Congressional Testimony

CONDUCT OF MONETARY POLICY (Pursuant to the Full Employment and Balanced Growth Act of 1978, P.L. 95-523) HEARINGS BEFORE THE SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE COMMITTEE. ON BANKING, FINANCE AND UftBAN AFFAIRS HOUSE OF REPRESENTATIVES NINETY-NINTH CONGRESS FIRST SESSION FEBRUARY 26 AND MARCH 5, 1985 Serial No. 99-1 Printed for the use of the Committee on Banking, Finance and Urban Affairs U.S. COVKKNMKNT I'KINTING OFFIOK WASHINGTON ! 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS FERNAND J. ST GERMAIN, Rhode Island, Chairman HENRY B, GONZALEZ, Texas CHALMERS P. WYLIE, Ohio FRANK ANNUNZIO, Illinois STEWART B- McKINNEY, Connecticut PARREN J. MITCHELL, Maryland JIM LEACH, Iowa WALTER E. FAUNTROY. District of NORMAN D. SHUMWAY, California Columbia STAN PARKIS, Virginia STEPHEN L. NEAL, North Carolina BILL McCOLLUM, Florida CARROLL HUBBARD, JR.. Kentucky GEORGE C. WORTLEY, New York JOHN J. LAFALCE, New York MARGE ROUKEMA, New Jersey STAN LUNDINE, New York DOUG BEREUTER, Nebraska MARY ROSE OAKAR, Ohio DAVID DREIER, California BRUCE F. VENTO, Minnesota JOHN HILER, Indiana DOUG BARNARD, JR., Georgia THOMAS J. RIDGE, Pennsylvania ROBERT GARCIA, New York STEVE BARTLETT, Texas CHARLES E. SCHUMER, New York TOBY ROTH, Wisconsin BARNEY FRANK, Massachusetts ROD CHANDLER, Washington BUDDY ROEMER, Louisiana AL McCANDLESS, California RICHARD H. LEHMAN, California JOHN E. GROTBERG, Illinois BRUCE A. MORRISON, Connecticut JIM KOLBE, Arizona JIM COOPER, Tennessee J. ALEX McMILLAN, North Carolina MARCY KAPTUR, Ohio BEN ERDREICH, Alabama SANDER M. LEVIN, Michigan THOMAS R. CARPER, Delaware ESTEBAN E. TORRES, California GERALD D. KLECZKA, Wisconsin BILL NELSON, Florida PAUL E. KANJORSKI. Pennsylvania BART GORDON. Tennessee THOMAS J. MANTON, New York JAIME B. FUSTER, Puerto Rico SUBCOMMITTEE ON DOMESTIC MONETARY POLICY WALTER E. FAUNTROY, District of Columbia, Chairman STEPHEN L. NEAL, North Carolina BILL McCOLLUM, Florida DOUG BARNARD, JR., Georgia JOHN HILER, Indiana CARROLL HURBARD, JR., Kentucky JIM LEACH, Iowa BUDDY ROEMER, Louisiana STEVE BARTLETT, Texas JIM COOPER, Tennessee THOMAS J. RIDGE. Pennsylvania THOMAS R. CARPER, Delaware ROD CHANDLER, Washington BEN ERDREICH. Alabama HOWARII LEE. Staff Director Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS Page Hearings held on: February 26, 1985 1 March 5, 1985 159 Letters of invitation to witnesses: Chairman Paul A. Volcker 3 Dr. Alan Greenspan 159 Dr. William Poole 159 Dr. Charles L. Scbultze 159 Dr. James Tohin 159 Notice of subcommittee bearings of: February 26, 1985 5 March 5. 1985 161 WITNESSES TUESDAY, FEBRUARY 26, 1985 Volcker, Hon. Paul A., Chairman. Board of Governors of the Federal Reserve System 8 Prepared statement 11 "Monetary Policy Report to Congress" 45 TUESDAY, MARCH 5, 1985 Greenspan, Dr. Alan, president of the Townsend-Greenspan & Co 162 Excerpts from statement 167 Poole, Dr. William, professor of economics, Brown University 189 Prepared statement 193 Scbu'tze. Dr. Cha-'les, senior fel'ow at the Brookings Institution 174 Prepared statement 178 MATERIAL SUBMITTED FOR INCLUSION IN THE RECORD Frank, Hon. Barney, "Text of the 1984 Republican Party Platform on Mone- tary Policy" Ill Poole, Dr. William, response to question of Hon. Steohen L. Neal in regard to the saving" rate 229 Tobin, Dr. James, statement entitled "Monetary Policy in 1985" 235 Written questions submitted by Chairman Fauntroy 131 Federal Reserve Chairman Volcker responses 134 Written questions submitted by Hon. Marcy Kaptur 148 Federal Reserve Chairman Volcker responses 149 APPENDIX "Bond Prices Register Their First Gains In Over a Week as Fed Funds Rate Falls," from the Wall Street Journal of February 87, 1985 278 "Dollar Eases From Highs After Remarks By Vokker on Intervention Trigger Sales," from the Wall Street Journal of February 27, 1985 279 "Dollar Falls After Volcker Testimony," from the Washington Post of Febru- ary 27, 1985 : 280 "Dollar Plunges in Late U.S. Trading," from the New York Times of Febru- ary 27, 1985 282 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis IV Page "Europe Pounces on the Mighty Dollar," from Business Week magazine of March 11, 1985 291 "Fed Debates a Chart's Shape," from the New York Times of March 4, 1985.... 