to see you end up some day as the fellow that they put it on your tombstone that, "Here lies Murray Weidenbaum, the econo- mist who was in charge when the economy went over the cliff." I mean, I don't want that to have to be there, and I know you don't, either. But we're on a course right now that poses great dangers. And I think your chance to act now may become more and more difficult the longer you wait. I just want to leave you with that thought. The CHAIRMAN. I suppose one of the ironies of this whole situa- tion is the budget deficits wouldn't be nearly as big if inflation had not come down. So you win a partial fight on inflation and it com- pounds this other problem. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 129 Let me just close, and hopefully, this will be the close. [Laugh- ter.] I want to repeat what I said yesterday at the end of the hearing, that regardless of whether people like the administration's policy, I happen to think that the policy is correct. I have supported it, as you well know, all the way along. But the ball really is in Congress court right now, without a doubt. Whatever the initial recommen- dations on the budget were—bad, good, indifferent, or whatever— the fact of it is that we have passed the budget resolution, which is a reduced deficit from the earlier projections, still way too high, in my opinion. But nevertheless, I have grave doubts as to whether Congress has the ability to discipline itself in the 13 appropriations bills to meet that budget target that was set by the two budget committees in both the House and the Senate. I don't think, at least at this point in time, with July, August, and September left, 44 days, or however many it is, that the major responsibility for doing something about this economy at least to meet that horrible $103 billion or $110 or $130, lies upon the Con- gress. Nobody else can do anything about it. We are the only ones that have the ability to appropriate money. I suppose what we need—Murray and Don may agree with this— you know, it's easy for Senators and Congressmen, having been on both sides of the government, been in the executive as a mayor, been in the legislative branch. It's much easier in the legislative branch because you can take most any position you want and you don't have any responsibility whatsoever. It's almost like in flying. You're in the left seat and you've got a check pilot over there and he's not flying the airplane, but boy, he can find everything you did wrong. And that's the traditional adversary relationship be- tween the legislative and the executive branch of Government. I almost think it's too bad that there isn't somebody that could call Senators and Congressmen to a hearing and ask us questions about why we have so badly fouled the fiscal policy of this country. It would be an interesting concept. Mr. WEIDENBAUM. Can I give you a 10 second answer, because there's enough blame to go along both sides of the aisle, both Houses, both branches. We really haven't at critical times, and it really goes back to the Vietnam war, made the difficult choices. We say guns and butter. We had guns and butter and fat, literal- ly, if you look at the Federal budget. Senator RIEGLE. We still do. Mr. WEIDENBAUM. Yes. Senator RIEGLE. We still do. It hasn't changed. Mr. WEIDENBAUM. That's the problem. Senator SARBANES. But in that context, I welcome your recogni- tion that cutting the revenue base is a budget-buster as well. Mr. WEIDENBAUM. It's part of the reason that the deficit is as large as it is, no doubt about it. Senator RIEGLE. You know, Mr. Chairman Senator SARBANES. Particularly projected out into the future years. Mr. WEIDENBAUM, Yes, sir. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 130 Senator SARBANES. And what you've done is to project a policy that shows large deficits at a time that you're assuming an econo- my with fairly low unemployment. Mr. WEIDENBAUM. With declining unemployment. Senator SARBANES. Yes, which is really serious. Mr. WEIDENBAUM. And that worries me a great deal. Senator SARBANES. Yes, indeed. Yes, indeed. Senator RIEGLE. Mr. Chairman, I don't know that this will ever end, but this has been an important discussion. The CHAIRMAN. It will because when you finish, I'm not going to say another word. [Laughter.] Senator RIEGLE. You'd better wait on that until you hear what I'm going to say. You made a good point, I think, Mr. Chairman, about serving in both the executive capacity, as you have, and also in a legislative capacity and how these two things have to try to work together. I served in both parties here in the Congress. I've served as a Re- publican. I've served as a Democrat. I've served as a Republican under Presidents that were both of my party and the opposite party and I've done so as a Democrat. So IVe seen it all four ways from the inside. I just want to make this observation because it is not understood in terms of the dynamics of how we get out of this trap, this eco- nomic trap that we are in at the moment. And that is that we can talk about the Congress taking the lead. There are 10 good reasons why the Congress is not capable of taking the lead and leading the country out of this kind of an economic quandary. The CHAIRMAN. No, 535. [Laughter.] Senator RIEGLE. And here is one of the dilemmas that is faced. Take Howard Baker, a man I respect enormously, a leader of the Republicans and of the Senate today because his party is in the majority. Let's leave Tip O'Neill aside. How can Howard Baker, as a practical matter, come in here and in any sweeping way chal- lenge the policies or the spending preferences of an incumbent ad- ministration of the same party? It is virtually impossible and I know of no majority leader in recent history that has done it. And I am not saying that Howard Baker should be expected to somehow be different than his predecessors in either party. But the hard fact of the matter is that the party in power in the White House, having control here in the Senate, leadership of that party is not really free to map out a different economic course that is sharply at odds with the President. As a matter of fact, I think they've gone as far as they can in terms of scaling the deficits down from what the President asked for. You fellows asked for more spending, for bigger deficits. That is just the fact of the matter. On the House side, you've got Tip O'Neill of the other party nominally in charge, but he is not really. On the key test votes on economics, Tip O'Neill has not been able to deliver the votes for his point of view and the White House has, in fact, been able to deliver the votes for its point of view. So it is just important to bear in mind the dynamics on the legis- lative side this time for anybody to say in textbook fashion, why doesn't the Congress lead the country out of this quagmire over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 131 both fiscal policy and the contradiction of fiscal and monetary policy. The hard fact of the matter is that the Congress is inherent- ly incapable of doing that right now. I wish that were not the truth. I wish we were able to do it. But we need somebody else and the country needs somebody else. That is, we need the President and the administrative machinery making that kind of an effort. And if you do not have that, if you have a President or an ad- ministration that is serene, that is at peace with what is happen- ing, that thinks that things are going to get better on their own and does not want to go out and lead an effort for a major adjust- ment in the policy mix, a mid-course correction, it will not occur. It cannot occur. And you do not have to take this from me. You can sit down with the head of any major bank in this country today, any major financial institution, any major corporation that has looked at this thing and they will say precisely what I am saying— that you cannot lead a major adjustment in policy, one, without the President, or two, without the President in front leading that work effort. I am prepared to work on a bipartisan basis within that kind of work effort, but, my friend, I can't call that meeting, Tip O'Neill can't call it, Howard Baker can't call it, Jake Garn can't call it. No one can call it. The only person that can really put this puz/le to- gether, in a leadership sense, is the person who is the elected leader of the entire country, and that happens to be the President, and you work for him. I've made my suggestions, but until that step is taken, we are not going to get out of this paralysis that we are in. Mr. WEIDENBAUM. Let me assure you, when Senator Baker, Sena- tor Garn, the other Republican Senate leaders, come to the White House and meet the President —— Senator RIEGJ.E. You have to involve both parties. Mr. WEIDENBAUM [continuing]. That is a very independent, tough-minded group. Senator RIEGLE. You have to ask both parties. Mr. WEIDENBAUM. That makes their views known loud and clear to us. Obviously, no longer being a member of our party, you are not invited to those Republican meetings, The CHAIRMAN. I could call a meeting and nobody would come. Senator RIEGLE. I'd come. I'd come, Jake. [Laughter.] The CHAIRMAN. I'm glad you reserved one final comment for me. A vote is going to get us out of this. That is simply, you are right. A group of 535 people have an almost impossible task to lead. But however bad this budget resolution is, we can, at least, play our part by attempting to meet those budget guidelines in the appropri- ations process. Murray, we thank you for coming. And gentlemen, if Mr. Olsen and Mr, Maude would come to the witness table—we do have a vote, I will go and return as rapidly as I can and stay as long as necessary so that we can hear your testimony. The committee will stand in recess for 15 minutes. [Recess.] The CHAIRMAN. The committee will come to order. Mr. Olsen, in utter frustration, probably went out into the hall. Mr. Maude, why don't you go ahead and start and I am sure he will return quickly. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 132 STATEMENT OF DONALD E. MAUDE, CHIEF FINANCIAL ECONO- MIST AND CHAIRMAN, INTEREST RATE POLICY COMMITTEE, FINANCIAL ECONOMIC RESEARCH DEPARTMENT, MERRILL LYNCH, PIERCE, FENNER & SMITH Mr. MAUDE. I want to first of all apologize, Mr. Chairman. We had 80 copies of this sent down by Federal Express. They received it yesterday morning. The courier got it and did not believe that this was the correct address and never delivered it, and we are still trying to track it down. I think I did manage to have 8 copies sent down. I think you've got a copy and Senator Riegle does, too. Because I did not have enough copies to pass out, I had wanted to just very briefly summa- rize this, but this won't take more than 10 minutes. I think it would be appropriate for me to read through it because many other people in the room do not have a copy. [The complete statement follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 133 Summary of Statement Made By Donald E. Maude Chief Financial Economist Chairman, Interest Rate Policy CommitLee Merrill Lynch 1 am indeed pleased to have the opportunity to testify before, this Comittee on the occasion of the semi-annual Humphrey-Hawkins hearings or. Federal Reserve policy and at a time, when the spotlight bas temporarily shifted from the fiscal to the monetary sphere. Obvious]y, given the impor- tance of monetary policy to our nation's future economic direction and as one whose vocation it is to scrutinize the Fed's activities on a day-to-day—and sometimes on an hour-to-hour—basis, I can appreciate the importance of such semi-annual reviews of polity. In this spirit, my remarks this morning will be confined to the state and conduce of monetary policy. However, I cannot emphasize sufficiently the importance of fiscal policy and the role that pro- spective huge budgetary deficits over the years ahead will pJay in Jeter- mining the direction of Interest rates and our future economic health, tlo alteration in the way the Fed conducts policy on the monetary side—no natter how dramatic it nay be—can pave the way £or sustained lover interest rates arid vigorous economic recovery in the absence of a rcajor resolution on the fiscal side. At the outset, I would like to provide my broad view cm the conduct of monetary policy under the stewardship of Federal Keserve Board Chalnr^ii Paul Volcker. After more than a decade of misguided ttonetary policies that culminated in a worldwide wave of inflationary psychology, a massivi: attach- on the dollar in the foreign exchange markets, a flight from financial to real asse.ts and a total destruction In the Central Bank's credibility. Chairman Volcker has aln.ost single-handedly reversed the tide. I'nder his leadership, the Fed li ^s ti-mained the onl> an v.i-in flat ion grime in town. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 134 Through perseverance and determination in. sticking to course, he has regained in two years the anti-Inflation resolve credibility that bad increasingly befn in a state of erosion throughout the L97C's. Of course, In the process, substantial costs have been Incurred. It would be sad indeed if one of those costs turns out to be the Central Bank's loss of independence.' from the polit- ical arena. Were the Fed r.o find 1 ts Independence rplinquislied, there would be no game in town at all. Furthermore, I can assure you that even any slight hint of such n possibility would seiid the financial markets in a total state of ctiaos and interest rates soaring to new heights. This is not to say, however, that the Fed's conduct n£ policy since the appointment of Chairman Volcker and the inception of a more monetarist doc- trine of reserve targeting in October 1979 has been impeccable and that there J.E r.o need for some adjustments in policy Implementation. Indeed, it has been anything but perfect and some adjustments In implcnentation and monetary aggregate definitions are not only appropriate, but mandatory in my view. An elaboration ot my observations along these life? will provide the thrust of my testimony. The Setting . I need not elaborate here on the dismal economic performance that has transpired since the adoption o£ the Fed's new operating procedures in late 1979, (A more detailed articulation was put forth In a speech I made to The National Press Club back in May and which I submit for the record.) Suffice It to point out that the U.S. economy has experienced no real growth and declining production since the end of 1979—a performance unprecedented over the postwar period. In addition, the unemployment race, as all of you well know, stands at a new postwar high, the auto, housing and capital spending sectors remain strangled by stratospheric real rates of Interest and bank- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 135 ruptcitis foiilJiLut: i-i- iL.i'JU at an alarming pace. Corporate balance- eheett, are seriously sti jined, savings and loan associations, Jn the niai rtj art? paying mort tor uioiity t-lian tiit-y arc t-arnlng on asstts and experiencing a drain on capiLjJ with <;ath passing Jay, commercial banks are exceedinS-1}' tight ^Jid state and local govfemnients are Increasingly seeing surpluses dv/Indlo—or even turiilng into dt'ljcits. In short, we have a serious liquidity prrblxrn on uur hands. I point oikt thtse dfevelopments not to play the role of an alarmist, merely suggest that eoBie pieces of the economic-financial-monetavy puzzle have to be missing. This would especially appear to he the case since these difficulties have been intensifying rapidly over the first half of this year when stated tt-l and H-2 growth was running well in excess of the upper erd of the Fed's targets, thus forcing a restrictive monetary policy. In eifcct, on the one hand, economic, financial and interest rate developments suggest to me that the Fed has been overly restrictive. On the other hand, the mone- tary aggregates—as officially defined—suggest to me that the Fed has been overly accommodative. Somehow, une would think that the reconciliation of such an anomaly would receive the highest of priorities. Possible ReconclliaLion - It ia my judgment that the true stance of monetary policy Is more accurately reflected by tht dismal state of the economy, severely strained liquidity in the corporate sector and financial system and historically high real rates of interest than by stared monetary aggregate growth thus far this year. As such, the Fed, in chasing after monetary targets in order Co sus- tain credibility in the credit markets, lias been pursuing an unduly restric- tive course. Under such circumstances, one could make a valid case for a more accommodative policy than is presently in place. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 136 I am very much aware that this statement represents music to your col- lective ears. However, before you turn up the volume. It should be emphasized that any accommodation on the part of the Fed should have as a prerequisite further tightening on the expenditure side of the fiscal side. Otherwise, any relief from monetary accommodation will be short-Jived. Indeed, I am sure that Chairman Volcker has considered the possibility that such accommodation— if it served to take the edge off of the urgency to take more responsible measures on the fiscal side—could very well backfire and exacerbate the sit- uation. Convincing the Chairman that tfiie would not be the case—by actions, not by words—might go a long way in reaching the fiscal-monetary detente so urgently needed. tfr-_lj. jtot_ What Ij: js_5up])oagd_Tg_Be_Or_ Haa_ Been. Without getting tech- nical to any large degree here, it is my view that the M-l that has been grow- ing way above targets and forcing a restrictive policy thus far this year is not a valid measure of what it has gauged through the years. Technically, M-l Is supposed to measure the level of "transactional" (or readily spendable) deposits and currency in the system. It Is not supposed to include savings- type deposits or balances being built up for precautionary reasons. In the past, 11-1 served tte purpose well. However, with historically high interest rates and resulting financial innovations over the years, its ability to cap- ture strictly transactional balances and to exclude savings balances has diminished significantly. In this regard, as you know, banks were allowed to introduce nationwide NOW accounts beginning in January 1981. n'ith the knowledge that some of the increase in such accounts would come from savings accounts and would not represent transactional balances, the Fed utilized a "shift-adjusted" M-1B measure last year to more accurately reflect what was going on with spendable Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 137 balances. This adjustment was dropped in December, though, and since then all "other checkable" deposits have been, defined as "transactlonal" in nature. As the following table shows, the Fed's own survey assured that as recently as October of last year, fully one-half of rtie increase in these deposits was coining from savings accounts—and should not be included in the targeted M-I measure. In November, the shift ftom savings accounts declined to 22.6X and in December it rose to 30.42. With the slowdown in the growth in other checkable deposits from May to October, it does seem reasonable to assume that the dollar magnitude of such shifting had diminished significantly. By way of example, after drawing $9.5 billion out of savings accounts from January to April, NOW accounts subsequently only pulled an additional SJ.O billion from savings accounts from April to the end of October. However, since October, these deposits have surged by $18.3 billion— accounting for 91% of the M-l increase. Certainly, it would seem reasonable to ae that this surge indicated that shifting from savings accounts had resumed. Yet, for some unexplainable reason, the Fed stopped making such adjustments after December. Had they continued to use such a measure, M-l growth in June would have been 0.7% below the upper end of target—not 0.12 above. This estimate is based upon the assumption that only 2k'i of the growth in NOW accounts was coming from savings—the average percentage of shifts in 1981. I suspect that even a larger proportion emanated from non-transactional sources. (The analytical underpinnings for such a view, articulated in the attached January 29 edition of the WEEKLY CREDIT MARKET BULLETIN, is sub- mitted for the record.) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 138 In addition to capturing ron-tran.iactional savings-type deposits, there is reason to suspect that the stated M-l m^asur;' has included *'on-tran.s-- actioiifll "precautionary" balances as we! L—especially uvfi the Xcivemhcr- Jaiuiary period. Such balances, of course, should net be included in P*-I (and have not in tlie past). Indeed, ehc buildup of tliesi; balances i-'ss due c<_ ec:onon;ic weakness--not ccor.omi*.- strength. (For tLc teccrcl, ii: chtn tcfi-u'd, I have included the Kcbnsary 5 edition of the WEEKLY CKF.I'IT !i,\,.KV.7 SSitft Adj. Ml-B Change 1981 — Jan. j.4 - n.I 16.3 Feb. 1.5 - I.0 Marth 5.0 3../, April 8.9 fa..8 May - 4.1 - 3..5 June - O.P - I.3 July 0.9 0.7 Aug. 1.6 1..3 Sept. 0.3 - 0,. 1 Oct. 1.7 I,,5 Nov. 3.5 2..8 Dec. 4,4 3.? 1981 Total: 1982-- Jan. Feb. JLirch April May June Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 139 H-2A _S_o_t_What It JB Supposed To ftc _0r Has Been. Another force keeping the Fed on a restrictive course has been above-target growth in tt-2. Indeed, such rapid growth forced the Fed to remain tight last spring even when M-l growth vas well below target. However, M-2 today Is not what It was in the paet. (In this regard, 1 have attached for the record an analysis o£ the problew with M-2 that was done in the CREDIT MARKET DIGEST last September.) In short, vhat the analysis argues Is that M-2 growth has been overly stated by historically high interest rates and the growing proportion of its components earning market rates of interest. These two factors did not exist in the 1960's and early 1970's. In effect, as high interest is credited to the M-2 components, it represents 3 transfer of funds from borrower to deposits included in M-2—not newly created money by the Fed or enhanced overall liquidity. While the analysis is too lengthy to detail at this time, the following table should make ray point clear. In it, I have presented tlie actual M-2 level for each of the past nine years and the first two quarters o£ this year along with the annual dollar amount of increase. In column three, 1 have computed the amount of the M-2 growth that stemmed from interest credited (on the assumption that interest was reinvested in the initial deposit). After subtraction of interest is indicated in column four—the actual net new increase in M-2 (theoretically due to Federal Reserve policy). As can be seen in the final two columns, stated M-2 growth (which includes interest credited and net new increases in H-2) was 8.32 in 1980, 9.8Z In 1981 and roughly 9.6S over the first half of this year. However, if we net out Interest, we find that "interest-adjusted M-2" rose by a mere 2.02 in 1980, 1.7% last year and roughly 1,9% over the first half of this year. Such weak growth over the period, as reflected in the adjusted measure, would seem more Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 140 In sync with the economic and ftnanclai situation that has yrevailetl over that period of time. M-2 Growth Before and After Adjustment For Interest Credited Int. Adj. Int. Adj. Stated M-2 Inrereat M-2 Int. Adj. M-2 M-2 M-2 Incr. Credited Incr. M-2 Growth Growth 1974 890.0 1975 973.9 83.9 42. S 41. 1 931.1 4.6 9.4 1976 HOI. 8 127.9 50.0 77.9 1009,0 8.4 13.1 1977 1244.5 142.7 55.9 86.6 1095.8 8.6 13.0 1978 1354.3 109.8 63.2 46.6 1142.4 4,3 8.8 1979 1469.9 115.6 79,5 36.1 1178.5 3.2 8,5 I960 1591-7 121.8 98.0 23.8 1202.3 2.0 8.3 1981 1747,3 155.6 135.0 20.6 1222.9 1.7 9.8 19B2 I Qtr. 1851.5 176.4 148.0 28.4 1251.3 2.2 9.8 II Qtr. 1894.9 173.6 155.0 16.6 1269.9 1.5 9.4 In summary on the foregoing points, it is &y view that if the appropriate adjustments co make M-l and M-2 consistent with what tHey were- in the past wefp made (namely transactions balances and primarily net now savings and time deposits), ve would find that both have been growing below targets for some time now. It is curious that the Fed has not deemed such an approach appropriate under the circumstances. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 141 Certainly, the stated rapid M-l and M-2 growth since October of last year does not seem consistent with the Fed's reserve posture over the sa»e period. From November to June, for eKanple, nonborrowed reserves have grown at a ntere 3.42 annual rate and total reserves at a 5.72 annual rate. Generally, thee^ are not reserve growth rates that produce rapid money growth. Let me make it quite clear, though, that I am tint advocating a cavt in by the Fed for political expediency. Accotmcdation activated by this consideration would be disastrous, t am advocating accommodation on pure fundamental economic, monetary and financial grounds. Mone_tary_ PoHjry Conduct: Considerat_ions , 1) Refine M-l measure to net out savings-type and transactions! balances and use an interest-adjusted H-2 measure. 2) Continue following a policy geared to the consideration of both M-l and M-2 (do not just slavishly target and respond to one aggregate) and do so in the context of bank credit growth. If bank credit growth is nodest and M-l and M-2 growth rapid, Cor example, the monetary aggregates should play a diminished role in policy formulation and vice versa. 3) Eliminate "base drift" from annual targeting. Targets for each succeeding year should be based upon Che midpoint M-l and M-2 levels of the present year's targets (for more detailed analysis, see attached edition of the May 21 WEEKLY CREDIT MARKET BUIXETIN). Had this been done for this year's targets, M-) growth thus fat would have been below the lower end of the 2-1/2% to 5-1/2?. range, 4} Smooth out the roller-coaster movements in nonborrow'd reserve growth. Such a roller-coaeter course can be seen from the following graph. As can be seen, the roller-coaster reserve growth has heen matched by roller- coaster M-l growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 142 MQNBORHOWED RESERVES AND M-1 (13-Week Moving Avev age Percent CTiange with M-1 Lagged by Two Months! ON0J FMAMJJASONOJfMAMJJ ASQNDJFMAMJ 1379 1980 19S1 I<182 5) Immediately Institute the proposed practice of publishing the mone- tary statistice (K-l) on a four-week moving average basis to smooth out the week-to-week, "noise." 6) Key the discount rate to a level 2% to 3Z above the twelve-month Moving average rate of inflation as measured by the personal consumption deflator. Thie would be changed each month with Inflation. As such, an eas- ing of rates would occur during decelerating inflation and rising rates during accelerating inflation and act as an automatic stabilizer. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 143 Remarks by Donald E. Maude Chl*f Financial Economist Chairman, Interest Rate Policy Committee Merrill Lynch _ M*y5,1»82 /. The Setting... The battle of the budget continues to ebb and flow here in Washington as political positioning between the Democrats and Republicans, in antici- pation of the summer campaign and autumn elections, appears to be the order of the day—and the key motivating force. The Democrats, on one hand, seem to feel no urgency to make tough and politically unpopular de- cisions that could alleviate the budgetary deficit logjam on interest rates and economic recovery, indeed, as things stand right now, they seem to be basking in the enviable position of entering the campaign against an oppo- sition party and incumbent administration whose economic recovery pro- gram thus far has turned out to-be a total failure. The Republicans, on the other hand, have appeared more conciliatory in the budget deliberations as they, too, seem to sense that failure to deliver their program's promise for declining interest rates and brisk economic recovery could be devastating to chances of victory in November. In effect, the budget appears to have become a political tennis ball, moving from court to court with the partici- pants'primary goal being the determination of the political affiliation of winners and losers in November. Unfortunately, the real winners and losers from the outcome of this vol- ley will not be those residing on this side of the Potomac. Instead, it will be those working on Wall Street and residing on Main Street across the nation. Indeed, presently at stake is no less than the very survival of key industries and financial institutions that are so critically needed to sustain the Ameri- can system of capitalism. It is indeed a pity and a clear and present danger to the nation's financial fabric that these latter economic and financial con- siderations have apparently continued to take a back seat to political ma- neuvering in the all-important and critical battle of the budget. To some, of course, this would appear to be an overdramatization of the situation and a myopic obsession with budgetary deficits that should be taken with a grain of salt as coming from one subjected to day-to-day shattering on the battlefield of the bond and money markets—and having a Keynesian-oriented training to boot. Obviously, this might preclude one's ability to step back and see the clearer "big picture". After all, everyone including the President has told us that deficits really do not matter that much. To the monetarists, there is nothing wrong with the financial mar- kets that could not be rectified by a credible monetary policy. To many in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 144 the administration, the heart of the problem has been a monetary policy that produces erratic week to week movements in the money supply—not deficits. Smooth out money supply growth and all the financial markets' problems will go away. To the supply siders, rates would plummet and the economy would enter into a sustained period of brisk economic growth in a noninflationary environment if only we would return to the good old days of the gold standard. To some in Congress, the problem of high interest rates does not lie with their failure to further cut expenditures, but with Paul Volcker. Replace the Fed Chairman and the financial markets' problems would disappear. Others, such as Arthur Laffer, would say that nothing has to be done. Just give the President's program time to work. The "real" part of the pro- gram in the form of a full 10% tax reduction has not even taken effect yet. When it does, there will be a surge in private savings and consumer spending—both at the same time—and from a tax cut that will be spread over a year's time, mind you, that wilt boost the economy and allow the fis- cal 1983 deficit to be financed smoothly in a declining interest rate environ- ment. In fact, this scenario seems to be the consensus forecast among most private economists. Many political analysts as well would adhere to such a scenario. After all, this is a critical off-Presidential election year in which the incumbent administration needs to maintain most—or all—current Republican repre- sentation in order to further carry out its program, ft will do everything in its power to engineer an environment of declining interest rates, rapid eco- nomic growth and declining unemployment and a moderate rate of infla- tion. The same, of course, was true during the off-Presidential election year of the first Nixon Administration in 1970. However, that year witnessed the fifth postwar recession, a 51 % increase in the unemployment rate and an unthinkable 4.8% annual rate of increase in consumer prices—the second largest yearly gain over the postwar period. The next major Congressional etection year came in 1974—a period during which the nation experienced double-digit inflation, historic highs in interest rates and the steepest re- cession of the postwar period. The 1976 Presidential election year saw an economic "pause1' that many feel helped lead to the defeat of President Ford. In the 1978 election year, the Carter Administration did manage to stave off a recession, but only at the cost of fostering policy moves that led to a total destruction of credibility in the international financial markets and the need to sharply boost interest rates with a dollar support package Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 145 just four days prior to the election. And need one elaborate about the envi- ronment during the 1980 Presidential election year of recession, double- digit inflation and sharply rising interest rates during the summer campaign and autumn election period. From this recent history of election year economic and financial environments, it becomes quite clear that Murphy's Law is still alive and well. II. Where We Presently Stand—The Stark Realities... While the economy remains quagmired in its eighth postwar recession, it is becoming increasingly clear that the worst is behind us. With the re- cession now some ten months old, it is likely that economic recovery is just around the corner. After all, postwar business cycle history shows that the average duration of recessions has generally been around eleven months. What is more, the depth of the present recession in terms of contraction in both broad and narrow economic measures is about comparable to pre- vious recessions. At the same time, the nation has benefited from a dra- matic deceleration in inflation. Indeed, producer prices have declined for two consecutive months and consumer prices in March posted their first decline in seventeen years. Certainly, these considerations do not paint an ominous picture by any means. However, the recent recession must be viewed against a backdrop of economic levels from which it started. It came on the heels of a rather ane- mic and short-lived, one-year expansion subsequent to the 1980 recession—an unprecedented development, (nstead of contracting from expansion peak levels of activity, the economy began contracting from close to trough levels. As a result, I would offer the foflowing quite sobering observations: ... In the Economy, since trie end of 1972, real GNP has actually de- clined by 0.3%. This decline over a ten-quarter span is unprecedented in our postwar history, which has seen real GNP expand at an average annual rate of 3.5%. The lost real output since the end of 1979—the difference be- tween historical experience and actual results—comes to a whopping $127.3 billion. Industrial production stands more than 9% lower than at the end of 1979 and the degree of idleness in the nation's factories is flirting with a postwar record. Not surprisingly, in the process corporate profits have plunged by a whopping 31 % since early 1980—on an after-tax basis. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 146 Business failures are up 92% since 1979 and are flirting with depression levels. What's more, the size of current liabilities of such failures have more than doubled over the same period. The consumer sector as well does not have much to cheer about. Wages and salaries in real terms, for example, are 7.3% lower now than in early 1980 and the savings rate remains at historically low proportions. Consumer confidence is now at the lowest level since the Conference Board began recording the pulse of sentiment, and buying plans continue on the decline. The value of consumers1 home equity has stopped going up and has actually posted a slight deterioration since last August. The unem- ployment rate is now at a postwar record of 9.4% and, if one includes "dis- couraged workers", it is close to 13%. Mortgage loan delinquencies at the savings and loan associations are some 27% higher than in early 1980. Add to this the fact that new home sales are at a postwar record low, housing starts have run below one million units for eight consecutive months—the longest sustained period of starts running below this ben- chmark level—auto sales are close to postwar lows even at a time when major promotional programs have been in place, International Harvester, the plight of the airlines, the trucking industry and farmers and it is quite difficult to celebrate about the fact that recovery may be around the cornet. ... In the Corporate Sector, balance sheets are in the worst state of health ever. Even in the face of sharp inventory liquidations and capital spending paring, capital expenditures are still outpacing internal cash flow by 13% at a time of severe profit squeeze. The failure of the bond market to open up for sustained periods of time has made nonfinancial corporate bal- ance sheets laden with short-term debt. During the fourth quarter of last year, for example, the ratio o1 short-term to total credit market debt stood at a record 42%. Throughout the 1950'sand 1960's, this ratio ranged be- tween 26% and 30%. It was considered alarming in the mid-197Q's when it moved up to the mid-30 % area. Available liquid resources are at alarmingly low proportions. Liquid assets as a percent of total financial assets, for example, stood at a meager 19% during the fourth quarter of last year. In the 1950's, this ratio was as high as 50%. In the 1960's, concern was ex- pressed on the corporate sector's ability to meet current bills from liquidity. Liquid assets as a percentage of current liabilities was in the 60% area in the 1950's and the 40%-50% range in the 1960's. Now, it stands at 22%. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 147 With such a financial state, it is little wonder that many corporations have been precluded from raising funds in the capital market and have placed the burden on the banking system. The interest servicing burden on corporations alone is eating up almost 50% of internal cash flow. Back in the 1960's, it was less than 10%. This has obviously kept the rating agencies—Moody's and Standard and Poor's—burning the midnight oil. Thus far this year, for example, of the accelerating pace of rating changes that have taken place, more than two-thirds have represented downgrad- ings. ... In the Financial System, even the average citizen on Main Street is familiar with the plight of the S&L's. Net of interest credited, they have only experienced inflows in two out of the last thirteen months (October and February). Last year the S&L's experienced a $4.6 billion erosion in cap- ital and fully 85% of such institutions are losing money every day they open for business as the return on assets is now falling short of the cost of funds by 1 1/2%. Unless a sharp decline in rates ensues, the spread threatens to get still wider. Even with a sharp and sustained decline in rates—a highly unlikely event—a/most 800 more S&L's will be operating with no capital by the end of 1982. It is because of this that forced mergers by the Authorities are on a sharply accelerating track. Certainly, given the current situation, the relatively meager $6.3 billion reserve held by the Fed- eral Savings and Loan Insurance Corporation does not offer one great sol- ace. While the commercial banks have avoided the type of plight experi- enced by the thrifts, they have not come away unscathed. Given the dismal state of the corporate sector and international problems that have sur- faced, problem or nonperforming loans have continued on the ascent and remain at exceedingly high levels—a highly atypical development during a recession. Over the past eight years or so, the banks' equity to asset ratio has declined by almost 16%. In short, bank balance sheets give the appear- ance that we are at the peak stage of an economic expansion—not the trough of a recession. The banking system, given continued strong loan demand by corporations an an exceedingly stringent reserve policy by the Fed, has yet to rebuild its balance sheet. No wonder, all but one of the top ten banks in the nation have had ratings lowered on their senior debt. ... State and Local Government, as well are severely feeling the pinch from combined recession and exceedingly high jnterest rates. By the end of this year more than half the states will be operating with surplusses Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 148 below the critical 5% level. In about fifteen states, actual deficits will be posted. Services have been scaled back and many states are increasingly looking for increased revenues through taxation. Keep in mind, these states are just now beginning to feel the squeeze from budget cuts on the Federal level. This is occurring at a time when many states are not allowed to go to the capital markets at current interest rates and many localities incur the risk of downgrading of ratings. ... In the Farm Sector, the very cornerstone of the American econ- omy, a plight not witnessed since the Great Depression is in progress. In real terms, for example, net farm income plunged from $17.7 billion in 1974 to $8.7 billion in the fourth quarter of 1981. Squeezed by weak crop and live- stock prices, costly machinery and prohibitively high interest rates, many farmers now find mortgages at the risk of foreclosure. Those who have been forced to liquidate have had to settle for 50 cents on the dollar. Many farmers find income as low as during the Great Depression. Certainly, given the state of the manufacturing sector, it is difficult to say how these beleaguered farms can be absorbed elsewhere into the economy. Unfortu- nately, as long as rates merely stay where they are, this plight will heighten over the months ahead. Already we have seen the repercussions of this sit- uation on the budgetary deficit as it has had to be enlarged in response to the initiation of recent price supports. And with all of this abounding afl around us because of the two- pronged pinch of a recession and exceedingly high interest rates, one stil) gets the impression that a good portion of the budget batt)e is political in nature and that an eleventh hour sense of urgency just does not exist. III. Where We Go From Here... Certainty, given the preceding considerations one would hope that there is nowhere for the economy to go from here but up. At the same time, one would hope that the only place interest rates could go from present real levels, not witnessed since the Great Depression, would be down. While some degree of confidence can be attached to the former, the same cannot be said about the latter. Looking at the matter in greater detail ia our view that the reliquef ica- tion of the consumer sector with respect to debt-to-income ratios and the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 149 final workoff of unwanted inventories during the first quarter and on into the spring months are in the process of sowing the seeds for economic re- covery during the summer months. Such seeds, of course, will be fertilized with the July 1 enactment of the 10% tax cut and Social Security benefit cost of living increase. The key question that one must ask, however, is how sustainable will such a recovery be. The key here, of course, lies in the in- terest rate outlook. With further paring in capital spending, inventory reduction and a mod- eration in money supply growth in May and June, it most certainly is proba- ble that recent upward pressures on interest rates will abate quite modestly. Unfortunately, such a tranquil environment in the financial mar- kets will probably further reduce the sense of urgency in Washington to make the hard choices that are required to materially reduce prospective budgetary deficits. This is quite disconcerting since the spring tranquility should shift to a summer eruption in the financial markets. As we shift from spring to summer, there will indeed be signs that the economic recovery is in the process of unfolding. Unfortunately, this will probably give the mar- kets the worst of both worlds. On the one hand, the recovery will be strong enough to impart a negative psychological tone on the credit markets and possibly rekindle fears of crowding out. On the other hand, though,it will not be sufficiently robust to meaningfully boost internal corporate cash flow—an event that normally is counted upon to alleviate short-term bor- rowing needs. At the same time, the markets and the Fed will have to brace themselves for a potential major explosion in money supply growth in early July. As was the case in April, some of this growth will be related to techni- cal phenomena and faulty seasonal adjustment factors. Unlike the April bulge, however, it will also be predicated upon fundamental grounds as the economy is in the process of recovery, the 10% tax cut goes into effect and the cost of living increase in Social Security benefits will be providing an infusion of real spendable money into the system. Given the likelihood that money supply growth will be well in excess of targets going into July, the Fed will have no choice but to forcefully tighten policy. The story does not end here. As we shift from the second to the third quarter, the Treasury's net new cash needs will be in the process of tripling—from about $14 bil- lion in the second quarter to $40 to $45 billion in the third quarter. Add on top of this actual financing pressure the fact that the OMB's "Mid-Season Review" places projected budgetary deficits for fiscal 1983 well into the triple-digit territory and the ingredients for retesting the old highs in long- term rates will be firmly in place. It is during this period that some commer- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 150 cial paper issuers may be forced out of the market into the banking system and long-term issuers may decide to "throw in the towel" in order to access the availability of funds at any price. Quite obviously, we are slowly building the foundation for a potential majof crisis environment during the summer months. One can only hope that such an environment will represent sufficient encouragement to the Administration and Congress to take major initiatives toward making the hard choices that would materially reduce looming budgetary deficits ahead. If in fact these initiatives are taken, the summer pressure in the fi- nancial markets can lead to an autumn respite. If indeed such initiatives are genuine, meaningful and credible to the financial markets, the road could be paved for a continuation of a more-than-cyclical deceleration in inflation and a sustained decline in interest rates to inflation-adjusted levels that bear a more realistic semblance of underlying fundamental real- ities. Tfie fate of interest rates, the future economic contour and the success or failure of the Economic Recovery Program, therefore, rests here in Washington—not several hundred mites north in Wall Street. IV. Is the Present Quagmire intractable? Certainly, one cannot take a great deal of heart from the present situa- tion and events that are likely to unfold over the quarters immediately ahead. We seem *o be stock within a vicious cycle in which large budget deficits and historically high real rates of interest beget weaker economic performance, which beget stilt higher deficits and, in turn, higher real rates of interest. On the monetary front, a Federal Reserve policy designed to bring down interest rates at the expense of excessive reserve growth would initially foster economic growth and would allow Federal deficits to recede in the short run. However, a policy fostering excessive money growth would uitimatety lead to accelerating inflation—possibly lo new peak rates, an economic recession and growing budgetary deficits. On the other hand, a responsible monetary policy geared to gradually reduce the rate o1 growth in money at a time when Treasury financing needs are huge would require sufficiently high real rates of interest to keep private corporate borrowing in the capital markets at a minimum. This, in turn, would lead to diminished capital spending and dismal productivity growth which might ultimately lead to accelerating inflation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 151 This is not to say, though, that the potential tor a rosier future does not exist. Just think of what has transpired over the past several years. Infla- tionary psychology and behavior has been broken to the quick. The com- modity price bubble has burst. The price of gold is less than half its level of 1980. Silver has taken even more of a pounding. Masses that were running out of financial assets into real assets, collectables, etc., are now reverting back to more productive forms of investment. The speculative housing bub- ble has been pierced. Labor, far from placing as their major priority the practice of keeping up with inflation, is now willing to take pay cuts just to maintain the present working status. The previous worldwide oil shortage has turned into a glut, seriously jeopardizing OPEC's clout in influencing economic and financial events around the world. The Administration is desperately attempting to reverse the trend of accelerating Federal Gov- ernment expenditures. And, last but certainly not least, the monetary authorities have achieved impressive success in reducing the year-over- year rate of growth in money supply for three consecutive years now. Certainly, forces toward disinflation have been more dramatic than one could have hoped for just one short year ago. Unfortunately, however, there remains one substantial logjam precluding a reversal of the vicious cycle in which we find ourselves. In short, budgetary deficits at the Federal level are out of control. If nothing is done about them, all the gains that we have ex- perienced over tne past year or more could evaporate as quickly as they evolved—and all of the severe economic pain and the lost output would have been for nought. The information set lorth herein was obtained from sources which we believe reliable, but we Qo not guarantee i!s accuracy. Neithet me information, nor any opinion expressed, constitutes a solicitation by us of the purchase or sale of any securities or commodities. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 152 Weekly Credit Market JMerrill Lynch Pierce Bulletin 'Fennei 6 Smith Inc. Financial Economics Research January 29.1982 year is already well in excess of targets, real rates of verview & Preview interest ara at postwar record levels (almost triple ttie The credit markets sounded an upbeat role during the levels of the 1960's and most of the J 970'sJ and the past week despite the release at economic and finan- economy remains in a recession with the unemploy- cial data tha: could just as easily have estendert the ment rate on the verge of mowing above the "magic" recent tailspin in debt prices. On tha economic from, 9% area. At the same time, it finds an Administration the upturn in The index of leading indicators, the Ihiid that appears complacent about and unwilling to attack consecutive monthly increase in the ratio of coincident the problem of burgeoning budgetary deficits as lar as to lagging indicators, the rise in durable goods oideis the eye can see. Furthermore, the moral support the for December and the laiest fall in initial unemployment Fed had enjoyed over the Administration's first yaat iri claims ail reinloice recent indications that the thrust of office ts now crumbling rapidly—though through 3 •he recession is losing momentum. On the financial UniQuely disguised facade. Cleariy, the Fed will bfl front, the surge in the roomy supply during the first standing atone in the highly pressurized political envi- two weeks of January portends continuing uncer- ronment of 3 critical election year. tainty over how the Federal Reserve will resolve the perpleung problem of nigh monetary giovjth in 9 reces- To be sure, the present quagmire in which the mone- sionary environment while the largar-than-ax peeled tary authorities now find themselvas so deeply en- S1O Billion Treasury refunding package highlights the trenched stems largely from a supply-side fiscal burgeoning deticit financing needs of the Government. philosophy within the Administration that has chosen toignore the devastating impact — both real and expec- Nonetheless, in contrast to the undeniably negative tations! in nature —of huge budgetary deficits on (he response that Euch news would have elicited several financial markets. However, part of the Fed's present weeks ago, market participants chose to anticipate predicament in which an even more draconian policy possible favorable developments ttiis time around. stance may Be required in 1982 than in 198'—the These include, most importantly, a signiiicant reversal year of a recession--may \>e from its own doing and in the money supply bulge in the weeks ahead, a from a failure to achieve its Ml-fl growth targets last reduction in inventory financing on the pan of bu- year. sinesses, reduced near-term pressure on the fed lo adopt some tightening measures such as a discount Looking at the matlel in greater detail, the Fed has iate hilie and the prospect of a successful lelunOing established an already stringent 2 !4 %-5'/i % taigel for operation. It will be recalled that tha last Quarterly its newly defined M-1 in I 982 -slightly lower than the refunding in November kicked off a major rally and the 1981 shifi-art|u5ted Ml-B target of 3V7%-e% and latent demand ffu !he issues included in the upcoming flDC'acmOly lower ilnan fie unadjusted M1 -B target of package appears to bs st'oog, particularly- among insti- 6%-8'/i%. At <he same time, they have retained the tutions seeking fo lock in yields to accommodate IRA 1981 M-2 target range of 6%-9%. Given the normal accounts and among foreign investors. However, the relationship between nominal GNP growth and mone- apparent positive market psychology that exists going tary growth that has prevailed throughout the 1960's inio the refunding period is a fragile one indeed and its and 1 970's and assuming [hat the rise in the GW sustenance will depend critically on the actualization at dellator can decelerate from about 9% in 1991 to theie anticipated favorable developments. aiound"'% in 1 982, the Fed's targets leave little (com fO> ieal GMP growth for the year - less than 2%. How- ever, even to achieve this subpar pace of real growth, Special Analysis the aggregates would have lo grow at the upper end of S'anding at tho Crossroads. «1B Per) now finds itself their targeted ranges. What's more, due to seasonal almost totally l)o«ed into a cornet whereby, in order to and technical factors they will, from time |o time, reinforce its fragile credibility at this ciitical juncture, it exceed these rajiges which mould most certainly elicit is compelled to adhere 10 a determined and telatwety a restrictive monetary posture lhai would further in- stnr* monetarist approach to policy. However, this sure a weak economy. comes at a time when monetary growth thus far this. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 153 Adding to the problem is the tact Chat the Fed is adjusted M1-B was almost 51 billion less than the calculating its allowable average M-1 leval for the increase in unadjusted Ml-8. Beginning in December, fourth quartet of 1982 off of an artificially low fourth- however, Ihe Fed ceased distinguishing from increases Quarter 1981 base. Specifically, with en actual 1981 in other checkables emanating from demand and sav- growtrtin MI-Bof 4-9%. its average leval during the ings deposits and began tracking the old gross Ml-B 199J lour In. quarter stood at S 437.6 billion. However, under the new definition of M-1. This is rather curious this average M1 B level loll 'a> short of what it would in light of the fact thai other checkable deposits rose have been had growth been Within its actual targeted again in December—by $2.2 billion —and lumped bv a range of 6%-8'/i%. As the following table shows, had whopping $5.6 biflion over tha (irst two weehs oi the Fed merely achieved MI -B growth a! the lower end January. Given these jumps in uther chetkables, we o* its targets, the fourth-quarter 1981 base would suspect that the Fed has unwittingly bloated the M-1 have been $442 billion-s4.<i billion higher. Had [lie figures with some balances thai are not transactional in F«it hJr the midpoint of its targets —presumably the nature and has failed to make proper adjustments. ultimate goal in targeting, the base would have Been $447 2 WNiqrt-$9,6 billion higher. With regard to M-2 as well, it afjpeors the Fed is placing itself in an untenable srtuanon by aiming for 3 6%-9% In this regard, it is important (o note tha! Ihft maximum target, given the fact that over 47% of its component allowable 1982 fourth-quarter M1-B level-whicn is now earning market related rates of rnrerest. As & would result from uppur-encf-of-ranger growth — is a result, at least a 7 Vi % rate of growth is already locked (unction of the fourth-quarter 1981 base off of which in on the basis of interest credited —and not net new it is calculated. For instance, as the table also shows, creation ol savings balances caused by Fed induced had the Fedusedthe lower end of its 1981 target level money creation. This leaves little leeway for the expan as a base. Ml -B could average $466.3 billion in the sion of transacdonal balances or of net new savings fourth quarter of this year and not exceed the upper balances without the Fed seriously overshooting its end of its 5.5% target. However, using the lower targets. Given these consrdera(ions and the overly actual base. Such a levef would represent a rate of restrictive posture the Fed would have to assume in growth 1% above the upper target or $4.6 billion. order not to surpass its targets for 19e2-wrtrt its Using the midpoint of the 1981 target as 9 base, the negative consequences for the economy it is our allowable levy of Ml-B during the fourth quarter view that the Fed should show some flexibility in would be $47 1 8 billion with a 5.5% annual tale of formulating ihefourth-Quarter 1981 base to be utilized gronih. However, such a level off of the actual 1 981 for target calculations, continue to shift adiust Ml-1 and base would result in a rate of growth of 7.8%-almost make the appropriate interest rate credited adjustment 2Yi% or STO.T billion above the upper end of the in setting M-2 targets. targets. In effect, by the use of the below-target 1981 fourth- quarter M1-B level as a base of calculation tor 1982. THE POTENTIALLY RESTRAINING IMPACT (he Fed is compounding its stringency in terms of ON FED POLICy OF PRELIMINARY actual allowable Ml 6 levels. This is known as nega- 1982 M-1 GROWTH TARGETS tive base drift- in marked contrast to the positive Base drift the Fed has enjoyed over the years when actual IVQB18IH Hn Hn.lVI) M4'l LMNI fa M1 -B growth came in above tai-gets. Just as failure to H*J«tU«<l Wl" Ifcn !l*i] lull WQ 12HK take into account base drift in setting targets during I'lll'l] ilTup" WQ32 HUl&Htt fcs(«t 'H those periods was criticized as an overly accommoda- tive posture, failure to take into account negative base drift can be criticized as overly restrictive —especially at a time when real high rates of interest prevail and the lo.(,(M $442 0 $466 3 economy is sluggish at best. MMit 447.2 471.8 4S2.4 477 3 Further compounding the Fed's problem is the fact that it has ceased adjusting M-1 lor shifts into other check- able deposits from savings accounts. This would make sense if the level of other checfcables had been terelmg DONALD E. MAUDE olt for some time, since it would imply thai all shifting Chief Financial Economist had reached a conclusion. However, as recently as Cha/rfnan !int>rt!!s! Hail* Policy Commit fee Novtfjiijicr, other checkjble deposits had increased by £ 2 8 billion and it was assumad by the Fed that about ROBERTA. SCHWAftTZ 32% of the rise sifinunEil from transfers from savings Senior Financial Economist accounts As a result, the monthly increase in shift- Vve Chairman Interest Rate PoitCY Committee irli Si,,rf MARIA F RAMIREZ, MaiJset ft, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 154 Weekly Credit Market Merrill Lynch Pieice Bulletin Fenner fi Smith Inc. Financial Economics Research Fabrusry 5,1982 Market Overview & Preview managed to create more than its tail share of uncer- tainty in the financial markets. Such a sharp contradic- Thef rscal-monetary policy clash was heightened in trie tion between the pace of economic activity end Marches iast week as the Treasury came to market monetary growth deserves heightened focus when with a record S 10 billion quarterly financing operation one takes into account the fact that the 5.2% annual at the very lime the Fed was implementing $ further rate of decline in real GNP during last year's fourth tightening move, The credit markets' response was quarter was more severe than all but thiee other quar- understandable, Institutional investors, feeling no ur- terly contractions during, previouspost^aT recessions gency to rush into the Treasury's auctions vnrth the At the same time, ihe rapid 9.4% annual regie of growth knowledge that there will continue to be far too many inM-1 from October to December was only surpassed such Eruptions over the months, quarters and years in si* other quarters since 197Q. What is more, while ahead, seemed content to earn comparable yields in the economy apparently continued to slip in January, the short-term markets. As a result, the dealer commu- M-1 growth seems destined 10 post an annual Mte of nity apparently ended up with the lion's share of the growth in excess o( 20% newly auctioned Treasury securities — leading to a fur- ther weakening in the markets' technical tone. Of critical importance to both the Fed and the financial markets is the manner by which this contradiction will While this fiscal-monetary clash will continue to be be resolved. On this mattei. two points of view appear played out in the trenches. for some lime to come, to have emerged. In one camp are those whu h-isVit market participants will also be viewing it at the higher the view that strong growth in M-l since October is otttcial policy levels this week with the release of the fundamental in nature and thai the economy Over the President's budget message and Chairman Volcksr's period was significantly stronger than suggested by semi annual testimony before Congress. Qo the fiscal the GNP data. In the other camp are those who feel Tin: side, it is likely that a rather optimistic scenario of rapid M-l giovuth was only partially fundjmental in declining budgetary deficits over the years ahead will nature and certainly not reflective Q| actual underlying be presented. However, such a scenario will no doubt economic conditions. be viewed with more than a fair share of skepticism. Those in the former camp woutfl expect strengthening Viewed with far less skepticism on the other hand, will economic statistics and little —if any —dissipation in be statements by Chairman Volcker to tha effect ttiat the recent monetary biulge over the months immedi- the Fed will continue to pursue its goal of reducing the ately ahead to reinfotee theit view. Under these condi- rate ol growth in money and credit. Ironically, such tions, of course, the Fed would be required to take statements should prove heartening to institutional further forceful tightaning actions. Those Of tile latter investors who will benefit greatly from a tough mone- persuasion, on the other fund, would enpect continued tary policy resolve. However, it W'fl require both firm economic weakness to be reflected iii the statistics statements and an unwinding o( the recent monetary and a meaningful weakening in monetary growth over bulge to pry this group loose from the sidelines. In the the remainder of the first quarter. Under [hese condi- meantime, a tough monetary stand can only be inter- tions, the Fed would not have to take Either tightening preted as a negative development to a dealer commu- actions and the resulting weakening in the demand for nity that makes its trading decisions on ''. ,t basis of the funds coulo1 allow interest raies 10 ease once more day-to-day overnight financing rate- It is our view that the interpolation of the tatter co<»u bears the most semblance to reality and that its rpiuk- Special Analysis ing scenario is ttie most likely onp to prevail. To foe sure, Tha Economic-Monetary Growth Contradiction, exist- the worst of the recession was probably witn^saei) in ent for somfl months now, continues to perplex ana- October of last year. However, this by no means implies lysts both within and outside of the Fed and has (ConnnuBti on Pdge 4' Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 155 that the recession is avee. The inventory liquidation coTini as a precautionary measure This would appeal phase, which brings witrr it cutbacks in production, To be suggested by the 1981 and last month's pattern rising unemployment and dtciioished short-term busi- 0( "other checkable" deposit growth. ness credit demands, is almosi always (he last to come-and, indeed, the necessary ingreOient paving B/ way of illustration, with the introduction of natfin- Ihe way lor an ensuing recovery. Admittedly, given the wide NOW accounts last year, Other checkable da- normal lagged impact, there is no question that the posits soared by S39.2 billion ovei Ihe January-April Fed's highly aggressive reserve provision over the period. From April to October, however, (hey ortly summer and early autumn m on ids and the sharp de- Increased by $5.6 billion a S900 million monthly cline in interest rates in November <lnl Corilnbule to an rate. On the other hand, iince October they fiave acceleration in monetary growth. Hovvever, there are increased by 5)1.8 billion- close to a S4.0 billion several cofjerit leasons to view trie magnitude ant) average monthly pace. Because November was the nature of growth with a great deal ol suspicion last monlh that irte Fed rtisiinguishsd between what portion of the other checkable deposit increase came Specifically, several quite atypical developments in from demand deposits and what portion came from (lefJosir flows in progress since late October might sayings-type denosits, oiiehas in inake individual |Udg- suggesi that the dismal economic environment and meht wilh regard^ to OCD yromih over the last two uncefiafnTy over future employment ore spec ts during months. Novemoei ami December-3 time when the Confer- eice Board's tonsuiriBr confidence index plunged by Inthislattar regard, it is interesting to note thai of the I -" ", -causr-d a dramatic surge in precautionary Bal- $44.7 billion increase in other clieckables from De- ance preferences. This cautious mood, in turn, seems cember, 1980 to October, 198), Ihe Fed assumed 10 have led to the diversion ol nontransactional (includ- that S33.8 billion came from demand deposits. Not ing certain lime deposits and holdings of credit market coincidentally. over the same pefiod, actual demand instruments) funds into M-1 type deposits. Such a deposits posted a S32.7 billion decline - almost an diversion of fiwids could have been further bolstered in equal offset. Vet, the $1 t.B billion inoease in other January as individuals may have temporarily parked checkables since October tame al ilie same time that funds in readily accessible deposits until they have had demand deposits lose by SS.3 billion. Even more note- time to bettef choose among 'he myriad of Individual worthy is the fact that S 7.5 billion of ihedher checka- Retirement Account programs being advertised in the ble deposit increase came over the first three weeks in media. January — a time when one could reasonably assume sauings-ty&e money was temporarily being parked Perhaps prodding an important clue to the desire to prJoi to making an IRA account decision. Under the build up precautionary balances- even at the expense Pect's new M-1 definition, though, these would be of some interest income — mas the shift in The behavior classified as transactional balances-a rafner tjues- of time and savings ficoosiis since late October. Specif lirjnabla procedure ically, after increasing al an average monthly Dace of SB.4 billion from December, 1980 to October, 1981, Glvet Ihe preceding consideunions, therefore, i( is our time deposits Ohich carry competitive rales of inter view that some of the recent M-1 strength stems from est, but are not liquid! increased at a monthly rate of economic weakness—not stiength-and a tertipowy 54 2 billion over the November December period. Sav- parking of savings-type funds in NOW accounts As ings deocisi's. on thp r.ir.er hind, Iia<i been declining at such, it is likely lhat the Fed's response to the mone- an average monthly clip of SB.3 billion over thy tary surge will be a steal deal more restrained than December-October period However, over the would have beer) ihecase in other periods of encessrve November-December period, these mere liquiO de- M-1 growth. posits actually lose by 54 1 tjiNfofi. While renewed caution resulted in some shifting DONALD E. MAUDE Brnong M 2 Components, it gfso probably ted 10 some Chief Financial fconomis i shifting from M-2 type accounts into M-1. In effect, Chairman Interest felt foln y Cuniniiltee Ihe dramatic slowdown in lime cferjosi! growth proba- bly stemmed from the desire to allow some six-momti ROBERT A. SCHWABTZ money market CD's to mature and ro place tne pro- Senior Financial fcoimmist ceeds in a more liquid savings. NOW or demand sc- Vice Chairman interest Rale Policy Committee 'f lesea/eriS taff MARIA F RAMIREZ. Manke' £conrjn Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 156 Weekly Credit Market Merrill Lynch Pierce Bulletin FennerS Smith Inc. Financial Economics Hesearch May 21.198? Market Ovetview & preview The fixed-income market en)oyed a major rally during the past week, particulaily the Treasury bill sector, iri response to steoped-up purchases by investors seek- ing quality instruments, a larger- than-expected infu- Viewing the matter i.-> greater detail, li is no secret thai sion of raseryes into the banking systein on (tie r-art ot The Fe't's attempt !o hit M-1 racers since the mid- the Fed, a considerably reduced dealer inventory posi- 19?D's ftfts been mat wir/> Is-ss than resounding suc- tion resulting from the Fed's activity and additional cess. In this regard, it would seem reasonable to data depicting a weak housing market, sluggish in- assume that trie most appropriate measure of the f eQ's come giowih and a subdued inflation rate. Of the targeting success or lack thereof would be its history oi aforementioned factors, the key ingredient sparking coming close to the midpoint of specified annual the market's strength was the Fea's more aggressive ranges estaUtishud for the fourth quarter ol each year. easing postuiE which may lend credence to ihe view — tr> addition, in those years in which actual growth rates discussed in The Special Analysis betovv— that the Cen- did deviate from target midpoints, a successful ap- tral Bank has been overly restrictive in its pursuit of proach to targeting would mandate that [he miss be unrealistic monetary targets. To be sure, there is some consistent with the underlying economic and inflation question as to what extern the Fed's activity was environment. For example, in years of expanding eco related to the unsettled conditions stemming from Ihe norriK activity and accelerating inflationaty pressures. difficulties experienced byg securities firmasocnoserl one would assume that the miss should be biased to rnoie lonOamental considerations. In ail likelihood. below the midpoint as the Fed seeks to "lean against the former has played a role which suggests that the the wind." In periods, of declining economic activity fed may pull back somewhat once the market's fears and decelerating inflationary pressures, the Fed would are allayed. Such a pullback, however, should still leave seem [iistified to aim lor .1 growth rate above thy laiget policy in a mote accommodative mode than was in midpoint. effect several weeks ago. Accordingly, most if not all of the inteiest rate declines recorded over the past week should remain intact over the next month or so. There- As the lollo Lvuig fable ctejrty shows, ho wever. trie only aitei, however, the economic and monetary environ- year in which !ne Pea came clust? to the midpoint o/rts ment is eipectefl to tuin decidedly less positive toi the targeted tangs was in !976 when the fouith ttuartef fixed-nicome market. 1375 to fourth-Quarter 1976 yrowtft came in just 0 2% above the target mirtooait. In each olthe follow- Special Analysis ing tour years when the economy mas expanding and inflation accelerating, actual growth exceeded the mid- point <if target ranges by anywhere from 1.3% in The Oihei Side si the M-1 Base Drift Coin is cvming 1978 10 2.4% in 1 377. Whai is more, in three of those home 10 hsvnl rhe Fell thai finds itself hopelessly four yeais the actual growth of M-1 surpassed the fioserf iriro a corner in which it feels compelled So upper and of Ihe fed's targeted range. Ironically, the rigorously pursue monetaiy targets in order to maintain Only year in which M-1 gro wth fell short of the targeted rts bald earned and ectinfjrtHcatly costly trttt-inflation midpornl was in 1981 -a yea( of recession and a credibility. Unfortunately, (he Fed's attempt to hrt mov- dramatic deceleration in inflation ing targets lor aggregates that continue to u.idetgo change as each day passes has tended to peipewale Such a performance is mo$t disconcerting rfi antl of" the we(y excesses rn both directions that the pursuit ol itself Even nxtre ilisiufbintj. however. Jias been lite nianeiansm was intended to eliminate And, unless a impact ol "base tint!" on iheperpetuation of excesses di as (ic iedressirtg of the entire taigeiing procedure arid doting periods ot over accommodation and stringency aggregate definitions is fonheoming soon, continued during periods of under acccmmoriat'nn. Such a php- (ContinuedorrPageil Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 157 nomenon can be seen from columns 3 and 4 in the Along these lines, it should be liept in mind that the Fed table. In column 3, tar example, is shown what the set the 1982 targets in July of last year—supposedly actual fourth-quartai average M-1 level -would have on the Bssurrtpiion that the midpoint of 1 981 targets bean each year had the Fed achieved target midpoint would have been achieved. growth over the actual level that prevailed during tfie fouuli quarter of the previous year. In column 4 is Given the overly accommodative pasture aided and shown the actual M-1 fev6(s thai «nsusO Item the abetted by positive base drifi over ifie 1976-80 pe- year's growth ana that were utilized by the Fed as a tlod. the Fed was able to sustain negative (inflation- base of calculation lot the subsequent year's targets. adjustedl shori-ierm rales of anywhere from 1.0% in In 1977, for example, M-1 would have averaged T98O to 3.3% in 1979. Certainly, Ihese rates of 5325.0 billion in the fourth guartei had the Fed inlflrest told the true tale of the Fed's posture. Given achieved the 5.5% target midpoint growth. However, the overly restrictive posture in T381 and thus !ar this since M-l grew at an annual rale of 7.9% in 1977, the year, on the other hand, teal short- term fates were a actual level stood at $333.3 billion — some SB.3 billion positive 5.2% last year am/stsrKt close to the double- higher than the midpoint of large J. digit area at present—aider! and abetted by negative basesirifs. Cerfamfy, this combined with key sectors of By setting its 1 978 target growth rale of M-1 off of the the fcofomy close to depression levels, a sA»arp decet- actual prevailing base of $333.3 billion —and not off of Gf9tJQniFi inflation and minimal reserve growth over trie what would have been the on-iarget level—the Fad in past year or so would appear to tell the true tale of the essence built in and validated the S8.3 billion 1977 fed's posture at present. In light of past and recent excess through the process o( base dull. Most discon- developments, it is our view that the fed should elimi- certing was the Performance in 1 979 —a time of rap- nate the practice of base drift and target each year's idly accelerating inflation. Alter already incorporating money Supply growi'i using the target midpoint level in the I 977 and 1 978 target overshoots of $8.3 billion the fourth i/uarlei of each year as the basis of the and $9.8 billion respectively into the new base level for subsequent year's growth. In this way, the Fed would 1979 growth calculation of 5360.8 billion, the M-1 find that M-1 growth in early May has bean running at increase was soma 515.9 billion in excess of the target an annual rate of 1.8% —below, not above, targets. In midpoint. This base excess or drift was also validated future years, such an approach would preclude the in the setting of !98O targets off of a S3S7.5 billion Fed's abilitv of validating and perpetuating either ex- fourth-quarier 1 979 base level. cesses or deficiencies. In effect, if excess growth were to develop one year, it would have to be squeezed o Jt In nf/ec:, had the actual growth rates over this period the next and vice versa. Such an approach would buy been calculated off (tf the midpoint of ffie previous tha Fee breathing room this year while, at the same year's target —ana no! the acrua/ higher level—M-1 time, serve as a discipline on the Fed jn subsequent gtawth would have been !'.O%in 1378, 10.4% in years-thus sustaining monetary eiedibility. Certainly, 1973 and 11 3%,,, ;9SD. As a result, the actual M-1 this approach would be preferable to a raising of the level Ity The fourth qusrl&r of 1980 stood $42.3 billion 1982 target ranges. fiigher Iliac the level that would have existed had the fsa hit the midpoint of its targets over the 1976-' 960 period. The difference in effect represents accumula- ted base drift for the period. Given this consideisliori. (ftere'ore, there is Hale wonder thai inflationary ex- ressesbuitt up dramatically and the recession that was anticipate!/as early as 1978 was forestalled for two years. The other side of the base drift coin, however, ts now corning home lo roost and is serving to *)(a£erbale the strains in the financial system and recessionary ten- dencies In 1981, for example, M-l growth was 2.3% below the midpoint of ihs Fed's targets. As a result, the M-1 base level off of which targeted 1982 giowth DONALD E. MAUDE is being calculated is $436 7 billion- $9.5 billion be- Chiei Financial Economist luw th" base that would have been produced wiih Chairman Interest flare Policy Corrtmrtree target mirfpnint growth. In essence, not only :s the M-1 target for 1982 3.5% lower than thai in !981, bull! is being cutciifared off of a base $3.5 billion tower than it won/if have been hart fie red hit its 198 I targets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 158 Merrill kynch A bimonthly supplement to the Weekly Credit Market Bulletin and Daily Credit Market Comment PERSPECTIVE & PROSPECTIVE MONITOR Special Analysis • The M-2 Targeting Dilemma: Has The Fed Be«n Chasing Its Own Tail? Page 8 Donald E. Maude Cniet Financial Economisl Cliairman Interest Rate Policy Committee Robert A. Schwartz Senior Financial Economist Vice Chairman 'merest Rale Policy Committee Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 159 Special Analysis terns and exc«edmgly high inierest rates have had on The M-2 Targeting Dilemma: Has The Fed nontransactionat balances as wall. Been Chasing Its Own Tail? ll is oui view that failure of the Fed to do so over the Since January of this year the pace of economic activity y in e t a e r r e a s h t e r a a d te w fr o o u n l t d o p n r e a c l s u u d s e ta a in n a y b l c e n e b a a i s i i i s n , g l i u h j p i r B p W by f o se n r v ti i n iv ; j has stagnated, the i-ilc oi inflation has receded dramati- to ihwait the Administration's economic recovery pro- cally from the double-digit 10 the single-digit territory, gram before it has a chance to materialize nntl fjuar<ii)tiv- bank credit growth has moved comfortably within the ing that Federal budgetary deficits will mount sdl) furihcr. Fed's 6%-9% target for (he year and shift-adjusted MI-B This would bt' !he case since, according to our rnlculd- through July had grown at a rate well Wow the lower tions (to be elaborated upon later in the Analysis) an 8% end of Ihe Fed's 3-1/2% io 6% bug-term large! Still, plus M-2 growth over the next year would appear ex- with all of this, until just recently the Fed has kept a tight tremely likely even with zero growth in its components - lid on reserve growth and the Fed funds rale was allowed Ml-B, time and savings deposits, money market funds, to continue trading in the 18% 20% range during the overnight RP's and Eurodollar deposils. With these other May-July period — well above the 15% average of Febru- components growing over the year ahead, ol course, ex- ary and March. cessive M-2 growth would appear all bul assurer! In such A major reason for ihe Fed's posture during the spring a likely event the question then becomes, ctin aftri ihcAiU and early summer monihs lies with the tact that M'2 had a more reslrjciive monetary policy be successfully cm- been growing above, the upper limit of its 6-l/2%-9% pfoyed to reduce the M-2 rate of growth? To gam stinw target range. In Ihe past, with (he Fed giving equal insight Into the ansiveis Io these questions, oiie must first weight to both Ml-B and M-2 in (he formulation ol pol- recognize what impart Institutional changes, alls-red in- icy, a similar confluence of events would haue brought vestment preferences of consumers and practices of fi forth n respectable easing in policy and in (he Fed funds nancial institutions, munetacy agyreyale tl,'limiii)iiLil rate. Over the past several months, however, such has considerations and a high interest rale environment have not been the case. The Fed's departure from past prac- had on M-2 —as contrasted ro actual Fedtral Receive tices stems from a decision reached at the March FOMC policy actions meeting, when Ihe Committee decided lhat -"greater weight than before be tjtuen Io the behavior of M 2" in The Changing Nature of M-2 formulating monetary policy Since the Mid-1970's... At that lime, ii was iiurei'd thai a change in emphasis wasappropiiate in tight of (he f.id lhat Ihe nationwide in- Sei^era) dramatic and critical institutional deuelupments troduction of NOW ocenunls, uncc th« beginning ol the in the financial system and nuiltyts have emi.-ry.jt.! >»ici' year had caused a massive shifting of deposits that was the mid-1970s. These developments, in turn, have had expected to continue distorting measured Ml-B growth a profound impact on M-2 growth over the past sei/erdl to what the Committee considered an "unpredictable ex- years. In the past, it should be kept in mind. M-2 merely tent." In eliect, Ihe Fed was giving recognition to the im- consisted oi currency, demand deposits and time anci pact that instiluticuial changes and exceedingly high savings accounts of commercial banks Tile yield on the interest rales wern hawing on transactional balances and latter accounts was governed by Regulation Q During decided to focus more on M 2, which measures bath past periods, the monetary mechanism Worked quite transaction at and nontransactional (sav ing- type 1 bal- well, though it was not without its temporary painlul el- ances. feds on tile banking system and the housing market and As a resuli of this decision based Upon the staffs anal- inequities to small savers who were generally precluded ysis, the Fed chose to ignore the fact that real GNP de- from the opportunity of earning compeiiiive market rsi^s clined by 1.9% and the price deflator receded Io an of interest on money market instruments—whose de- annual rale of 6% during the second quarter and lhat by nominations were loo iarge for all but the most wealthy June Ihe role oi growth of =hift-adjusted Ml-B stood 1- individuals and large institutional investors During pe- 1/2% below the lowt'r end of its long-term (fourth-quar- riods of monetary tiqhlness. yields on credit nirttfti'l in ter J'JSl over fourth-quarter 198O) target. Instead, it slrumenfs (Treasury bills, federal Ayeticy sedulities, etc } mjifitainifd a tight rein on n-serve growth in response to tended to rise above those du.iilahle on time aiiJ W'inys an 8.3% annual rate oi growth in M-2 which stood al Ihe accounts —causin a disinter medial ion fiom M-2 Kpe de- upper end ol its long-term target Still, while the Fed's ra- posits into the credit markets This changing iloiv of tionale for initially questioning the reliability of the Ml-B funds, ol course, resulted in a weakening in M-l and M- data is somewhat uiuler<;t>inf]<iblc. oni; has to question 2 growth and subsequently led the ivay tar an ensimj in the inconsistencies between weak economic activity, de- monetary policy and interest rates. celerating inflation, weal* bank credit and below target In the 1970's, however, the financial system began Ml-R gtowtli on Ilie om' h.i»rl -uid excessive M 2 (.trowlh 'lirvL'k'pinij ways to .iddjit to the rnonL'r.iry yniji.nl on on the oihei Wliaf is s0 dticonterung about tlie Fed's flows. The firs! response in the early 1970s was '.'te tiea- shift m emphasis to M-2 is that il has been done and lar- tion of the money market mutual fund as a vf hide by geis have heen OTtahlislied accortlirigly apparently with- which small saveis tauld take advantage of competirii'f out the Fed taking rogmzante of the dramatic impact thai money mjrlit't yields. It was not until the Sale 1970'* ush- institutinnal ch-inaes shifting household iriueslment pat ered in sustained historitdlly high interest rates, however. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 160 thai ihey began to giow rapidly. The second response dein^ilb tose lo about 73% furlh*i increasing the pro- came irom financial institutions during the summer o! portion of M 2 earning intevc-ii However, only 2% o( 1978. iwhen Li was felt that 7%-S% money maikdi rates the lotal actually earned a higher nidrket rate of interest u/ould lead in massive ttis intermedia lion and a collapse and tlial jjas only slightly more than 5%. Since mid- in the housing market. Al that lime, (he Federal Reserve 1978, however, money maikel rales have risen lo levels and the Federal Home Loan Board decided to allow almost three limes higher than rates than can be cunied commercial banks and npnbank thrifts to issue special 6- on savings and short maturity time deposits and the month money fnarkel re: filicates and 30-month savings yrcnvlh u( spetial money market tcrudcates and money C(.'itilk.lies at market rale* o/ interest (lied Jo the compii m.irkt-l funds have literally e\|il<n!(=(l. As a result, during i.iWe maturity Treasury yield) and in denominations the second quarter of thii yeai, Ml A represented only small enough Id iilwacl funds from sni.ilter savers and in- 21 TP of the total, liontndrliH interest e.irriiiig rfaposils vestors. The mosl recent response by institulions who are 39% and higher yielding m.irket rates of inleveit compo- pieduded from liquidating sixuruics bcriiuse of Ihe sub- nents a lull 40% of the total. Tlw.s«? higher yielding com siantial realized losses that would be incurred has been ponerits are up sharply front 19% in 1979 and 32% ill the increased uiili;ation of such portfolios lo gain funds 1%0 The rapidly rising proportion of M-2 stains mfli- through RP's kct raieio! inlciest since 1977 has aHJin™i.illy htscn aurj- In recognition of the fact that a glowing proportion of mented by an .icru.il doubling 111 \Sit- level of money what Tht- Fed considered alternatives to traditional sav- alas inys account type vehicles that ivery not being captured The ciJnihlnalK o( thes (actors is reflected in "la by ihf uld defmiuom of M-2. this a<jc;te(!ate was roiie- tile I. which shuvvs a bredlidi-i i of the components ol fined m !f!7^ lo include deposits of nonhank thrills, nortltafisniiK'nai M-2 (M-2 i , MM!) in the upper nioni'y market funds, RP's and tufOrioltar deposits Ap part ul Ihe table is the actual n raije duilar level (or each 7'irirenily not rfctigiitzi'd Uy ihf f't'il at the lime would he i.ornpoii.>nt since 107 !> nnd ti slinurwl intcti'it 1.110 i>( the rijle played by th? shirtiny comprisilion of sailings, and return p^id The bottom of r table slinws ihe aity.il investiiwriis and interest rates themselves in M-2 growth dolldi amount o! mrereit Ih.ii acc d lo ttdd; compo- Looking at this mailer m more specific terms, the rap- nent during the same p^nod !-(w accounts for idly yrowing role mat ioteiest rales themselves hiiue e>iampl«, we have, assumed an iinnllfrest rate of 5.2% pS! played in M-2 ijtowlti is illustrated [n Ihe following bar year Print to 1179, romnicrrjal l hh.'ink^ were allowed to chart. As it shows, the noninteresl hearmij component of pay 5% and nonbanli thrift l/4% an such deposits M-2-which i* the same as Ml-A-m 1974, the year of Alter 1979, however, (ht L j was r.iiwd to 5-1/4% 'he previous cyclical p?ak in interest rates and monetary ant) 5-1/2% r.'spectiwiy G rnllv. llleii' deposit1: haue reli,iinl. represented 30% of the total. Biisically alUif ihe been dbout e.qu,illy fii--iribii]i'(.l !>.><wc-i'ji thu reniainde.i of M-2 was represented by time and sai'iny* the thrifts For nine deposits, thf cattjl.wov,s were sonie- ^(counls ihat earned a low uonmarket rale of teturn oi wh.it more complex sintf (ticij intlofli' rc<jul.ir nJliir vi.-ly about 3% By 1977, iU> noninterest bearing component low yieldmij liuii.' account-- atni hujhci y)B'ldiii;j. special 6- had declined to 25% yf the lolal and time and savings monlh money mnikel ('l)\ and 30 nionlii saunvjt r«rtjfi Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 161 NoBtraaoctioinl M-2 Ca»pn«i«t« Aad latent*! Puld HofltnM. M~l «••• Fwd aia... flHi-t«l'*c r fin^M r I t M ii m* TIM EH*- *L*wt. H&A. I*W l«W Jbft. L*Ml *«£" (Ml Js£ 1. A'lmn LM|* & Fm>UUl|UM^UMin L—1 1975 I 735 4 5.8% »83.9 5.2% 13404 6.6% 1 36 55% 1 T.5 5.3« 1976 861. J 58 447.7 5.2 3%6 6.6 3.4 5.8 13.6 51 1977 963 a S.fi 486.5 5.2 4S49 6.6 3.8 5.3 18.6 43 1978 ]<H4.1 61 476.1 5.2 533S 6.? 10.3 7.8 23.9 80 1979 1J42.1 7.0 416.7 5.2 656. 5 7.6 43.6 11.0 253 11. 1 1 980 12SS 6 79 396.S 5.2 7099 9.1 698 126 26 1 134 W8I 1Q t^WJ J 99 3720 5.2 782 B 11 1 929 15.5 326 n.2 «Q 1316.0 104 360.7 52 7989 11.5 119.3 16.2 37.1 18.3 il. AdUfl LqtrrtAt P>1d l'J7D * 428 t!97 was 102 KJ4 97 ft 500 229 262 02 07 977 559 24 9 300 0.2 OH y?H 632 24.4 36.1 08 I 9 97'J Tib 21 9 50.0 48 ^ 8 ')SO 980 208 646 S3 38 [(/• no - 1 13 2 7 6 6 3 l If 'J if 6 i 8 9 6 2 8 7 1 1 1 9 2 4 56 cales — itie composition of which has undergone major Fed funds rale and (he olher chetkables in Ml-B were shifts tlitciugh the years. not imputed with any inferest return —when in (act they By way of example, up uniil mid-1978, all time de- do earn aver 5% irt genera). Oti the olhet hand, we do posits were of (he lo«/e; yielding nature. The allowable acknowledge the possibility thai actual interest income yield schedule on such deposits varied from 5% lo 7-3/4% estimated on 6-rnonth money market CD's and 30- up until the lale-19?0's and from 5-1/4% to 7-3/4% month cerliricates may be overstated somewhat for a thereafter, depending upon maturity and the depositoty given period when rates were higher than the ptecedrrtg institution For simplicity, we have conservatively esti- period since some ol these instruments are those thai mated art uileiesl rats o! 6 6% on these accounts. By the wete issued during the prior period at the (hen existing second Quatlet o! this year, however, the composition of yields. The combination of these considerations, how- lime deposits was dr.imotically different The lower yield- ever, would suggest that the overall returns iiid'Caled are ing jugular time accounts had declined to 32% ol the to- sufficiently representative. tal, 30-month certiiicates moved to 10% and special Asthe table shows, the interest rate faclor In M-2 sifjce money market CDs soared to 58% of the fofa! To take ]977 ha5 increased dramatically. In 1977, interesi paid 1'nebe shifts into account, we calculated ihe relum on amounted to $55.9 billion-or $4.7 brHrori per month. nvjney maiket C.fH by usintj the average 6-month Trea. During the second quartur of Ids year. tiKercii (wid i,m :,ury bill rale lor the p.-nods ami on 30 month certificates ai an arirulai rate of $137 6 bifiion-or $11 ,S Ulion per by uyna Ihe Iw'i year avc-faye yield on comparable ma- month. Table II provides still another way of looking at lurity Treasury notes- off ai which their returns are the matter by showing the aciual dollar changes in M-2 peqijcd Wi'ujhdna rh<- toMl tune deposit component ac- and interest paid and (he percemasje ol the total change cording^, we fmd that the rate of return rose from 6 7% represented by interest alone. Back in 1975. for exam- in 1*17? IG 11 5% during the second quarter of this year. p|B| 36 8% of the increase in M-2 was accounted for by For the yield on money market funds, we haue used the interest. In 1980, interest paid represented %.9% of the 90 rlay commei-eiaJ paper rate as a proxy and for over- increase in M-2. These statistics point to the dilemma night HP's and Eurodollar deposits we useil the average now faced by the Fed. Given annualized interest pay- Fed funds rate. rvienis on M-2 components in Jime running at an annual These inierebt earning:, estimates, we would poin! rae ol $138.6 billion and should no auslamed decline in out, are on the conservative side since money market interest rates occur Over the ne«t year, the inteifist com- tund yields have at limes exceeded (hose on commercial ponent alone will provide an 8% rate ol growth in M-2 paper, Eurodollar dopdiir^ generally yieW more than Ihe ouei the period Yef, if the Fed dogmatically pursues an Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 162 M-Z growth target of 6-1/2%-9-t and other compo- Again, the problem of using M-2 as a proxy rests with nents groui as well (even if Ml-B growth remains at the the fact that it measures changes in "gross" deposits not lower end ol the. Fed's 1982 targets} M-2 growth on bal- net new deposits after required interest payments ate de- ance will be al the upper end or aboue its target, ii this ducted. This is quite ironic when one considers the fact turns out to be the case, however. there would be little that the outflow of funds from the savings and loan asso- reason to expect any easing in policy or decline in inter- ciations has been a highly publicized phenomenon- For est rales. What's even more disconcerting is the fact that example, many in the iinancial community are aware the trend giovoth of market related components of M-2 that the S&L withdrawals exceeded new deposits by has accelerated recently. This would imply even higher $4.6 billion in April, a minor bit m May and a whopping interest rale component giowlh as each month goes on. $5 & billion in June. Yet, they are not aware tha_t aftei In effect, the Fed will find ilself likened to the dog ihat taking into account interest credited to accounts, ihe out- continues to chase its own tail. The faster it chase?, the flow in April was only $2.9 billion and gross deposits and faster the elusive tail mowes. The same could be the case interest actually increased by $1.7 billion in May and uiith M-2 targeting without taking info account the inter- close to $500 million in June. The reason increases in est rate factor. deposit levels due to interest crediting is not deemed im- Despite Ihe dramatic bloating effect interest has re- portant in the thrift industry is du« to the fact that it does cently had on M-2 growth, one might make the case that nol represent nel new external sources of deposits with the source of M-2 growth is really a moot point. The im- which mortgage lending can he expanded. In effect, in- portant consideration is deposits have in fact grown at an creases in deposit levels clue to interest crediting merely overly rapid rate. However, in this tegaid, one must de- represent a shifting of funds from one area of the institu- fine the relevance of M-2 and determine if the current ag- tion io the other—usually from operating revenues or gregate does in (act measure what ii is supposed to capital. If a net deposii outflow is just rnalchecl by interest gauge. Along these lines, it has been pointed out in Fed- credited, the institution has not gained any net new ex- eral Reserve literature that the purpose ol the M-2 mea- ternal funds. sure is twofold: first, to measure the availability o( new The same case applies to the commercial banking sys- lendable funds in financial institutions and. second, to tem components of M-2. Net new lendable funds that measure overall liquidity—or spending potential—in Ihe banks previously did not have only materialize when the economy. gioss deposit increase exceeds the amount of interest that has to be transferred from one area of the bank to Gross M-2 As A Proxy Of The Availability the actual accounts. Table 111, which shows the iinancial Of New Lend able Funds institution M-2 sources of funds—M-2 less money market One of the majot concerns on the part of the monetary fund shares—indicates that throughout the last half o( the authorities u/rth rapid M-2 growth over the second half of 1970's gross deposit increases did exceed interest paid-, last year and thus far this year is that it suggests that Ihe resulting in nel deposit gains. However, two key devel- banking system—both commercial banks and nonbank opments have tended to mute such gains and to lead to thrifts—are flush with newly created funds that can be actual net losses in 1980 and the first half of 1981 First, unleashed al any moment to fuel an inflationary pace of gross annual gains in time and savings deposits declined economic activity. Yet. this perception about all financiai- from a high of $120 billion in 1976 to $33.5 billion in type institutions just does not mesh with Ihe well-known 1980 and $19.2 billion during the second quartet of this plight of nonbank ihiiflE and the relatively modest in- year. At the same time, intetesi paid on such accounts crease in total commercial bank credii since the begin- moved from $49.1 billion in 1976 to 185 4 billion in ning of ihe year. 1980 and $1(1.6 billion during the second quanei of 1981. As a result, what were net gains of $70.9 billion in lime and savings deposits in 1976 became net outflows Tible 11 of $51.9 billion in 1980 and a S92.1 billion annual rate RelaUoitihlp Between M-2 Cbtagvf during the second quarter of this year As the table And The IMcnM B»rt CompiNMrt shows, these outflows ivere further augmented by net (iflBbwu Al Annual Rtfet) outflows faun overnight RPs and Eurodollar deposits in S980 anc3 the first quarter of Ihis year and were stemmed XdK-1 somewhat by an increase during the second quarter. In 1980, these outflows were negated to a certain exienl by P*itod Lnwl iBCtrtV PiU faliraal an increase in demand deposits and currency and other 1975 $1022.4 1116.2 I 42.8 3t.8% checkable deposits. However, on a net after interest 1976 11*€.7 144.3 50.0 34.7 basis, at depository institutions. M-2 declined by $40.5 1 19 9 7 7 S 7 1 14 2 0 9 1 4 . 1 5 1 1 2 D 7 7 . 4 4 5 63 5 . . 2 9 4 s 3 e . e 9 b th il i li s o y n e a i i n a [ n 9 d 8 a 0 l , an $2 a 2 n .1 n u b al i l r li a o t n e o d f u $ ri 4 n 4 g .0 th b e i l t li o o s n t d q u u r a i r n t g e r t h o e f 1 19 9 8 7 0 9 1 16 5 0 2 3 5 . 5 9 1 10 2 5 4 . 0 4 7 98 9 . . 0 5 6 93 4 . 1 0 second quarter. 1981 This net oAitflow of deposits, of course, forced the fi- IQ 1&98.3 137.2 IZ6.3 92,1 nancial institutions to scramble lot funds from more KQ 17«.3 180.1 1376 76.4 broadly defined M-3 sources—such as large time de- posits, term RP's and Eurodollars and CD purchases by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 163 the proportion of these holdings moved back above 158 "h ol the total Since that time, however, the pattern has Table111 changed dramatically in 19HO, iore*amp)t, Jt-spite lofty Net Changes InBank Related interest rates throughout ihe major part of the year, the M-2 and M-3 proportion of liquid financial asset acquisitions repre- IS Billions At A nnud Rs'3 sented by credit market instruments deilintii Jo 15.5% M-Z During (he first quarter of this year, the household sector NunMHF actually liquidated credit market instruments at an annual M-» Nil N« Cbanflc rate of $23.5 billion. Ml-B N*t Chut> Tn This does no* imply lhat lha individual's interest in CH ( * V f e ig f > In C O *» th ji . ft C I. t S ia H t^ T B H In P R 1 H ,* . Non T -M oo M l F market-related high yielding investments has diminished, f**r*od fe MI -A Check. Dgft. Egm. M-2 however. Instead, with convenience that money market 1974 $11.2 $ 0.1 S- 2.3 _ S 9.0 funds afford and the fact thai iheir purchase does not en- 1975 12 6 0.7 59.3 -0.1 72.5 compass Ihe payment of a commission (or load), they 1976 17.1 16 70.9 5.4 95.0 have taken the place of former investments in credit mar- 1977 23 4 1 4 42.2 4.2 71.2 ket instruments. During (he first quarter oi this year, for 1 1 9 9 7 7 8 9 2 1 3 8 2 1 4 ii . 4 2 - 8 8 . . 0 6 - 3 1. 4 4 3 1 8 S . . 8 5 example, almost 75% of the increase in liquid financial 1980 10 1 6.4 -51.9 - 5.1 -*>.5 asset holdings were in the form of money market fund 1981 shares. Unlike credit market instruments, however, IQ -812 119. 2 -54.8 - 5.6 -22.4 money marvel funds represent part of M-2. Indeed, fully ffQ • 1'tf, 563 -92.4 11.2 -440 63Sb of the M-2 increase since last December has been accounted for by money market funds. To the extent thai money market fund share holdings represent an alterna- M-3 tive to other investments, however, one could seriously NCI Cb N .n « et Nfl question their inclusion in a monetary aggregate in- Quiw 1° <Jua*< Tcul tended to measure savings-type deposits that have the P 1 1 1 9 9 9 j 7 7 n 7 5 4 o 6 J T * n m E 0 - 7 i _ R i 9 r 1 M P' . i M H M ol _ d F i C n D g . 1 Tl -1 L 1- 7 9 « . . 8 1 * C - -1 1 M" 0 _ 8 a . - 7 3 . a 5 _ NM f M 8 o C _ 4 u j .3 D u f usc p a c o t h f o e t a a e c n n k y y t s i e a a a t l r i r e m o i f a e s . c b m t e u G i i a n n i l v g l i y m e n c d a o l r , t a n h w v i e t e n r i f s t o a e c n d d t i f t f t h i i h n c e a t u s o t l e t t t f r h t u a o e n n d s d n s a i u f c o f t m e i v o r e b e n r n e a t r t l i h a b o e t f a e c l t a o t i h n m u e c r e s m e s e s 1177 79 19.0 26.9 981 from other credit market instruments thai are not in 197H 11.4 57 335 50.6 894 eluded in M-2 I 1 9 9 6 7 0 9 6 b . 4 8 2 1 8 7 4 1 -15 0 . . 5 1 3 a 3. 4 9 -3 49 2 .4 .1 cre D di u l e m t a o r k s e u i c i h n s s t h r i u ft m in e g n i t n s v a e n s d t m a e lt n e t r n p a r t e i f v e e r s e n cl c a e s s s if b ie e d t w te e c e h n - 198 1 IQ •4.S Ufa 54.4 505 28.1 nically as deposits and the growth of the economy over IIQ -6.5 1 9 -22. 4 -22 1 -66.1 the years, a more accurate measure oi liquidity should take these developments, into consideration. In the fol- lowing table, for example, is shown the total of all de- money market funds, as. is indicated in Ihe lovuet hall of posits (which would include money market funds) and (he (ab!e. Still, even with these other sources, the institu- credit market instrument as a percent of bolh disposable tions experienced a net outflow of $32.1 billion in 1980, personal income and current dollar GNP As it shows, a net gam of $28 1 billion in the first quarter and an out- both measures of liquidity reached a high in the 1977-79 flow of 566 1 billion duiiny the second quartet. In effect, period and has since declined. Indeed, deposits and the bloating effect of the interest rate factor since 1979 credil market instruments as a percent ot GNP was lower has masked the fact that a respectable amount of aciual during the first quarter of this year than was (he case dur- disintermediation has been underway—and has dramati- ing the highly illiquid 1974 crunch period. The lack of an cally accelerated over the past several years. oi/erabundance of liquidity in the economy has been fur- ther mirrored in Ihe rate of growth of M-2 plus other liq- uid assets thus far this year. Specifically, afler growing at M-2 As A Proxy of Overall Liquidity an average annual rale of 10.5% during the 1977-79 pe- In The Economy riod, this measure of liquidity slowed to 9.1% in 1980 to Table IV shows shitting financial asset preferences of the an annual rale of 9.5% in the first quarter of this yeai household sector since the mid-1970's During the last and to less than 7% in April and May. This stands in period of cyclically high interest rates in 1973 and 1974, sharp contrast to the acceleration tn M-2 growth over the for example, over one-third of the acquisition of liquid fi- comparable periods. nancial assets were in lh« iorm of credit market instru- ments—primarily in U.S Government securities. As rates came down in 1976, on the other hand, funds Conclusion flowed back into the banking system and credit market A substantial portion of rapid M-2 growth throughout th* instrument holdings declined to about 15% of all such major portion of 1980 and thus far this year seems to be assets. In 1979, as rates once again began la rise sharply. more reflective of recent Institutional changes in the fl- 12 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 164 Tabk IV Breakdown Ot Liquid Financial Auct HottUmgm Of The HoutehoM Scctoi (1 Bllhons Al S <\ Atfrniri RaUs) r*w-i<.* CwtH MIct HoKvMkl. O<bnDtp«m Prrlod Cl»lHHl tltl aMmkat. C Ji n v d tr l o l A M M kt f . U <<M H ii o n f fc T m o i u i l _rn B Mcn F w w y i N d U * . F % i u r H fT l f i f A ta i t i D O w l r h vr e t f * ^» f « e l % .l i4 W7S IU6.3 S386 33 1!% 5 - 0% 977 810 1974 1M4 38 S 372 2,4 23 632 60.5 19?r> ll«y TO& ?r. 5 1 3 1.1 8SO 733 ]97<i 146 1 ZZ7 155 - 0 12*. 2 ,145 W 1-I7 ) S 1 lf 6 « H 4 .5 . W 16 . I <i 2 :w 1 7 M b n . 2 1* S7 n 1 12 3 . 1 'i S 4 7 (. M SS 2 I ').-'> £11 1 HI 5 JMe 3'L 4 16 3 •Jft 2 4r> I IIHTJ I')7Q JO 6 155 ?•);! 148 1372 i.'J6 IQ 199 ] 123 5) (1181 1484 745 74.2 :VJ3 nancia! system, shitting household investment prefer- gle measure of money supply —whether il tre MV-B or M- ences, definitional roni[derations with regard to the 2 —carries with it suhstantiai risks Tliese risks have not agijrt?g;ites nurf historically hkjh interest rate;. It has not Iven fully appreciated by those in the nionetaiisl tsrnp in our uit'u;. s^iveii as an accuiale or reliable proxy of the who heivi; claimed through Ihe years (tint the simple way availability of r.e* lendablc funds in the financial institu- to achieve sustained economic growth and reasonable tions or overall liquidity in iVie economy As such, contin- price stability is through the establishment of an approrm- ued emphasis on this aggregate as a determinant of ate steady path of 'money supply" growth. monetary poJiry ove* the quarters ahead would only in- As a result, there is no getting away from the fact that Sure its continued iap«i giowlh and lofty interest rale monetary policy is more an art than a science As such, levels <irnl a sustained pyvioci n( economic stagnation. any one monetary measure musl be complemented by Such a policy would seam to us to be ill-advised orher measures of money, reserves, the overall level of Initt't'il blind puisuit of such established Teirgeis lhal interest rales. Ihe slate o( ihi> economy and inflation and were *.(.•( tony before (he Fed had any inkling of recent inflationary expectations in the formulation of monetary ilevi'lopmoiils u-oiild jppcaf enWtly iiuitk-ss This Is the policy. It is upon all of [hew faUois —noi jusl a single cri- case since the most rapidly growing cotnponents of M-2 terion—lhat the success of lack thereof of the Fed's policy recently are those completely outside f>i the Fed's direct stance should be gauged. Using this broader criterion, control and their growth is being fostered — not cui- the Fed has been anything but expansionary since No- i.iilcit K' hi'ih inlercst r.ilei and .1 restTiclwp monelaru vember 1980 as has been siHjqestecl by vapid gross M-2 poky A].>iijj these lunjs. ii is ,i widely acwpwd iact ot liic- ijiuwllt A-, ,i re»ull, Prtt policy rws l»-cn wijnrficunlty in teritr.il banking circles lhat the hroadet lh? aggregate, more creiiihle than skeptics apparently jwiceive. lha less Jirccl control rwer il is capable ol Uiinij exeTled ll is Siccnuso of this that the Fed hili pursued a policy oi controlling reserves under ils operating procedures estab- lished iii October 1979. Measured in these terms, thy Fed ha«i been light since the end of last year indeed. Sinco that time, total reserves have grown at a meager Table V 1.1 '& annual rate and n on borrowed reserves haue actu- Relative Measures Of ally declined at an annual rste of 0.7% Liquid Financial Assets GiveTi this coiistdeialiOTi. one u/ou'd certainly ques- (1 BiU«ins Al S.A Annual Rales) t p io e n ri o t d h e < ii r e a l i p a r b o il x it y y o o f f th "a e r s o t w an " c M e - a 2 n d g r a o s w a t h g u o id v e e r t o t h th e e S c a o m n e Period Ll A g. . F •» >n i . j A l D u P d I i L A lq. . F ^ D U . I A G « N < f U d sl u u c g t g o is f h m M on l- e B ta r g y r o p w o t li h c y o v T e h i e s th e e m ( e its a t s u f r ie es li c o o i m 1 b 9 in 8 e 1 d w se it e h m 1 1 ^ 9 7 7 3 4 H 66 5% 8 7 8 J more consistent with the recent iweakoess in interesl-rale u75 81 7 '! adjuM.'d — not gross-M-2 gfowlh. Perhaps the Fed 1976 104 fib shouU ink*- Ihfse two measures into acicounl m tslablish 1977 128 Hji ing targets arid gauging the impact of its policies. This 1 1 9 4 7 7 9 8 1 1 2 2 . 9 9 H H 7 7 Woulti riirtnte a lou/er interest-adjusted a.tid a highfr 1^80 IO.M 7 ft gloss M 2 large! ranije ihii! is currently being puisued 1981 Whan all is said and done, therefore, the conduct ot IQ 103 7U monewjy policy on the basis of Ihe performance o! a sin- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 165 Mr. MAUDE. I need not elaborate here on the dismal economic performance that has transpired since 1979. A lot of those were al- luded to this morning in terms of the state of illiquidity—and I am departing from the text—in terms of the state of illiquidity in the corporate sector, the fact that fully 85 percent of all S. & L.'s now who open their doors are losing money each day because of the negati/e spread of IVb percent. The farm sector—we all know how serious the situation is there. We know that we've been in a reces- sion, or practically in a recession, for almost 3 years, which is un- precedented in post-war history. Production is lower now than it was 3 years ago. The gross national product, even with the increase that we got for the second quarter, which is illusory, I would sug- gest—we are looking at an economy which is really, really in dire straits. If you look at the corporate sector, the balance sheets are more liquid than they have been since the Depression. We already know that bankruptcies are at depression levels. SERIOUS CONTRADICTIONS With the confluence of these situations and the fact that infla- tionary psychology has been snapped hi the bud, at least temporar- ily, in the commodities markets, in terms of labor negotiations—it seems to me, as recently as last year, that there were some very serious contradictions going on. This became even more clear to me during the first half of the year. We're looking at a situation where we were in the eighth postwar recession. We're looking at a situation where inflation had been decelerating very dramatically. We're looking at a situation where we were getting depression levels in housing and autos and all this illiquidity, and yet, all along, for the first 5 months of the year, we had all these situations at the very time that the Fed was having to maintain a restrictive policy because the stated rate of growth of Mi and the stated rate of growth of M was running 2 above targets. Something had to be inconsistent there. You don't have money supply in terms of what it's supposed to measure and what it has measured in the past, going above targets during a period when you've got these economic events going on. And it led me to do a little bit of work. In terms of Mi, for example, and there's a lot of importance on Mi and M—I heard it mentioned more here today than I have a a lot of other hearings, but it's important in terms of the rational ex- pectations in the credit markets. When the Fed sets a target for an aggregate and it fails to hit that target, it does risk the chance of losing its credibility. I was very disturbed to a certain degree to hear Chairman Volcker indicate that he was willing to tolerate Mi growth above target. I am agreed that they have to be accommodative. But I think that there are technical things that Chairman Volcker can do and the Fed staff can do to take away that risk of credibility loss and still allow them to be more accommodative. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 166 My studies in Mi, for example, have shown that MI has really, if you make the proper adjustments and you try to measure transac- tion balances, which is what Mi historically has measured, if you make the appropriate adjustments out of the stated Mi, you prob- ably will have found out that all through the first half of the year, Mi has been growing at the lower end of its targets. Now I make that conclusion on the basis of two criteria. You know last year, the Fed, because of the nationwide introduction of NOW accounts, the Fed initially allowed for an adjustment to Mi by shift adjusting that proportion of NOW accounts or other check- able deposits that they presumed through survey came from sav- ings accounts, in order to net out savings money from Mi. They did that all last year. During the spring and the summer, this big surge in the demand for people to shift money into NOW accounts started to wane. Other checkable deposits started increas- ing by a modest amount every month during the summer. So at the end of the year, the Fed assumed that that had tran- spired and they went into an Mi definition without distinguishing any more how much of that M, was coming from other checkable deposits. I don't know why they did that, because starting in October, there was a renewed surge in other checkable deposits. I've got a table indicating that in my statement. And what you'll find out is that if you take the MI increase from October, which is when we had the major acceleration, you'll find out that 86 percent of that increase was in the form of other checkable deposits, or what Chairman Volcker refers to as NOW accounts. Now in my mind, given the fact that the economy had hit the low point or actually, was declining rapidly, consumer confidence underwent a sharp contraction in November and December. In my mind, a lot of this buildup in Mi was due to the fact that people were scared. They were not letting their money roll over in 6- month money market CD's. I can assure you—I have done the work on it—the data flows in terms of what happened to savings deposits and money market CD's shows that there was a major move out of anything with a fixed rate obligation or a fixed maturity obligation because people were getting scared. So I think a lot of the Mi buildup in November and December, and I think it can be justified on a careful analysis of reserve and savings and demand deposit flows, and I think that that has done this internally. They couldn't make the proper adjustment and I guarantee you, Mi was not growing above targets, Mi that we used to know as a transaction balance measure. I am kind of perplexed that the Fed has not deemed it worthy to go back to making these appropriate adjustments and announcing it to the market. So I think that that makes a lot more sense than merely indicating that we're willing to let money grow above tar- gets. Explain why you are, come out with adjusted numbers that the markets can look at. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 167 M GROWING ABOVE TARGETS 2 The other anomaly that I found out, especially during the spring of last year, as we were starting to slip into the recession, was that the Fed was adhering to a very tight policy during the spring and summer of last year. M, was growing way below targets. Why were they adhering to a policy? Because M was growing way above tar- 2 gpCfL"QS. That led me to look at something else which I found very per- plexing. If you take into account the fact that we've had major in- stitutional changes over the second half of the 1970's and the fact that back in 1974, 1 percent of M was earning a market-related 2 rate of interest. As of last year, 47 percent of M was earning inter- 2 est. Now this interest being credited to the accounts and being rolled over is not net new money being created by the monetary policy; it's merely money being shifted from a bank's capital or a bank's profits into an account. I think the perfect example there is if you look at the S. & L. flows—the savings and loans. Interest being credited there is being taken now directly from capital. That's why you're seeing capital erode every month that the numbers come out and it's going to consumers. But that doesn't mean that this is net new money being created by the Fed. But it is picked up by M . a And if you were to look more realistically, if you were to equate M and all the monetarist studies, look at relationships based upon 2 M, of the last 50 years and even more, and M of the last 50 years 2 and even more, my argument is equate what we're looking at now with what it was 10 years ago and 15 years ago. What I did do was to go back and look at M-, in 1974, which had no money market funds in it—it had small savings deposits—net out the interest that was being paid, and come out with an interest-adjusted M,. Now I carry that through to the later years and obviously, the interest-adjusted part gets larger. If you look at column 3, in 1974- 75, the interest credited to M , time and savings accounts, is $42.8 2 billion. In 1981, it was $135 billion. In the second quarter of this year, it was $155 billion. This is just interest being credited. So what I did was to take the stated M and net out the interest 2 and what we find is a completely different pattern of M growth. 2 Instead of growing 8.5 percent in 1979, 8.3 in 1980, 9.8 last year, and around 9.6 the first half of this year, if you adjust for interest, you will find out that the pattern of M follows the pattern of the 2 economy over the past 3 years. It went from 4.3 in 1978, down to 3.2 in 1979, 2 percent in 1980, 1.7 percent last year, and roughly 1.7 percent the first half of this year. I think if you look at the adjusted numbers, they tend to track much more closely with what we've been seeing in reality. And I think that these numbers have not been measuring what they're supposed to measure. I'm not refuting the relationships of what we used to know as M a with the economy in inflation and what we used to know as Mi. What I'm merely suggesting is that appropriate changes have to be made. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 168 Let me just list a couple of proposals that I would make to the Fed if I were capable of doing so. First of all, I would refine those definitions of Mi and M . Second, 2 I would continue, as Chairman Volcker has been doing, to follow a policy geared toward looking at a number of aggregates and a number of variables, not just slavishly adhering to an Mi or an M 2 target. I think that bank credit should be looked at much more closely than it is right now. ELIMINATE "BASE DRIFT" Another thing that I think is very important, and I don't want to get technical, but this has been going on for a couple of years un- derneath people's noses without realizing it—I think the Fed should be forced to eliminate the use of what we call the "base drift." Now base drift worked to the Fed's advantage through the 1976-79 period. Merely what that means is the fact that if the Fed overshoots their target in any one year, when they set their targets for the year after, they use that higher fourth quarter base to cal- culate the growth rates. So what they're doing is validating excessive growth in periods of inflation when they overshoot the targets. Likewise, if you look at the other side of the coin, last year the Fed missed their targets. They came in below their targets. So what that did was to cause the Fed to have to go through negative base drift, which in effect meant it had to be substantially more restrictive than it would have had to be. So I think that an appropriate policy would be to have the Fed go back each year they have to set—they have to use as a base to calculate the growth rates for the subsequent year the midpoint of the target for the current year. That will allow base drift either in a positive way or in a negative way. I think another thing that I would recommend, and I don't want to join in with the administration on this, I would recommend that they try to smooth out their operating procedures. I think if you look at the chart on page 11 of my presentation and look at the rollercoaster course in nonborrowed reserves, which is the broken line, and the rollercoaster course in Mi, you'll find out that had they tried to smooth out their nonborrowed reserve provision, which is what they target, you could have had a much smoother course of money supply. I think next to finally the Fed ought to immediately institute their practice of publishing 4-week moving averages of Mi. I don't know why they haven't come through with that. With all the gyra- tions in money that we saw in June and July, that was an appro- priate time to do it. My studies have shown me that they would reduce the volatility on an average by more than 1 billion if they would do something like that. It's not that difficult a thing to do. Why are they dragging their feet? Finally, another recommendation which I think is worthy of con- sideration—I know the monetarists will kill me for this—but I think it might be an interesting exercise to see what would happen if the discount rate were geared toward some rate of inflation. For example, the 12-month moving average of the personal consump- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 169 tion expenditures, maybe 2 or 3 percent above it. It would not put a control on the Fed funds rate, but at least on the discount rate it would be sensitive to inflation. If that were intact in 1980, I doubt that we would have needed credit controls because the discount rate would have gone up to 20 percent. And that's the floor on the Fed funds rate. The funds rate would have gone even higher. I think you would have had the re- cession, or at least a slowdown, long before we had to put on credit controls. I think, by the same token, if it followed inflation, if it followed the deceleration we've seen over the past year, I don't think you would have seen the economy as weak as it is now, either, because it is a floor. I don't say control the Fed funds rate. Let that still operate ac- cording to the supply and demand for reserves. But the discount rate does have an influence. And to the extent that that could have brought it down, that may have helped. And to the extent if the Fed does enter into a new inflationary posture, they have no choice. The discount rate has to go. It would be changed every month with the release of the personal consumption expenditure. With that, Mr. Chairman, I'll conclude. The CHAIRMAN. Before we turn to Mr. Olsen, let me just say on your last three comments, on the nonborrowed reserves, the weekly reporting and the floating discount rate, I badgered the Fed about that for at least the last 3 or 4 years. They've never come here to a hearing that I didn't ask them why they didn't do those things. So I can't answer why they have not. But on those three points, I certainly agree with you. The mechanics of handling that would Joe much better if they would change their procedures. Mr. Olsen? STATEMENT OF LEIF H. OLSEN, CHAIRMAN, ECONOMIC POLICY COMMITTEE, CITIBANK, N.A. Mr. OLSEN. Thank you, Mr. Chairman. I welcome this opportuni- ty to share with you some of my views on monetary policy and the economy. I have submitted a very brief statement that is well within the confines of the 10-minute limit on witness' remarks and I would like to go through it rather quickly. The CHAIRMAN. Our problem is not controlling witnesses; it's ourselves that are hard to control. [Laughter.] [The complete statement follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 170 Statement by i*il H. Olsen Chairman Economic Policy Committee Citibank, N.A. Mr. Chairman, I welcome this opportunity to shore some of my views on monetary policy and the economy. There is today a very considerable concern about the high level of interest rates. There are many people who believe these interest rates are high because the Federal Reserve is pursuing an overly restrictive monetary policy. This reasoning leads to the conclusion that interest rates could be reduced rather quickly if only the Federal Reserve would adopt a more expansionary monetary policy. In my opinion, Mr. Chairman, this proposition is invalid and it could lead to serious mistakes if it becomes the rationale for a change in Federal Reserve policy. The primary objective of monetary policy is not interest rates, but income. Changes in the rate at which the money supply grows, together with its velocity or turnover, determine increases in the money value of all output of goods and services in the United States. Or to put it another way, the growth of the money supply determines the rate of increase in dollar income. Over the past four years, the monetary authorities have sought to slow the average growth of money income in an effort to reduce the rate of inflation. In this regard, the monetary authorities should be credited with success in reducing inflation from 9-10% in 198i to an estimated 6-7% in the current calendar year. Inasmuch as the Administration has explicitly supported this objective of monetary policy, it, too, should be commended for the cooling of inflation. Inflation in 1976 averaged only 5.2%. By 1961 inflation, as measured by the GNP deflator had risen to more than 9%. But this year inflation is expected to average only 6-7%. Achieving this reduction in inflation has not been pleasant. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 171 Real output has not increased since the first quarter of 1979. The year-long recession that began in July 1981 partially explains this stagnation in physical volume of production. But monetary policy, on average, has achieved a slowdown in nominal income in these past three years and because of the imprecision in the execution of monetary policy, it also produced the recession that we are now suffering. Clearly disinflation is not painless. But I would quickly point out that returning to inflationary monetary policies is hardly a painless alternative. And there are some measures which could to help to mitigate the distress of the from high and accelerating inflation to decelerating and lower inflation, Ambiguity regarding both the near-term and the long-term course of economic policies sharpens the pain of disinflation. For example, there are employed people who are so thoroughly convinced that efforts to combat inflation will fail that they are seeking very large wage increases to protect themselves. The political cost of ending inflation, they reason, is too high. Their large wage demands, if met by employers, can only be sustained in these times of weak demand by trimming the total wage bills through layoffs. The lucky ones who retain their jobs have higher wages but at the expense of increased unemployment. Businessmen are also plagued by uncertainty when they look at the abortive antiinflationary efforts that litter the political lan<3scape of the past 15 years. Why, they ask, should this episode be any different. It is only a natter of time before monetary policy will have to yield to the political pressures for the reacceleration of money growth. And the financial markets continue to behave as if they expect that inflation will accelerate once again in the years ahead. The unwillingness to buy long-term bonds is a manifestation, not only of the losses that have been inflicted on investors by accelerating inflation over the past 15 years but the fear that this history will be repeated. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 172 Are these fears and uncertainties justified? Look at the debate over fiscal policy alone. The refusal to reduce government spending sufficiently to achieve a meaningful reduction in the federal deficit is used to support the belief that inflation wiU accelerate again. I recognize that substantially higher taxes could also reduce the deficit but such an increase in taxes is not as beneficial as cutting spending. Higher taxes finance higher levels of federal spending, and higher spending is associated with higher inflation. In the heat of political debate partisans quite naturally seek to intimidate opponents whom they believe to be responsible for the distress and the pain caused by efforts to reduce inflation. But members of Congress should be mindful that such debates only serve to convince the people that inflation will soon accelerate. Congressmen are often quoted word for word by members of investment policy committees who are arguing against purchases of long-term, fixed-rate government and corporate bonds. People in the financial markets are not unmindful that government is issuing long-term, fixed-rate bonds to finance current consumption of those Americans who are beneficiaries of the various federal transfer programs. The failure to acknowledge explicitly that it is the intent of policy to reduce inflation permanently is feeding cynicism. And that cynicism is heightened by partisans who are intent on raising the political costs of fighting inflation. A Congressional resolution providing explicit bipartisan agreement that monetary and fiscal policies are engaged in a long-term effort to reduce inflation and that this policy will not be reversed, as it has been so many times in the past, would do a great deal to reduce the uncertainty about the political will and ability to reduce inflation. Such a resolution should acknowledge that this effort began in the Carter Administration and continues in the present Administration. Those members of Congress who see no need to persist in the program of disinflation could, vote against such a resolution. But it would provide the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 173 American people with a. clearer intent of Congress in supporting or rejecting the long-term efforts, particularly of monetary policy in reducing the rate of inflation. Monetary policy has been successful in trimming the average rate of growth of money and all money income over the past 3 1/2 years. But it has achieved this slowdown with disturbingly wide swings in the rate of growth of money which were reflected in the performance of the economy. The swings in the rate of growth of money that are troubling are not week to week, or month to month, but those that occurred ovur six to nine month intervals or, if they were of shorter duration, of unusual magnitude. Money supply contracted by 3% at an annual rate in the second quarter of 1980. The imposition of credit controls contributed significantly to this decline. It was then followed by an increase of about 15% at an annual rate from early July through mid-December of that year. And from April to October of 1981 there was no increase in the money supply. As « consequence, the economy contracted by siightly more than 1% in money terms and by nearly 10% in real terms in the second quarter of 1980. It then recovered at an extraordinarily rapid rate, culminating in a nearly 20% increase in mney terms and nearly 9% in real terms in the first quarter of 1981. These percentages are all at annual rates. The economy declined in real terms in the second quarter of 1981 by 1.6% at an annual rate, rebounded very moderately in the third quarter and then declined very sharply in the fourth quarter of 1981 and the first quarter of 1982. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 174 What we have is the evidence of volatile money and a volatile economy. The very sharp acceleration in the economy in the second half of 1980 raised inflation expectations particularly in the financial markets but elsewhere as well. It discredited the anti-inflationary economic policies and that damage is still being repaired. So it is highly desirable, in restoring the credibility of policy, to achieve a more stable and persistent path far both money growth and economic growth. It would be very damaging to the anti-inflationary effort and to the long-term credit markets in particular if monetary policy were suddenly to become highly expansionary in a vain effort to extricate the economy from its present predicament. Some increase in money is desirable, but a sharp and prolonged spurt would be destabilizing. Focusing on the current situation I would begin by noting the increase in money supply that occurred in October of last year through to mid-January. It grew at an annual rate of about 15%. The economy has yet to reflect the stimulus of that increase, it was muted by the decline in the turnover of money in the first quarter of the year. The secular or normal trend of velocity currently is estimated to be at about 4%. With a return to this more normal velocity, we could expect the economy to grow in money income terms — nominal GNP — at about 9-10% beginning at some point in the months immediately ahead. However, since mid-January there has been no increase in the money supply and were this to persist through the third quarter, the recovery would be stifled. What I am saying is that some increase in the money supply is clearly necessary bringing it along the upper end of the Federal Reserve target path of 5 1/2% from the fourth quarter of last year to the fourth quarter of this year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 175 It appears that the economy for the month of June was below the average for the second quarter. If July does not exhibit a relatively strong upturn, it will be difficult for the third quarter average of real economic growth to run above the second quarter- Anecdotal information from retailers suggests that July business is not doing very well. To put it into more technical terms, velocity or the turnover of money does not yet appear to be accelerating. furthermore, it appears that money supply in July is likely to decline unless the Federal Reserve moves more aggressively to reduce the federal funds rate in order to achieve an increase in bank reserves and money. That seems to be happening now with the announcement of the reduction of the discount rate of one half of one percent. It appears that the underlying demand for credit in the economy by ail borrowers — households as weil as businesses — is diminishing and had the Federal Reserve persisted in pegging the federal funds rate at an unsustainably high level, it would as a consequence have intensified the drag on monetary growth. Recovery in the economy, incidentally, will help to lower short-term interest rates. Improved corporate earnings and cash flow will diminish the need for leaning heavily on short-term borrowing. It has been particularly distressing to many corporations in this recession that the bond market has been so inhospitable that persistent fears of inflation continue to haunt portfolio managers. The heavy reliance on short-term debt at a time of declining corixirate profits has reduced the liquidity of corporations. Prolonged recession would exacerbate this condition and further jeopordize the credit worthiness of many companies. Consequently, economic recovery becomes rather important as we move through the third quarter. 1 believe that a recovery will take place. I believe that the velocity of money will begin to increase. Consumption spending will strengthen as the summer ends as a result of increased disposable income arising out of the tax cut, and finally I believe that the monetary authorities will succeed in holding the rate of growth of money at the upper end of their target range, A 5-6% rate of growth of money supply coupled with a 4% velocity should give us 9-10% nominal income. And the persistence of the Federal Reserve in holding to its targets will help to enhance its credibility in the financial markets, ff Congress explicitly supports the Federal Reserve in that effort by additional reductions in the federal budget, simultaneously Digitized for FRASER with the recovery, confidence would be greatly strengthened. http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 176 Mr. OLSEN. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Mr, Olsen. After listening to a lot of witnesses and reading a lot of state- ments about monetary policy and the vast differences of opinion that you can get, I'm not really going to delve into where we ought to be and what, exactly, the discount rate ought to be. But I'd like to ask you, Mr. Olsen, if you agree with Mr. Maude and me that, structurally and internally, the nonborrowed reserves, the report- ing of Mi and things that I was complimenting Mr. Maude on be- cause I agreed with him, do you agree that the Fed could do a lot better job specifically in some of the mechanics, and whatever tar- gets they picked and all of that, be able to smooth out the handling of the money supply? Mr. OLSEN. I do believe that there is more that they could do. In my prepared remarks, partly to be brief, I pointed to the undesira- ble volatility in the rate of growth of money and the high volatility in the performance of the economy as a consequence over the past 3 years. And I do believe that additional steps taken earlier could well have avoided a good deal of that degree of volatility. CONTEMPORANEOUS RESERVE ADJUSTMENT We now expect to see the introduction of contemporaneous or near-contemporaneous reserve adjustment next year. The Federal Reserve has decided to proceed with that. One of the haunting prospects is that some years later we'll look back and it will have made a contribution to a more stable policy and you'll wonder why wasn't it done 2 or 3 years earlier instead of debated for such a long time? The CHAIRMAN. Yes, I wondered that. You can go back in the hearing records and over and over again, I didn't understand why they were on lagged reserve accounting and didn't go to contempo- raneous reserve. I never could get any satisfactory answers. We never did have any witnesses that did not agree that reporting weekly Mi figures was ridiculous, that they were meaningless, they weren't accurate. I was at an international monetary conference in London. Every- body I talked to said it's silly and I said, why do we do it? So final- ly, they've decided they're going to get off that; yet, they haven't implemented it yet. They've announced that they would. So I don't expect any magic or any great changes as a result of these, but I think that they would be very helpful, at least. Let me ask you, Mr. Maude, a question. One thing that disturbs me, and you've heard me enough even earlier today saying where I think the major blame is. Without question, it's with the Congress of the United States because the Fed can't fight inflation alone. If we had had a more restrictive fiscal policy, then the Fed wouldn't be a target. Everybody would probably be saying, gee, the Fed has done a marvelous job. They simply have to be coordinated to go hand-in-hand. And yet, over and over again, over the past couple of years, I have had people say, if Congress will just do this. And I'm saying this in the context that we have not done enough. But in January 1981, no one would have believed that we would take $14 billion out of the 1981 budget and $36 billion out of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 177 1982 budget. We performed, relatively speaking, far better than anybody else and there was no response. You can go back to Chairman Volcker before this committee and say, well, if Congress will just do this, then this will happen. Now as I said earlier, they've all been wrong, but how much is enough? Either one of you can respond. How much is enough to get some response in the market on fiscal policy? Mr. MAUDE. I think you've got to show direction and I think it's got to be convincing, I think the financial markets have been bat- tered around for so many years with resolutions which, as former Treasury Secretary Simon said, have really never been worth the paper that they've been written on. It's going to take more than resolutions. It's going to take you more than The CHAIRMAN. Let me interrupt you there. I agree. Passing budget resolutions that are not implemented, passing one in the summer of 1980 that said we're going to have a $200 million sur- plus was nothing but a 1980 election year document. I agree with all of that. But in this case, there was a difference for the first time in $50 billion of already-appropriated money, not reductions in future ap- propriations. It had already been appropriated in those 2 budget years and was rescinded. Now that hadn't happened. So I understand the rhetoric of the years past and the unkept promises over and over again. And if I were in the money-lending business, I'd say, hey, those guys never tell the truth. But we've essentially had no response from a dra- matic turn-around, even though not nearly enough. But $50 billion was not a resolution. It wasn't a statement. It was removed from existing budgets. Mr. Olsen? Mr. OLSEN, The answer isn't a simple one, but let me go back a little bit in history. Apart from the fact that accelerating inflation over the past 15 years eroded the value of fixed-rate obligations, the acceleration in money growth in the second half of 1980 ap- pears to have been particularly damaging to the credibility of the fight against inflation. We saw bond prices plummet and long-term interest rates, in- cluding mortgate rates, rise very rapidly in the second half of 1980. In the winter of 1980-81, in debates held around the investment policy committees and finance committees of countless financial firms across the country, the dominant view that emerged was that long-term fixed-rate lending had lost its economic legitimacy. There were explicit decisions to substantially back away from the purchase of such investments, in some cases, in totality. Those resolutions continue to hold at many of those financial firms. FEDERAL DEFICITS That was before, incidentally, the size of the present Federal deficits were even known. At that time, the deficits that were then being viewed were somewhere in the neighborhood of perhaps $50 or $60 billion, not well in excess of $100 or $150 billion. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 178 When those budget deficits came along, even though we have had a cooling off of inflation, those budget deficits are being em- ployed to continue to support the argument that fixed-rate, long- term lending has no legitimacy. The CHAIRMAN. Let me play the devil's advocate on that point because you know that's what I'm doing because I cannot be con- sidered anything but a fiscal conservative and I'm sure that you're aware of that. My voting records and attitudes on budget deficits have been very clear for a long period of time. But as a percentage, GNP, all sorts of other measures you want to make, these deficits, in real terms and those relative compari- sons, aren't any bigger or as big as many others in past years. And yet, there was not this response then. There was high inflation, higher than now, and bigger deficits, relatively speaking. And I'm not using that argument to defend these. I'm not one of those who says there's a smaller percentage Mr. MAUDE. I think there's one key difference. There is one key difference this time around which is troublesome. In the past, defi- cits were cyclically-induced and they always occurred the latter stages of a recession and at the beginning of the recovery. Theoreti- cally, even though history doesn't show that it worked out this way, because spending kept on increasing rapidly, but theoretical- ly, as the economy picks up, you could look forward to the possibil- ity of, if not a surplus, at least a dwindling deficit. Now with the 3-year tax cut in place and with the indexation of tax rates going onstream later on in 1985, now the markets are looking at deficits that are increasing year after year during a period of time when very strong economic growth is projected as well. And that can only bring forth a clash. The CHAIRMAN. We've only had a balanced budget once in the last 22 or 23 years. So if they were expecting surpluses, they were awfully naive. Mr. OLSEN. Let me offer also an answer to your question. The budget deficits of 1975-76, as ratio to GNP or whatever measure, were as large as the deficit that is occurring this year and would occur next year. We made those relevant measures, incidentally, and we have even made the arguments, pointing out that interest rates fell in 1975 and 1976. The decline in long-term interest rates in particular in those 2 years, in economists' terms, reflected the fact that portfolio manag- ers had declining inflationary expectations, or at least they weren't increasing. And one of the reasons why was because we came out of the 1974-75 recession with a decision on the part of portfolio managers to increase the proportion of bonds in their portfolios and reduce equities because equities had gone through such a bad time in the 1974 recession. So they bought bonds for 3 years, raising those ratios and it re- flected, in fact, that they weren't that concerned about inflation. The Secretary of the Treasury in those years had the good for- tune of having to finance a deficit into a market that was extreme- ly hospitable in which inflationary expectations were not particu- larly high because of the recent past history did not give them reason to have a great deal higher inflationary expectation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 179 The present environment is different. In the present environ- ment, the portfolio managers have very high inflationary expecta- tions. The present deficit has to be financed into a market that is not hospitable at all. Additionally, as Mr. Maude has pointed out, if I can add one point to it, in the past, either explicitly or implicitly, everybody knew that monetary policy would become more expansionary in order to bring about a strong recovery in the economy. Rising rev- enues would reduce the deficits. Less well known was that ulti- mately, inflation and bracket creep would not only diminish the deficits further, but, as a matter of fact, give additional funds to support increased spending very substantially over time. In this case, monetary policy is clearly committed to a moderate course and will not finance a rapid recovery in the economy in order to cause deficits to melt. And that's something else which the financial markets are aware of. This fiscal policy hasn't gotten on board to fight against infla- tion. Monetary policy has. And that's why the financial markets are distressed. The CHAIRMAN. Well, I agree with you there. I made that point over and over again, that we have not done our job in Congress, have not done our part in trying to solve the problem. BALANCING THE BUDGET But one of you mentioned the tax cuts that are in place. It seems to me that when you're trying to balance the budget, that there are two ways to do it. Obviously, you can cut spending or you can in- crease taxation. When you're looking at the capital markets, how- ever, and the available venture capital, investment capital, for whatever purpose, it doesn't seem to me to make much difference whether you're out borrowing it, except for the interest cost, or taking it away from the people in the form of taxation. So to those who want to do away and cut the tax cuts, when even after them, we're still being taxed at one of the highest levels in the history of this country, far higher than traditional levels, that that isn't an answer at all to try and reduce the pressure on the markets because of these large deficits by taking the money out of the pool of available capital through taxation rather than through borrowing. Now I agree, borrowing is worse, but not a lot. Except for your interest costs, which adds to the deficit. But still, it's not going to be available for long-term capital investments if you're taxing it away. Mr. OLSEN. You're absolutely right, Mr. Chairman, and in addi- tion to that, you haven't cut the taxes if you are financing the tax cut with borrowed money. You only cut taxes when you cut spend- ing by the amount that you've cut taxes. You can just as well send the taxpayer a postcard the day after he gets his tax cut and ask him, would you please lend us back the money that we just gave you? You're absolutely right in your description of that and Congress and the administration, to the degree that they're not reducing the deficit, they really haven't cut the taxes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 180 And there was another point I mentioned in my The CHAIRMAN. We haven't cut taxes in any event with the bracket creep and the increase in the social security taxes. In real terms we haven't cut them, let alone what you're talking about. Mr. OLSEN. Not if you're going to have to borrow the money to finance the deficits over time. The CHAIRMAN. Let me ask you this question. What do you think the condition of the economy would be today, regardless of all of the comments that Reaganomics is failing, supply side economics is failing, if we had gone on with that additional $50 billion of spend- ing—and I'm talking about budgets where it was rescinded, where this is not prospective. This was done and those budgets were al- ready there and we rescinded that kind of spending. What would the economy be like today? [Pause.] Ronald Reagan doesn't exist. Supply side economics didn't exist. We just continued on that path, spent that additional $50 billion? Mr. MAUDE. I was going to say Brazil, possibly, but go ahead. Mr. OLSEN. Well, as a matter of fact, your question is fascinating to me because as I heard Senator Riegle and Senator Sarbanes questioning Mr. Weidenbaum so vigorously and characterizing the distress in the economy today, I thought to myself, well, suppose we had not attempted to fight inflation 4 years ago, but instead, we had continued along the path in which inflation was now beginning to accelerate rather markedly, and government spending was now beginning to rise at a rather alarming rate. You were getting above 10 and going toward 15 percent and above, I wondered if we were holding these hearings today and there had been no change in policy and we would be looking at, say, a 15 percent rate of inflation at the present time and government spending rising at 15 percent plus per year, whether you wouldn't have had cries of distress throughout the country also, particularly by all those people who are on relative fixed incomes, for example. And in addition to that, with inflation running at that rate, we would have substantially higher interest rates than we have today. They would have been characterized as high nominal rates, but they would have still been very high. The CHAIRMAN. I'm not trying to be partisan at all because I don't care who solves the problem, as I've said the last couple of days and many other times—Republicans or Democrats, I'm not much interested in that. But to say that supply side economics is not working, regardless of who proposed it, I happen to think it is, not nearly as well as I would like to. As I said earlier, I'm not happy with 15 percent interest rates and the whole condition of the economy. But I do sincerely believe that had we not made some of these changes, you would have had far more serious problems as well. And the longer we avoid tackling the problems of the entitlements programs and the transfer of payments because it's not politically possible to do so—I pity future congresses, whether they're con- trolled by Democrats or Republicans. They will have a problem that can only be much worse than it is today. I don't think there's any doubt about that. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 181 SOCIAL SECURITY PROBLEM The social security problem itself, forgetting the budget, the sol- vency issue has to be faced. Sooner or later, the day of reckoning will come. And my colleagues on either side of the aisle that don't even dare mention the word social security, let alone talk about slowing the growth of it, boy, it's going to be a lot tougher—politi- cally, economically, every other way, the longer that decision is deferred. But I guess politicians, as long as you can postpone something to the future, you'll face it then rather than now, because I think we have an obligation to all those people who are on social security, totally apart from this argument of the overall budget, to make certain that that system is solvent so that they will get their pen- sions and that generations who are now young and paying these tremendously high taxes to support it, can expect that they will have a pension as well. The more I study it, I think we can blame the Fed and we can blame Ronald Reagan and we can coin the term "Reaganomics" and I think the major fault has to lie here in the Congress of the United States. And I don't know how anyone can interpret it any other way in light of the facts. The Fed didn't create that trillion- dollar debt. It didn't have anything to do with it at all. Presidents can recommend. We can blame them for what they recommend, but we don't have to agree with what they recom- mend. I get a kick out of blaming this President or any other because of the deficits. I guess it's a tribute to their forcefulness that they just coerced all us independent souls into voting their way because we don't have to when we get over on that floor. We can vote any way we desire if we have the courage to do so. I just, as I said over and over again, feel very frustrated about the prospects until Congress becomes part of the solution rather than part of the problem because I think that most every other seg- ment of the economy is trying. Management is. Labor certainly has been attempting to contribute to the problem with unprecedented cutbacks in their wages and fringe benefits. It seems like very part of the team is trying to play, except Con- gress, and we're going on about our business as usual. Gentlemen, I don't have any more questions. I do appreciate your patience in waiting so long into the lunch hour. I hope that your stomachs are not growling too badly. But thank you very much for coming today. The committee is ad- journed. [Whereupon, at 1:07 p.m., the hearing was adjourned.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis FEDERAL RESERVE'S SECOND MONETARY POLICY REPORT FOR 1982 TUESDAY, JULY 27, 1982 U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, D. C. The committee met at 9:30 a.m. in room 5302, Dirksen Senate Office Building, Senator Jake Garn, chairman of the committee, presiding. Present: Senators Garn, Riegle, and Proxmire. The CHAIRMAN. The committee will come to order. Today the Banking Committee continues the third day of hear- ings on monetary policy and we are very happy to have before us this morning Beryl Sprinkel, Under Secretary of the Treasury for Monetary Affairs. Mr. Secretary, we will be happy to hear your testimony at this time. STATEMENT OF BERYL W. SPRINKEL, UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS Mr. SPRINKEL. Thank you, Senator Garn. It's a pleasure to be with you today to discuss the administration's views on monetary policy. This administration assumed office with the firm conviction that the process of inflation is a major obstacle to vigorous economic performance and expansion of individual opportunity. As a result, a major part of the President's economic recovery program was the call for a gradual deceleration of monetary growth to a noninfla- tionary pace. The basis of this monetary program was and still is the recognition that sustained inflation—no matter what may be the initiating force—requires the accommodation of excessive money creation, Since that recommendation was made, monetary policy has become the subject of much public debate and controversy. In the process, the administration's views on monetary policy have some- times been misunderstood and misinterpreted. Our views are actu- ally very basic and straightforward, so I would like to take this op- portunity to restate them as concisely as possible. In addition, I will mention some things that we do not advocate, but which are frequently attributed to us. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 184 VIEWS AND RECOMMENDATIONS Basically, our views and recommendations can be summarized as follows: One, the primary cause of the accelerating inflation that has oc- curred in the United States over the past \Vz decades has been a persistently excessive rate of money growth. Two, reducing the rate of money growth is essential to control- ling inflation. Three, inflation, and the inflationary expectations that it gener- ates, have been a major factor in the secular rise in interest rates. Four, since inflation and high interest rates are an anathema to sustained economic growth, noninflationary monetary policy is a prerequisite to restoring the sound economic prosperity that we all seek. Five, the deceleration of money growth should be accomplished in a gradual, steady and predictable fashion, in order to minimize the economic disruptions and costs associated with moving the economy from an established inflationary path to a noninflationary one. Now let me mention some views that many are attributing to us that we do not hold: One, we do not expect the Federal Reserve to achieve precise week-to-week or month-to-month control of the money supply. They do not have the power to do so, and efforts to try to do so would likely prove to be extremely destablizing. We do believe, however, that the Federal Reserve has the ability to maintain the average quarterly rate of money growth within the announced target range. Two, we do not advocate the use of high interest rates to fight inflation. High interest rates are the legacy of persistent inflation- ary money growth, not an element of anti-inflationary monetary policy. Stubbornly high interest rates are the inevitable result of letting inflation occur in the first place, A reacceleration of money growth would cause further inflation and guarantee even higher interest rates in the future. Three, we do not believe that monetary policy is the source of all economic problems, nor is it the cure-all for all ills. Prudent mone- tary policy is a necessary condition to achieve real economic growth and prosperity, but it is not the panacea. A year and a half ago we recommended that the rate of money growth be slowed permanently. That recommendation is complete- ly consistent with the stated policies and objectives of the Federal Reserve. The target ranges for 1982, and those which the Federal Reserve has tentatively set for 1983, are appropriate to provide for both economic recovery and continued progress on inflation. The Fed has made significant progress to date toward achieving nonin- flationary money growth, and we fully support their plan to perse- vere in that policy. Our support for prudent, noninflationary mone- tary policy has not changed or waivered. To the contrary, the progress on inflation over the past year should serve to encourage us all that the ultimate goal of a perma- nent reduction in inflation is within our reach, if only we continue along the path of a sustained deceleration of monetary growth. But Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 185 if we succumb to the temptation to declare victory too soon, by mis- taking success in the first major skirmish for a permanent routing of the enemy, then we will not only prolong and worsen inflation, but significantly reduce the chances of ever bringing it under con- trol. While earnest in intentions, those who counsel a return to the quick-fix prescription of easy money are advocating actions that are actually inimical to the very thing they seek—permanently lower interest rates. Faster money growth would soon validate the very fears which have been responsible for the maintenance of high long-term interest rates—fears that the current slowing of in- flation will be temporary. While there might be some immediate easing of short-term interest rates in financial markets—and I am not even certain of that—long-term interest rates would soon rise, reducing greatly the potential for future output and employment growth. Periodic calls for the Fed to loosen the monetary spigot also serve to exacerbate the credibility problem. For this reason, the administration supports the Federal Re- serve's decision to maintain the existing money growth targets, rather than giving in to the pressures to revert to inflationary monetary policy. We would hope that the objective of permanent elimination of inflation through a sustained monetary discipline would be a bipartisan, national goal. It should not be allowed to become an issue of partisan politics. Neither the administration nor the Federal Reserve is happy about the level of interest rates, and neither views these rates as a necessary evil in the fight against inflation. However, the solution is not to sacrifice the policy which is in place, but to assure the public that the policy will remain in place. The record of the 1970's clearly shows that a little more money growth does not provide a lasting increase in production and em- ployment. Any boost to production and employment that comes from accelerating money growth is temporary, while the inevitable permanent effects are inflation and higher interest rates. Acceler- ating inflation, escalating interest rates, and the resulting deterio- ration of the incentives to save and invest are, in fact, powerful and pervasive deterrents to sustained growth. Also, it is folly to trust that faster money growth would now result in more produc- tion because various segments of the economy are operating at less than full capacity. The experience of the past 15 years should be ample evidence that inflation is not a problem which arises only when the economy is fully employed. Sustainable economic expan- sion requires a financial system based on a reliable dollar and that means monetary discipline. GRADUAL DECELERATION OF MONEY GROWTH To some, perhaps, the administration's repeated call for a gradu- al, stable and predictable deceleration of money growth may now seem trite or dogmatic. Let me assure you that it is neither. There are very real, very important economic reasons why we have re- peatedly made this prescription. That is, a deceleration of money growth that is not gradual, not stable and/or not predictable has very real, adverse economic consequences. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 186 First, let me discuss the importance of a gradual deceleration of money growth. After more than a decade of accelerating inflation and rising interest rates, inflationary expectations had become deeply entrenched in economic institutions and behavior. It would, of course, have been technically possible for the Federal Reserve to reduce money growth abruptly to a noninflationary rate. But it was felt that such a sudden move would cause severe short-term economic disruption and hardship. The gradual approach would provide the public more time to adjust its inflationary expectations downward, thereby minimizing the transitional costs in terms of lower output and higher unemployment. The transition is drawn out by this approach, but the immediate negative impact on real economic activity is reduced. Specifically, we recommended that the rate of money growth be cut in half by 1986—with a steady de- celeration each year. It would be naive to expect that such progress toward a noninfla- tionary economy could be made without experiencing some eco- nomic hardship. Some of the disruptions associated with the transi- tion to a noninflationary economy are of course being felt now. These hardships are not to be dismissed. In terms of its implica- tions for the long-run prosperity of the Nation, however, the impor- tance of controlling inflation cannot, in my opinion, be overstated. The hardships are temporary, but the damages of allowing infla- tion to accelerate would be lasting and pervasive. The administration realizes that even temporary economic dis- ruptions have real consequences for people here and now. We rec- ognize, however, that many attempts to provide immediate relief ultimately result only in more severe problems. Also, it is a mis- take to presume that all problems in the economy are the result of monetary restraint. In many cases, they are more properly charac- terized as long-term, structural problems that cannot be cured by returning to inflationary money growth. Many of our most serious sectoral problems today reflect the damage of a decade of rising in- flation and interest rates; these problems would only be compound- ed by the resurgence of inflation and further increases in interest rates that would accompany faster money growth. Not only would the trend of unemployment continue upward, the dislocations and economic pain that would accompany the next effort to establish a noninflationary monetary policy would be even greater. Let me now turn to the importance of stable money growth. I want to reiterate and emphasize that when we say stable money growth, we do not mean precise week-to-week or even month-to- month control. There are too many factors over which the Federal Reserve has no control that cause temporary aberrations in the money stock to expect such precision. However, the Federal Re- serve itself maintains that the average quarterly growth of Mi can be controlled within a band of plus-minus 1 percent. Thus, on a quarterly basis, the Federal Reserve has the ability to keep MI within its announced target range. Such stability in money growth would greatly enhance the stability in the financial markets and provide for lower interest rates. The stability of money growth takes on greater importance when viewed in the context of the record of monetary actions over the past decade and a half. On several occasions since 1965, money Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 187 growth was slowed abruptly in response to concerns about infla- tion. But, in each case, the effort was soon abandoned and the rate of monetary expansion subsequently was accelerated further. In each case, the economy suffered the immediate costs of monetary restraint—recession and rising unemployment—but was denied the lasting benefit of reduced inflation. This stop-and-go pattern is, of course, exactly what many are advocating that the Federal Reserve do once more. The result was a steadily rising long-term rate of money growth, punctuated by several short periods of monetary re- straint. The rising trend resulted in an ever-worsening inflation and an upward-ratcheting of interest rates, while the brief bouts of monetary restraint generated or intensified economic recessions. These episodes eroded confidence in the willingness or ability of the government to fulfill its promises to control inflation. This effect on the credibility of anti-inflationary monetary policy is seen clearly in the pattern of long-term interest rates since the mid-1960's. With each stop-go episode, long-term rates became in- creasingly resistant to the Government's assurances that anti-infla- tionary policies would be maintained. The lows in long-term inter- est rates which were recorded near each cyclical trough have risen sequentially with each successive cycle. The reason is obvious—ac- celerated money growth, renewed inflationary pressures and rising interest rates have followed each recession. Because episodes of reducing money growth have occurred before, history alone gives the financial markets no assurance that we are witnessing a permanent shift to noninflationary policy. If a period of slow money growth is followed by a long period of rapid money growth—as it was in late 1981 and early 1982—that uncer- tainty is reinforced. It signals to the financial markets that their worst fears and doubts may be coming true—that the Government cannot be relied upon to adhere to noninflationary monetary policy over the long run; that anyone who bets on inflation coming down and staying down—that is, anyone who lends money at a lower in- terest rate—can count on losing it to the tax of inflation. In the current environment of uncertainty and concern about the budget deficit, the effects of volatile money growth are magnified. Hence, the stability of money growth is a particularly important aspect of monetary policy in the current situation. With the experi- ences of the past decade fresh in the public memory, erratic money growth adds to the uncertainty that noninflationary monetary policy will, once again, not be maintained over the long run. That skepticism helps keep interest rates high, even as actual inflation falls. A sustained increase in the rate of money growth in the last half of this year or an announced increase in the money growth targets would simply reinforce and justify that skepticism. Discussions, proposals and political pressures to increase money growth have themselves contributed to the problem of high interest rates by adding to the markets' fears. To repeat, random variations in monetary growth from 1 week or 1 month to another are to be expected, and there is no reason to attempt to offset such changes. The task is to assure that these random changes do not persist and become several months or quar- ters of very rapid or very slow monetary growth. To the extent, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 188 therefore, that the Fed is successful in holding quarter-to-quarter money growth closer to announced target ranges, the credibility of long-term policy is greatly enhanced. The evidence gathered at the Treasury Department indicates that reducing the quarter-to-quar- ter variability in money growth would give market participants greater confidence about the future and remove one of the factors which has been a source of continued upward pressure on long- term interest rates. Senator Garn, shortly we will have this study completed and, with your permission, I would like to submit it for the record and it should be in the next few weeks. All the research is completed. We've got some fine-tuning on the words. I think it's important. The CHAIRMAN. We would be very happy to do that. [Summary of the study referred to follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 189 August 13, 1982 The Effect of Volatile Money Growth on Interest Rates and Economic Activity: Summary of A Study* Four types of policy action are capable, JJ^JJEJj*cij>lg, of reducing market interest rates, to some degree)fKetour are changes in debt management, reductions in spending or tax changes that reduce future budget deficits, direct controls, and improvements in the conduct of monetary policy. The focus of this study is on the effects of variable monetary growth. The analysis is conducted, however, within a general model of the economy, which incorporates the influence of other factors and the interplay of various factors through the markets for assets, goods, and money. The results presented here were generated from a condensed version of this model. The complete results will be presented in the full technical report. The principal conclusions of the study, to date/ are: (1) Sustained high variability of money growth has increased uncertainty about the expected return from holding bonds. The study suggests that the market charges a risk premium on long-term bonds of 4% to 6% to compensate for the risk of loss of capital values arising solely as a result of the variability of money growth. (2) Variability of HI growth cannot be reduced to zero. If variability is reduced to the level of 1977-79, however, interest rates on long-term bonds would fall 2% to 3%. (3) Short-term interest rates would be reduced also. (4) Lower monetary variability should not be accompanied by faster money growth. Paster money growth would certainly raise interest rates. One reason is that market participants would not believe that the "* ThTisi~is'""a "summary of" a research effort by the Office of Monetary policy Analysis of the U.S. Treasury, requested by and submitted to Beryl W. Sprinkel, under Secretary for Monetary Affairs. The research has been conducted by Professor Allan H. Meltzer of Carnegie-Mellon university and Angelo Hascaro of the Treasury Department. The full technical report is in the final stages of preparation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 190 current reduction in inflation will persist if money growth is reaccelerated. A second reason is theft temporary changes in money growth — up and down — are a main cause of variability in economic activity, in addition to contributing to risk premiums in interest rates. (5) Reducing the variability of money growth would reduce the variability of GNP growth. A main finding of the study, replicated for different periods and using different measures of money, is that, on average. Federal Reserve actions have added more variability to the economy than they have removed. The estimates suggest that improvements in the implementation of monetary policy can reduce the magnitude of fluctuations in GNP growth by one- fourth to one-half of their present values. (6) Much of the increase in variability of money growth since late 1979 comes from two sources. One is the imposition and removal of credit controls in 1980, The other is the monetary control method of the Federal Reserve. The following comparison of money growth, using quarterly average growth (at annual rates) for the period before and after October 1979. shows how much money growth has been reduced, and variability increased, in the recent period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 191 11 '.Quarters 11 '.Quarters Ending Beginning September 1979 October 1979 (1st .Quarter 1977- (4th iQuarter 1979- 3d .Quarter 1979) 2nd .Quarter 1982) Average Growth of Ml 8.3% 6.3% Standard Deviation 1.5 5.2 Range for HI Growth 5.2 to 10.3 -3.1 to +14.8 Average Growth of Monetary Base 8.6% 7.1% Standard Deviation 1.0 2.7 Range for Base Growth 7.1 to 10.5 1,9 to 10.3 1980 IV - 1982 II Average Growth of Ml 5.8 Range: 0.3 to 10.9 Standard Deviation 3.9 Average Growth of Base 6.1 Range: 1.9 to 10.3 Standard Deviation 3.3 Ijiterest Rates, Inflation and Monetary .Variability To estimate the effect of monetary variability on interest rates, the sources of change in quarterly values of money and monetary velocity were separated into "predictable" and unpredict- able components. The "predictable" components of money growth and velocity are the parts that can be forecast from knowledge of seasonal factors and the past history of each series. The unpredictable, or random, component includes everything else. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 192 The anticipated rate of inflation is estimated in a Similar way.* Anticipated inflation for next quarter is the rate at which prices are expected to rise on the basis of the momentum in the price series and knowledge of seasonal and other factors, The momentum of inflation reflects the maintained rate of money growth, but factors such as sustained shifts in the demand for money can also affect the aeries. Random and transi- tory price changes are removed from the measure of anticipated inflation by the procedure which is used. The rate of interest has four components. (11 A rea^ rate representing an estimate of the productivity'Ur^capital. In the results presented here, the expected return on capital is embodied in the intercept term of the regression. (2) The effect of anticipated inflation. l£ there ate no effects of taxes and inflation on real rates, anticipated inflation raises market interest rates point for point. Recent estimates for the United States suggest that taxes and other factors reduce the effect of anticipated inflation on interest rates by about one-half, in the results presented here, anticipated inflation refers to the expected rate of price change in the next quarter only. (3) A risk factor representing the variability of the unpredictable component of money growth. (4) A risk factor representing the variability of the unpredictable component of monetary velocity. All unpredictable changes in GNP growth, other than those resulting from unpredict- able money growth, influence interest rates through this component. This study indicates that item (3) -the risk premium which is generated by variable money growth -is a principal reason the current "real" rates are considered to be high. The empirical results, using the ten-year U.S. Government bond^rate are presented in jhe following table. * The rate of price change is an endogenous variable in the model which is used in this study. Thus, the expected rate of price change should be consistent with the structure of the model, including information about the probable pattern of the exogenous variables. Time series analysis alone is not suf- ficient to guarantee this result. This shortcoming has been corrected, with no appreciable effect on the results which are presented here. The complete results will be presented in the full technical report of the study. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 193 Interest Rate Equation: Long-Terra Interest Rate iQuarterly: 1969.Q4 - 1982Q2 51 Observations Dependent Variable: 10 Year Government Bond at Constant Maturity Independent Variable Coefficient Std. Error t-Statistic Constant 3.19347 1.015 3.146 Expected Inflation^ 0.30238 0.1198 6.780 Velocity Volatility2 0.19315 0.0903 2.140 HI Volatility3 0.73328 0.1081 6.780 Rho 0.6222 0.1271 4,897 Summary Statistics R-Squarect: Adjusted R-Squared: 0.9033 F-Statistic (4,46): 117.S Durbin-Watson Statistic: 2.1042 Sum of Squared Residuals: 27.81 Standard Error of Regression: 0.7775 '.Q(8 degrees of. freedom)_t 9.355 1 Expected inflation is the next period's inflation forecast. The forecast is derived from a time-series model estimated over 1953Q3- 1980Q1, ARIMA (0,1,1), on the quarterly logarithmic first-difference of the GNP deflator. Values to 1980Q1 are in-sample estimates, while subsequent values are one-step-ahead forecasts using the ARIMA model. 2 velocity volatility is the square-root of the average of the sum of squares of velocity innovations over four periods with a one period delay. The innovations are from an ARIMA (Q,l,2) model estimated over 1953G3-198QQ1, with subsequent values being obtained from one- step-ahead forecasts to 1982Q1. 3 Ml volatility is the square-root of the average of the sum of squares of Ml innovations over four periods with a one period delay. The innovations are from an ARIMA (1,1,0) model estimated over 1953.Q3- 198QQ1, with subsequent values being obtained from one-step ahead forecasts to 1982Q1. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 194 A series of charts show the effects of components (2), (3) and [4) on the ten-year U.S. Government bond rate from 1969 IV ' through the second quarter of 1981. Each component IB multiplied by its estimated effect on interest rates to obtain the contribution of that factor to the interest rate. The solid line in each chart shows the forecast of interest rates based on all four of the factors and the clotted line is the actual interest rate. The broken line in the lower portion of the chart shows the contribution of a particular factor. Chart 1 Comparison of 10 Year Bond Rate Estimated Rate from Equation, and Contribution of Velocity Volatility actual = dotted line fitted = solid line velocity volatility effect=dashed line 12 69 70 71 72 73 74 75 76 77 78 79 80 8L 82 Chart 1 shows the contribution of the velocity effect. The variability of unpredictable changes in velocity contributes between 0.3S and 1.3% during the period. There is a slightly rising trend in recent years. Federal Reserve statements place heavy emphasis on the effects of these changes, but this study suggests that this influence has been relatively small. The most that can be expected from reductions in the variability of the demand for money (or velocity), based on the findings of this study is about 1/2% reduction in long-term rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 195 Chart 2 Comparison of 10 Year Bond Rate Estimated Rate from Equation, and Contribution of Monetary Volatility actual=dotted line fitted=solid line HI volatility effect=dashed line 69 70 71 72 73 74 75 76 77 78 79 80 81 82 Chart 2 shows the effect of variations in the unpredict- able component of money growth — called Ml volatility on the chart. The effect of Ml volatility on the interest rate can be seen clearly in the peaks reached in 1971, 1975, and 1981 and in the troughs reached in 1972 and 1978. The chart indi- cates that a return to the lower monetary variability of pre- 1979 should be be accompanied by a decline of 3% to 4% in the ten-year bond rate. A common problem with estimates of this kind, however, is that the very large increase in variability and large increase in interest rates after 1979 might tend to cause an overestimate of the importance of monetary volatility. Therefore, the response was reestimated for the period 1969 IV-79 III. A similar, but lower estimate of the effect of variability, is obtained. Using both estimates, a 2% to 3% reduction in interest rates on long- term bonds is a reasonable estimate of the response to more stable monetary growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 196 Chart_3 Comparison of 10 Year Bond Rate Estimated Rate from Equation, and Contribution of Expected Inflation actual=dotted line f ittecl=solid line expected inflation effeet=dashed line 16 12 "•»• **" **«•«*» 69 70 71 72 73 74 75 76 77 78 79 80 81 82 Chart 3 shows the effect of expected inflation. The surge in interest rates from 1972 to 1974 and the decline to 1976 reflects the strong influence of changing expectations of inflation following the removal of price controls/ the Soviet wheat purchases, the oil shock and the aftermath of these events. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 197 The Effects of^ Less Variable Honey Growt.h^_gn._GMP Growth The Federal Reserve tries to reduce fluctuations in the economy by varying interest rates, reserves and money growth. Their ability to reduce fluctuations is limited, however, by two difficulties, one is the difficulty of producing accurate forecasts, a difficulty shared by all forecasters. The other is the difficulty of knowing whether observed changes in economic behavior are temporary or persistent. Mistaken forecasts and misinterpretations of observed changes would cause the Federal Reserve (and everyone else) to misperceive and misinterpret what is happening, persistent changes could be treated as temporary or transient; transient changes could be misperceived as permanent. As a result of these, and perhaps other errors arising from efforts to smooth the money market, or from the use of lagged reserve accounting, a complex structure of reserve requirements or inaccurate seasonal adjustment, the Federal Reserve can, in principle, add more variability to the growth of GNP than it removes. Consequently, the Federal Reserve can make "business cycles" worse. To estimate the amount of variability introduced and the amount removed, the study computes: (1) the variability of the predicted component of GNP growth; (2) the maximum variability in the predicted component that would occur if money growth remained constant; (3) the sum of the predicted and random components — variability of actual GNP; and (4) the maximum variability of (actual) GNP if money growth remains constant. These calculations are shown in Table 1, columns (1) and (2). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 198 Table 1 variability of Quarterly GNP Growth with Current Monetary Policy and with Constant Money Growth (annual rates in percent) (1) (2) (3) Actual Constant Constant __^ Policy Hj^Growth Basg Growth Period 1953-80 Predicted Component 0.9 0.7 0,6 Total GNP Growth 1.9 1.9 1.8 1953-69 Predicted Component 0.7 0.6 0.5 Total GNP Growth 1.7 1.6 1.6 1969-80 Predicted Component 3.8 1.8 0.9 Total GNP Growth 5.9 3.9 2.1 Column (3) shows similar calculations with growth of the monetary base constant. Again, these are estimates of the maximum variability. Actual variability would be lower, since reducing uncertainty about monetary growth would reduce the variability of interest rates and the demand for money. These results indicate that, on average, constant money growth (or constant base growth) would have probably reduced the variability of GNP and, at least, would not have increased it. For the period 1969-80, in which the oil shock and the Government's reaction to the situation had a large negative influence on GNP growth, the reduction in variability of GNp growth is greater than 50%. These findings suggest that the Federal Reserve operations have increased the variability of economic activity. Less variable money growth, on average, should produce steadier growth in GNP. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 199 Actual and potential Contrpl_pf Money Last year, the Federal Reserve released a study of monetary control in i960. According to their estimates, 95% of the time the error in controlling the quarterly (or annual) growth of Ml could be held within ^1%. Actual control in I960 — and in most other years for which the Federal Reserve announced targets — was much less precise. The actual performance shows an average deviation from target in the range of -2.0 to + 2.5%. A principal reason for the poor performance is that the Federal Reserve attempts to forecast either interest rates/ or the demand for money and credit. Their forecasts are relatively inaccurate, so they introduce large errors into the control procedure. In addition, use of lagged reserve accounting, seasonal adjustment, borrowing arrangements and other procedures also increase variability. Significant reductions in interest rates and in the variability of GNP can be achieved, if the volatility of money growth is reduced. The size of further reductions in interest rates that can be achieved are approximately: (a) 1/2% by reducing the variability of monetary velocity; (b) 3% to 4% by reducing the anticipated rate of inflation. The latter cannot be achieved entirely in the near term. This study suggests that some reduction in anticipated inflation has occurred, and further reductions are likely this year if money growth is held within the announced target. A reduction in expected inflation to 6% from present levels reduces long-term interest rates by about 1%. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 200 Mr. SPRINKEL. Thank you, sir. This leads me to the predictability part of our prescription for monetary policy. To the extent that money growth proceeds in a reliable pattern, uncertainty is reduced and interest rates can fall. In the current environment, the problem of the predictability of future monetary policy is compounded by concern about the Feder- al budget. The perception of unbounded growth of Government spending into the future raises fears that higher inflation and/or higher tax rates lie ahead. The financial markets fear that the Federal Reserve will be pres- sured into monetizing the implied deficit. That is, financing spend- ing by creating new money. These fears are aggravated by congres- sional statements about the need for faster money growth. Any sig- nals that the Fed is coming under political pressure to revert to in- flationary money growth only adds to the concern. CURB EXCESSIVE GOVERNMENT SPENDING Both the Congress and the administration, by their actions, must demonstrate to the public that the Federal Government has the collective will to discipline itself now and in the future against the fiscal excesses which have otherwise come to be expected of it. We must face the fact that any Government spending—no matter how well intentioned its goals or beneficial its impact—imposes costs on the economy. In the short term, Government spending can be fi- nanced three ways—through taxation, by creating new money or by borrowing. Ultimately, however, only two sources of revenues are available—direct taxation and/or inflation. Therefore, the situ- ation is simply this: If we are to allow Government spending to grow unchecked as it has over the past several decades, we will face accelerating inflation—and the escalating interest rates that go with it—high and rising tax rates or both. There are no other choices and the current situation in financial markets should be heeded as a sign that the public is aware. Monetary policy issues and its impact in the economy are more complicated than the simple "tight" money/"easy" money charac- terizations that are commonly made. The experience of a decade of accelerating inflation and rising in- terest rates has radically altered the behavior and expectations of the American public. As workers and producers, as savers and con- sumers, and as borrowers and lenders, our collective behavior has been contaminated by inflationary psychology. The mechanism by which increases in money allowed interest rates to fall, and the economy to expand—which most of us learned in Economics 101— has been shown to be such a simplified view that it is no longer very useful. The public has become so attuned to the long-run rela- tionship between money growth and inflation that those favorable short-run effects of accelerated money growth are increasingly transitory. In addition, the way in which a given monetary policy is pur- sued—whether it be "tight" or "easy" in the common parlance—is extremely important. The same monetary policy—in terms of the amount of money growth provided by the monetary authority—can have very different effects on the economy. For example, an annual Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 201 increase in money of 6 percent has very different economic implica- tions if it results from no growth for 6 months, followed by 12-per- cent growth for 6 months, instead of, say, 6 months of 5-percent growth and 6 months of 7-percent growth. The ultimate result in terms of money growth would be the same, but the immediate impact on the economy would be radically different. Recognizing the important economic implications of the pattern of the rate of money growth, the administration recommended, and has consistently supported, not just a deceleration of money growth,- while deceleration is vital to controlling, we believe that it is best if that deceleration is achieved in a steady and predictable fashion. We made that recommendation 18 months ago, believing that such a policy would provide the monetary restraint needed to control inflation, but with the least possible disruption of economic activity. That is, given the task of controlling inflation, we believe that that goals could be achieved with the least possible loss of output and employment, if the deceleration of money growth were steady and predictable. No economic event or development in the past 18 months has altered that view and conviction. Thank you, sir, [Complete statement follows.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 202 STATEMENT OF BERYL W. SPRINKEL UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS BEFORE THE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS UNITED STATES SENATE WASHINGTON, D.C. Tuesday, July 27, 1982 Chairman Garn, Senator Riegle, and distinguished Members of the Banking Committee, it is a pleasure to be with you today to discuss the Administration's views on monetary policy. This Administration assumed office with the firm conviction that the process of inflation is a major obstacle to vigorous economic performance and expansion of individual opportunity- As a result, a major part of the President's economic recovery program was the call for a gradual deceleration of monetary growth to a noninflationary pace. The basis of this monetary program was and still is the recognition that sustained inflation — no matter what may be the initiating force — requires the accommodation of excessive money creation. Since that recommendation was made, monetary policy has become the subject of much public debate and controversy. In the process, the Administration's views on monetary policy have sometimes been misunderstood and misinterpreted. Our views are actually very basic and straightforward, so I would like to take this opportunity to restate them as concisely as possible. In addition, I will mention some things that we do rio^ advocate, but which are frequently attributed to us. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 203 Basically our views and recommendations can be summarized as follows: (1) The primary cause of the accelerating inflation that has occurred in the u,s. over the past decade and a half has been a persistently excessive rate of money growth. (2) Reducing the rate of money growth is essential to controlling inflation. (3) Inflation, and the inflationary expectations that it generates, have been a major factor in the secular rise in interest rates. (4) Since inflation and high interest rates ace an anathema to sustained economic growth, noninflationary monetary policy is a prerequisite to restoring the sound economic prosperity that we all seek. (5) The deceleration of money growth should be accomplished in a gradual, steady and predictable fashion, in order to minimize the economic disruptions and costs associ- ated with moving the economy from an established infla- tionary path to a noninflationary one. Now let me mention some views that many are attributing to us that we do not hold: (1) We do not expect the Federal Reserve to achieve precise week-to-week or month-to-month control of the money supply. They do not have the power to do so, and efforts to try to do so would likely prove to be extremely destabilizing. We do believe, however, that the Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 204 Reserve has the ability to maintain the average quarterly rate of money growth within the announced target range. (2) We do not advocate the use of high interest rates to fight inflation. High interest rates are the legacy of persistent inflationary money growth, not an element of anti-inflationary monetary policy, stubbornly high interest rates ate the inevitable result of letting inflation occur in the first place, ft reacceleration of money growth would cause further inflation and guarantee even higher interest rates in the future. (3) He do not believe that monetary policy is the source of all economic problems, nor is it the cure-all for all ills, prudent monetary policy is necessary to achieve real economic growth and prosperity, but it is not the panacea. A year and a half ago we recommended that the rate of money growth be slowed permanently. That recommendation is completely consistent with the stated policies and objectives of the Federal Reserve. The target ranges for 1982, and those which the Federal Reserve has tentatively set for 1983,.are appropriate to provide for both economic recovery and continued progress on inflation. The Fed has made significant progress to date toward achieving noninflationary money growth, and we fully support their plan to persevere in that policy. Our support for prudent, noninfla- tionary monetary policy has not changed or waivered. To the contrary, the progress on inflation over the past year should serve to encourage us all that the ultimate goal of a permanent reduction in inflation is within our reach, if only we continue Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 205 along the path of a sustained deceleration of monetary growth. But if we succumb to the temptation to declare victory too soon, by mistaking success in the first major skirmish for a permanent routing of the enemy, then we will not only prolong and worsen inflation, but significantly reduce the chances of ever bringing it under control. While earnest in intentions, those who counsel a return to the quick-fix prescription of easy money are advocating actions that are actually inimical to the very thing they seek — permanently lower interest rates. Paster money growth would soon validate the very fears which have been responsible for the maintenance of Jiigh long-term interest rates — fears that the current slowing of inflation will be temporary. While there might be some immediate easing of short-term interest rates in financial markets, long-term interest rates would soon rise, reducing greatly the potential for future output and employment growth. Periodic calls for the Fed to loosen the monetary spigot also serve to exacerbate the credibility problem. For this reason, the Administration supports the Federal Reserve's decision to maintain the existing money growth targets, rather than giving in to the pressures to revert to inflationary monetary policy. We would hope that the objective of permanent elimination of inflation through a sustained monetary discipline would be a bi- partisan, national goal. It should not be allowed to become an issue of partisan politics. Neither the Administration nor the Federal Reserve is happy about the level of interest rates, and neither views these rates as a necessary evil in the fight against Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 206 inflation. However, the solution is not to sacrifice the policy which is in place, but to assure the public that the policy will remain in place. The record of the 1970s clearly shows that a little more money growth does not provide a lasting increase in production and employment. Any boost to production and employment that comes from accelerating money growth is temporary , while the inevitable permanent effects are inflation and higher interest rates. Accelerating inflation, escalating interest rates, and the resulting deterioration of the incentives to save and invest are, in fact, powerful and pervasive deterrents to sustained growth. Also, it is folly to trust that faster money growth would now result in more production because various segments of the economy are operating at less than full capacity. The experience of the past fifteen years should b« ample evidence that inflation is not a problem which arises only when the economy is folly employed. Sustainable economic expansion requires a financial system based on a reliable dollar and that means monetary discipline. To some, perhaps, the Administration's repeated call for a and_ gr ed ic t a b 1 e deceleration of money growth may now seem trite or dogmatic. Let me assure you that it is neither. There are very real , very important economic reasons why we have repeatedly made this prescription. That is, a deceleration of money growth that is not gradual, not stable and/or not predictable has very real, adverse economic consequences. First, let me discuss the importance of a gradual deceleration of money growth. After more than a decade of accelerating Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 207 inflation and rising interest rates, inflationary expectations had become deeply entrenched in economic institutions and behavior, it would, of course, have been technically possible for the Federal Reserve to reduce money growth abruptly to a noninflationary rate- But it was felt that such a sudden move would cause severe short-term economic disruption and hardship. The gradual approach would provide the public more time to adjust its inflationary expectations downward, thereby minimizing the transitional costs in terms of lower output and higher unemployment. The transition is drawn out by this approach, bjt the immediate negative impact on real economic activity is reduced. Specifically, we recommended that the rate of money growth be cut in half by 1986 — with a steady deceleration each year. It- would be naive to expect that such progress toward a non- inflationary economy could be made without experiencing some economic hardship. Some of the disruptions associated with the transition to a non-inflationary economy are of course being felt now. These hardships are not to be dismissed. In terms of its implications for the long-run prosperity of the nation, however, the importance of controlling inflation cannot, in my opinion, be overstated. The hardships are temporary, but the damages of allowing inflation to accelerate would be lasting and pervasive. The Administration realizes that even temporary economic disrup- tions have real consequences for people here and now. We recognize, however, that many attempts to provide immediate relief ultimately result only in more severe problems. Also, it is a mistake to presume that all problems in the economy are the result of monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 208 restraint. In many cases, they are more properly characterized as long-term, structural problems that cannot be cured by returning to inflationary money growth. Many of our most serious sectoral problems today reflect the damage of a decade of rising inflation and interest rates; these problems would, only be compounded by the resurgence of inflation and further increases in interest rates that would accompany faster reoney growth. Not only would the trend of unemployment continue upward, the dislocations and economic pain that would accompany the next effort to establish a noninflationary monetary policy would be even greater. Let me now turn to the importance of stable money growth., I want to reiterate and emphasize that when we say stable money growth, we do not mean precise week-to-week or even month-to-month control. There are too many factors over which the_Federal Reserve has no control that cause temporary aberrations in the money stock to expect such precision. However, the Federal Reserve itself maintains that the average quarterly growth of HI can be controlled within a band of +1 percent. Thus, on a quarterly basis, the Federal Reserve has the ability to keep Ml within its announced target range. Such stability in money growth would greatly enhance the stability in the financial markets and provide for lower interest rates. The stability of money growth takes on greater importance when viewed in the context of the record of monetary actions over the past decade and a half. On several occasions since 1965. money growth was slowed abruptly in response to concerns about inflation. But, in each case, the effort was soon abandoned and the rate of monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 209 expansion subsequently was accelerated further. In each case, the economy suffered the immediate costs of monetary restraint — recession and rising unemployment — but was denied the lasting benefit of reduced inflation. This stop-and-go pattern is, of course, exactly what many are advocating that the Federal Reserve do once more. The result was a steadily rising long-term rate of money growth, punctuated by several short periods of monetary restraint. The rising trend resulted in an ever-worsening inflation and an upward- ratcheting of interest rates, while the brief bouts of monetary restraint generated or intensified economic recessions. These episodes eroded confidence in the willingness or ability of the Government to fulfill its promises to control inflation. This effect on the credibility of anti-inflationary monetary policy is seen clearly in the pattern of long-term interest rates since the mid-1960's. With each stop-go episode, long-term rates became increasingly resistant to the Government's assurances that anti-inflationary policies would be maintained. The lows in long-term - interest rates which were recorded near each cyclical trough have risen sequentially with each successive cycle. The reason is obvious — accelerated money growth, renewed inflationary pressures and rising interest rates have followed each recession. Because episodes of reducing money growth have occurred before, history alone gives the financial markets no assurance that we are witnessing a permanent shift to noninflationary policy. If a period of slow money growth is followed by a long period of rapid money growth — as it was in late 1981 and early 1982 — that uncertainty is reinforced. It signals to the financial markets Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 210 that their worst fears and doubts may be coming true — that the government cannot be relied upon to adhere to noninflationary monetary policy over the long run; that anyone who bets_ on inflation coming down and staying down (that is, anyone who lends money at a lower interest rate) can count on losing it to the tan of inflation. In the current environment of uncertainty and concern about the budget deficit, the effects of volatile money growth are magnified. Hence, the stability of money growth is a particularly important aspect of monetary policy in the currrent situation, with the experiences of the past decade fresh in the public memory, erratic money growth adds to the uncertainty that noninflationary monetary policy will, once again, not be maintained over the long run. That skepticism helps keep interest rates high, even as actual inflation falls. A sustained increase in the rate of money growth in the last half of this year or an announced increase in the money growth targets would simply reinforce and justify that skepticism. Discussions, proposals and political pressures to increase money growth have themselves contributed to.the problem of high interest rates by adding to the markets' fears. To repeat, random variations in monetary growth from one week or one month to another are to be expected, and there is no reason to attempt to offset such changes. The task is to assure that these random changes do not persist and become several months or quarters of very rapid or very slow monetary growth. To the extent, therefore, that the Fed is successful in holding quarter- to-quarter money growth closer to announced target ranges, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 211 credibility of long-term policy is greatly enhanced. The evidence gathered at the Treasury Department indicates that reducing the quarter-to-quarter variability in money growth would give Market participants greater confidence about the future and remove one of the factors which has been a source of continued upward pressure on long-term interest rates. This leads me to the predictabili ty part of our prescription for monetary policy. To the extent that money growth proceeds in a reliable pattern, uncertainty is reduced and interest rates can fall. In the current environment, the problem of the predictability of future monetary policy is compounded by concern about the Federal budget. The perception of unbounded growth of government spending into the future raises fears that higher inflation and/or higher tax rates lie ahead. The financial markets fear that the Federal Reserve will be pressured into "monetizing" the implied deficit: that is, financing spending by creating new money. These fears are aggravated by Congressional statements about the need for faster money growth. Any signals that the Fed is coming under political pressure to revert to inflationary money growth only adds to the concern. Both the Congress and the Administration, by their actions, must demonstrate to the public that the Federal Government has the collective Vill to discipline itself now and in the future against the fiscal excesses which have otherwise come to be expected of it. We must face the fact that any government spending — no matter how well intentioned its goals or beneficial its impact — imposes costs on the economy. In the short term/ government spending can be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 212 financed three ways — through taxation, by creating new money or by borrowing. Ultimately, however, only two sources of revenues are available — direct taxation and/or inflation. Therefore, the situation is simply this: if we are to allow government spending to grow unchecked as it has over the past several decades, we will face accelerating inflation (and the escalating interest rates that go with it), high and rising tax rates or both. There are no other choices and the current situation in financial markets should be heeded as a sign that the public is aware. Summary Monetary policy issues and its impact in the economy are more complicated than the simple "tight" money/"easy" money characteri- zations that are commonly made. The experience of a decade of accelerating inflation and rising interest rates has radically altered the behavior and expectations of the American public. As workers and producers, as savers and consumers, and as borrowers and lenders, our collective behavior has been contaminated by inflationary psychology. The mechanism by which increases in money allowed interest rates to fall, and the economy to expand — which most of us learned in Economics 101 — has been shown to be such a simplified view that it is no longer very useful. The public has become so attuned to the long-run relation- ship between money growth and inflation that those favorable short-run effects of accelerated money growth are increasingly transitory. In addition, the way in which a given monetary policy is pursued — whether it be "tight" or "easy* in the common parlance — is extremely important. The same monetary policy — in terras of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 213 amount of money growth provided by the monetary authority — can have very different effects on the economy. For example, an annual increase in money of 6 percent has very different economic implica- tions if it results from no growth for six months, followed by 12 percent growth for 6 months, instead of, say, six months of 5 percent growth and six months of 7 percent growth. The ultimate result in terms of money growth would be the same, but the immediate impact on the economy would be radically different. Recognizing the important economic implications of the pattern of the rate of money growth, the Administration recommended, and has consistently supported, not just a deceleration of money growth; while deceleration is vital to controlling inflation, we believe that it is best if that deceleration is achieved in a steady and pre- dictable fashion. He made that recommendation IB months ago, believing that such a policy would provide the monetary restraint needed to control inflation, but with the least possible disruption Of economic activity. That is, given the task of controlling inflation, we believe that that goal could be achieved with the least possible loss of output and employment, if the deceleration of money growth were steady and predictable. No economic event or development in the past 18 months has altered that view and conviction. oOo Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 214 CHART I Growth in Nominal Gross National Product and Adjusted Monetary Growth 16 ADJUSTED MONETARY GROWTH; (solid line) 14 '14 NOMINAL' GNP GROWTH (dotted line) 12 12 "10 I I I I I 62 64 66 68 70 72 74 76 78 80 82 Note: Adjusted monetary growth is the sum of the 4 quarter growth in M1 and the trend growth of Ml velocity; GHP growth is over 4 quarters. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 215 CHART II Growth in HI .and the Monetary Base 20 MONETARY BASE (dotted line, right 16 1 scale) / 12 r4 GROWTH IN «1 (solid line, left scale) t8 1 II I I II II II [ | II I I I II I I I |II 1 1 II II II I [ II I I 1 "t2 1979 1980 1981 1982 Growth is annuallEed race over Ill-weeks ago Data are 4 rweek moving averages Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 216 CHART III Short Term Monetary Growth and Short Term Interest Rate* 16 THREE MONTH ».""• TREASURY BILL ; ;; *\ JI \-f '• (right scale) f MONETARY GROWTH (left scale) J F MA M J J A S O N D J F M A M J JA S O H D J F M A MJ 1980 1981 1982 Note: Data for Ml are four week moving averages growth is relative to one year ago Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 217 The CHAIRMAN. Thank you, Mr. Secretary. May I say that I ap- preciate the directness of your testimony. There has been before this committee a lot of speculation on the administration's position. Is it this or that or something else? After your testimony today, being as specific as it is, there should be no doubt about what the administration's position is on this subject. Mr. SPRINKEL, I hope you're right. The CHAIRMAN. Well, there are some who will still not want to, but if they read your statement, it certainly could not be consid- ered wishy-washy testimony in any way whatsoever. It is very spe- cific if they care to read it. In his testimony before this committee last week, Federal Re- serve Board Chairman Paul Volcker stated that: Periods of velocity decline over a quarter or two are typically followed by periods of relatively rapid increase. Those increases tend to be particularly large during cy- clical recoveries. In your statement today you say while the Federal Reserve cannot control money growth precisely week to week or month to month, growth of the monetary aggregates over a calendar quarter can be controlled. In controlling money growth over a quarter, to what extent should the Fed make allowances for the quarterly changes in veloc- ity of which Chairman Volcker referred to last week? PREDICTING MONETARY GROWTH Mr. SPRINKEL. I think it's very risky to attempt to, first, predict velocity and then take actions and predict what kind of monetary growth will occur with respect to those velocity changes. We know something about velocity. We know, for example, that it has a cy- clical component and also a secular component. If we refer, for example, to Mi velocity, we know that the secular trend in Mi velocity has been approximately 3l/4 percent per year on the plus side. We also know that during periods of recession when you look back and compute present velocity at the time, it goes down, just as in periods of recovery it goes up. To get that average 3 Vi or so percent, in the early phase of a re- covery it tends to rise at a more rapid rate than 31A percent. I can remember a famous debate in this town some years ago when Dr. Burns said that there would be a 5-percent increase in velocity in the first year of an economic recovery and everyone knew that that was wrong except it turned out to be right, and I expect that same sort of phenomenon to occur in the present environment as the re- covery gets underway. And I would certainly not believe it would be useful therefore to slow down the rate of money growth because velocity is going to snap back in the early phase of this recovery. The Federal Reserve can control money growth with some degree of precision. It cannot impact velocity. Velocity is determined es- sentially by the public and I would hope that the Federal Reserve would set their monetary targets as they have and stick to their course. This means that a given amount of money growth will give you more stimulus when velocity is rising rapidly as it does during the early phase of a recovery, but it also avoids the squeeze later Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 218 on. If you continue stable money growth you're not likely to get a sharp decline in economic activity subsequently. The CHAIRMAN. How would you evaluate the Fed's proposal to in- stitute contemporaneous reserve accounting? Mr. SPRINKEL. I'm very pleased by that move. On prior occasions I have represented the administration's views on what could be done technically to improve the ability of the Federal Reserve to get better control of the volatility of money growth and usually the first prescription mentioned was moving from lagged reserve ac- counting to contemporaneous reserve accounting. Essentially they have announced they will do that sometime, between now and, hopefully, next spring. In addition, moving toward a more flexible discount rate policy, that is a discount rate kept in line with the market rates—and there's some evidence they're doing that because they cut the dis- count rate recently—is, in our opinion, very important. And the third point that I think is relevant is: To focus on what they can control, namely, total bank reserves or the base. If they do those three things, I'm quite convinced that we'll have reason- ably stable growth in money. They have started and we applaud that action. The CHAIRMAN. How expensive do you think it will be for the commercial banks? Mr. SPRINKEL. Well, it's going to be costly to some of them. There's no doubt about that. And that was one of the major rea- sons that many commercial bankers opposed it. There's an easy so- lution. If we're getting a public benefit out of moving toward con- temporaneous reserves, as I believe we are—I think we will all benefit from getting more stable growth in money—it seems to me this should be a public cost, not a private cost. And the way to do that is slightly cut bank required reserves. Bank reserves are a tax and slightly reducing that tax will, of course, offset any added cost. Now there's a question of equity, how much cost each bank incurs in moving toward contemporaneous reserves—but in principle, if we're concerned about the undue cost to banks, then it seems to me that the simple thing to do is to slightly cut reserve requirements and that will offset the increased costs. The CHAIRMAN. One of our witnesses last week, Donald Maude, from Merrill-Lynch, argued, "reported data on Mi and M are 2 giving misleading indications as to how restrictive monetary policy has been." With regard to Mi, Mr. Maude argued that NOW ac- counts have accounted for 91 percent of the increase in Mi since last October and, two, that most of this growth has represented shifts of savings accounts, not growth of transaction balances. With regard to M , Maude argued that high interest rates have 2 caused interest credited to be a much larger component of the growth in M and that interest credited is not newly created money 2 or enhanced overall liquidity. Adjusting for NOW accounts and in- terest credited, Maude found Mi grew at an annual rate of 4.8 per- cent during the first half of this year and M grew at an annual 2 rate of only 1.9 percent. Do you believe that because of the arguments made by Mr. Maude that monetary policy may have been far too tight this year? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 219 FEDERAL RESERVE TARGETS Mr. SPRINKEL. So far this year, the Federal Reserve is within its targets. Now early in the year, as you know, it was over its targets, but in recent weeks they ve moved back somewhere in the upper end of the Mi range. Now it's indeed true that as interest rates move around, either up or down, this has an effect on how you and I and others allocate our liquid assets. This is inevitable. This cannot be controlled by the Federal Reserve. It will be controlled by us. Hence, it has an impact on how fast, Mi and M grow, one vis-a-vis the other. 2 As I pointed out earlier, I view the trend in bank reserve growth and/or base growth as being much more indicative of whether monetary policy is tight or easy and there is no evidence that I can find based either on the growth in monetary base or in bank re- serves that Federal Reserve policy has been unduly tight. For example, if we take the rate of growth of the adjusted mone- tary base since last October, the annual rate of growth has been 8.3 percent and that's fairly expansive. There were periods when it was high. More recently it's been lower. But it's averaged about 8 percent. If, instead of looking at changes in monetary base, you look at what's happened to bank reserves—adjusted reserves—since last October, the growth in adjusted reserves has been 8.1 percent. No evidence, from my point of view, that we have had an unduly re- strictive monetary policy, on average, since that time. There has been some volatility in the series and, again, in more recent weeks and months there's been less growth in bank reserves than there was previously, but essentially we've been on a path that leads to expansion in some of the M's, with some changing mix between them. If we are in a pattern of significant further decline in inter- est rates, I'm sure that the next person that testifies can again point out that there's been a change in the mix, but I think we should not be misled as to whether or not monetary policy has changed. What the Fed can do is control reserves or the base. They cannot control that mix. Therefore, I think it's very risky to point to changes in the mix and say that Fed policy has been too tight or too easy. The CHAIRMAN. Thank you, Mr. Secretary. Senator Proxmire. Senator PROXMIRE. Thank you, Mr. Chairman. Secretary Sprinkel, as you know, I have great admiration for you. I've heard you testify before this committee many, many times over the years and in your private capacity at Harris Bank and you're certainly a very able economist as well as a very consistent one. CONTINUOUS DEFICIT I didn't hear much or haven't had a chance to see much in your testimony about the role of the deficit in high interest rates. It seems to me that the colossal deficit that the Congress has run over the past 20 years, the fact that we have a trillion dollar na- tional debt, the fact that we face huge deficits this year, as your Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 220 Secretary, Secretary Regan, said the other day; next year $110 bil- lion. He hopes in the future it will be less. Many disagree with that and say it might be more. But it seems to me that that has to be a big element in keeping interest rates high. I don't know how we can avoid that. The Feder- al Government, as I understand, now takes not the $1 out of $6 it used to take in the early 1970's for example; it takes more than half or is going to take more than half. Do you feel that this continuous deficit isn't an important role? Is that why you didn't put much emphasis on that? Mr. SPRINKEL. Well, I did indicate the disadvantage of sharp in- creases in Government spending which have been essentially re- sponsible for these recurring deficits. I think it's very important that we get spending under control as your question indicated. I also think it's important that over time we get that deficit under control. It's an unmitigated evil. I can think of no advantages of a large deficit; I can think of a large number of disadvantages. One part of your question was directed at the relation between the interest rates per se—nominal interest rates I presume you meant, the actual ones that are printed in the newspapers these days—and the size of the deficit. Intuitively, I believe that it has some kind of an impact. I'm quite confident that, other things being equal, the larger the deficit, the higher the real rate of inter- est. But the problem is, when I try to find support empirically— and we have spent a lot of time at Treasury and I've encouraged some of my friends on the outside to do the same thing—I can't find the empirical support. That doesn't mean it doesn't exist. It may be there, but the effect is faint and it gets swamped by the many other factors that affect interest rates. Senator PROXMIRE. Let me just ask you, Mr. Secretary, don't you think that the present situation gives you some empirical evidence, the fact that now the deficit is so big the Federal Government is so enormous and interest rates are so unprecedentedly high, just as the level of deficits that we face in the future and have faced re- cently is almost without precedent. Mr. SPRINKEL- Well, that's sort of a self-fulfilling observation, but if it's really true you should be able to find over a lot of time in the past in the United States and in other countries that same rela- tion, and if your staff can find it I'd appreciate it if they'd give it to me. Senator PROXMIRE. All right. Let me suggest this. In the past there's been the expectation, which is very important as you know in the level of interest rates—the expectation that the deficits are temporary. Often they've been associated with war, for example, which we know we assumed in the past will last 3 or 4 years. That's what's happened. After the war we've had far less—the defi- cits have dropped very sharply and the demand for Government has dropped sharply. Now we face the situation where I think many, many investors think this is going to go on indefinitely, maybe 10 or 15 years. It's gone on for 20 now, year after year after year, and they seem to be accelerating. So why wouldn't that be an important factor in inves- tor psychology, particularly on long-term rates, when investors say, "I'm not going to put my money in a 30-year obligation or 20-year Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 221 obligation because if I do inflation is going to be so high and the demands by the Government for credit are going to be so big that those interest rates are going to continue high. Mr. SPRINKEL. I think it is an important factor in the psychology of the marketplace. I can put it in slightly different terms. Suppose they, No. 1, believe that that deficit is going to persist, as you suggest, and they have every reason for believing it, because it's been around for a long time. We've had a surplus of a half bil- lion dollars or so only 1 year in the last 15 or so. And if they be- lieve that a substantial portion of that deficit is going to be fi- nanced with new money—that is, monetary policy is going to ac- commodate the financing of the debt—then there's every reason to believe that money growth is going to accelerate and therefore in- terest rates are going to go higher, and therefore should stay high, and not go down. Conversely, let's suppose the Federal Reserve has at long last convinced all of us that this time they're not going to move back to accelerating money growth, but you still have a big deficit. Clearly, the deficit per se, even if not financed with new money, has an ad- verse impact on the economy. It absorbs savings, $100 billion plus a year. On the one hand, we're trying to encourage the Congress and with some success, of adopting laws that will encourage savings, in- vesting, and provide more incentives for work; and then on the other hand, we have a large deficit which is going to absorb those increased savings or existing savings. Therefore, we will not get the shift of resources from consumption toward capital investment and therefore not get a recovery that has in-depth capital formation, re- sulting in higher productivity improvement. So even if it does not lead to inflationary expectations and therefore higher nominal in- terest rates, I think there's good reason to believe that it will deter the achievement of our mutual objective of getting healthier eco- nomic growth. So I have no disagreement at all with you concerning the adverse effects of deficits on the economy. The only problem I have is trying to look at data in the past and find a very close relation be- tween the size of deficits and the level of the nominal interest rates. Senator PROXMIHE. Now I also got the impression from your testi- mony that you feel that if we are simply steady and persistent, if we stick with the policy of the gradual increase in the money supply and don't depart from it with some kind of quick fix, as you say, that we're going to get things under control. As I look at it, however, we now have a record, at least the record for the last 41 years, in the percentage of unemployment, 9.4 percent; we have business failures right and left. We have par- ticular difficulty in the credit sensitive industries because interest rates are so high. We're operating, as you know with less than 70 percent of capacity, a very low level on the basis of any historical experience. The credit sensitive industries are even worse off, auto- mobiles operating at less than 50 percent of capacity; homebuilding at far less than 50 percent of capacity. How far down does the level of capacity have to go before we get some substantial relief here in interest rates? It seems to me that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 222 you're saying, "it's all well enough for us to be patient here in Washington," but it's pretty hard to be patient if you're in these industries that are failing, if you're an employer or employee. I just don't get from your testimony any notion of how we can turn this thing around other than just hope that something is going to turn up if we stick with it for another 10 years. Mr. SPRINKEL. The reason, of course, is that I was addressing monetary policy, not the prospects for the improvement in the economy. The one important change that I didn't hear you mention was the very sharp reduction in the rate of inflation. Senator PROXMIRE. Until the last 2 months. Mr. SPRINKEL. Until the last 2 months. The question is which series do you believe, and I guess I don't believe the last 2 months. I do not believe it's 12 percent, just as I didn't believe it was zero percent earlier in the year when the indexes were saying that. I think the inflation is 5 to 6 percent, somewhere in that range. Now there is no doubt that the economy has gone through a wrenching recession. I just returned from the Midwest, close to your home area, as well as the west coast, and they have a depres- sion in some parts of particular industries, and I certainly have great sympathy for the painful adjustments that are occurring. GOOD PROSPECTS FOR A RECOVERY Now the question is, Is there any prospect of a recovery and is it going to be a lasting recovery? I think there are good prospects for a recovery. I've been in the forecasting business for 30 years, until when I came down here. I've been through eight recessions now. Never can one tell with absolute certainty when the turning point has come or the time you know for sure you're well on your way, but you have to watch the odds and the odds certainly have been shifting over the past few months, from my point of view, toward greater probability of recovery. Leading indicators have been up. Money supply, after having very slow growth in parts of last year, has had more growth of late. Inflation rates have come down. We know that as inflation rates have come down that any increase in nominal income will result in some real output growth. We know that the sharp contraction in real GNP in the fourth quarter of last year and the first quarter of this year became a slight positive, 1.7 percent, which is nothing to write home about, but it's certainly better than a sharp contraction. So that I would say that all the signs point to the probability of a moderate rate of expansion in the months ahead. Now can it be a lasting one, which is another part of your question? It cannot be a lasting one, in my opinion, unless interest rates continue to move down. There has been in the last month or so a very sharp decline in interest rates. Yesterday the prime was cut again in some banks Senator PROXMIRE. Short-term rates. Mr. SPRINKEL. Also long-term rates. They're off about 100 basis points from approximately a month ago. Short-term rates are off more than that, closer to 150 or 175 basis points. I firmly believe that the probability is that interest rates will continue to move down. If we've got a 5- to 6-percent inflation rate Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 223 and the world believes it, you and I believe it, and the marketplace believes it and we believe we are going to keep it, that implies in- terest rates in the 7-, 8-, 9-percent range, not in the 14- to 15-per- cent range. When we came into office, as you may remember, the prime rate was 21.5 percent. Yesterday some of them moved to 15.5. We expect to see further downward movement, and therefore, if we are to have a sustainable recovery which will lighten the load on those that have gone through this very painful cyclical adjust- ment, we must achieve further declines in interest rates. That's why my testimony focused on consistency, continuity in both mone- tary and fiscal policy to convince the marketplace that this time we mean it, so that the downward adjustment in interest rates, which is well under way, will continue into the months ahead. All the recoveries that I remember were led by consumer spend- ing, not by capital spending. Capital spending comes along 9 or 12 months later, but it's not going to come along if we don't get those long-term interest rates down in the months ahead. I'm confident we will do so, but I don't know for certain. Senator PROXMIRE. I have one other question, Mr. Secretary. The witness who follows you, Mr. Roberts, has indicated that he thinks that Mi is a grossly misleading indicator these days because of the change in the way people now keep their cash, keep their liquid assets I should say, and that total net credit would be a far more appropriate target policy and that it ought to be used as an addi- tional target, not the exclusive target but an additional target. What's your feeling about that? Mr, SPRINKEL. Well, just as I think it's very difficult for the Fed- eral Reserve to control Mi, M , M , it's even a greater difficulty for 2 3 them to control total credit. They can't do it. That is, they have no handle for controlling total credit just as they have not a very good handle for controlling Mi or M . 2 Senator PROXMIRE. Would you say no handle? Mr. SPRINKEL. Well, they can affect bank reserves, but there's not a close relationship between changes in bank reserves and changes in total credit. There is a reasonable relation between changes in bank reserves and Mi, but when the public shifts its preferences among the various components of money, as when in- terest rates move a lot, that relation becomes looser. Now I keep a chart that relates Mi to total spending and it's a pretty good rela- tion. That is, this is a fairly sensible objective to try to control Mi, but they can't do it with great precision because of the shifts that you referred to. They can control the monetary base and/or bank reserves with precision. There will still be a little noise in the M, s and ever more noise total credit. But to answer your question pre- cisely, I do not think the Federal Reserve should go even further into the series that they have even less control over and set that as an objective, and how can the Congress enforce someone achieving an objective it does not have the power to achieve? I would like to see them move back and set their objectives in terms of the series they can control; namely, either bank reserves or the monetary base. Senator PROXMIRE. For the record, I wonder if you could provide us with a series of options to get interest rates down. You obviously come down very hard and clear on what you feel is the best policy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 224 and I'm grateful for that testimony, but I think there may be other options the committee might like to consider because I think all of us are very aware of the fact that high interest rates are at the heart of our problem and we'd like to consider the broadest possi- ble choices. At least this Senator would. Mr. SPEINKEL. I'll be glad to think about a few, but the only ones—I have thought about them—and the only ones that I think will really work and continue to work are the policies I have al- ready discussed. Senator PKOXMIRE. That's fine, but you might just mention some of the others and give us a word or two as to why you think they're not appropriate. Mr. SPRINKEL. I'll be glad to. [The following statement was received for the record:] STATEMENT OF BERYL W. SPRINKEL, UNDER SECRETARY OF THE TREASURY FOR MONETARY AFFAIRS, ON ALTERNATIVE WAYS To REDUCE INTEREST RATES (Requested by Senator Proxmire* Interest rates remain high primarily for two reasons—they contain an expected inflation premium and a risk premium. The route to lower interest rates is there- fore, first, to control inflation; thai requires noninflationary money growth. Second, the risk premium now contained in interest rates could be reduced steadier and more predictable money growth and if the uncertainties surrounding the growth of government spending and the deficit were reduced. It is frequently suggested that interest rates could be reduced by either reacceler- ating money growth or by some form of direct controls, such as credit allocation or usury ceilings. Increasing the rate of money growth would not produce a lasting de- cline in interest rates. Any immediate drop in interest rates that might accompany faster money growth would be extremely short-lived; ultimately, faster money- growth causes inflation and generates inflationary expectations which causes inter- est rates to rise, not fall. Inflationary money growth in the past is a major cause of current high interest rates. Reverting to inflationary money growth would only assure that high interest rates will continue into the future. There is no evidence that direct controls on credit allocation or interest rates would be effective in reducing interest rates in the long run. Such controls may hide the symptom of high interest rates lor a time, but they are not a cure for the under- lying problem. The experience with credit controls in 1950 is a good case in point: interest rates fell temporarily while the controls were in place, but rose again to new highs once they were removed. In addition, credit and interest rate controls are difficult and expensive to administer, and, by interfering with the normal function- ing of the financial markets, cause enormous distortions and inefficiencies in the allocation of credit. Senator PROXMJRE. Thank you, Mr. Chairman. The CHAIRMAN. Thank you, Senator Proxmire. Secretary Sprinkel, I'm sure there will be some additional ques- tions for you in writing. Senator Riegle apologizes for not being able to stay. He's also a member of the Budget Committee and had to attend that other meeting. But I certainly appreciate the direct- ness not only of your testimony but of your answers. We are often accustomed to witnesses, particularly economists, before this com- mittee who are always hedging their answers and it is refreshing to have someone who, as you always have, gives direct responses. We may not always agree, but it's nice to know exactly how you feel and we thank you very much for that. Mr. SPRINKEL. Thank you, sir. It's a pleasure to be here. The CHAIRMAN. Thank you very much. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 225 Next I'd like to call to the witness table someone who is used to being on the other side of the table, on this side, Steven M. Rob- erts, who used to be a staff member of this committee, a very valued staff member. We are happy to have you before the commit- tee today in a different capacity, the other side of the table. We ap- preciate your willingness to be here and testify, so if you'd like to proceed. STATEMKNT OF STEVEN M. ROBERTS, DIRECTOR, GOVERNMENT AFFAIRS, AMERICAN EXPRESS CO. Mr. ROBERTS. Thank you very much, Senator Garn. It is a treat to be on this side of the table. The CHAIRMAN. And making real money in the private sector, right? Mr. ROBERTS. You mean what I made when I was on the other side of the table wasn't real money? [Laughter.] I'm grateful to you and the members of this committee for this opportunity to share with you my views on the conduct of mone- tary policy by the Federal Reserve. I am here today because of my deep concerns about high and volatile interest rates and their effect on our economy, and about the serious conflicts that exist be- tween fiscal and monetary policies. MONETARY AND FISCAL POLICIES Monetary policy is an important element in our overall economic strategy and the Federal Reserve's ability to act flexibly and inde- pendently of day-to-day political pressures must be guarded and protected. Fiscal policy is the other important component of eco- nomic policy. But, as you well know, it lacks flexibility and politi- cal independence, and, more importantly, at this point, credibility. Unfortunately, observers throughout the world do not believe we have the ability to manage our fiscal affairs appropriately. The re- action by our financial markets to the first budget resolution is clear evidence of skepticism in this country with regard to the Con- gress commitment to reduce spending and deficits. And, the persist- ence of high real interest rates is a clear signal that our policy mix needs to be changed—fiscal policy is too loose and monetary policy too tight given our current economic conditions and problems. Looking at the current situation pragmatically, I have serious doubts that genuine substantive changes in fiscal policy can be ac- complished until after the elections. At that point the serious ques- tions concerning entitlements and defense spending can be debated in a less politically charged, more rational atmosphere. But that does not mean that we should sit back and be compla- cent. Events can be permitted to proceed without additional shifts in policy. In my view this will mean most probably an anemic re- covery with the strong possibility that governmental and private credit demands will exceed supply and interest rates will rise as re- covery begins, thereby limiting the chance for even moderate eco- nomic growth. I believe that there is an urgent need for the Congress, the ad- ministration, and the Federal Reserve to seek innovative ways to restore confidence in our economy and its institutions and to set Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 226 the tone for releasing the enormous economic strength that this country has hiding underneath the burden of high interest rates and skepticism. There are things that can be set in motion now that would be very helpful to getting us on the right track. RECOMMENDATIONS Specifically, I would recommend the following actions: First, for monetary policy, I would drop Mi as an intermediate target for monetary policy because that variable is grossly mislead- ing. Second, I think the Federal Open Market Committee should im- mediately adopt a "total net credit" aggregate as an additional target for policy. Third, the Federal Reserve should immediately bring together senior representatives from the private sector to function like the Committee on Interest and Dividends of the early 1970's—charged with a mandate to come up with specific alternatives to get inter- est rates down and to reliquify major sectors of the economy. Fourth, this committee should serve as a catalyst in rebuilding the vitality of our long-term financial markets which are now very, very quietly still. You should undertake an in-depth set of hearings on the problems facing those markets and what can be done to re- store their strength. Fifth, the Federal Reserve should be asked immediately to stop reporting Mi data weekly and to move ahead quickly with other technical changes to improve the monetary policy process. With regard to fiscal policy, the time has come for a thorough reexamination of the fiscal policy process, a process that is too big and too complex for piecemeal change. This could be done by the passage of legislation to establish a commission—much like the first Hoover Commission in 1946—to look at ways to make Govern- ment more effective. Second, to increase the credibility of fiscal policy the budget proc- ess needs to be improved—a multi-year spending cap to reduce Fed- eral outlays as a share of GNP should be adopted by the Congress now (whether or not the balanced budget amendment to the Consti- tution is approved). Finally, while the Hoover-type commission is being organized, the Budget Committees of the House and Senate should set up sev- eral specific private sector advisory groups to recommend changes in the budget process by November 30 of this year. There should be individual groups from the business community, from the account- ing professions, and other specific constituencies as deemed appro- priate. This would allow necessary changes in the budget process to begin immediately with the start of the next Congress. Rather than going into the details of these points, I'd like to have them included in the record and answer any questions that you might have. [Complete statement follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 227 STATEMENT OF STEVEN H. ROBERTS DIRECTOR - GOVERNMENT AFFAIRS AMERICAN EXPRESS COMPANY Thank you, Chairman Garn. I am grateful to you and the members of the Committee for this opportunity to share with you my views on the conduct of monetary policy by the Federal Reserve. I am here today because of my deep concerns about high and volatile interest rates and their effect on our economy, and about the serious conflicts that exist between fiscal and monetary policies. Monetary policy is an important element in our overall economic strategy and the Federal Reserve's ability to act flexibly and independently of day-to-day political pressures must be guarded and protected. Fiscal policy is the other important component of economic policy. But, as you well know, it lacks flexibility and political independence, and, more importantly, at this point; credibility. Unfortunately, observers throughout the world do not believe we have the ability to manage our fiscal affairs appropriately. The reaction by our own financial markets to the first budget resolution is clear evidence of skepticism in this country with regard to the Congress* commitment to reduce spending and deficits. And, the persistence of high real interest rates is a clear signal that our policy mix needs to be changed — fiscal policy is too loose and monetary policy too tight given our current economic conditions and problems. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 228 Looking at the current situation pragmatically, I have serious doubts that genuine substantive changes in fiscal policy can be accomplished until after the elections. At that point the serious questions concerning entitlements and defense spending can be debated in a less politically charged, more rational atmosphere. But that does not mean that we should sit back and be complacent. Events can be permitted to proceed without additional shifts in policy. In my view this will mean most probably an anemic recovery with the strong possibility that governmental and private credit demands will exceed supply and interest rates will rise as recovery begins, thereby limiting the chance for even moderate economic growth. I believe that there is an urgent need for the Congress, the Administration, and the Federal Reserve to seek innovative ways to restore confidence in our economy and its institutions and to set the tone for releasing the enormous economic strength that this country has hiding underneath the burden of high interest rates and skepticism. There are things that can be set in motion now that would be very helpful to getting us on the right track. Specifically, 1 would recommend the following actions: Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 229 - FOE Monetary Policy o Drop M-l as an intermediate target for monetary policy — that variable is grossly misleading. o The FOMC should immediately adopt a 'total net credit' aggregate as an additional target for policy. o The Federal Reserve should immediately bring together senior representatives from the private sector to function like the Committee on Interest and Dividends of the early 1970's — charged with a mandate to come up with specific alternatives to get interest rates down and to reliquify major sectors of the economy. 3 This Committee should serve as a catalyst in rebuilding the vitality of our long-term financial markets by undertaking in-depth hearings on the problems facing those markets. > The Federal Reserve should be asked immediately to stop reporting H-l data weekly, and to move ahead quickly with other technical changes to improve monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 230 - For Fiscal Policy o The time has come for a thorough re-examination of the fiscal policy process, a process that is too big and too complex for piecemeal change. This could be done by the passage of legislation to establish a Commission — much like the first Hoover Commission in 1946 — to look at ways to make government more effective. 3 To increase the credibility of fiscal policy the budget process needs to be improved — a multi-year spending cap to reduce Federal outlays as a share of GNP should be adopted by the Congress now (whether or not the Balanced Budget Amendment to the Constitution is approved). D While the Hoover-type Commission is being organized the Budget Committees of the House and Senate should set up several specific private sector advising groups to recommend changes in the budget process by November 30 of this year. There should be individual groups from the business community, from the accounting professions, and other specific constituencies as deemed appropriate. Let me now turn to a more detailed discussion of each of these points. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 231 First, the nacjrowly defined money stock — H-l _-_- has serious definitional and prediction problems because^ of HOW accou_nts__and__ other financial innovations that make Interpretation of observed changes difficultat best. Therefore, H-l should be dropped as an intermediate target for monetary policy. It makes no economic sense for the FED or anyone else to focus attention on a variable whose definition is changing by actions in the market almost daily, whose behavior is impossible to predict, and whose relationship to income, employment, prices, and trade is uncertain. I am not alone in this recommendation. In fact, Frank Morris, the President of the Federal Reserve Bank of Boston and a member of the POMC, has also made this same point publicly. For many years the relationship between H-l and each of the final targets of monetary policy, namely, income, employment, prices and trade were fairly close and predictible. However, during the mid-1970's circumstances began to change and such changes have continued. The changes were brought about by three events — continued high inflation rates, continuing high interest rates, and financial deregulation. Innovation in financial markets is extremely fast. New financial products such as overnight repurchase agreements, money market funds. Eurodollars, NOW accounts, money market funds, and cash management accounts are appearing with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 232 increased frequency as individuals and corporations seek to earn a market rate of return on liquid assets. These important and popular money substitutes cannot be incorporated into the definition of M-l quickly enough to maintain the meaningfulness of that aggregate, indeed, the appropriate definition of money — M-l in particular — has proven to be quite elusive. Recall the FED's attempts to have two different M-l variables several years ago. I think they used the names "M-1A" and "M-1B". Last year the PED used a variable that was called "M-l shift adjusted". Thus, the PED has recognized that there are significant problems with the M-l concept. But nevertheless, FED policy continues to focus on what is a very misleading variable. Deregulation has already complicated the fomulation of monetary policy based on changes in growth of the monetary aggregates. With additional financial deregulation being considered the situation will get even worse. Here is what one senior staff member of the Federal Reserve Board's Division of Research and Statistics recently said; As you know, monetary policy formulation is now keyed to selecting targets for growth in the monetary aggregates that are expected, to produce certain results in terms of income/ output, prices, etc. Deregulation, especially of the terms of deposit liabilities may well complicate this process by changing the relationship of income to money — defined to include primarily some collection of deposit liabilities. As early as 1978, the creation of the 6-month MMC, by reducing constraints on the availability of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 233 mortgage money at s&Ls, probably meant more income could be financed at higher interest rates with the same level of money. More recently, the nationwide spread of HOW accounts last year induced shifting of funds into these accounts, which are included in narrow money—HI, from savings accounts and other non-Mi sources, thereby distorting the relationship of Ml growth to income flows. The Federal Reserve made some rough adjustments to our data to take account of these shifts, but these adjustments were not fully understood or accepted by many observers of monetary policy, and they probably did not raise the level of comprehension of monetary policy by the general public. Moreover, reflecting their use as a savings vehicle, deposits in NOW accounts this year do not seem to have behaved exactly as funds held in demand deposits used to, further complicating monetary policy formulation. More generally, as deposit categories are deregulated, their character may change, and with this change policy makers would no longer be able to rely on historic relationships in evaluating their choices. These problems may be most acute in the transition phase to a new deposit structure— as they were last year with NOW accounts— but they are likely to persist as a byproduct of deregulation for some time. If the above statement by the Federal Reserve's own staff is accurate, and I believe it is, not only is M-l a very misleading indicator of policy at this time, but more importantly all of the monetary aggregates must be interpreted with extreme caution. During what may be a lengthy transition period reliance solely on monetary aggregates as short-term indicators of FED policy should be avoided. I agree with my monetarist friends who say that over the long-term/ that is over the full course of the business cycle, it is important to maintain growth in the monetary aggregates at rates consistent with reducing inflation. This must, however, be done in an intelligent manner. It does not mean Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 234 that the FED should be slaves to M-l, or any other aggregate, on a week-to-week basis, or even on a month-to-month basis. Technical complexities and market induced changes in the definition of what money means to those who use it cannot be easily incorporated into monetary aggregate measures or targets. Furthermore, we have seen recently that changes in velocity in the short-run can be very misleading and in some circumstances could result in faulty policies. During this transition to a deregulated financial environment monetary policy will continually be grasping at the appropriate monetary target variables. I recommend that the FED look at all available indicators not just the monetary aggregates. Other useful indicators should include: intermediate targets such as nominal and real interest rates and net total credit, or the ultimate objectives themselves, income, employment, prices, and trade. The FED should be asked to explain their policies in terms of the affect they have on these variables as well as on the monetary aggregates. Several people, including Secretary Sprinkel have recommended that the Federal Reserve adopt the monetary base or nonborrowed reserves as a target variable. I believe that there would be serious problems with this. First, both of these variables should be viewed not as targets of monetary policy, but rather as instruments of policy that might be used Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 235 to attain the intermediate target objectives. Instruments and targets are two different things. Second, the monetary base is composed of two parts — currency and. nonborrowed reserves. Changes in currency are beyond the control of the Federal Reserve, they represent a derived demand. Whenever a bank is in need of currency it can be obtained from a Federal Reserve Bank, most often by a debit to their reserve account. While the FED could take additional action to offset the demand for currency it is questionable that they should do so in all instances. Third, the FED is already using nonborrowed reserves as its instrument variable, and adjusts changes in the instrument according to changes in economic and financial conditions as they occur. Second, the federal Reserve for its ^jgjjrXjnust recog_ni_z_e_ that c^ ec! it^avai 1 j bi 1 i ty an d q r owt h ace j u s t a s_jjnpor t ant a_s monetary grpwth_-_ _j jgct . r^na j^re ingne t arj. sjn _i_s com ing jindei: and abroad. The FOHC shouj.d_be asjted to_^ immediately hold public hearings^^n_tj]e_a^visability of establishingi^LS ^ne^gf^i^s intermediate targets tqt:al^nej: credit— the outstanding^ indeb^t^anesj_oj^ all U.S. nonfinancial j borrowers. Their present credit aggregate — bank credit — is seriously inadequate because it represents only a small portion of the total. Establishing a target for total net credit, moreover, would be entirely consistent with the objectives and requirements of the Humphrey Hawkins Act. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 236 DuiJirtg the past several years an increasing number of well qualified observers of monetacy policy have recommended to this V and other Congressional Committees that the Federal Reserve adopt a more useful credit aggregate target than the one they currently use — bank credit. Unfortunately/ the FED has only paid lip-service to such recommendations, or has argued that they cannot control anything but bank credit. According to Professor Benjamin H. Friedman of Harvard University, based on a variety of methodological approaches, total net credit in the united States bears as close and stable a relationship to U.S. nonfinancial activity as do the more familiar asset aggregates like the money stock. Friedman's research has shown that the U.S. nonfinancial economy's reliance on credit, scaled in relation to economic activity, has shown almost no trend and very little variation since world War II. Secular increases in private debt have largely mirrored a substantial decline (relative to economic activity) in federal government debt, while bulges in federal debt issuance during recessions have mostly had their counterpart in the abatement of private borrowing. This type of stability would make total net credit a useful target for monetary policy. Henry Kaufman of Salomon Brothers has indicated much the same thing in testimony before this committee some years ago. So that you have the full benefit' of his views I have Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 237 attached to my testimony a piece of recent testimony given by Professor Friedman, I recommend it to you. Having a broad credit aggregate as an intermediate target for monetary policy would have the added benefit of bringing into clear focus the effects that borrowing by the Federal government, directly and indirectly through Federal credit programs, has on the availability of credit to the private sector. The large deficits this year, and projected for the next several years, will, given a fixed supply, put upward pressure on interest rates since rates are the "main" allocator of credit among competing users. I emphasize the word "main" because the Federal government does have a unique position as a borrower . Third, the ^ede^caj^Reser^ve should iminedj atej/y ejtab^lish a L j Committee^ to _function_ like^he^Commrttee on Interest arid DividendSj_which_w_as jj hold j^ng down^_ i n t e re s t r a t e s . Since the shift in the Federal Reserve's policy strategy in October 1979 interest rates have been set primarily, and credit allocated, by participants in financial markets. Therefore, participants in financial markets must also take on some additional responsibility for the economic well-being of this country. Individual companies will act in the short-run in their own best interest and in ordinary circumstances they should. However, circumstances are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 238 now such that participants in financial markets must be brought together and they must act collectively to get interest rates down in the long-run best interest of the country. This can be done by private initiative without resorting to mandatory controls/ but rather voluntarily with some input from the Federal Reserve. We in the private sector can no longer enjoy the luxury of merely sitting back on the sidelines carping about policy-makers' dilemmas. Everyone is asking a very pertinent question about monetary policy: What can be done to get interest rates down so that the economy can be revived? Chairman Volckec's response to this question has been that the FED has little leeway to act. We can, of course, debate whether this is true. But, as long as the Board thinks this is true they will be reluctant to act. Some observers have suggested that credit controls be used to do what the FED cannot or will not do. The politics of current circumstances preclude this type of action. I think it highly unlikely that the President will ask for credit control authority to be restored and thus I consider the issue dead. However, this does not preclude the Federal Reserve oc the Administration from turning to the private sector for voluntary action/ nor does it preclude the use of 'jawboning", a tactic that has been successful in similar circumstances in the past. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 239 During the period of Nixon wage and price controls the Committee on Interest and Dividends was created to advise the Federal Reserve on ways to keep interest rates down. One suggestion that was made by the CID and adopted by many banks was to have their prime rates set according to formulas linked to their cost of funds. While the exact formulas differed many banks set their prime 3/4 to 1 percentage point above the cost of funds. While circumstances differ now, I think similar innovative suggestions would be found by senior financial executives that would result in a significant lowering of the prime and other short-term rate in very short order. But, this and similar initiatives must come from the private sector with guidance from either the FED or the Administration. No lender will voluntarily reduce their spreads unless they have good reason to believe that their competitors will do likewise. I am confident that if something akin to the Committee on Interest and Dividends was re-established tomorrow that additional innovative ways to lower interest rates through private sector initiatives could and would be found. FQurth,._ tbe___p_qtentia1 loss of aur_j,ong_-1erm_bond markets sjiould jio Ignge^r^be^ ignored. It would be a serious mistake to permit all borrowing to be concentrated in short-term instruments which can be subject to significant internal and external shocks. As mote and more financing is done short-term, fluctuations in short-term interest rates will Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 240 reach every nook and cranny of the economy quite quickly, which may be neither desirable nor healthy for the long-term. committee shQujj^innnedjately undertake a broad _set_ of hearings jesj. gnej t o u n_d_g rst_agd_ the _pr ob 1 em_s i n Ion g ~ t e_r m ma r k e it .s wha t L they Imply for^ the future of our fin^angj.a^l^ system ,^an^ approaches to infjsinq^rigw_liXe into those rnarkets. It would r be a serious mistake to let those markets evaporate, which is exactly what has happened in Europe. This issue needs little further explanation. A story in last Friday's Washington Post explains the situation very clearly, and therefore, I have attached a copy of it to this testimony. Investors and borrowers have avoided the long-term bond markets for some time for two reasons; the high costs of borrowing long, and uncertainty about the future. As a result corporations have turned t'o short-term sources of funds for both liquidity needs and perhaps even to finance needed investments. Many corporate treasurers are taking this approach in anticipation that rates vill drop and that they then can find more permanent financing at more favorable rates. But, what are the implications for the long-term markets if rates do not fall or worse yet rise and stay high? Will the long-term markets be lost forever or for an extended period of time and will all financial decisions in the future be based on short-term or floating rate credit? What would the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 241 implications of this be for future investment spending? What dangers does this pose foe stability of financial markets? These are important questions that should not be avoided. This is why I urge this Committee to hold comprehensive oversight hearings on this issue as quickly as possible, ^ut iti place several technical changes ^in its procedure that it has in di cat e d . t w i 1 1 ma k e a nd sho u 1 d a 1 so cons id er 3 ever a 1 ot he r s . Important changes in the reporting of weekly M-l data and reserve accounting have been announced but not implemented. The FED should also consider linking the discount rate to market rates and staggering reserve maintenance periods. Both of these latter changes would tend to smooth interest rate movements. This committee has been instrumental in getting the FED to consider changes in the reporting of weekly H-l data and lagged reserve accounting. Although the Board has approved in principle these changes they have yet to be put in place. While the Board should be complimented for their decisions, they should also be urged to move ahead quickly to implement those decisions. I would also note that I think the Board has not gone far enough on its decision about weekly H-l data. Consistent with my recommendation that M-l be dropped as a target variable I think that the Board should publish H-l only once a month. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 242 It is my understanding that the Board is now considering an additional change to the maintenance of required reserves. This change would basically divide those institutions required to hold reserves into two groups, and would have each group report in alternate weeks -- thus the term, "staggered reserve periods". This would be a significant and useful change because it would permit banks in one group to provide excess reserves to banks in the other group, thereby reducing the variability in interest rates that occurs now as all banks scramble to meet their reserve requirements on the same day. I would also suggest that the discount rate might usefully be tied to market rates of interest once the FED moves to a contemporaneous reserve system. This would make changes in the discount rate more frequent. And, although the FED would lose the so-called "announcement effect" that changes in the discount rate now have, that loss would be small by comparison to the gain in control of reserves. Consideration should also be given to making the discount rate a penalty rate during periods when additional restraint is needed. S. 1 xt j\ , t o_f\i rt jigr_. the po s s i b i I i ty^ Qr^credj. bj JL _f_l_g_cal policy an^d^^j^e ^budget process, a bi-partisan body of k no w 1 e dgeabj^e _p_e_rs o_n_s ,_ much 1 i k e t he or igji^a i j^ jHooye^ Cgmm i s s ion _in__I_9_46_/ _3hould_ be established by l_aw. In _fac_t this process f Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 243 has already been jget in motion. Last year Senators Roth and Eagleton introduced S. 10 in the Senate and Congressman Boiling introduced H.R. 18 in the House to create a Commission on More Effective Government. The mandate given by the legislation could and should focus on the fiscal policy process in general, and the budget and appropriations processes more specifically. The idea for such a Commission has been endorsed by the President. I understand that s, 10 has been passed by the Senate by a vote of 79 to 5, but that H.R. 18 is still pending in a House Subcommittee. I would urge you and your colleagues to ask the House to move ahead with its consideration of H.R. 18 or S. 10 as quickly as possible. The Commission's work may take eighteen to twenty-four months so additional delays in its formation could be costly. I admit that the challenge that faces us/ and I mean that collectively, to control Federal spending is immense. But it is not beyond our capacity to get tough on spending. However, the Balanced Budget Amendment to the Constitution, if it is adopted, is no panacea. Additional approaches to deal with the problem, such as a legislated spending cap with appropriate changes in the Budget Act to make it effective and credible, can be constructed and enacted. I need not get into this issue in much detail, because the members of this committee are more aware than I about the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 244 public perception of fiscal policy and the budget process. Steps need to be taken now to give the congressional budget process more credibility. The best way to do this is to show significant self-restraint/ not just once but over a period of time. The FED by adhering to targets that it has set during the past several years has shown that this approach works to restore credibility. The Congress can do the same, but again time is of the essence. Attached to my testimony is a draft proposal for a Joint Congressional Resolution that may be useful in this regard. It proposes five year goals for reducing Federal outlays as a share of GHP. While this is not a new approach, it is timely. The Chairman of my company, James D. Robinson III, has been discussing this type of resolution with various members of Congress, the Administration, and the business community. It has been well received, not because it is a cute-all for our fiscal problems — it is not — but because it represents a starting point foe changes in the budget process. Also attached is a short talking paper explaining the need for this type of approach. Some type of credible action to reform the budget process is needed now. The financial markets would react favorably to such a meaningful and credible commitment to reduce federal outlays over the next several years. The establishment of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 245 goals to accomplish such reductions would be useful, but only if the goals are adhered to by the Congress. This will require changes in the Budget Act to establish such goals and to put in place a mechanism foe adhering to the goals. Seventh, ._ Credibility. In fj.scal policy needs to be established ^nd^it^annot wait for an amendment jo the Ccjnst^it.uti^on^ tq^ _be_enacted__aiid__rat if ied_ by the jtatea. The Congressional Budget process^ needs to be improved an& _a jirnif jgdeJby^ the Congress immediately tp make cpmmitmerit can be made now by^ resolution goal jbg reduction of federal outlays^ as a share of gjcoss natigna^ prgduct_gver_ the^ next f iye yeajrs^, say^ t^o 2j percent or less or some other ap£ r^p r i a t e p e re e nt ag e • Other changes in the budget process such as the establishment of a credit budget, the establishment of a capital budget, the establishment of a multi-year budget [say for two years), a 2/3 vote for any budget resolution, a line item veto for the President, and other ideas should be explored. Finally, while ^he j-dea^of^a^Hoc^ver-tYpe^ Cjjminissign i^swa^ through CongrejS^ and^ thg process of organizationj, the ajpprojpriate jojnmittees of the Congress shojjld on reforming Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 246 To _fu_cthet_ the possibility _£p_t credible changes, in the budget. process^ non-partisan, _np ^-political private ^_sect_or. ajvisory groups^ t he agp ropr i aj.e. cprom i^tegs__gf t h e jjongrgss; . If the private sector, and especially the financial markets are concerned about fiscal policy, federal spending, and federal deficits they should do their part in recommending useful changes in the process. This would be yet another example of private sector initiative and should include representives of financial markets, the business community, accounting firms, and other important constituencies. These advisory groups should be formed quickly and given a short time frame within which to make their recommendations, so that changes in the budget process can proceed to be considered as soon as the 98th Congress begins its work. Thank you. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 247 &K Utasljmglon Friday, July 23,1982 Companies Rushing to Borrow By James L. Rowe Jr. ond-biggest bank, announced that it past four week*, rates remain histor- Wuninjloii Pan stiH HUM was selling (300 million at notes, ically higb, , ,. '- NEW YORK, July 22-Compa- But with ran exception!, moat nies have been rushing to sell short' companies that would have sold 20- Furthermore, potential p term bunds and notes during the year bonds five years ago are selling of Song-terra bonds still are past few weeks HI a frantic attempt note that mature within five yean buying then, remembering to take advantage of the sharp de- all previous "rallies" since tta or leas, according to Bernard Har- cline in interest rates. interest-rate siege began four The list of companies that haw mon, vice president of the brokeiag* ago, sharp declines in sold what analysts Hay is more than firm Drexel Biunham Lambert Inc. quickly followed by returns to ' $1 billion this week and last reads The window » open, but it's open • highs, -_ like a who's who of corporate Amer- crack," he said.. ica DuPont, F<id Motor Credit, Most companies ue reluctant to Investors who Bought Caterpillar, General Mills, Getty Oil, aeH debt securities (such as not** rallies were left with securities Mead, Champion International and hoods) that mature in more leas than their face, value whed At 6:25 p.m. today, BankAinerica than 10 years became, even with the roee again. _,.* Corp, which owns the nation's sec- ateep fall in interest costs during the See COMP AMKS,< COMPANIES, From C9 three years, inveatnrs can redeem But James W. Simpson, managing them or extend them for another director o.f industrial finance for three years at an interest rate set by Merrill Lynch White Weld, the in- a formula lied to other interest rates. vestment banking arm of the na- The final maturity of these notes tion's biggest securities firm, said will be 1997. investors are starting to get interest- BankArtrerica's so-called money ed in buying longer-term securitie& multipliers are the equivalent of BO- "For the first time in a year," called zero-coupon bonds. Instead of Simpson said, "the yield curve is receiving interest every qauter or - positive-" That means an investor every nix months, investors pay a > gets a higher return for a 20-year price leas than face value and receive bond than for a six-month note. the full amount of the note at matu- ' When short-term rates are higher rity. The notes will pay $1,000 at ma- than long-term rates, there is no rea- turity. An investor who buys a money son for an investor to take the risk of multiplier that matures on Dec. 15, putting funds out for a longer peri- 1987 pays. I5W>. For a note, that re- od. turns $1,000 on June 22, 1993, an i And Hemy Kaufman, the oft- investor pays $250 today. •, quoted economist It" Salomon William Keneiael, a principal of • Brothers whose forecasts are closely the investment banking firm Morgan watched, is predicting today that Stanley & Co., said that companies, short-term interest rales will decline for the moat part, are using the further. He also says those declines funds they raise in the bond market ' probably will be short-lived. to pay off short-term borrowings | But long-term investments stillfrom their banks ur in the commer- are not attracting investors or issuera cial paper market. The bank prime ^ and. in the early stages of the rally, rate, for example, is IE percent r many companies are setting notes Rates have plummeted in recent with a new gimmick exlendability. weeks, according to William Sullivan For esample. Caterpillar Tractor of the Bank of New Yorfe, because sold $150 million of three-year ex- recent declines in the money supply tendable notes that carry a yield of have permitted the Federal Reserve i U'/i percent t*> alarl At the end of to loosen its monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 248 July 14, 1902 TESTIHOBY BEFORE THE j]Nimp_STA_TES HOUSE OF REPRESENTATIVES CCMMITTEEJ3N BflMKIHG, FINflHCE^jffD^Ura_ SUBCOMMITTEELCK JKJMBSTIC HMETflRY KJLICT Benjamin M. Friedman Professor of Economics Harvard University A CREDIT ia»ffiT_Fps_.psEraRy POLICY He. 1 am grateful for the opportunity to review with this committae the proposal for an alternative monetary policy framework that. I presented to it almost a year ago. During the past year, as the U*S, economy has undergone its second business recession of the 1980s, monetary policy has been more than ever the focus of national attention. As people have continued to examine closely the course of monetary policy and its impact on economic events, they have increasingly begun to question not just the specific stance ol monetary policy at any tine but also the operating framework that defines U.S. monetary policy. In particular, many people have questioned whether the framework now in use, which centers on specific target rates of growth for the monetary aggregates, is the best way to conduct monetary policy today. I believe that this more fundamental concern is highly appropriate, and I hope that the committee's inquiry into possible alternative targets for monetary policy will further the prospects for a serious evaluation of this issue — and, if a sufficient consensus emerges, for actual reform. I am honored to take part in this discussion. I believe that reform of the U.S. monetary policy framework is now Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 249 overdue; that the exclusive emphasis on monetary aggregate targets has outlived its usefulness? and that a broader framework, based on both money and credit, would be more appropriate in today's economic and financial environment. Specifically, I propose that the Federal Reserve System adopt an explicit two-target framework in which it would focus both on the money stock and on the quantity of credit outstanding. I believe that a two-target aoney-and- credit framework for monetary policy would be more likely to achieve the objectives of economic growth, economic stability and price stability that both th* Congress and the American public seek. In this testimony I will first review several factors that account for the recent widespread disillusionment with the monetary target approach which now dominates U.S. monetary policy making. Next, I will outline the basic idea underlying the use of an intermediate target for monetary policy, and state four important criteria for choosing such a target. I will then say why, on each of these four criteria, credit is just as good a target as is money. Finally, I will outline the two-target money-and-credit frame- work that I have proposed, and explain why it is likely to be superior to the current money-only framework,* Bie ^isillusioninBnt with Honetary^Targefc5 Monetary aggregate targets have occupied center stage in U.S. monetary policy making in recent years. 3he Federal Reserve System firet used such targets in a formal way in 1970. In 1975 the Congress passed House Concurrent Resolution 133, requiring the Federal Reserve to formulate monetary policy •In what follows I will draw heavily on several of my recent papers, especially "Tine to Re-Exandne the Monetary Targets Framework" (New Biglanfll Economic^ Review, March/April, 1982) and "Monetary Policy with a Credit Aggregate Target' (forthcoming in the Journal jif Monetary Economics, available now in mimed) . See these two papers for further detail, including supporting evidence on the comparisons between money and credit. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 250 In terms of specific money growth targets to be reported to Congress in advance, and in 1978 Congress reinforced this requirement under the Humphrey- Hawkins Act. In October 1979, the Federal Reserve publicly reaffirmed its commitment to monetary aggregate targets, and adopted a bank-reserves operating procedure for seeking to achieve then. Several strands of economic opinion and analysis, shared in varying degrees among people concerned with monetary policy, apparently led to this focus on monetary aggregate targets. One was the belief that the supply side of the U.S. economy was essentially stable, and that economic fluctuations were due mostly to instability in aggregate demand which a more stable money growth rate could help avoid. Another was the widely perceived problem of determining hew any given level of interest rates would affect the economy, as rapid and volatile price inflation made "real" interest rates ever more difficult to measure; by contrast, measuring "money" was supposedly straight- forward. Still another was the increasing focus on price inflation itself as a major economic policy problem, together with the belief (apparently supported by the then available evidence) that the rate of money growth placed an effective ceiling on the economy's inflation rate. Finally, a matter of importance at least to economists was the belief that behavior in the economy's financial markets, including especially decisions by house- holds and businesses about how much money to hold, was more dependably stable than were important aspects of behavior in tha economy's product and factor markets. No doubt other influences, perhaps including political and even personality factors, were also at work in bringing about the adoption of the monetary targets framework during the 1970s, but this set of ideas probably comprised the central thrust of that important development. Each of these Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 251 propositions, if true, would have represented a significant argument in favor of the use of monetary targets, and the joint validity of all of them would have< constituted an overwhelming case for that way of designing and carrying out monetary policy. i Regardless of whether or not the best possible assessment of the available evidence actually supported these propositions at that time (a question which in hindsight people may debate without limit), they do not appear consistent with the facts today, ttte experience of the 1970s, and of the 1980s to date, has sharply contradicted each of them. Oil shocks and agricultural price shocks have powerfully illustrated the importance of instability on the economy's supply side as a cause of economic fluctuations, As financial market participants have shown their innovative skills by developing a wave of new financial instruments and new ways of using old ones, measuring "money" has become anything but straightforward. Price inflation has been able to outpace by substantial margins the ceiling supposedly set by money growth rates, at least for several years at a tine, tad economists' historical relationships describing the public's demand for money have all but collapsed. For all of these reasons, today's disillusionment with the monetary targets framework for U.s, monetary policy is not sinply a matter of unhappiness over the economy's recant performance. After all, any specific adverse economic e^ierience could be due to either poor policy decisions or poor execution, or even bad luck, rather than an inadequate framework. The desire for change today is instead more fundamental, and therefore more persuasive. The well understood propositions that would favor the exclusive reliance on monetary aggregate targets, if they were true, just do not match today's environment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 252 Using^and Choosing Monetary Policy Targets Central banks have often found it useful to formulate and implement monetary policy by focusing on some intermediate target or targets. Under an intermediate target strategy, the central bank specifies soae financial variable(sj —in the United States today, the major monetary aggregates — to stand as proxy for the real economic targets at which monetary policy ultimately aims, such as economic growth, price stability, employment, and international balance. The result IB, in effect, a two-step procedure. The central bank first determines what growth of the intermediate target is most likely to correspond to the desired ultimate economic outcome. It then sets some operating instrument over which it can exert close control — in the United States either a short-term interest rate or, since October 1979, the quantity of reserves — so as to achieve that growth rate for the intermediate target itself. The essence of the intenwsdiate target strategy is that, under it, the central bank is required to respond quickly (and fully) to any information reflected in the movements of whatever the intermediate target happens to be. Under the current framework in the United States, with monetary aggregates used as the intermediate targets, any movement in the public's money holdings immediately creates a presumption that the Federal Reserve System should react. In principle the Federal Reserve is always free to change the money growth targets, of course, but in practice It is typically reluctant to do so. Ihe intermediate target strategy instead calls for actions aimed at regaining the stated targets, so that the economic signals contained in movements of the monetary aggregates create a presumption of immediate response, Ely contrast, the presumption of this strategy, strictly implemented, is that there will be no response to signals arising from other sources but not Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 253 reflected in the intermediate targets. If the intermediate target strategy with the monetary aggregates as the central targets is faulty, what should the Federal Reserve da in its place? One plausible response to the changed circumstances 1 have summarized above would be to reject the usefulness of any intermediate target at all for monetary policy. Without an intermediate target, the Federal Reserve would focus its policy directly on the nonfinancial economy — which, after all, constitutes the ultimate reason for having a monetary policy. Such a direct approach may well constitute the most effective policy framework, and an informed public discussion of the idea would be highly useful. Even so, ft practical assessment of the situation suggests that, at least for the immediate future, both the Congress and the Federal Deserve itself are firmly committed to having some kind of intermediate target to facilitate monitoring monetary policy on an ongoing basis. Today's hearing on alternative targets for monetary policy appears to be in this spirit. The question at hand, then, is to choose some alternative intermediate target to use in addition to (or perhaps even instead of) the monetary aggregates, as a focus of monetary policy. To be sure, an enormous variety of financial variables is available for this purpose. Hie problem is not just finding potential targets but identifying targets which, if used, would lead to a superior performance for monetary policy. The structure Of the intermediate target strategy itself suggests four important criteria for choosing such a target. First, and most obviously, the target should be closely and reliably related to the nonfinancial objectives of monetary policy. Second, movements of the target should contain information, about the future for current but not readily observable) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 254 movements Of the nonfinancial objectives of policy. A close relationship per ee is necessary but not sufficient to make a useful target. Third, the target must be closely related to the operating instruments which the central bank can control directly —in the U.S. context, once again, either reserves or a short-terra interest rate. There would be little point in having an intermediate target Chat the central bank could not reasonably expect to effect within some tine horizon like a calendar quarter or a half-year. Fourth, data on the target must be readily available on a timely basis. Ihese four criteria will largely determine the suitability of any financial variable — including the monetary aggregates as under the current framework, or a credit aggregate as I have proposed, or any other alternative that the committee wishes to consider — as an intermediate target for monetary policy. Evaluating Credit &s a^ Monetary_^Policy JT&rget I have proposed a credit target for D.S. monetary policy because 1 believe that at least one specific credit aggregate, total net credit (the outstanding indebtedness of all U.S. nonfinancial borrowers), satisfactorily meets each of the four criteria I have stated above. Before proceeding to such a conclusion, it is essential to ask at the Outset, "satisfactory" in comparison to what? Because the current framework used by the Federal Reserve System relies on monetary aggregate targets, the immediate standard required to support a proposal for change is that the proposed new target must meet these four criteria at least as well &s do the monetary aggregates that ax* the current focus of monetary policy. 1 believe that total net credit does meat each of these four criteria at least as well as the monetary aggregates. First, results based on a variety of methodological approaches Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 255 consistently indicate that total net credit in the United States bears as close and as stable a relationship to U.S. nonfinancial economic activity as do the more familiar asset aggregates like the money stock {however defined} or the monetary base. Moreover, in contrast to the familiar uset aggregates, among which there appears to be less basis for choice fron this perspective, total net credit appears to be unique in this regard among major liability aggregates. Unlike the asset aggregates, the stability of the relationship for total net credit does not just represent the stability of a sum of stable parts. Because this first criterion for selecting a monetary policy target is the me that always receives the most attention, and rightly so, it is worth reviewing the relevant evidence with some care, Bie U.S. nonfinancial economy's reliance on credit, scaled in relation to economic activity, has shown almost no trend and but little variation since World War II, After falling from 156% of gross national product in 1946 to 127% in 1951, and then rising to 144% in 1960, total net credit has remained within a few percentage points of that level ever since, (The yearend 1981 level was 143%.) Other- wise it has exhibited a slight' cyclicality, typically rising a percentage point or two in recession years (when gross national product, in the denominator, is weak) and then falling back. Although the individual conponents of this total have varied in sharply different directions both secularly and cyclically, on the whole they have just offset one another. In brief, the secular rise in private debt has largely mirrored a substantial decline (relative to economic activity) in federal government debt, while bulges in federal debt issuance during recessions have mostly had their counterpart in the abatement of private borrowing. For purposes of monetary policy, however, what matters is not just Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 256 stability in the sense of zero time trend but stability in a more subtle (and, importantly, a dynamic) sense. Empirical analyses relying on several different methodologies —ranging from comparisons of "velocity" ratios, to comparisons based on detrended data, to "predictive" performance in regression equations explaining the variation of nominal income, to more complicated analyses based on bivariats and multivariate vector autoregreesion systems — all show that the relationship between total nonfinancial debt *nfl economic activity is fully as stable and regular as is the relationship for any of the Federal Reserve's standard "M" aggregates (on either the pre- or post-1980 definitions) or the monetary base. Further, the stability of the credit-to-income relationship is a phenomenon in no way restricted to the United states in the post World War II period. Ti'he U.S. nonfinancial economy's reliance on debt relative to economic activity has shown essentially no trend over the past 60 years. (She 1921 level was 142%.) Nonfinancial borrowers' outstanding debt rose significantly in relation to gross national product only during the depression years 1930-33, when the economy was deteriorating rapidly and many recorded debts had defaulted 3e facto anyway. Otherwise the postwar stability in the United States appears to be continuation of a pattern that dates back at least six decades. Among foreign economies, analysis of post World Wax II data thus far has demonstrated a similar comparability of the credit-to- income and money-to-income relationships in Britain, Canada, Germany and Japan. In sum, there is ample ground for believing that total net credit is as closely related to nonfinancial economic activity as is any of the monetary aggregates that are so central to today's monetary policy framework. Second, the finding that the credit-to-income relationship is as regular and as stable as the money-to-income relationship would be of little Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 257 interest in a monetary policy context if the economic behavior underlying these results were such that money "causes" income while income in turn "causes" credit. The evidence contradicts that notion, howeverj indeed, if anything, they suggest the opposite. "Hie relevant causal links between financial «ni3 nonfinancial economic variables appear to be highly complex, but results based on econometric exogeneity tests show that money and credit play royghly parallel roles, with credit somewhat more significant than money in determining the variation of either zeal income or prices. Still further results of decomposition of variance, based on a variety Of different statistical specifications so us to avoid spurious conclusions, suggest not only that current movements of financial variables do contain potentially important information about future movements of nonfinancial economic activity but also that credit contains more of such information than does money. Third, while it would be difficult for the Federal Reserve System to exercise very precise control over the total net credit aggregate over short time horizons, recent experience has demonstrated that the monetary aggregates are not easy to control either. What matters for the choice of monetary target variable, once again, is the comparison of money and credit. Evidence based on both quarterly and monthly regression relationships suggests that, if the Federal Reserve chose to pursue a total net credit target, it could achieve a degree of control over that target fully comparable to what is possible for the major "M" aggregates. Itie exact comparisons differ accordina to the time horizon used for judging successful control, and also according to whether the operating instrument the Federal Reserve used would be nonborrowed reserves (as since October 1979) or the federal funds rate (as before that date). In sun, however, the evidence is consistent with the Federal Reserve's being able to inlluence a total net Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 258 credit target, via either a reserves or an interest rate instrument, in a way that is at least comparable to its influence over the monetary aggregates. Fourth, any intermediate target procedure based on & credit aggregate target would be useless if the relevant credit data were not readily available on a within-quarter basis. Although the standard vehicle in which the Federal Reserve publishes data on the total net credit aggregate is the flow-of-funds accounts, a publication which appears only once per quarter, the great bulk of the underlying data are actually available monthly. As of yearend I960, for example, the toal net credit measure for the united States was 53,907.5 billion, of which 53,486.6 billion, or 89%, consisted of items regularly reported each month. Somewhat ironically, most of th* items not currently reported on a monthly basis are the lending activities of various components of the federal government itself. Of the $420.9 billion of 1980 yearend total net credit not reported on a monthly basis, $352.6 billion represented credit advanced directly by the U.S. Government or by its sponsored credit agencies and mortgage pools. If the federal government were merely to comply itself with the reporting requirements it already imposes on the private sector, therefore, more than 98* of the total net credit aggregate would be available monthly. Moreover, even without any extra reporting effort, the credit data currently available on a monthly basis comprise an aggregate that fully meets the first three criteria for choosing a monetary policy target. The correlation between the complete total net credit series and what is now available monthly is very high 1.99985), and the sum of what is available monthly exhibits just as close a relationship to nonfinancial economic activity as does the complete series. In sum, total net credit, measured by the outstanding indebtedness of all U.S. nonfinancial borrowers, meets each of the four criteria for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 259 choosing a monetary policy target at least as well as do the monetary aggregates. A Proposal jor^i TVo-Target Honey-and-Credit Framework I therefore propose that the Federal Reserve System adopt an explicit two-target framework, in which it would focus both on the money stock and on the quantity of credit outstanding. The Federal Reserve should pick one monetary aggregate, presumably HI, and one credit aggregate, total net credit; specify target ranges for both; and provide the quantity of reserves (or set a short-term interest rate) aimed at achieving these two targets. A deviation of either money or credit growth from its respective target range would then constitute a signal warranting reassessment of that reserve provision path (or interest rate level). One potential difficulty in implementing this hybrid money-and"-credit framework is a problem inherently associated with any policy of pursuing two targets instead of one. What if both targets are not simultaneously achievable? For all practical purposes, however, the Federal Reserve's current policy framework already suffers from just this problem, as the experience of Ml and K2 during 1961 demonstrated. If only Kl had mattered, the Federal Reserve would have had to conclude early on that its policy was too restrictive in relation to the specified target. By contrast, if only M2 had mattered, it would have had to draw the opposite conclusion. In resolving these conflicting concerns, the Federal Reserve had to decide on the relative importance of Ml and M2, and to determine why one was growing more slowly than anticipated and the other more rapidly, A two-target framework based jointly on money and credit would in part have the same features. If money and credit were both growing in line with their respective targets, then -the Federal Reserve would judge the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 260 prevailing reserve provision path (or short-terra interest rate) to be appropriate. If both vere above target, then the implication would be to slow the provision of reserves (or raise the interest rate). If both were below target, the implication would be to speed the reserve provision path (or lover the interest rate). If one vere above target and one below, however, then — just as now, with an Ml and an M2 target — the Federal Reserve would have to assess which was more important under the circumstances, and determine why one was moving in one diiction and one in the opposite direction relative to their respective stated targets. The key advantage Of an explicit two-target framework based on both money and credit, in comparison to a two-target approach based on two separate definitions of the money stock, is that it would draw on a more diverse information base to generate the set of signals that presumptively natter for monetary policy. Money is, after all, an asset held by the public, and each monetary aggregate is just a separate subtotal of the public's monetary assets. By having an HI and an M2 target, as at present, the Federal Reserve is relying solely on the asset side of the public's balance sheet but adding up those assets in two separate ways. By having a money target and a credit- target, the Federal Reserve would create a presumption of responding to signals from both sides of the public's balance sheet. 3he evidence that is now available indicates —not surprisingly, on sowe reflection — that both sides of the balance sheet do natter. This two-target money-ana-credit policy would reguire no legislation. Oi the contrary, the Humphrey-Hawkins Act directs the Federal Reserve to specify a target for credit growth as well as for money growth. In practice, however, the Federal Reserve has typically specified such a target but then ignored it. Moreover, it has chosen to focus only on credit extended through Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 261 the banking system, which the available evidence indicates is far from the best source of information about the ecimomy, even from within the liability •ide of the public's balance sheet. Nothing in the legislation, however, requires that the Federal Reserve place its primary en^hasis on money to the exclusion of credit, or that it focus only on bank credit among the available credit Measures, in a legislative sense, therefore, a two-target money-and-credit framework would simply have the Federal Reserve be even- handed within the requirements already laid down by the Humphrey-Hawkins ACt. In conclusion, I will simply restate my belief that a two-target money-and-credit framework for monetary policy would be superior to the current money-only framework, and that, over time, a monetary policy based on both money and credit would be likely to help achieve a more satisfactory performance of the American economy — to the advantage of all. Mr. Chairman, thank you £or the opportunity to present my view to this committee. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 262 June 2b, 1982 A PROPOSAL FOR FISCAL RESPONSIBILITY AND LOWER INTEREST RATES The Dilemma: Fiscal policy is too loose and monetary policy too tight. The 3-5 year outlook is for budget deficits perhaps averaging $200 billion a yean. Interest rates are far too high. Hot since the Civil War have real rates of interest been this high. Politics make any meaningful budget compromise unlikely. There is no probability that entitlements will be touched until after the November elections. Absent any meaningful change in the intermediate term outlook for budget deficits/ the securities markets will not recover and interest rates will remain excessively high. High U.S. interest rates have led to an over valued collar. High U.S. interest rates are causing interest rates offshore to remain higher than local economic conditions warrant. This in turn has had a serious negative impact on most foreign economies. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 263 Most expect recovery later this year. Few think it will be strong or sustainable because of the conflict between tight monetary policy and the pent-up demand for credit. It fiscal policy remains out of control, rates won't fall much and the recovery will be short lived. Further, the next cycle will begin with historically high interest rates. Most observers expect consumers to lead us out of recession. Their ability to do so is reduced if interest rates are high and credit is not available. (At these real rates of return, the incentive for consumers to stay in short term investments is substantial.) IZ. The Conditions and Outlook inflation is down considerably energy prices have fallen and are unlikely to rise much over the next 18-24 months (barring serious problems in the Middle East) food is plentiful and retail prices look relatively stable wage settlements are starting to be made on a much more realistic basis Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 264 Unemployment is high; especially in certain industries and regions, and among minority groups and the young Overall, plants are operating at, postwar lows, 70% of capacity or less Many product, commodity, and service prices are falling and there is very little possibility for the markets supporting much in the way of price increases. Host capital investment projects and much investment spending is being deferred, reduced or eliminated. Businesses are focusing on remaining liquid or in a number of instances remaining solvent under the burden of high borrowing costs. The financial markets appear to be in a fragile condition, with almost all borrowing concentrated in the short-end and no activity at all in the long-term bond market. Maturities and exposure continue to pile up. A number of companies — large and small — will be put out of business. Bankruptcies are occurring at record rates, if the system causes good companies, not just the inefficient, to go up, then there is something wrong with the system. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 265 ill. Proposal: Demonstrate a credible resolve by Congress to yet spending tinder control. L. Pass a Spending Ceiling Bill. Congress should take immediate steps to pass a Congressional resolution that would impose an aggregate cap on federal government spending for five years (three would be a minimum). This could be as a % of GNP and/or a maximum allowable annual rate of growth. The resolution should proscribe and call for a permanent amendment to the Budget Act of 1974 early in the next Congress establishing multi-year spending goals. This would: clearly reflect to the business and financial world that fiscal policy is headed in the right direction allow the Fed to ease monetary policy create pressure for restraint in government spending that heretofore has been provided by tight monetary policy (i.e., some say high interest rates are needed to force fiscal responsibility; this would be a roore liveable substitute) By focusing on aggregate spending as a share of GNP, the political issues of which program Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 266 (entitlements vs. defense vs. tax increases, etc.) are avoided until after the election....as they will be anyway, be an important step toward materially lower interest rates l. Use such a move by Congress to Encourage the Administration to be realistic about the need to tackle entitlements and defense — with the President in a strong leadership role. Encourage the Fed to materially ease monetary policy. (This move by congress — if strong enough to represent a credible beginning to more responsible fiscal policy — can give the Fed an acceptable reason to change their policy.) Encourage business and labor to lobby within their own tanks for a slowdown in price/wage increases. 3. In view of current economic conditions and the outlook I think, we have a window of opportunity whereby the Fed should change direction and increase the money supply with an objective of inducing substantially lower interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 267 Lower interest rotet would take the pressure off operating margins — this removes temporarily the need for price increases. Host manufacturers are operating at such low utilization rates their motivation is to sell product, not to increase prices. Substantially lower interest rates would allow the "re-liquification of America." One of the substantial problems existing today is the level of exposure of many companies to short term debt maturities. A downward move in interest rates would allow refunding and re-spacing of maturities, and increase profit margins. 4. A number of people will violently object to such a move by the Fed. Comments will be made that the Fed has lost its backbone, returned to whipsaw management, buckled under the pressure of Congress or the Administration, etc. It will be claimed that this will lead to renewed and. substantial inflation. In my view, economic conditions will not permit this to happen. There is very little opportunity in the marketplace to increase prices in the near term. Conversely, substantially lower interest rates offer the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 268 opportunity to get companies back into a sound, liquid condition. Improved liquidity plus lower cost of capital should restore their interest in bringing capital projects back on stream. Some will claim that the long markets will not respond. Investors have been burned before and such a move by the Fed would be a clear signal they would be burned again. I challenge this because any substantial downward move on short rates will ultimately bring long investors back into the market. Bond portfolio managers cannot afford to watch rates move materially lowec without being enticed into the longer markets. I believe traders and speculators will provide the short term momentum that will then attract the more permanent investors. In addition/ the spending cap will send a positive signal to the markets regarding fiscal policy. In conclusion, we should keep in mind that such a cap will (a) force the hard trade-offs to be made within the budget process (b) serve also as a restraint to excessive taxation/ and (c) by leading to lower interest rates, generate higher tax revenues for the Treasury through higher profit margins and a growing economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 269 PROPOSED JOINT RESOLUTION TO REDUCE TOTAL FEDERAL OUTLAYS AS A SHARE OF GROSS NATIONAL PRODUCT a. The Congress hereby adopts the goal of maintaining Federal budget outlays at a level no greater than 20 percentum of the Nation's gross national product (defined as the final value of all goods and services in the economy). b. The Congress, in furtherance of that goal, hereby establishes as its interim goals for reducing the share of the nation's gross national product accounted for by Federal outlays (expressed as a percentage of projected gross national product) &s follows: 21.9% for fiscal year 1984, 21.4% for fiscal year 1985, 20.9% for fiscal year 1986, 20.4% for fiscal year 1987, and 19.9% for fiscal year 198B| and c. Not later than Hay 15, 1983 the committee on the budget of each Bouse shall report legislation to amend Public Law 93-344, the Congressional Budget Act of 1974, to require: 1. that the budget resolutions for fiscal year 1984 and each subsequent'years shall set forth percentage'goals for total federal outlays as a share of the projected gross national product for the current fiscal year and each of the four succeeding fiscal years, 2. that the budget resolution for fiscal year 1984 shall incorporate the percentage goals specified in part (b) of this resolution, and 3. that, for fiscal year 1985 and each subsequent year, the committee on ttie budget for each House shall report to its House a budget resolution which meets or falls below the percentage goal for total Federal outlays as a share of projected gross national product that was set forth for that fiscal year in the most recently adopted First Budget Resolution. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 270 ANALYSIS OF THE PROPOSED JOINT RESOLUTION a. This section represents a commitment by the Congress to reduce the share of GUP accounted for by Federal outlays to 20 percent or lese. The 20 percent figure Is taken from the Full Employment and Balanced Growth Act of 1978 as aaended by Public Lav 96-10. That amendment requires the President to set numerical goals foe reducing the share of GSP accounted for by Federal outlays in his Economic Report. b. This section represents the establishment of interim goals for the next five years by the Congress to reduce the share of GHP accounted for by Federal outlays. Th« 21.91 figure for Fit 1984 is taken from the projections included in the First Concurrent Resolution on the Budget for FT 1983 adopted by the Congress, subsequent reductions of 0.51 per year are specified for the next four fiscal years. c. This section directs the budget committees of each house to report changes in the Budget Act by a date certain to incorporate (1) a mechanism for establishing five-year numerical goals to reduce the share of GNP accounted for by Federal outlays in each budget resolution; (2) to maintain in the first budget resolution for FY 1984 the interim numerical goals specified in this proposed joint resolution; <3) a mechanism whereby the budget committee will report a budget resolution which meets or falls below the numerical goals set forth in the most recently adopted First Budget Resolution. The purpose of this is to assure that the numerical goals previously specified are a meaningful commitment by the Congress. This section of the resolution purposely leaves the details of bow the Budget Act is to be amended to accomplish the establishment of goals to reduce outlays as a share of GHP to the budget committees for two reasons. First, because of the complexities of the Budget Act itself. Second, because of the complexities that are certain to arise in establishing a mechanism for setting specific numerical goals in the budget process. It is recognized that some flexibility roust be built into the process to handle such things as unexpected national emergencies such as war, sharp changes in interest rates, or sharp changes in economic conditions. It is left to the Budget Committees to decide what type of mechanism is needed to alter the numerical goals once they are established, for example, a two-thirds vote of each house. Also, the Budget Committees may want to establish a mechanism for flexible adherence to the goal of reducing the share of GNP accounted for by Federal outlays. For example, a base night be established and a trend line established that represent 0.5% reductions each year with the flexibility to permit overages or underagea in a given year to be made up in the next year in order to keep the long-term goal on track.. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 271 The CHAIRMAN. We will be happy to include them in the record. CONTROLLING TOTAL NET CREDIT In your statement you suggest that the Federal Reserve should target total net credit. Given that the Federal Reserve has no au- thority to set reserve requirements on such financial instruments as commercial paper and long-term corporate debt, how could the Federal Reserve control total net credit? Mr. ROBERTS. I think the Federal Reserve today has a very big hand in controlling total net credit because the bank reserves that they do control set the level at which money growth will proceed and money growth, in turn, has an influence on the savings-invest- ment process, and therefore, on the availability of funds to be bor- rowed and lent. Thus, I think to a very great extent they already do have an influence on total net credit. To be sure, there may be additional powers that would be desir- able to increase their influence on total net credit. At this point I am not prepared to recommend what those powers should be, but perhaps some additional powers are necessary. Let me use Germany as an example. They control the money supply and they also control credit very tightly. To be sure the Bundesbank has additional powers of persuasion given the limited number of banks in Germany, than the Federal Reserve has. So in that sense the Federal Reserve does not have comparable powers of persuasion as the Bundesbank. The CHAIRMAN. In your statement you say, "The Federal Re- serve's ability to act flexibly and independently of day-to-day politi- cal pressures must be guarded and protected." You would certainly get no argument from Senator Proxmire and me over that. You lis- tened to our speeches about the independence of the Fed for a long, long time. Mr. ROBERTS. I think I wrote some of them. Senator PROXMIRE. You sure did, mine. The CHAIRMAN. Does that mean that you would oppose proposals to make the terms of the Fed Chairman and Vice Chairman coter- minus with the President? Mr. ROBERTS. I would not oppose making them closer to the terms of the President. I think exactly coterminus might prove to be a little bit difficult to deal with. I think one proposal that was made several years ago was to have a 1-year lag between the appointment of the Fed Chairman and the election of a President. That I think would be livable and I see no problem with it. The CHAIRMAN. You do not feel even that would, at least in a small way, threaten the independence of the Fed? You've got a Chairman that is a year hangover and you know that 1 year later the President is going to be able to pick his Chairman? Mr. ROBERTS. I don't think that that would challenge the independence of the Fed any more than the powers that a sitting President now has to influence the Fed Chairman, The CHAIRMAN. What about the proposal to make the Secretary of the Treasury a member of the Board of Governors? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 272 Mr. ROBERTS. That I would have additional problems with. I think that that would politicize the process of monetary policy and I think it would be a dangerous precedent to set. I think one evi- dence of that is the fact that the Secretary of the Treasury was on the Board before 1933 I think and was then removed when the new powers of the Federal Open Market Committee were set up. The CHAIRMAN, I'm certain you would oppose the proposals of some that would put the Fed under the control of the Treasury? Mr. ROBERTS. I most certainly would. The CHAIRMAN. I would have been terribly disappointed if you had said otherwise. COMPARING Mi AFTER 5 YEARS In your statement you say, "The Federal Reserve should stop tar- geting Mi because of NOW accounts and other financial innova- tions." Last week, Murray Weidenbaum, outgoing Chairman of the Council of Economic Advisers, described to this committee how the definition of Mi has evolved over time to take account of such fi- nancial innovations. Chairman Weidenbaum concluded that as a result of this evolving definition of Mi that growth of M, demon- strates the highest statistical correlation of the growth of nominal income. How do you explain your apparent disagreement with Chairman Weidenbaum? Mr. ROBERTS. If you look at Mi now as compared to what Mi was 5 years ago in terms of definition, I think there's a drastic differ- ence. Five years ago before we had NOW accounts, before we had money market funds, before we had 6-month money market certifi- cates, Mi was a true measure of transaction deposits. Now what we have in Mi is a mixture of both transaction depos- its and savings deposits and I think that savings deposits have a different relationship to GNP, employment and prices than trans- actions accounts. I think additionally, as the deregulation process proceeds, and the DIDC creates new instruments that have transac- tion-like characteristics, that you could have enormous shifts of funds out of what are savings accounts or what are money market funds or what are other similar instruments into Mi, and you would see an explosion in the Mi measure that would have nothing to do with economic activity. I wouldn't know how to interpret that large increase in M in any other way than that it has no relation- t ship to past or prospective economic activity. It's merely a shift of funds, encouraged by a new instrument, that is not an increase in transaction accounts in the pure sense. The CHAIRMAN. Steve, I had the opportunity to at least glance through your testimony and may I say on fiscal policy that I am very impressed with your recommendation. I think that the reexa- mination of the budget process is something that we've proven in the last 2 years absolutely needs to be done. It is not functioning well at all and we've put ourselves into the position of making some choices that have been very difficult. I also agree very much with your recommendation about caps on Federal spending as a share of GNP. Senator Proxmire said earlier to Secretary Sprinkel, "What about the need to overcome this Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 273 spending glut that has been going on?" We're so far higher than traditional spending levels of GNP and, in my opinion, that simply cannot be dismissed and say it's all monetary policy; we can just go on increasing the percentage of spending and have no repercus- sions on the economy. I think that's utterly ridiculous and it's over- looked constantly by Members of Congress and others. Although I support the balanced budget amendment, we simply cannot go ahead and pass that during an election year, have it take a year or 2 to go through the States which I think it will, and then 2-year implementation after that, and not start controlling our spending now. You can't keep going on the way we're going and then suddenly there's an amendment that says you've got to do it and you've got to fall off a big cliff to accomplish it. So it seems to me your recommendation is absolutely on target that, fine, pass the constitutional amendment, but we've got to start disciplining ourselves in the meantime, and that means reducing that percent- age of GNP that we are constantly appropriating year after year. We're kidding ourselves; that constitutional amendment will become only a political document for an election year unless we start disciplining ourselves. So I'm very impressed with your testi- mony on fiscal policy. Mr. ROBERTS. Let me say that I think the Congress could take a lesson from the rules that it has charged the Fed to follow; that is, to set annual targets, multiyear targets, and then discipline itself to meet those targets. And that's what the recommendation in my testimony is designed to do. But it's got to be like the Fed, a mul- tiyear commitment for a gradual reduction in spending in a share of GNP. If you'll recall, in 1979, Senator Proxmire and yourself were in- strumental in getting the Full Employment and Balanced Growth Act amended to require the President to establish goals for reduc- ing outlays per share of GNP. If it's good enough for the President, it ought to be good enough for the Congress. The CHAIRMAN. It is, but you've also been around this body long enough to know that the hardest part of your recommendation is the part where you recommend that we discipline ourselves. Senator Proxmire. Senator PROXMIRE. Mr. Roberts, I want to congratulate you on what I think is an excellent statement. You've been around the committee long enough to know what serves the interest of the committee and what doesn't. ADJUSTING PRIME RATES TO COST OF FUNDS Your recommendations are concise and to the point and I think they're very timely. One of your first recommendations is that the Federal Reserve should immediately bring together senior repre- sentatives from the private sector to function like the Committee on Interest and Dividends, which was important during the early 1970's. That was the Nixon appointment at that time and as I un- derstand it they adopted, you say on page 13, "One suggestion that was made and adopted by many banks was to have their prime rates set according to formulas linked to their cost of funds." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 274 Is that the kind of recommendation that you would expect would be timely and appropriate now and would help to get interest rates under control? Mr. ROBERTS. I think it would be very timely. I'm not sure what the spread should be. Conditions were different in the early 1970's than they are now. But if you look at current short-term rates, you have a prime rate of 15.5 or 16 percent; you have CD rates of about 11 percent, which is the cost of bank funds, and there's a huge dis- crepancy, much different than three-quarters or 1 percent. Draw your own conclusions. The same point was made this morning with the announcement of the cut in the prime in a Washington Post article, that the spread between the cost of funds is now huge and that additional cuts in the prime rate should be forthcoming. Senator PROXMIRE. Is that showing up in the increased profitabil- ity of banks? Mr. ROBERTS. I think in general, rather than Senator PROXMIRE. I can't understand that. You know we have a very competitive banking system. The banks are very eager to lend money, as they showed in the Oklahoma case—sometimes a little too eager. But if the cost of funds is around 11 percent, this indi- cates a lack of effective competition, doesn't it? Mr, ROBERTS. I think there is competition in the market. Bank profits are generally higher when interest rates are high, than when they are low. This is especially true now, as opposed to 10 years ago, because of the increased use of floating rate instruments and discrete pricing of banking services. I think that the banks will adjust downward, but there's a tendency for the prime to trail the market on the way down and to lead the market on the way up. I think that's a natural inclination. Anybody who wants to make a profit and maintain a spread would react rationally. My suggestion is that now that the Fed, after October of 1979, has given the marketplace the ability to set rates and not to dictate to the marketplace what rates should be, and therefore, that par- ticipants in the marketplace have some responsibility for the well- being of the economy, not only their own well-being. Senator PROXMIRE. Well, you say in your recommendations, "The Federal Reserve should bring together senior representatives of the private sector." Who would be the kind of people that would be ap- pointed to that? The representatives, obviously, of the banks, sav- ings and loans—what other—corporations? Mr. ROBERTS. Financial and nonfinancial corporations, brokerage houses—anybody that has a major financial interest in the way the economy is moving ahead. I think it should be a broad group and I think it should have a broad mandate to look for innovative ways to get interest rates down. Senator PROXMIRE. Well, that's very helpful. Now, Secretary Sprinkel testified that there's no evidence that monetary policy is too tight. You say fiscal policy is too loose and monetary policy is too tight. How do you answer Secretary Sprinkel's argument that mone- tary policy is about right? Mr, ROBERTS. Secretary Sprinkel also said that he judges the in- flation rate to be 5 or 6 percent, with the prime rate of 15.5 to 16 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 275 percent. That means a 10 percent real rate of interest, which I think is a signal that monetary policy is too tight. Look at bank- ruptcies. How do you judge bankruptcies? Is that an indication that monetary policy is too tight or too loose? There are lots of other things besides the rate of growth of the money supply, however you measure it, that the Fed needs to look at, and some of those varia- bles are indicators. PROBLEM CONTROLLING TARGET FOR MI Senator PROXMIRE. You seem to be coming on with the notion that you would increase the rate of growth in the money supply. Your only specific suggestion in here—you didn't say that in your testimony. You said that you would drop Mi and develop a total net credit and rely on the recommendations of these experts that would be appointed to some extent. But should we ease up on the rate of increase in the rate of credit and money supply? That's the real fundamental question. Mr. ROBERTS. I think there should be some easing, yes. I don't think the targets should be changed, but I agree entirely with Chairman Volcker that if for a period of time money growth is above target that in this current economic environment there should be little problem. We have so much excess capacity that it would not be inflationary. Senator PROXMIRE. Money growth is above target. Why shouldn't we change the targets under those circumstances? Why shouldn't we increase the targets? Mr. ROBERTS. Well, first of all, I think the target for Mi ought to be dropped. I said that in my testimony. Therefore, I see no reason for changing it. If you want to make a change, drop it. Senator PROXMIRE. Drop the ranges that we've asked the Federal Reserve to tell us about? Mr, ROBERTS. For Mi' Senator PROXMIRE. For Mj? Mr. ROBERTS. And maintain them for M and M . 