286 Fed Held Inhibited by Dollar Rise," from the New York Times of February 27, 1985 283 "Fed's Interpreters View Rise in Rates," from the New York Times of March 4, 1985 287 "Fed, Reagan And the Dollar," from the New York Times of March 3, 1985 285 Federal Reserve Press Releases: March 8, 1985: "Two Part Modification in Seasonal Credit Program" 306 March 29, 1985: "Federal Reserve Board and Federal Open Market Com- mittee": record of policy actions taken by FOMC at meetings of Febru- ary 12-13, 1985 249 "Fortune Forecast: Don't Count Inflation Out," from Fortune magazine of January?, 1985 304 "Growth and Inflation Debated," from the New York Times of March 8, 1985.. 290 "Higher Treasury Yields Expected," from the New York Times of March 4, 1985 288 "Should the Fed be more open in its money policy?" from the Christian Science Monitor of March 5, 1985 292 Solomon, Anthony M-, former president of the Federal Reserve Bank of New York, remarks on November 20, 1984, entitled "Some Problems and Pros- pects for Monetary Policy in 1985" 271 "Stock Prices Rise in Active Trading On Help From Strong Bond Market," from the Wall Street Journal of February 22, 1985 277 "Surge in the Money Supply Will Cause Fed to Tighten Policy, Analysts Believe," from the Wall Street Journal of March 4, 1985 289 "The Flight To the Dollar," from the New York Times of February 27, 1985 284 "Treasury and Federal Reserve Foreign Exchange Operations" report by Sam Y. Cross, executive vice president in charge of the foreign group at the Federal Reserve Bank of New York and manager of foreign operations for the System Open Market Account 293 "Volckei Implies Moves to Check Dollar Are Weak," from the Wall Street Journal of February 27, 1985 281 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONDUCT OF MONETARY POLICY TUESDAY, FEBRUARY 26, 1985 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON DOMESTIC MONETARY POLICY, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met at 10:10 a.m. in room 2128 of the Rayburn House Office Building, Hon. Walter E. Fauntroy (chairman of the subcommittee) presiding. Subcommittee members present: Chairman Fauntroy; Represent- atives Neal, Cooper, Carper, Erdreich, McCollum, Hiler, Leach, Bartlett, and Chandler. Full committee members present: Vento, Schumer, Frank, Wylie, McKinney, Wortley, McCandless, Grotberg, Kolbe, and McMillan. Chairman FAUNTROY. The subcommittee will come to order. Today, we hold the first of this committee's semiannual hearings on the conduct of monetary policy held pursuant to the Humphrey- Hawkins Full Employment and Balanced Growth Act of 1978. Our witness today is the Honorable Paul A. Volcker, Chairman of the Board of Governors of the Federal Reserve System, who will testify on the Federal Reserve's Monetary Policy Report to the Congress. We are holding these hearings at a time when almost everything seems to be going right in the economy, and yet large and dark clouds loom over our prosperity. On the bright side, we have expe- rienced a very strong recovery from the recession of 3 years ago and a sizable decline in unemployment. We are now well into the expansion stage of the economic cycle, but inflation remains at the lowest rate we have seen in nearly 20 years. However, on the nega- tive side, the unemployment rate remains above 7 percent, and more than 8 million Americans remain without jobs. Also looming over the economy is the remarkably high value of the dollar in for- eign exchange markets and the related deterioration in the U.S. balance of trade, to the point that the United States last year im- ported $105 billion more in merchandise than we exported. While we are pleased with the strong gains the economy has shown, we are concerned