2 3 Senator PROXMIRE. I see. Now I just had one other question I think. Secretary Sprinkel said that it was impractical to expect the Fed- eral Reserve to control the total net credit. You've answered this in part in response to the Chairman, but I'd like to get a more specific answer. He said we have trouble controlling M,, which we do; M! is easier to control than the total net credit. You have indicated that there are some areas of total net credit—I guess Sprinkel did—out- side the purview of the Federal Reserve. Are you suggesting that we broaden their power over commercial paper, for example, and some of the other credit aggregates they don't have any control over? Mr. ROBERTS. I think that's something to be explored. I wouldn't say, yes, they should have increased control over commercial paper or anything else at this point. But as I look at the historical evi- dence presented by Professor Friedman from Harvard and several other economists who have looked at these things very carefully, there's a steady and persistent relationship between net total Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 276 credit adjusted for the rate of growth of the economy. It's about 143 percent adjusted for the way the economy changes. The Fed has some influence to change that by supplying addi- tional reserves if need be, especially if total net credit is lagging sorely behind what historical evidence suggests it should be. I look at the evidence and I'm convinced—and I wasn't convinced when I was on the committee staff several years ago—but I am convinced now based on this new research that the Fed ought to pay attention to total net credit, that bank credit is just one part of it but it's not the entirety, and you learn something from total net credit. You learn right now that the Federal Government is going to take almost 50 percent of the share of all credit generated if you include off-budget and on-budget items in the next year. That means that the private sector is going to be crowded out. There's important information there. Senator PROXMIRE. You can make an argument on that, but my question is whether or not they can actually control it? Mr. ROBERTS. They can control it just as well as they can control M or M . Reserves are no longer set on savings and consumer time 2 3 deposits of any type, but changes in reserve availability influences their growth indirectly. Senator PROXMIRE. I also get from your argument and your pres- entation this morning that maybe the decision in October 1979 was wrong; forget about interest rates and concentrate on'the rate of increase in the money supply. I say that because there is this colos- sal spread. Interest rates seem to be way out of tote with what they ought to be in view of the cost of funds. So why shouldn't there be some return perhaps to an attempt on the part of the Federal Re- serve to bring interest rates down as such, rather than simply the money supply? Mr. ROBERTS. As you know, in October 1979 I supported that change in policy because I thought it was important to focus in on the rate of growth of money. However, I think that conditions have changed. Mj doesn't mean the same thing now as it did in 1979, as Mr. Maude's testimony of last week clearly shows. NOW accounts weren't here in 1979. I think, also, that tight adherence to the rate of growth of the money supply week to week, month to month, quarter to quarter even, has proven to be quite hard to follow. That's why the Full Employment Act requires that the Fed target the rate of growth of money over a year's time and I think that the tight adherence to monetarism can in certain circumstances—and I think we're in those circumstances right now—be fairly dangerous. Therefore, at this point, I think the Fed ought to look at other var- iables. Senator PROXMIRE. Including interest rates? Mr. ROBERTS. Including interest rates, including real interest rates especially. Senator PROXMIRE. Thank you. Thank you very much, Mr. Chairman. The CHAIRMAN. Mr. Roberts, we're happy to have you before us today. I have no additional questions. Senator Proxmire, do you have any more? Senator PROXMIRE. It was a very good statement. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 277 The CHAIRMAN. Very good. Thank you very much. We appreciate you returning to the site of your previous activities. Mr. ROBERTS. Thank you. The CHAIRMAN. The committee is adjourned. [Whereupon, at 10:45 a.m., the hearing was adjourned.] [Additional material received for the record follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 278 Answets to Additional Questions For Steven M. Roberts From Senator Donald W. Riegle 0.1. Whom would you appoint and what exactly would be the mandate and time frame of your proposed Committee to get interest rates down? A. As I indicated in my testimony the private sector has a responsibility for acting in the national interest in setting terms and conditions on credit because of the Fed's October 1979 shift toward controlling money and reserves and letting the marketplace set interest rates. Prior to October 1979 the FED set interest rates and the marketplace would often have to allocate credit in non-price terms. Some type of allocation system, perhaps, should be restored. What I have in mind is a public-private group to generate innovative ideas to reduce interest rates and then to obtain broad support from the private sector to put those ideas into action. Committee membership might include; Public Sector Secretary of Treasury Chairman of the Federal Reserve Board Chairman of the Council of Economic Advisors Private Sector' Representatives of large, medium, and small banks Representatives of non-bank financial institutions Representatives of major manufacturing corporations and small business I would also recommend that Arthur P. Burns, now Ambassador to the Republic of Germany and a former Chairman of the CID, and Secretary Schultz, a former member of the CID, be asked to participate. Also, former FED Chairmen Martin and Miller, and former Treasury secretaries Dillon, Fowler, Simon, Connolly, and Blumenthal could contribute needed ideas and support. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 279 One group of bankers that might be asked to serve on such a committee would be the Federal Reserve's Federal Advisory Council which is made up of twelve bankers, one from each Federal Reserve District, and already advises the Board regularly. Other bankers might also be "included to broaden the base. People like Peter G. Peterson of Lehman Brothers, Jim Robinson of American Express Company, the Chairman of Ford Motors, the Chairman of General Electric/ and other prominent business leaders would also add to the collective wisdom of the body. The mandate should be to find several complementary ways to get interest rates down without fueling inflation. This may mean some non-price rationing of credit and some self restraint by borrowers. The time frame for formulating approaches to the problem should be short — within the next 30-45 days. The Committee should function for a year or less as needed. Let me stress that the initiative has to be voluntary, but with broad compliance based on a consensus that steps are necessary and the burdens need to be shared more broadly than they are currently, 0-2. You recommend in your testimony that the "FOMC should immediately adopt a 'total net credit" aggregate as an additional target for policy". What do you mean by a •total net credit" aggregate? A. "Total net credit"'is a term used by Professor Friedman at Harvard. It includes the outstanding indebtedness of all U.S. non-financial borrowers. He suggests that this indebtedness be scaled to economic activity. At year-end 1981 outstanding indebtedness of all U.S. non-financial borrowers was 143% of gross national product. Q.3. How would the FED accumulate the data and measure the total net credit? A. The Federal Reserve publishes data on total net credit in its quarterly flow of funds accounts. As of year-end 1980, total net credit was $3,907.5 billion. Much of the underlying data are available and reported regularly each month. According to Friedman, $3,486.6 billion or 89% of the total year-end 1980 data was available from monthly series. Much of the monthly Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 280 data that were not available was federal government borrowing. The government could improve its own reporting system to bring the monthly data availability close to 100% of that available quarterly. 0.4. How would the FED establish a target for total net credit and how would the FED adjust monetary policy to achieve such a target? A. Total net credit adjusted (or scaled) for GNP growth has been fairly steady at 142-143%, except during the 1930's depression and just after WWII. If 143% of GNP is taken as the long-term stable trend, then the FED'S target would be calculated from its forecast for GNP for the year multiplied by 143%. If, during a recession, GNP grew more slowly than predicted, the scaled net total credit aggregate would rise above 143% because the denominator would grow more slowly than the numerator. To get the aggregate back down to 143% the FED would adjust policy to improve GNP. This is an over-simplification, of course, in essence, more money or lower interest rates would tend to increase GNP. Q,5. How would targeting of total net credit assist in achieving monetary policy objectives such as economics growth, price stability, employment and international balance? What is the relationship between total net credit and these objectives? A. Using total net credit as an additional target variable would provide additional important information as to economic activity and what monetary policy should be doing to achieve its ultimate objectives for income, employment, etc. To continue the example from the previous question, an acceleration of total net credit might serve as an early indication of weakness in GNP, as additional credit is needed to finance economic activity. The opposite might also be true: a deceleration might indicate strength in internal cash flow, profits and output. I suggest that Professor Friedman's work on this be sought by the Committee to answer the last part of this question. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 281 0.6. What economic signals would be contained in various movements and fluctuations of total net credit? A. See answer to Question 5. Q.7. How would the Federal Reserve System exercise very precise control over the total net credit aggregate in the short run? A. It would not and should not exercise precise control of total net credit or any other intermediate target variable over short-time horizons! Monetary policy objectives can only be attained over longer time periods (a year or two) because of the lags between policy changes and changes in intermediate or final targets. Changes in economic variables over short-time horizons can be and often are misleading. It is long-term trends that are important. 0.8. What, if any, new powers would the FED need to adequately implement or credit aggregate (target) such as you have suggested? A. Ho additional powers are necessary. However, it might be desirable to give the Fed some additional authority to provide incentives to lenders to increase lending in certain areas — such as agriculture, autos, small businesses. But such powers would need to be considered carefully. Experiences of other central banks should be looked at. I can mention two variables that have been looked at in the past — loan to deposit ratios, and capital-asset ratios. The current system might be improved if the FED had greater control over these variables. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 282 The Trouble with Monetarism ALAN REYNOLDS In the entire history of this country, before 1968, long-term in- terest rates were never above 5-6 percent. Since then, however, interest rates have tripled. Young people now think it is perfectly normal that mortgage rates can only go up—as they have in every single year since 1972. Something terrible happened to the economy after 1968, got even worse after 1972, and deteriorated into acute stagnation af- ter 1979. There has been virtually no increase in real output per employee for nearly a decade. World trade grew by 7 percent a year for twenty-five years before 1973, but that growth was cut in half since then (actually falling one percent last year). •It is time to retrace our steps, to find out what went wrong. Advice from the familiar economic experts will not be better than it has been. A Keynesian adviser to J.F.K. now argues that budget deficits force the Federal Reserve to print less money; a founder of the rational expectations school says deficits force the Fed to print more. The head of a huge forecasting empire, built upon the idea that deficits stimulate investment, now casually ar- gues the exact opposite. The monetarist economist for a New York investment bank says the Fed is doing such a great job, that infla- tion and interest rates must be due to fiscal policy after all. An Ivy League professor, who has always argued that any inflation was a trivial price to pay for the low unemployment that would surely result, is now solemnly interviewed about what to do about infla- tion. The fiscal expert at a conservative think tank says deficits will be inflationary unless inflation shrinks them. A prominent monetarist who has always emphasized long-run trends in M2 now worries only about ten-week wiggles in Ml. To uncover the source of change, it is useful to look at what has stayed the same. Federal tax revenues rose by 15.8 percent in 1981—far more than .the incomes-of taxpayers. Marginal tax rates are still going up, not down.1 Does anyone really believe that the 1. Stephen A. Meyer & Robert J. Rossana, "Did The Tax Cut Really Cut Taxes?" Federal Reserve Bank of Philadelphia Business Review (January-Febru- ary 1982). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 283 20 Policy Review economy would have performed better if the tax collector had grabbed an even larger share? Nondefense spending will be at least 17.4 percent of GNP in fiscal 1982, up from 15.9 percent in 1979. Would anyone seriously argue that recession could have been avoided if the O.M.B. had only let federal spending drift even higher? No, this problem is monetary, not fiscal. For all practical pur- poses, "Reaganomics" means whatever the Federal Reserve is doing. If interest rates were remotely close to historical normality (namely, 3-5 percent), the budget would be in surplus. In fact, there is substantial evidence that expected inflation causes budget deficits rather than the other way around.2 Criticism from Wall Street The media would have us believe that "Wall Street" is not concerned about monetary policy, but only about deficits. Polls of dozens of institutional investors by Oppenheimer and Polyco- nomics, however, indicate that this is overwhelmingly untrue. Fortune's poll of executives says the same. Barton Biggs, the managing director of Morgan Stanley, recently described monetarism as "the God that failed." He reprinted a let- ter of February 22 from Peter Vermilye, Chief Investment Officer at Citibank, saying "the level of interest rates is a better barome- ter of tightness than the growth of the money supply in this era of conflicting monetary currents." The economists at Morgan Stan- ley and. Citibank are staunchly monetarist, but those responsible for investments are not. Many other Wall Street traders and economists have long been extremely critical of monetarism, including Henry Kaufman of Salomon Brothers, George McKinney of Irving Trust, Peter Ca- nelo of Merrill Lynch, and Edward Yardeni of E. F. Hutton. The widely-read Morgan Guaranty Survey (of February 1981) wrote that the nation "would be ill-served by rigid mechanical monetarism." "The widely-cited budget deficit problem," says Maury Harris of Paine Weber, "is due importantly to Federal Reserve policies that keep interest rates high." "Until such time as the Fed aban- dons monetarism," says David Levine of Sanford Bernstein, "our 2. Brian Horrigan and Avis Protopapadakis, "Federal Deficits: A Faulty Gauge. . ." Federal Reserve Bank of Philadelphia Business Review (March-April 1982). Also unpublished studies by Gerald Dwyer at Emory and Roger Kor- mendi. University of Chicago. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 284 Monetarism 21 financial markets will be in disarray."3 These are not uncommon views on Wall Street, though the media decided that this news is not fit to print. Instead, we hear the same tired voices agonizing over the budgetary consequences of monetary disorder. This is not the first time that the United States has contem- plated a fiscal cure for a monetary crisis. The huge tax increases of 1932 and 1968 demonstrated that it does not work. Today's monetary crisis is not new, but it has escalated into risky territory. The entire dollar economy worldwide is danger- ously illiquid, precariously dependent on short-term debt. Long- term financial markets are moribund. People, and the institutions entrusted with their savings, are unwilling to commit funds for long-term uses. Nobody trusts the money. Interest rates are held up by the rising risk of default right now, and by the risk of re- newed inflation in the future. We have the worst of two worlds: Much of the nation is experi- encing deflation while expecting an inflationary "solution." By April 1982, most indexes of commodity prices were at least 15-20 per- cent lower than a year before. Cotton was down about 25 percent— the same as in 1932—aluminum prices were down even more. Even the broad indexes of producer and consumer prices had posted some monthly declines. Even as the old guard was chant- ing that budget deficits cause inflation, inflation again went way down as the deficit went up—just as in 1975, or 1933. Yet even falling prices fail to persuade bond buyers that they will not be exploited once again by future inflation. Indeed, the more that current price indexes are squeezed by forcing producers into bankruptcy, the more likely an inflationary bail-out becomes. Existing monetary techniques can thus depress measured infla- tion for even a year to two without making a serious dent in ex- pected inflation. Trouble in long-term markets requires a long-term solution, a credible set of monetary institutions to protect ihe pur- chasing power of the dollar. Selling what exists at failing prices does not necessarily make it easier to produce more at stable prices. Liquidation of inventories, commodities, assets, and real estate has depressed current price indexes, but it has also raised the cost of living in the future. The value of lifetime savings has fallen, so people will have to work 3. Dr. Harris' remark is from testimony before the Joint Economic Oummit- tee, April 22, 1982; David Levine's is from a speech to (he New York Assrx'iation of Business Economists. April 6, 1982- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 285 22 Policy Review harder in the future to attain any expected standard of living. That makes the future look relatively grim, causing people to pre- fer present consumption. In this situation, providing added tax incentives to save will not finance future productive capacity, be- cause any added savings remain in the short-term money market. The problem is that the United States has no long-term mone- tary policy at all—nothing that inspires confidence. Instead, the nation alternates between robbing lenders with inflation and bankrupting borrowers with deflation. There is no way of know- ing which is coming next, so activities requiring long-term finan- cial contracts are severely restricted. There is no unit of account that is expected to hold its value over decades, and therefore little possibility of building for the future by borrowing against ex- pected future earnings. No indexing scheme gets around the problem of unpredictable money. A household cannot budget for the future, for example, if monthly mortgage payments can vary in ways that income may not. Monetarism was fun when it simply involved second-guessing the Fed. The self-appointed "Shadow Open Market Committee" would solemnly announce that there was too much or too little money, without assuming any genuine responsibility. Things are different now that prominent monetarists are in po- sitions of great authority. Monetarists can and do influence the Fed now, and are even in a position to propose sweeping mone- tary reform, legislation, or international conferences. Instead, we still get the habitual second-guessing. The Republican section of the latest Joint Economic Report, for example, writes: "Looking back, it would have been better if money had grown closer to 5 or even 6 percent per year in the second and third quarters of 1981 instead of at annual rates of 3.6 and 2.9 percent." Such retroactive fine- tuning serves no useful purpose. The bond and mortgage markets did not collapse over the past decade because money growth was one or two percentage points too slow for six months. Founders of Monetarism It can, of course, be argued that what we are experiencing is not genuine monetarism. When reality fails to live up to the promise of theory, it is always the fault of reality. Since October 1979, when the Fed did most of what the monetarists advised, interest rates, Ml and the economy have gyrated wildly. The monetarist Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 286 Monetarism response is that the problem originated with lagged reserve re- quirements in 1968, or the Fed should have stepped even harde; and faster on monthly ups and downs of M1 (for example, by push- ing the fed funds rate higher in January 1982, when Ml surged). Is there any example of monetarism anywhere that ever worked? Some point to Switzerland, where Ml rose 23 percent in 1978, fell 7 percent last year, and has been far more erratic over short peri- ods than in the U.S. Switzerland has a gold cover on its currency. Others point to Chile, where they stopped hyperinflation by usint^ fixed exchange rates. France tried a quantity rule from 1919 in 1925, but it blew up with a 50 percent inflation rate. But the fault runs deeper than the Utopian nature of monetar- ism. The fault lies in the deliberate demolition of proven monetary institutions (of the sort now used in Switzerland and Chile) for the sake of a hypothetical quantity rule that has never been put into practice. This requires a brief digression into the development of mone- tarist policy proposals. The early "Chicago School" of economics, around 1927-41, may have been more favorably inclined toward free markets than Harvard, but not much. Like most academics, the early Chicagoans were intimidated by the intellectual consensus of the day. It was thus conceded that industrial and labor markets were largely monopolized and rigid, so the influential Chicagoite Henry Simons redefined "laissez-faire" as strict legal limits on the size of corporations and the power of unions. To Simons, the "utter inadequacy of the old gold standard. . seems beyond intelligent dispute." The experts would simply "design and establish with greatest intelligence" a "definite me- chanical set of rules" for money. Simons' modest proposal in- volved "above all, the abolition of banking, that is, of all special institutional arrangements for financing at short-term. . .If such reforms seem fantastic, it may be pointed out that, in practice, they would require merely drastic limitation upon the powers of corporations (which is eminently desirable on other, and equally important, grounds as well)."4 The idea of a fixed rate of growth of the money supply origi- nated in 1927 with the even more interventionist left wing of the "Chicago School," namely Paul Douglas. Douglas (later a Sen- 4. Henry C. Simons, "Rules Versus Authorities in Monetary Policy (193d in Landmarks in Political Economy (University of Chicago, 1962). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 287 24 Policy Review ator) was then quite excited about a "planned economy" and "public ownership," and even called himself a socialist.5 "The obvious weakness of fixed quantity," responded Simons, "as a sole rule of monetary policy, lies in the danger of sharp changes on the velocity side." Moreover, "the abundance of what we may call 'near moneys/ " Simons wisely added, creates a "difficulty of defining money in such manner as to give practical significance to the conception of quantity." Just as Simons' solu- tion to big business was to make it illegal, his solution to free fi- nancial markets was to make them illegal too. Then a quantity rule might work. By 1948, Keynes had infected even Chicago, as shown by Mil- ton Friedman's "Monetary and Fiscal Framework for Economic Stability." That proposal was to run budget deficits in recessions and "the monetary authority would have to adopt the rule that the quantity of money should be increased only when the govern- ment has a deficit, and then by the amount of the deficit." The budget could be balanced over the cycle, or lead to "a deficit suffi- cient to provide some specified secular increase in the quantity of money." Some might worry, said Professor Friedman, that "explicit con- trol of the quantity of money by government and explicit creation of money to meet actual government deficits may establish a cli- mate favorable to irresponsible government action and to infla- tion." "This danger," he added, "can probably be avoided only by moving in a completely different direction, namely, toward an entirely metallic currency, elimination of any governmental con- trol of the quantity of money, and the re-enthronement of the principle of a balanced budget."6 By implication, that was still beyond "intelligent dispute." Needless to say, the nation did not move in the latter direction, nor did Professor Friedman ever really advise it to do so. By 1962, in his magnificent Capitalism and Freedom, budget defi- cits no longer worked to stabilize demand. The task had become one of steering between the Scylla of a gold standard and the Charybdis of wide discretionary powers. Professor Friedman ini- tiated the caricature of an "honest-to-goodness gold standard, in 5. J. Ascheim & G. S. Tavlas, "On Monetarism and Ideology" Banca Na- zionale del Lavoro Review (1979). 6. Milton Friedman, Essays in Positive Economics (University of Chicago, 1953) pp. 133-5. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 288 Monetarism 25 which 100 percent of the money consisted literally of gold." Since that sort of standard is indeed ridiculous, Professor Friedman in- stead suggested raising M2 by 3-5 percent every year. With prac- tice, however, "we might be able to devise still better rules, which would achieve even better results."7 This was a return to Paul Douglas, neglecting the doubts of Henry Simons and Frank Knight. On January 1, 1968, Milton Friedman wrote "We should at once stop pegging the price of gold. We should today as we should have yesterday and a year ago and ten years ago and in 1934—an- nounce that the U.S. will no longer buy or sell gold at any fixed price. .. .That would have no adverse economic effects—domesti- cally or internationally."8 The advice was taken that March. Professor Friedman later acknowledged "direct links" between his views and those of Jacob Viner, quoting Viner as saying, "if the mere cessation of gold payments did not suffice to lower sub- stantially the international purchasing power of the dollar I would recommend its accompaniment by increased government expen- ditures financed by the printing press."9 When the term "monetarism" was coined by Karl Brunner in 1968, it represented a healthy backlash against the excesses of fis- cal fine tuning. Yet monetarism too was part of the Keynesian tradition of demand management. The tools would be different, but the objective was still to manage the rate of growth of aggre- gate demand, whether over short or longer periods of time. Early monetarists were often quite activist demand-siders. John Culbertson, in 1964, argued that the U.S. should "give up our self-imposed constraints" and "make an end of monetary restric- tion." By breaking all links with gold, he said, we could safely pursue a "moderately expansive" policy of increasing the money supply "something like 6 to 8 percent." As unemployment came down to 4 percent, we might then print a bit less.'" Some monetarists still cannot resist offering advice for fine-tuning the growth of money to achieve some cyclical smoothing. Robert Hall (who joined me as a member of President Reagan's inflation 7. Milton Friedman, Capitalism and Freedom (University ul Chicago. 1962) Ch. 3. 8. Milton Friedman, An Economist's Protest (Thos. Morton, 1972) pp. 98-99. 9. R. J. Gordon (ed.), Milton Friedman's Monetary Framework (University of Chicago 1970) p. 167. 10. John M. Culbertson, Full Employment or Stagnation3 (McGraw Hill 1964} pp. 234-235. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 289 26 Policy Review task force before the election) wanted to increase the money supply at a 20 percent rate for at least six months in late 1976.M "The year 1973," notes Robert Gordon, "represented the high- water mark of monetarism."12 By then, all of the old-fashioned obstacles to scientific demand management had been toppled. The U.S. took the silver out of coins in 1964, lifted the gold cover on Federal Reserve notes in 1965, set the gold price free in March 1968, reneged on converting foreign dollars into gold on August 15, 1971, and embraced floating exchange rates by March 1973. The monetarists cheered. They had provided the intellectual rationale for the demolition of all institutional constraints on mon- etary policy. There was a promise to replace the old rules with new rules, but it has not happened. What happened is that rules were replaced by random whim. Henry Simons was right in 1936 to prefer rules to discretion, but wrong to propose an alternative that could only work if flows of money and credit could somehow be tightly regulated. "The defects of monetarism," writes Samuel Brittain, "are that it concedes too much power to official intervention, under- rates the influence of competition in providing money substitutes, and takes official statistics far too much at their face value. Fried- manites are often very good at analyzing how controls and regula- tions in the economy generally will be avoided or will produce unintended effects quite different from those their sponsors desire. But too often they evince a touching faith in government in their "'own special sphere."13 Meaningless Money Monetarism is properly a method of analysis or prediction, not a policy. No particular policy necessarily follows from a monetar- ist view of the world. Monetarists have favored a wide variety of policies, including some sort of commodity standard. The meteoric rise of monetarism had much to do with its sim- plicity, and to the persuasive talents and personal charm of its major salesmen. Monetarism begins with a seductive tautology: The rate of growth of spending or "demand" (nominal GNP) 11. Business Week (November 15, 1976) p, 26. 12. Robert J. Gordon, "Postwar Macroeconomics" in Martin Feldstein (ed.), The American Economy in Transition (University of Chicago 1980) p. 146. 13. Samuel Brittain How to End the Monetarist Controversy (Institute for Eco- nomic Affairs 1981) p. 84. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 290 Monetarism 27 depends on the rate of growth of money (M) plus velocity (V). Converting the old quantity equation into annual percentage in- creases, then M + V = GNP. If we could count and control M, and if we could predict veloc- ity, then we would reach the Keynesian heaven of managing "ag- gregate demand." And if we could also predict how much of that rise in GNP would be real growth and how much would be infla- tion, then we could use all this to "control" inflation. The only trouble is that nobody can do any of those things. Even if anyone could, there is no reason to suppose that these devices would actu- ally be used to avoid inflation or deflation. Basically, the goal of managed money is to control $3 trillion in annual spending through periodic adjustments in about $45 bil- lion of bank reserves. Not an easy task. First of all, what is money? In March 1979, the Shadow Open Market Committee noticed that "there is now a large and rapidly growing volume of financial assets not subject to ceiling rates on deposits. . .and in some cases not subject to reserve requirements." By February 12, 1982, one member of the Shadow Committee, Erich Heinemann of Morgan Stanley, was showing more concern: The improvements in the monetary definitions are unfortu- nately minor in comparison with the more fundamental con- ceptual problems associated with measuring money. To what extent are household money market mutual fund shares transaction or savings balances? Are institutional holdings of overnight RPs or overnight Eurodollars transaction balances since they are available each morning for spending? Are in- stitutional holdings of marketable and highly liquid short- term credit instruments such as Treasury bills, certificates of deposit, and banker's acceptances so easily convertible into transaction balances that they should be so treated;* If we ex- clude them from transaction measures, such as M-l, are we missing a large and important source of corporate liquidity? Anyway should holdings of Treasury bills, which are more liquid than CDs, be included in L, while CDs arc included in M-3? The questions go on and on, and few of them can be answered unambiguously- The questions linger, and the quality of virtually any definition of money remains uncer- tain. In this context, the redefinitions are minor refinements in the hopelessly difficult task of measuring money. These sorts of doubts have often marked the beginning of the end of confidence that controlling some arbitrary measure of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 291 28 Policy Review money is a practical way to ensure its value. At the end of 1975, I wrote a paper for Argus Research on "The Increasing Irrelevance of Ml." In 1979, when some prominent monetarists were saying that money growth was too slow, I wrote (with Jeffrey Leeds) that failure to count money market funds and repurchase agreements was understating the six-month rate of money growth by more than seven percentage points.14 Peter Canelo, a top bond analyst at Merrill Lynch, likewise be- came disillusioned about monetarism through his enormously de- tailed weekly reports on what the various M's really mean. Lately, Phillip Cagan of Columbia, one of Professor Friedman's first and best proteges, has expressed similar doubts.'5 On October 6, 1979, the Fed essentially announced that it would let interest rates approach infinity, if necessary, to slow the growth of bank reserves and Ml. The C. J. Lawrence survey of bond managers' forecasts for long-term government bond yields went from 9 percent on September 14, 1979, to 12.3 percent in five months. Now, there is no question that high interest rates can drive money out of Ml and bank reserves, but that also raises velocity. At high interest rates there is a powerful incentive to keep as little money as possible in Ml deposits, which pay little or no interest. Banks have an equally powerful incentive to use "liability man- agement" 16 make the most loans with the least required reserves, since reserves at the Fed earn no interest.16 Money market funds have been more than doubling in size each year and, at about $160 billion, are much larger than the en- tire stock of currency. You can write checks on most of these funds, or transfer to a checking account with a phone call. Over- night repurchase agreements and Eurodollars usually exceed $40 billion, and are curiously lumped together with 8-year certificates in M2. Such cash management devices have only been significant for two or three years, making the old historical relationships (such as postwar velocity "trends") quite suspect.17 14. "Understating Monetary Growth," first Chicago World Report (March- April 1979). 15. See James Grant's column, Bamwt'j July 27, 1981, and Sanfurd Roie's column, American Banker (Nov. 24, 1981). 16. James Earley & Gary Evans, "The Problem Is Bank Liability Manage- ment," Challenge (January-February 1982). 17. M. Dotsey, et al., "Money Market Mutual Funds and Monetary Con- trol," Federal Reserve Bank of New York Quarterly Review (Winter 1981-82). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 292 Monetarism 29 MasterCard plans to offer a "sweep account" for small deposi- tors, where check balances are kept within a desired range, and any excess or shortage is moved around from money market funds or other near-monies. If the Fed counts demand deposits at the wrong time of the day, they might not find much. There are other devices on the horizon such as CDs with check-writing privileges, checks on Visa cards, and retail repurchase agreements. The whole idea of measuring M is growing more obsolete by the day. The Fed makes the rules of the monetarist game, because the Fed defines the M's. The definition has changed four times since late 1978. How could any long-term rule be formulated in terms of a quantity of money when the definition of money is necessarily subject to continuous change? Money numbers are also constantly revised. In early 1982, we finally learned that a 5.4 percent rate of decline in Ml in the pre- vious May was really a 10.8 percent rate of decline; a 14.5 percent increase in November turned out to be 10.1 percent. How could the Fed possibly stabilize Ml before anyone knows how much it rose or fell? High interest rates drive money out of Ml into interest-earning, highly-liquid devices that have little or no reserve requirements. So neither Ml nor reserve aggregates (the base) have the same meaning as they did when interest rates were much lower. Most of the financial innovations are roughly counted in M2 or M3, but those measures also contain much larger amounts of longer- term savings. A fall in interest rates might well induce people to keep more of their income in Ml, but that shift from M2 into Ml would not be inflationary. An increase in real output would raise the need for cash to finance more transactions, but supplying that demand would not be inflationary. A rise in the savings rate would prob- ably increase M2, but that too would not be inflationary. It de- pends on real growth and velocity. In the fourth quarter of 1981, the interest rate on 3-month T-bills fell from 15 percent to 11.8 percent. The growth rate of M3, which is dominated by interest-sensitive instruments, slowed from 11.2 to 9.2 percent. The growth of Ml, which is discouraged by high rates, rose from zero to 5.7 percent. The monetary base slowed down. What does all this mean? Not much. Monetarists still can't decide on a meaningful and controllable measure of money. Phillip Cagan of Columbia and David Laidler of Western Ontario strongly favor M2. The St. Louis Fed and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 293 30 Policy Review Robert Weintraub of the Joint Economic Committee are sticking with MI. Allan Meltzer of Carnegie-Mellon seems to be leaning toward the monetary base. Milton Friedman used M2 last year to show that money growth had not slowed down, but uses Ml this year to show that money growth has not been steady. It makes a lot of difference. It should be obvious that high inter- est rates artificially depress Ml and raise its velocity, that the monetary base shows almost no predictable relationship to any- thing in the past two years, and that broader aggregates are not controllable by the Fed.18 Besides, the broader aggregates have been speeding-up in the last yar or two, so the traditional Fried- manite long lag with M2 supposedly points to more inflation ahead while Ml or the base does not. (M2 rose 10 percent in 1981; M3, by 11.4 percent.) Not all of the confusion, however, suggests that money is un- dercounted. Most of the monetary base and a big chunk of Ml is simply currency. David Whitehead of the Atlanta Fed estimates that most of the big bills (and 69 percent of all currency) are hoarded.19 In a period of great financial uncertainty and insolvency, the prospect of a major surge in the demand for currency should not be ruled out, despite the lost interest. In this case, the monetary base would be particularly misleading, as it was throughout the Great Depression. A lot of "currency in circulation" would not really be in circulation. Volatile Velocity Monetarists have a double standard when it comes to judging the stability of the money supply or velocity. Comparing percent- age changes between fourth quarters, velocity fell in 1967 and 1970, yet rose by 5-6 percent in 1965, 1966, 1973, 1975 and 1978. Robert Weintraub complains that this is "selective and myopic... terribly short-sighted and gives very misleading signals."20 He in- sists that velocity data should be smoothed by comparing averages 18. Nancy Kimelman, "Using Monetary Targets as Intermediate Targets: Easier in Theory Than in Practice," Federal Reserve Bank of Dallas Voice (De- cember I98i). Patrick Lawler "The Large Monetary Aggregates as Inter- mediate Policy Targets," Federal Reserve Bank of Dallas'Voice (November 1981), 19. "Money Suppjy Gauge May Be Inaccurate," Washington Report (April 20, 1982). 20. Maxwell Newton published the exchange in New York Post January 15, 1982. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 294 Monetarism 31 over the whole year with the year before, or better still, by com- paring three-year averages. When it comes to the money supply, however, monetarists cer- tainly do not mind comparing changes between fourth quarters (this is the way Fed targets are set), or even changes between 8-10 week periods converted into compound annual rates of change.21 If quarterly changes in velocity are likewise expressed as an an- nual rate of change, as Professor Friedman does for even shorter periods with Ml, then velocity swings far more wildly than money —up 13.2 percent in the first quarter of 1981, down 4.5 percent in the second, up 9.5 percent in the third, down 1.2 percent in the fourth, and down 10.5 percent in the first quarter of 1982. Mone- tarists are able to contrast the "stability" of velocity with the in- stability of Ml only by hiding the numbers. Velocity was relatively predictable in the stable world of Bret- ton Woods, but all models to predict velocity broke down after 1972-73, when the U.S. suspended gold convertibility and en- dorsed floating exchange rates. Interest rates now move as much in a day as they used to in a year. Thus, a survey on the demand for money by David Laidler laments that "it was never possible completely to get away from the conclusion that the function has shifted after 1972." "After all," Professor Laidler notes, "mone- tary policy is implemented over time, and unless the relationship it seeks to exploit can be relied upon to remain stable over time it cannot be used successfully."22 At the end of i960, a rigorous study by Robert Weintraub said, "We expect the trend rate of rise of MlB's velocity to drop from 3.2 to about 2% per year, with the spread of NOW accounts. Wo would compensate for this by adjusting the long run target for yearly M1B growth upward by 1 to 1 V2%."yt Velocity is officially classified as a coincident cyclical indicator, so it fell with the sharp fall in real output from last October 21. Milton Friedman, "Monetary Instability." Xetrswerk (Dcicmber 21, 1981). 22. David Laidler, "The Demand and Supply of Money Yet Again," paper presented to a Carnegie-Rochester conference, April 197!'. $<re also Albert Friedberg, "Gold and Demand-Side Monetarism," Bondwefk (November 9. 1981). 23. House Subcommittee on Monetary Policy, The Impact of iHf Federal Rewf System's Monetary Policies on (he Nation '$ Economy (U.S. Government 1980) p. 43. In this model (p. 33) "it lakes two to four years for changes in m<>nr\ growth to change the rate of inflation." so the slowdown in inflation in 1('H1 must have been due to slower money growth around 1977-79? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 295 32 Policy Review through March. The only half-hearted expansion the U.S. has ex- perienced lately was between the third quarters of 1980 and 1981. At that time, velocity of both Ml and the base did not rise by 2 percent, or by 3.2 percent, but by 6 percent. Is this the new "trend" for velocity if and when the economy recovers? Nobody has the slightest idea. Whatever "stability" can be found in long-run trend of Ml ve- locity is only because Ml has been redefined. The old Ml velocity showed an even clearer tendency to accelerate during each cyclical expansion, averaging 3.1 percent from 1961-69, 3.5 percent from 1970-73, and 4.9 percent from 1975-79. And the gyrations were becoming larger. The unpredictability of velocity became even worse after the October 1979 emphasis on the M's. "Erratic velocity behavior of the traditional monetary aggregates led the Federal Reserve to re- define the aggregates, However, the new monetary aggregates have also exhibited erratic velocity behavior. . . ,Paradoxically, the regulatory framework necessary to control the growth of a given aggregate sets in motion forces that ultimately reduce that aggre- gate's usefulness in policy implementation."24 A popular new theory in Washington implies that the ten-year collapse of bond and mortgage markets Is due to the ten-week wiggles in Ml since October 1979. Since the Fed stopped stabiliz- ing interest rates, interest rates have, of course, been less stable. Ignoring what interest rates do to the velocity of Ml, monetarists say it is changes in Ml that cause changes in short-term interest rates, rather than the other way around. It isn't a very persuasive argument, so this is how to "prove" it: First, take a four-week moving average of the volume of bank reserves and calculate the percentage change from the same pe- riod a year before. Plot this on a scale from 1 to 7 percent. Then put current interest rates on three-month T-bills on a scale from 10 to 17 percent. For 1981, believe it or not, these two series do appear to move up and down together (though not in 1980 or 1982). The Shadow Open Market Committee of March 15, 1982 con- cludes that "this leaves little doubt that interest rates rise and fall 24. Bryon Higgins & Jon Faust, "Velocity Behavior of the New Monetary Aggregates," Federal Reserve Bank of Kansas Economic Review (Sepiember-Oc- tober 1981). Also John Wenninger, et. al., "Recent Instability in the Demand for Money." Federal Reserve Bank of New York Quarterly Review (Summer 1981). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 296 Monetarism 33 directly with growth m reserves." But if 7-percent annual growth of reserves "causes" 17-percent interest rates and 1 percent growth of reserves "causes" 10-percent interest rates, then bank reserves must have been falling very rapidly when interest rates were 4 percent (?) A simpler explanation is that the recession low- ered both interest rates and reservable deposits last fall. Output or Prices? In his classic 1956 restatement, Milton Friedman wrote that "the quantity theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level."25 But the elaborate efforts to predict the demand for money broke down with collapse of gold convertibility and pegged exchange rates in 1972-73. The late Harry Johnson of the University of Chicago decided that monetarism was a passing fad, partly because of the monetar- ists' habit of "disclaiming the need for an analysis of whether mon- etary changes affected prices or quantities."2*' Allan Meltzer, for example^ acknowledges that "none of our models predict changes in output reliably." Few even try. Two leading Keynesians like- wise admit that their models too "were demand-oriented, and paid almost no attention to the supply side of the economy."J; Hem-t- ine supply-side counterrevolution. But even if the growth of money plus velocity were under con- trol, that is not enough. It is not a matter of indifference whether an 8-percent growth of nominal GNP consists of 8-percent infla- tion and zero growth or zero inflation and 8-percent real growth. "An increase in real activity raises the demand for real money, which, given nominal money and the rate of interest, is accommo- dated via a decline in the price level."28 Real growth is anti-infl^ tionary in fundamental and lasting ways. Yet growth may be stifled by a monetarist regime that cannot distinguish between a demand for cash to finance more real growth (or to guard against insol- vency) and some sort of inflationary impulse. 25. Milton Friedman (ed.), Studies in Ike Quantity Theory of Money, (Universm of Chicago 1956) p. 4, 26. Harry G.Johnson, On Economics and Society (University of Chicago 197T) 27. A. H. Meltzer, "The Great Depression" Journal of Monetary Efonami,-\ (November 1976); Alan Blinder & Robert Solow, "Does Fiscal Polity Slill Mat- ter" Ibid. 28. Eugene Fama "Money and Inflation" (unpublished. .Vitjmt ll»79\. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 297 34 Policy Review When not openly applauding stagnation as a "Phillips Curve" cure for inflation, monetarists sometimes make slow money growth an end in itself. "A renewed economic expansion," said a promi- nent monetarist newsletter last July, "would not be promising for innation. . .or effective monetary control."29 This is what the de- bate between monetarists and supply-siders is all about. Supply- siders want a monetary policy conducive to increased output at stable prices, not a policy to stamp out each glimmer of economic growth in order to keep Ml down. The supply of money is at best a tool, not a goal, and its value must be judged by results. Time Lags Monetarism has to postulate a time lag between changes in money and changes in nominal GNP or prices. Otherwise, the re- sults are often perverse. From April through October last year, the monetary base grew at a 2.6 percent annual rate, consumer prices at 10.5 percent. From October to February, the base grew at a 10 percent rate, but consumer prices rose at only a 4.3 per- cent rate. Without a lag, the uninitiated might suppose that faster growth of the monetary base caused slower inflation, or that the two series are not closely related. Milton Friedman recently wrote that "the lag between a change in monetary policy and output is roughly six to nine months; be- tween the change in monetary growth and inflation, roughly two years/'30 At the St. Louis Fed, R. W. Hafer says "a 1.0 percent- age point increase in the growth of M1B yields an identical in- crease in the growth of nominal GNP within one year."31 The President of the St. Louis Fed, however, seems to be defending a zero time lag, since his table relates money growth to simultaneous changes in GNP.32 An Atlanta Fed Conference on supply-side economics in April 1982 saw David Meiselman arguing for a lag of 7 quarters, Beryl Sprinkel for a few months. Pick one; some- thing is bound to fit. 29. Morgan Stanley, "Money and the Economy" July 13, 198J. (Lindley Clark of the Wall Street Journal has also written of the virtues of anemic growth). 30. Quoted in Antonio Martino, Containing Inflationary Government (Heritage Foundation 1982) p. 34. 31. R. W, Hafer, "Much Ado About M2," Federal Reserve Bank of St. Louis Review (October 1981). Hafer does not realize that critics of Ml are not necessarily saying M2 is any better. 32. Lawrence K. Roos, "The Attack on Monetary Targets," The Wall Street Journal (February 3, 1982). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 298 Monetarism 35 If the lag Is unknown, there is no way to tell if monetarism is right or wrong. There will always be some past period of relatively faster or slower growth of some M to "explain,'1 after the fact, why- inflation or output went up or down. That sort of retrospective, ad hoc monetarism is inherently immune to serious testing. If the lag is known, however, rational expectations would make it disappear. Knowing that more money now would cause more output in six months would make it profitable to build inventories right away, thus eliminating the six-month lag. Knowing that more money would cause inflation in two years would make it profitable to speculate in commodity markets and generally buy before prices went up—thus eliminating the two-year lag. If the time lag were known, people would act on that informa- tion and eliminate the lag. If there is nonetheless an unknown lag; then there is no way of knowing which change in output or price was caused by which change in the volume of cash. Monetarism would then be of little value for predicting the future or even ex- plaining the past. If there is no lag at all, then the causality be- tween money and spending could easily be backwards. That is, decisions to spend more might cause an increase in the supply of money, as people sold assets to get cash. On the face of it, one might suppose that decisions to spend are based on income, assets, and credit conditions—not merely on how much one happens to keep in a checking account. The idea that total spending can be controlled by controlling the forms of wealth became popular largely because of the apparent discovery of lags between money and GNP. The notion of money having a known effect on something in the future was thus crucial to plausibility of monetarism, but there is still no justification for it in theory or fact, nor any agreement on how long the lags are. Do-It-Yourself Monetarism The supply of money provides some information, even aside from velocity and price. Table 1 shows quarterly changes and an- nual trends in the monetary base, Ml, and in nominal and real GNP. Quarterly changes in Ml appear to explain simultaneous changes in nominal GNP in a few periods, but that causality could obviously be backwards (e.g., observe the generous rise in monetary base and falling Ml during the sharp recession in the second quarter in 1980). And what sense can be made of the first and third quarters of last year, when GNP grew very rapidly as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 299 36 Policy Review TABLE J Money, Spending and Production (annual rates of change, rounded) Quarterly Year-to-Year Real Real Base Ml GNP GNP Base Ml GNP GNP 1980 I 8 7 13 3 8 8 10 2% 1980 II 6 - 3 - 1 -10 8 4 8 -1 1980 III 10 15 12 2 8 6 8 -1 1980 IV 9 12 15 4 8 7 9 0 1981 I 5 5 19 9 7 7 11 1 1981 II 7 10 5 - 2 8 10 13 3 1981 III 4 0 11 1 6 6 12 3 1981 IV 2 6 5 - 5 4 5 10 1 1982 I 10 11 1 - 4 6 7 5 -2 Source: Federal Reserve Bank of St. Louis the base and Ml slowed sharply? The task here is to discover the stability of velocity and the appropriate Jag. The older tradition is that longer-term trends are what matter. On such year-to-year comparisons, Ml growth was unchanged between the third quarters of 1980 and 1981, though the base slowed significantly. With money growth unchanged or tightened, depending on definitions, what happened to the trend of nominal GNP? It rose by 50 percent over the year. A few months later, Lawrence Roos wrote that "Both M1B growth and GNP growth have been decreasing steadily since 1979. "33 Do either the quarterly or annual changes in nominal GNP look "too slow" before the fourth-quarter collapse? If so, then the recession after last July might be blamed on inadequate "aggre- gate demand," requiring bigger budget deficits or more Ml. If not, maybe it is time to discard demand management. It Won't Work To summarize, rebuilding long-term financial markets requires a credible long-term policy to maintain reasonable stability in the purchasing power of the dollar. Such a rule cannot be expressed as a quantity of money because (1) the definition of money is rapidly 33. Op. at Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 300 Monetarism 37 changing, (2) velocity is increasingly unpredictable, (3) any lags between changes in money and GNP are implausible or at least unpredictable, (4) spending depends on more than cash balances and desired cash balances depend on more than planned spend- ing, and (5) nobody can tell at the time if a rise in money and spending is financing more real output or rising prices (except by watching prices instead of money stocks). But that isn't the end of it. If a quantity rule for money could somehow pass these hurdles, it still would not work. If people thought a quantity rule would work, they would ex- pect inflation to average about zero for decades. The rush to buy long-term-bonds would quickly drop interest rates to around 3-6 percent. At such rates, the convenience of checking accounts and currency would make it a waste of time to employ complex cash management schemes. The demand for Ml would surge; velocity would fall. No fixed growth of Ml or the monetary base could cope with such a sudden rise in the demand for cash. Real cash balances could only rise, as desired, if prices fell abruptly. Sudden defla- tion would surely prompt an equally sudden violation of the rule. Knowing that, people would not believe the rule in the first place. If the move to slow growth of Ml was done gradually, to mini- mize the risk of deflation, that too would not be believed. People would rightly reason that the next president or Fed chairman would probably abandon the predecessor's long-term plan. Thus, long-term interest rates would remain high, and velocity might well speed up by more than Ml was slowing down. With rates high, any temporary reduction of inflation would raise real inter- est rates, causing bankruptcies that would force abandoning the gradual rule. Advocates of a quantity rule have had 14 years to agree on one and put U into action. Next time, it will not take that long for in- terest rates to triple again. Does that have to happen before any- one will admit that this experiment with managed money, like the Continental and Greenback dollars, is also a failure? How bad do things have to get before economists will admit that they made a mistake by endorsing the demolition of proven monetary rules from 1965 to 1973? Price Rules If monetary policy cannot effectively stabilize prices indirectly, by controlling quantities of M, then why not focus directly on Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 301 38 Policy Review some sensitive measure of price? If such prices are falling, that would be a sign that the demand for money exceeds the supply— time for the Fed to buy bonds (or gold), or to lower the discount rate or reserve requirements. If prices start to climb, it is time to tighten. In 1962, this was still the dominant view. Professor Friedman then wrote, in Capitalism and Freedom, that "the rule that has most frequently been suggested by people of a genuinely liberal persua- sion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level." If monetary policy had followed a price rule in 1928-31, the de- flation could have been nipped in the bud. As Lauchlin Currie noted in 1934, "the three years that preceded the depression wit- nessed a considerable fall in prices not only in this country but throughout the world."34 Another possible price rule—real inter- est rates—likewise showed that monetary policy was too tight in 1928-32. Alternatively, the sizable inflow of gold into the U.S. in 1929-30 was an equally clear signal that the supply of dollars was inadequate. The Fed, as Milton Friedman observes, was "con- tracting the money supply when the gold standard rules called for expansion."35 A quantity approach to money, on the other hand, would have given ambiguous signals about deflation until it was too late. There was no significant decline in the money supply until March 1931, and the monetary base continued to rise throughout the 1930-33 deflation, as people held more currency and banks held more reserves. A policy of slowly increasing the monetary base, as some now propose, would not have prevented the Great Contrac- tion. Any price rule or gold standard, however, would have worked. Broader price indexes, such as the producer price index, are too sluggish, among other problems (they are revised months later; seasonal adjustments and weighing of items are dubious; dis- counts and quality changes are missed, etc.). Looking at broad price indexes makes it easier to wrongly blame inflation on the "oil shock" of 1974, though commodity prices began rising sharply in 34. Lauchlin Currie, "The Failure of Monetary Policy to Prevent the De- pression of 1929-32" in Landmarks in Political Economy (University of Chicago, 1962). 35. H. G. Manne & R. L. Miller, Gold, Money and the Law (Aldine 1975), p. 75. Also M, Friedman & A. Schwartz, A Monetary History of the United States (Princeton 1963) p. 361. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 302 Monetarism 39 1972. Instead, a price rule must work with instantly available spot commodity prices. Money and commodity prices often move in roughly similar di- rections, as Robert Weintraub has noted, so monetary policy at those times could just as well moderate big swings in either one. When the two diverge, however, commodity prices invariably give a more accurate picture of emerging trends in the economy. Growth of Ml was essentially unchanged from 1973 to 1975, at 4.4-5.5 percent, but a price rule would have required a much tighter pol- icy throughout 1972 and 1973, and a much easier policy from April 1974 to July 1975 (when spot commodity prices fell 28 percent). Table 2 contrasts the monthly information provided by Ml and commodity prices in 1980-81. Either series pointed in the correct direction in 1980, but commodity prices convey a much better picture of the liquidity squeeze from October 1981 into early 1982. The seemingly rapid growth of Ml this period was not suffi- cient to prevent massive liquidation. An easier policy would havt* been prudent and desirable, providing people understood that the process would be reversed as soon as commodity prices began to turn up. In other words, chasing the elusive M's from week-to-' TABLE 2 Should the Fed Target Prices or Ml? 1980 1981 Commodity Price Commodity Price Ml Prices Rule Ml Prices Rule Jan. 0.8 2.1 loose 0.8 -2.3% light Feb. 0.8 2.0 loose 0.4 -2.5 tifiht Mar. 0 -1.7 tight 1.2 2.0 Icose Apr. - 1.3 -4.7 tight 2.1 1.1 loose May -0.2 -7.8 tight - 1.0 -IA tiijht Jun. 1.2 -3.9 tight -0.2 -2.1 tight Jul. 1.1 3.8 loose 0.2 t.3 loose Aug. 1.8 5.2 loose 0.4 1.0 loose Sep. 1.4 2.1 loose 0 -2.2 tight Oct. 1.2 0.8 loose 0.4 -2.0 tight Nov. 0.5 1.3 loose 0.8 -2.4 tight Dec. -0.7 -2.1 tight 1.0 -2.3 tighf Source: U.S. Department of Commerce, Business Conditions Dignt. Series 85 and 23. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 303 40 Policy Review week prevented the only sensible response to an unnecessarily wrenching deflationary experience. Other sorts of price targets have been proposed, but most are less direct ways of achieving similar results. Ronald McKinnon of Stanford proposes pegging exchange rates with countries that have a somewhat better track record on inflation, such as Germany and Japan. Edward Yardeni of E. F. Hutton and Donald Hester of the University of Wisconsin suggest keeping real interest rates from drifting too high or too low. Stabilizing commodity prices would do all this and more. If real interest rates are "too high," there is liquidation of com- modities, inventories and assets in order to acquire cash. Com- modity prices fall. The dollar's exchange rate will likewise be arti- ficially high, due to short-term capital inflows. Stabilizing the price of gold also stabilizes real interest rates, commodity prices, bond yields and exchange rates. Stabilizing any one of those things, if it could be done, would also tend to stabilize the others. Since broader price indexes are too insensitive, wliat about nar- rowing the list to only one commodity—namely, gold—that is notoriously sensitive to every whiff of inflation or deflation (in- cluding the inflationary propsect of war)? The London gold price dipped in February 1980 and fell 17 percent in March, correctly signalling the March-June decline in commodity prices. Gold rose 17 percent in June 1980, announc- ing the start of the July-November reflation. Gold prices have fallen since just before the presidential election, stabilizing only during the spurt in both money growth and commodity prices in March-April 1981. Watching gold prices works well, and limiting the extremes would work even better. That is no more difficult than stabilizing wild gyrations in interest or exchange rates, which has often been successfully accomplished. Participants in the gold market are not only concerned about current inflation, but about future inflation. Price movements thus tend to be exaggerated, when not on a gold standard, reflecting changing expectations about future inflation. This may be a useful characteristic, because it is the expectation of future inflation that destroyed the bond market. In October 1979, when the Federal Reserve announced that it would henceforth pay more attention to quantities of money and less to results, the gold price went from $355 to $675 in only four months. Other factors may have been involved, but it looks like a vote of no confidence. Conversely, the gold price fell sharply ever Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 304 Monetarism 41 since the election of President Reagan. No forecaster or monetary aggregate did as good a job as the gold market of predicting how- abrupt the disinflation would really be. Money growth was not clearly slow until May-September of last year, and even then the M's were throwing-ofT conflicting signals. Convertibility Paying more attention to the consequences of monetary pol- icy—prices, interest rates and exchange rates—would be a major improvement, but still remains a matter of discretionary manage- ment. In order to institutionalize a price rule, it is necessary to convert dollars for gold, and vice-versa, on demand at a fixed price. The "right price" is that price at which we observe neither inflation nor deflation. The only way that foreigners or speculators could upset the fixed gold-dollar ratio would be by monopolizing the stock of gold or dollars, which is clearly impossible. Stabilizing the value of dollars in terms of gold is not "price fix- ing" any more than stabilizing an index of prices would be called "price fixing," **Just as every commodity has a value in terms of the unit," wrote Ralph Hawtrey, "so the unit has a value in terms of each commodity.Il36 There has been a lot of misinformation spread around about the U.S. gold standard in the classical period (1879-1914) or the Bretton Woods era (1945-1973). When the period of managed and floating money since 1968 or 1973 is fairly compared with any sort of gold standard, gold systems show far more real growth, better stability of prices in the short and long run, longer expan- sions, more world trade, and long-term interest rates never above 5-6 percent.37 In any case, we can improve upon historical perfor- mance by learning from the mistakes. In 1978, Jurg Niehans of Johns Hopkins observed that "com- modity money is the only type of money that. . . can be said to have passed the test of history," and wondered if "the present pe- riod will turn out to be just another interlude." "The analysis of commodity money," Niehans regretted, "has made hardly any 36. Ralph Hawtrey, Currency and Credit (Longmans Green 1919) Ch 1. 37. My Gold Commission testimony is condensed in Economic Impact 1982/2 (U.S. Govt. Printing Office), and the Federal Reserve Bank of Atlanta will soon release my talk in the proceedings of an April conference on supply-side economics. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 305 42 Policy Review progress in the last fifty years. Actually, more knowledge was for- gotten than was newly acquired."38 In the past few years, however, there has been a gradual redis- covery of the value of commodity money in the work of such schol- ars as Robert Barro, Fischer Black, Benjamin Klein, Robert Mundell, Robert Hall, Thomas Sargent, Robert Genetski, Rich- ard Zecher, Paul McGouldrick, Michael Bordo and others. This is just the beginning. David Ricardo wrote about the central bank in England during 1816, a period of fiat money very much like the present. "In the present state of the law," wrote Ricardo, "they have the power, without any control whatever, of increasing or reducing the circu- lation in any degree they may think proper; a power which should neither be entrusted to the state itself, nor to anybody in it, as there can be no security for the uniformity in the value of the currency when its augmentation or diminution depends solely on the will of the issuers." "The issue of paper money," said Ricardo, "ought to be under some check and control; and none seems so proper for that pur- pose as that of subjecting the issuers of paper money to the obliga- tion of paying their notes either in gold coin or bullion."3<> The Bullion Committee explained the task before Britain rein- stated the gold standard in 1821: "The most detailed knowledge of the actual trade of the country, combined with the profound science in all principles of money and circulation, would not allow any man or set of men to adjust, and keep adjusted, the right pro- portions of circulating medium in a country to the wants of trade." Britain took Ricardo's advice and enjoyed over a century of unprecedented monetary stability and economic achievement. Eventually, the United States will do the same. There is no viable alternative. 38. Jurg Niehans, The T&eory of Money (Johns Hopkins 1978) pp. 140-41. 39. David Ricardo, The Principles of Political Economy and Taxation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 306 STATEMENT on behalf of -. NATIONAL ASSOCIATION OF REALTORS® regarding MONETARY POLICY to the SENATE COMMITTEE ON BANKING, BOUSING AND URBAN AFFAIRS by DR. JACK CARLSON August 12, 1962 I am Jack Carlson, Executive Vice President and Chief fit) Economist of the NATIONAL ASSOCIATION OF REALTORS ^. On behalf of the nearly 600,000 members of the National Association, we greatly appreciate the opportunity to submit our views on the Monetary Policy. RECOMMENDATIONS (1) We recommend this Committee consider instructing the Federal Reserve to use short-term interest targets in addition to and consistent with money growth targets, particularly during periods of time when the appropriate long and short-term monetary growth targets of the Federal Reserve are being met. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 307 (2) We recommend to this committee that it consider recommending to the Federal Reserve that in view of the fact that reductions in money velocity have caused the monetary targets to be increasingly restrictive, the Federal Reaerve should consider modifying the money growth targets upward during these periods of reduced money velocity. It is our recommendation that the targets can and should be increased by one percentage point for the remainder of this year and for 1983. (3) We recommend to this committee that it encourage the Federal Reserve to set a suitable date for implementation of contemporaneous reserve accounting. (4) We recommend to this committee that it recommend to the Federal Reserve that reducing information by which expectations on the short run money growth policy of the Open Market Commit tee are formed in the financial markets through averaging the weekly money stock measures is an inappropriate response to the problem of the formation of erroneous expectations. The plan to implement the averaging of the money stock measures should be cancelled. The Federal Reserve should implement measures to increasre the information by which these expectations are formed and not reduce it. (5) We recommend to this commit tee that it request the Federal Reserve to consider holding monthly briefings in New York Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 308 and Washington for financial market economists, practitioners, and others whose opinions weigh heavily in the formation of Investor expectations and report to the committee as to the feasibility of this proposal. The purpose of the briefing would be to reduce erroneous policy expectations in the financial markets particularly as they relate to factors that influence short and medium term policy modifications by the Open Market Committee. SUMMARY (1) Since late in 1979, major elements of Federal Economic Policy have been in direct conflict in that the Federal Reserve has pursued on anti-inflationary policy of credit restraint while the Congress and the Administration have pursued an inflationary policy of fiscal stimulation to increase economic growth and employment. (2) The result of this policy mix is an unusual set of elconomic conditions, i.e., lower inflation, higher unemployment, and stagnant economic growth co-existing with high and volatile interest rates. (3) High and volatile interest rates, by keeping the housing and auto industries, business investment and trade in goods and services depressed is preventing economic recovery and has Inflationary implications for the future. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 309 (4) We agree with Federal Reserve Chairman Volcker that there has to be far more done on the fiscal side in reducing deficits before a sustained and robust economic recovery can ensue. (5) Interest rate volatility is knovn to be a major factor In depressing credit dependent industries. This rate volatility has primarily been the result of an erratic growth path for money supply as represented by Ml. The Federal Reserve's capacity to control the supply of credit in order to produce a steadily growing money supply is limited. (6) The Federal Reserve should adopt, as has been recommended by Its own staff, a contemporaneous reserve requirement system in order that they have greater short run accuracy In managing reserves to meet money growth objectives. (7) The current economic conditions have confused the expectations of investors and consumers and they have responded to this by holding large amounts of liquid assets. This has caused changes In money velocity that have necessitated policy modifications by the Federal Reserve with respect to the monetary growth targets. (8) These policy modifications have not been effectively communicated to the financial markets and have resulted in erroneous monetary policy anticipations by the markets. Interest rates have, the refore, been higher during the early part of 1982 than they would have been If policy expectations had been more accurate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 310 (9) The Federal Reserve should Implement measures to reduce erroneous' policy expectations in the financial markets, particularly as it relates to factors that Influence short- i and medium-term policy modifications with respect to monetary growth targets. (10) The economy is now poised for recovery and with inflation currently reduced the Federal Reserve should shift its priority from reducing inflation to encouraging economic growth. It now can safely allow money to grow at least one percentage point above the current target range. This is particularly the case with current high liquidity preferences and low money velocity. The result of this would be to further lower interest rates and relieve some of the pressure from the interest sensitive industries and thrift institutions. A more rapid economic recovery would result from this policy change. Since late in 1979, the Federal Reserve has pursued a policy of bank reserve management for the purpose of regulating the growth rates of several monetary aggregates within prespecified annual target ranges. The policy was adopted as an approach toward reducing inflation by limiting the growth of nominal GNP. The theoretical justification is that, although there will be short-run impact on real output and employment from restraining money growth, the intermediate and long-term adjustment would primarily come out of the inflation component of nominal GNP which is the desired result. At the time, reducing Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 311 inflation, which was growing during some months at annualized rates in excess of eighteen percent, had acquired a national constituency for making it the primary domestic policy priority. Although the path of growth in the money aggregates has been volatile, their yearly growth has steadily declined over 1980, 1981, and the first half of 1982; and as consistent with theory, inflation has significantly declined. However, theory also suggests that Interest rates should have declined with the reduction of Inflation and the slowing of real output growth. This has not occurred. Interest rates and, particularly real interest rates, have reached and maintained record highs. Figure 1 INFLATION HNO INTEREST RATES 23-T 1978 1379 1380 1981 1382 iNFLflTIQN — LINE PRIME RATE — SHORT DASH CORPORATE BDHD RATE — LONG DASH Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 312 Figure 2 PERCENT CHRKGE IN REflL GNP 3-r 1378 1379 1380 1361 1382 figure 3 UNEMPLOYMENT RflTE 5.3' 1376 1373 1380 1381 1362 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 313 Figure 4 til GROWTH COnPflRED TO TflRSETS 20-P 13-- -3- 1377 1378 1373 1360 1381 1382 HI CROUTH — LINE THRGETS — DASH Figure 5 H2 SRQWTH COMPRRED TO TRRGETS 12-T 10-- 1377 1378 1379 1360 1381 1982 (12 GROUTH — LINE TARGETS — DASH Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 314 The primary reason for this departure from theorltlcal expectations Is that while the Federal Reserve was pursuing an anti-inflationary policy of credit restraint, successive Congresses and Administrations have direcly contradicted this by pursuing a policy of fiscal stimulation to increase economic growth and employment. Because the demand for money generated by the large and accelerating borrowing requirements resulting from this fiscal stimulation is large relative to available money, and does not depend on levels of output and cost of funds, the private demand for money had to carry the burden of adjustment to this conflict in policy. Interest rates remain high, contrary to the expectations of theory, because the assumption in theory that the demand for money depends on the price of money and levels of economic output has not held. The high interest rates we currently suffer are in place to effect the downward adjustment in private demands for money in order that the large and growing public demand for money can be accommodated despite the policy of deceleration in money growth being implemented by the Federal Reserve. This conflict in Federal fiscal and monetary policy has currently left us with an unusual set of economic conditions: low inflation, high unemployment, and stagnant economic growth coexist Ing with high and volatile interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 315 Figure 6 THE FEDERRL DEFICIT 140-T 120H- 100-i- 1378 1373 1381 1382 Figure 7 FEDERAL DEFICIT fii 0 PERCENT OF PERSONAL SflVINGG 1978 1373 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 316 Figure 8 FEDERHL DEFICIT Rfi fi PERCENT OF FERSONBL SAVINGS P. US OKPORBTE SWINGS 1373 1390 1382 Figure 9 FEOERfiL DEFICIT flS fl PERCENT OF TOTflL PRlVRTC WVIHG6 23-P 1378 1373 1380 1981 1382 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 317 _Figure 10 FEDERflL DEFICIT flS fl PERCENT OF NQMINflL GNP The adjustments forced on private borrowers have. In some cases, been unprecedented since the Great Depression, and no Indus try has suffered more than the housing industry. For forty months now, housing activity has declined, and this decline has accelerated during the last twelve months. More Americans during the last forty months have lost the opportunity to satisfy their hone owner needs than at any other time in United States history. This includes the drop through the years 1929 to 1933. Home sales have fallen 55 percent (from peak to trough) in dramatic and stark contrast to the physical volume of other sales in the national economy which have dropped only about three Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 318 percent. About 3.5 million households have been denied the opportunity to qualify for adequate housing of their own. Figure 11 HOUSING STflRTS flND HOME SfiLES 1373 1380 1381 1382 HOUSING STflRTS — LINE HOME SflLES — DflSH Figure 12 _ RGRL EFFECTIVE CONVENTIONS. "ORTGfiGE RflTE 1373 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 319 This loss has occurred while the demographic demand for housing is not significantly decreasing, even before considering replacement demand. The loss has not only kept would-be home buyers from achieving their dream of home ownership, but has caused home owners to lose as much as one-half of their investment in their homes. This loss occurred because real interest rates for new mortgages (interest rates after adjusting for inflation) have increased from the normal three percent level during the post-war period to highs of of 6.9 percent during 1981, near 15 percent in 1982, and 8.2 percent forecast for 1983. The higher real Interest rates, rising from three percent to above 14 percent, have caused a loss of at least 25 percent of the current marketable value of every American's home, as well as any other long-lived investment such as commercial, Industrial, and agricultural real property. When one considers the average equity of people's homes is sixty percent, this means nearly one-half of all Americans' equity in their hones has been taken away because of high real interest rates resulting from this policy conflict. Along with housing, other credit sensitive Industries have been caught in the jaws of this policy conflict. The auto industry and other consumer durable goods industries are heavily affected. Industries that support housing and consumer durable goods such as lumber, steel, plastics, rubber, and others have suffered severe declines. tfith the general decline in output, and also because of the high cost of funds, Investment in plant Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 320 and equipment has fallen drastically. Prolonged depression in investment lo bousing and business structures and equipment will virtually guarantee high prices and lagging productivity in the future. Figure 13 REffl. YIELD ON NEW ISSUES Of HIOH QRflDE CORPQRflTE BONOS 13-T 1378 19SO 1981 1382 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 321 Figure 14 PERCENT CHfiNfiC IN NONRESIDENTIflL INVESTMENT 10-r 1978 1373 1380 1381 1962 It has always been known by all of ua that the fight against inflation would not be an easy one. There was to be Buffering by many in order to achieve price stability. But the method of solely relying on monetary policy as the tool to obtain price stability has resulted in the casualties being predominantly distributed in the credit sensitive industries. Nevertheless, substantial progress has beea made in reducing the cost of production and there Is now opportunity for strong sustained economic growth with more suitable prices. Along with the fall in prices, real incomes have been steadily growing. Consumers have been liquidating their debt and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 322 the debt service to income ratio is the lowest it has been in years. Although there has been some Increase in the consumer price index lately, the increases have been centered on energy and housing costs and there are reasons to believe this acceleration will be short-lived, or are the results of statistical quirks. Energy surpluses are beginning to build again as energy producers renig on OPEC production agreements. This may limit future increases in oil prices. The rise in home prices lacks credibility given the current depressed housing market leading to an upward bias in measured inflation. On a more optimistic Bide, producer prices for finished and Intermediate goods, as well as crude materials, continue to be moderate and give reason for optimism that the growth in prices in the future will be moderate. Wage demands have finally begun to moderate with actual wage declines being registered in some cases and capacity utilization is extremely low. These indicate that renewed growth will not be inflationary. The dollar's position on the international currency markets is currently too strong, but should trend toward an appropriate lower value in relation to other currencies as our lot erst rates dec line. Nevertheless, its continued strength will also help keep renewed economic growth noninflationary. Finally, our current confused economic state has driven investors to cautious liquid positions so they are now poised and capable of investing in Che new opportunities that vovld arise in a recovery. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 323 Figure 15 PERCENT CHflNGE IN PRODUCER PRICES WO BVEJWGE HOURLY EflRNINGS 20-r 1378 1380 1381 1362 Figure 16 PRODUCER PRICES — LINE OVERflfiE HOURLY EARNINGS — DflSH CflPflCITY UTILIZflTION 1978 1379 1380 1981 1382 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 324 Figure 17 U.S. TRflOE-HEIGHTED EXCHHNGE RflTE .80' 1378 1379 I960 1381 1382 !_•... ; Figure 18 • PERSONflL SflVINSS RflTE 8.0-T 7.3-- 7.Q-- 1978 1373 1380 13S1 1382 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 325 However, there will be no strong and sustained recovery until the conflict between fiscal and monetary policy is removed. The economy is now at a crossroad. One road leads to economic recovery and prosperity. The other to depression as the many businesses that have survived so far begin to fail when Interest rates do not come down and a recovery does not occur. The way to get on the right road ta not now in dispute. Just AS the national consensus two years ago was that controlling inflation was the nation's top economic priority, the consensus is now for reducing the federal deficit and borrowing, lowering Interest rates, increasing employment and raising the standard of living of Americans- Although the recent budget resolution has been a step in the right direction, we agree with Federal Reserve Chairman Volcker in saying that there has to be far more done on the fiscal side in reducing deficits before a sustained and robuat economic recovery can ensue. This is particularly the case if the Congressional Budget Office is correct in saying that even with the expenditure cuts and tax increases in the latest budget resolution, federal deficits will be near $140 to $155 billion over the next three years. This state of affairs simply cannot be allowed to continue. Reduction of the federal deficit is crucial if economic disaster is to be avoided. In order to bring about this reduction, I sincerely request you give consideration to the recommendations of the NATIONAL ASSOCIATION OF REALTO.RS ^—' whi ch Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 326 (1) Federal spending growth must be slowed dovn and reduced In all parts of the federal budget, including defense, entiClement programs, and other programs. Spending this year has overrun Che conml tmeats of the President and the Congress by double the rate compared to the last ten CR) years. REALTORS ^—' have been responsible for recommending many of the cuts which were subsequently proposed by the President and enacted by the Congress last year that affected real estate and we called upon other industries to follow our example of accepting the necessary sacrifices. (2) Deferral of tax relief planned for July 1983 and indexing scheduled for 1984 should be considered among ways Co meet this need. (3) Tax increases to discourage consumption, but not savings and investment, should be adopted along with spending tin reductions to help limit the deficit. REALTORS w in the first place recommended individual tax relief should be United to five percent across the board each year, instead of ten percent, and that the tax relief should be no larger thaa spending reductions to achieve a balanced budget by (4) Finally, w« recomaecded that Congress adopt a Constitutional Amendment to restrain the growth of federal pending and taxes in relationsbiop to the growth of people's income and to restrain the growth of deficits. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 327 Although reduction in the federal deficit has priority over the range of policy options, Improvement in the exercise of monetary policy is also of high importance. Interest rates have been extremely volatile since the Federal Reserve began targeting money growth as its primary policy objective. Also, partly as a result of this concentration on money growth targets, real interest rates have reached prohibitive levels even though inflation has sharply declined. Monetary policy improvements must address these problems of interest rate volatility, the formation of erroneous policy expectations with respect to money growth, and prohibitively high real interest rates. These vill be the issues to which our recommendations on monetary policy Improvements will be addressed. With respect to the volatility of interest rates, we know that Increased rate volatility is an inherent consequence of the policy technique of targeting money growth. However, the excessive magnitude of the volatility we have experienced has resulted primarily from an unnecessarily erratic growth path in tbe money supply. Excessive interest rate volatility is a major factor in depressing credit dependent industries- The Federal Reserve's capacity to control the supply of credit in order to produce a steadily growing money supply and stable Interst rates has been demonstrated to be limited. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 328 Techniques of controlling the monetary aggregates have been discussed and the current policy of lagged reserve requirements has received considerable attention. Under lagged reserve requirements, required reserves are to be met with a two-week lag. That is, for average end-of-day deposits during a given seven-day confutation week, reserves are to be held during a seven-day maintenance week ending fourteen daya after the end of the computation week. Vault cash also is lagged two weeks. That is, vault cash held during the computation week Is to be used co satisfy reserve requirements during the maintenance week two weeks later. Also, member banks could not only make up reserve deficiencies in the next reserve maintenance week, but could carry forward excesses into the next maintenance week. This last provision, which is called the carry-over provision, obviously complicated reserve accounting. Studies by the staff of the Federal Reserve found, as reported In a staff paper to the Board of Governors on September 14, 1981, that there was widespread support for lagged reserve requirements (LRR) among depository institutions because it reduced the costs to banks of acquiring current data on their required reserved in time to adjust their reserve positions. However, LRR added to the size of these adjustments for banks clearing through the Federal Reserve. Movements in reserves over the maintenance week are typically accompanied by movements in deposits in the same direction, and with contemporaneous reserve requirements (CRR), changes in excess reserves are partially Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 329 offset by the associated changes in required reserves. In contrast, with LRB this offset does not occur and necessitates larger reserve adjustments at the end of each maintenance week. The study continues by saying that reflecting ttieae additional adjustments, which are made id part via the federal funds transactions and member bank borrowing, LRR added somewhat to pressures for fluctuations la the federal funds rate near the end of the maintenance period. Accordingly, the volume of system defensive open market operations needed to constrain settlement day fluctuation in the funds rate increased. Finally, the staff report says LRR has no discernible impact on the precision of monetary control under a federal funds rate operating target, which relied mainly on Influencing money demanded. However, under a reserve operating target) LRR Impairs short-run monetary control by delaying the response of mofiey market Interest rates to changes In the quantity of money demanded. For example, with fixed weekly targets for reserves, the switch to CRR would speed up the impact of changes id money or required reserves and interest rates by two weeks. Empirical evidence comparing the relation beteen reserves and money in the years before and after the switch to LRR suggested that raon t h-t o-motith monetary control could be noticeably Improved under reserves targeting by a return to CRR. Also included in the paper were the recommendations of the staff which state that the return to CRR would entail substantial • tart-\ip and continuing costs for both depository institutions Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 330 and the Federal Reserve System. It would also be considerably more complex administratively, particularly for reserve pass-through relationships, than the present lagged reserve requirement system. Nonetheless, the staff IB of the view that a CRR system as proposed in their memorandum is operationally feasible. With regard to the benefits of such a system, CRR would offer the potential for improved month-to-oonth control over the monetary targets, though the monetary control gains would be appreciably less over longer periods, say a three to six month horizon. The staff went on to recommend a CRR system with the following features : (1) Only depository Institutions reporting deposits weekly would be subject to CRR. (2) CRR would apply only to transactions deposits; reserve requirements on other reservable liabilities would continue to be met on a lagged basis. (3) Vault cash holdings In a previous period would continue Co be counted as reserves in the current maintenance period. (4) The computation period for transactions balances would end on Monday, two days before the end of the maintenance period . 5) Both the computation and maintenance periods would be two weeks in length rather than the present one week. However, for purposes of the monetary statistics and the estimation of required reserves, deposits would continue to be reported on a weekly basis. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 331 (6) The current carryover limit of plus or minus two percent of daily average required reserves would seem appropriate. ..= f,*.**.^*,*.^ o ^«.n. , «. ^»« «- endorses the t uuu ui l iv recommendations of the Federal Reserve staff and requests that this committee encourages the Federal Reserve to set a suitable date for implementation. The unusual economic conditions and regulatory, attitudinal, and technological evolution, have all made the art of monetary management very difficult. The current economic conditions have confused the expectations of investors and consumers and they have responded to this by holding large amounts of liquid assets. Hew financial 1nstrumente that have been developed having characteristics of both transaction account a and savings accounts are now widely available to the public, and current conditions are causing them to use these accounts in new ways > Since the mo net a ry aggregates that are targeted for policy purposes ate defined on the basis of accounts that segregate the transaction and saving functions, setting policy based on those aggregates is sometimes difficult to sustain and more importantly for short run Interest rates, difficult to Interpret. Chairman Volcker has testified, "the great bulk of the increase la Ml during the early part of the year—almost 90 percent of the rise from the fourth quarter of 1981 to the second quarter of 1982—was concentrated in NOW accounts, even though only about a fifth of total Ml is held in that form." He also Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 332 states, 'In contrast to the steep downward trend In low interest savings accounts in recent years, savings account holdings have stabilized or even increased in 1982, suggesting the importance of a tfigh degree of liquidity to many individuals in allocating their funds. A similar tendency to hold acre savings deposits has been observed In earlier recessions." In the Federal Reserve's Midyear Monetary Policy Report to Congress it states, "Looking at the components of M2 not also included In Ml, the so-called non-transaction components, theae items grew at a 10-3/4 percent annual rate from the fourth quarter of June 1982. General purpose and broker/dealer money market mutual funda were an especially strong component of M2, increasing at almost a 30 percent annual rate this year. Compared with last year, however, vhen the assets of such money funds acre than doubled, this year's increase represents a sharp deceleration." Money market mutual funda are similar to NOW accounts in that they have characteristics of both transactions and savings accounts. The report continues, "after declining in each of the past four years--failing 16 percent last year—savings deposits have increased at about a 4 percent annual rate thus far this year. This turnaround in savings deposits flows, taken together with the strong increase In NOW accounts and the still substantial growth in money funds, suggests that stronger preferences to hold safe and highly liquid financial assets la the current recessionary environment are bolstering the demand for M2 as well as Ml." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 333 This increased demand for Ml and M2 affects the ratio of these aggregates to gross national product. This has policy implications because the determination of whether money growth is excessive or constraining is based on an assumed ratio of the money aggregate to gross national product. An assumed velocity if you will. That is how the target ranges are decided upon. Chairman Volclcer stated, "the Committee (Open Market Committee) was sensitive to indications that the desire of individuals and others for liquidity was or-^sually high, apparently reflecting concerns and uncertainties about the business and financial situation," he also states, "Judgments on these seemingly technical considerations inevitably take considerable importance in the target-setting process because the economic and finaneial consequences (including the consequences for interest rates) of a particular Ml or M2 increase are dependent on the demand for money." In other words, the determination of whether money Is tight or loose at a particular level depends on the velocity to a considerable extent. In reference to Federal reserve policy early this year when money growth was veil above target, Chairman Volcker states "In the light of the evidence of the desire to hold more NOW accounts and other liquid balances for precautionary rather than transaction purposes during the months of recession, strong efforts to reduce further the growth rate of the monetary aggregate appeared inappropriate." He continued, "Moreover—and I would emphasize this--growth somewhat above the target ranges would be tolerated for a time in circumstances la which It appeared that Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 334 precautionary or liquidity motivations, during a period of economic uncertainty and turbulence, were leading to stronger than anticipated demands for money." The Chairman also stated that the behavior of velocity and Interest races weighed heavily In this policy determination. The problem with this is that just as the Federal Reserve's policy decisions on acceptable money growth is complicated by the velocity problem, It Is doubly difficult for the members of the financial community who have recently had to trade based on expectations of Federal Reserve policy, to form expectations on that policy. The Importance of Federal Reserve policy Is indicated by the attention that is paid to the weekly release of the monetary aggregates. This attention has been so great that the expectations formed by them have been of some concern at the Federal Reserve. Recently, the Federal Reserve has said it Intends to counter this by averaging the weekly numbers to reduce their volatility and hopefully their importance In forming expectations about Federal Reserve policy. It is our feeling that this is the exact opposite of the approach the Federal Reserve should take to this problem. Instead of trying to reduce the information available to the financial markets for forming expectations on Federal Reserve policy, they should be increasing it. During the early part of this year expectations of emmlnent tightening of money growth and higher interest rates were formed because of persistent money growth above Federal Reserve targets. The expectations of higher interest rates inflated long term interest rates and drove long Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 335 tern borrowers into the short term market which helped Inflate those rates as well. The statements of Chairman Volcker on the policy considerations of the Open Market Committee at the time indicate that these expectations were overly pessimistic. When the Open Market Committee modified its policy due to velocity and liquidity preference changes, the modification was not effectively communicated to the financial markets. This resulted in erroneous expectations and probably resulted in interest rates being higher than they would have been if policy expectations had been more accurate. Ve believe the Federal Reserve should implement measures to reduce erroneous policy expectations in the financial markets particularly as they result from abort and medium term policy modifications by the Open Market Committee. Juat as the Federal Reserve periodically reports to Congress on Federal Reserve policy and responds to their questions, they should perform a similar function for members of the financial markets. What we propose is that the Federal Reserve hold monthly public briefings in New York and Washington for financial market officials and tbe public whose opinions weigh heavily In the formation of investor expectations. These briefings should be held soon after each meeting of the Open Market Committee and should be conducted by the Federal Reserve Chairman, a Federal Reserve Governor, or possibly a member of the Open Market Committee. The subject of the meetings would be the short-run targets for money growth of the Committee. Also discussed would be factors which could cause Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 336 variance from the Committee's targeted grovth path and what the likely Committee response to those variances would be. It Is our feeling that such briefings would reduce much of the uncertainty in the financial markets vith respect to Federal Reserve policy fox management of money grovth* This would certainly reduce the impact of volatile movements ID the money stock measures on interest rates and could, therefore, reduce the large risk premiums that are currently imbedded in those rates. We strongly encourage this committee to request that the Federal Reserve consider this proposal and report on its feasibility. Finally, 1 would like to address the problem of sustained high real Interest rates that are enduring despite our current reduced level of inflation. To be sure, the primary policy measure to be taken to remedy this problem is to reduce excessive borrowing by the Federal Government. However, the Federal Reserve must also have a responsibility to help maintain real interest rates at levels necessary to promote growth in output and employment with low Inflation and stable prices. The economy, though currently languishing la a deep recession, is now poised for a recovery. With wage growth moderating, capacity utilization low and consumer liquldty high, we now have our best opportunity to initiate a sound recovery with low rates of inflation. Our priorities Must now turn to this recovery which will bring the country back to economic prosperity. Monetary policy must do Its part to help bring the recovery about, and to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 337 continue to play a role In sustaining strong economic growth by keeping real interest rates from reaching excessive levels. *..,. „«,.*„„„„ » —»~— *~ ..-. has In the past u and continues to support the Federal Reserve's policy of gradual reduction in the rate of growth of money and credit in order to reduce inflation- However, we would like to additionally recommend at this time that this committee consider requiring the Federal Reserve through amendments of the relevant sections of the Federal Reserve Act, to utilize the policy tools at its disposal to maintain real short-term Interest rates at historic evels (3 to 4 percent) during any periods of time that the long and short-term monetary monetary growth targets of the Federal Reserve are being met - The adoption of this proposal would insure that during periods where low Inflation and high real interest rates exist while money growth Is within the short _and long run target ranges of the Federal Reserve, monetary policy would shift In priority from restraining inflation by reducing money growth to encouraging economic growth and higher employment by reducing real interest rates. It Is our feeling that current Federal Reserve policy has not been aggressive enough in helping to bring economic recovery even though inflation is low and money is growing at acceptable rates. Our recommendation will ensure that the appropriate monetary policy priori ties are being exercised relative to the prevailing economic conditions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Consistent with this idea of matching policy priorities With prevailing economic considerations, it is our feeling that the Federal Reserve should review its short run monetary growth targets given the high liquidity preferences of the public and the resulting low money velocity. Considering also the low current rates of inflation, the Federal Reserve can now safely allow money to grow at least one percentage point above the current target range for the remainder of this year and through 1983. The result of this would be to further lower interest rates and relieve some of the pressure from interest sensitive industries and thrift institutions. A more rapid economic recovery would surely result from this policy modification. Unfortunately, however, this policy and other Federal Reserve policies to lower real Interest rates can not be expected to be maintained unless runaway Federal deficits are brought under control and reduced. In conclusion, I would like to say that the Federal Reserve must be commended for its effectiveness in reducing inflation in this country. However, the execution of Federal fiscal and monetary policy mus t be improved and made consistent if we are to have a strong sustained recovery and balanced economic growth with high employment, low Inflation, and an increasing standard of living for all Americans. It is to this end that our recommendations are here presented to this committee. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1982, July 26). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19820727_chair_federal_reserves_second_monetary_policy

@misc{wtfs_testimony_19820727_chair_federal_reserves_second_monetary_policy,
  author = {Paul A. Volcker},
  title = {Congressional Testimony},
  year = {1982},
  month = {Jul},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19820727_chair_federal_reserves_second_monetary_policy},
  note = {Retrieved via When the Fed Speaks corpus}
}