about the continuing lag in employment and the worsening trade imbalances. Monetary policy is not, of course, the only instrument of economic policy that bears on these issues. We have heard in numerous hearings of the role that fiscal policies, especially our enormous budget deficits, have played in keeping real interest rates high, distorting the recovery, raising the value of the dollar, and crowding out production and employment in our manufacturing1 and agricultural sectors. Almost all of us, therefore, recognize the importance of restructuring our fiscal poli- (l) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 cies, althougn it would help if the President gave as much priority to reducing the deticits as he does to preserving his defense build- up and his tax cuts. Still, monetary policy, with or without proper fiscal policies, will greatly influence what happens to unemployment and inflation this year, and what happens to tne value of the dollar and the bal- ance of traue. I have asKed Chairman VoicKer to address these issues in his testimony and it is these issues that 1 would like to focus upon in tnis and future hearings, inasmuch as money and credit targets are tools of policy implementation and not ends in and of themselves, I am more interested in the Federal Reserve's assumptions about the economy tnan tne monetary aggregates themselves. Recent history has taught us tnat those targets are, justifiably, rather ilexible. I know, for example, that the Feueral Keserve considers lo\v in- flation to be a primary objective. But, is the current 7 percent un- employment rate an acceptable price for maintaining a 3- to 4-per- cent inflation rate? What will the Fed do and what can the Fed do to bring down unemployment without reigniting inflation? What guidance should we in the Congress generally, and in this commit- tee particularly, provide as to the relative weight which ought to be given to one or another of these two objectives? What rate of economic growth and level of unemployment can be sustained at stable prices, given the likely labor and commodity market condi- tions and productivity trends? What can monetary policy do to help reduce the value of the dollar and ease the trade deficit without generating a dangerous swing to an undervalued currency? What do these exchange rates and trade conditions portend for employ- ment and employment policies, as well as for inflation? Should monetary policy even be concerned with the dollar's value? It is these and related questions that I hope we can discuss in tnese hearings, so that when we write our report, commenting upon these policies, we will provide genuine and constructive guidance for the Congress and for the Federal Reserve. Chairman Voicker, we are honored, as aiways, to have you before the subcommittee. I know that you will take my ques Lions and my inquiries 111 the spirit that I have given them: not as accusations or attempts to fix blame, but as serious efforts at a dialog between this committee and the Federal Reserve. We are trying to convey to you our concerns to learn what is possible, what is not, and what is counterproductive; and to discover together the kinds of econom- ic policies that will bring about what we ail want: full employment with stable prices. [The letter of invitation to Chairman Voicher to testify and the notice of the subcommittee hearings follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis U.S. HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON DOMESTIC MONETARY POLICY Of THE COMMUTES ON BANKING, HNANCE AND URBAN AhhAlRS NINETI-Nlrt'l N tONliHESS WASHINGTON, DC 20515 January 16, 1985 Tne HonoraDle Paul A. Volcker Chairman The Boaro of Governors of the Federal Reserve System 20tn and Constitution Avenue, N.W. Washinyton, D. C. 2U551 Dear Paul: At the request of the Chairman of the Full Committee on Banking, Finance and Uroan Affairs, the Subcommittee on Domestic Monetary Policy will hold hearings on the conduct of monetary policy and the f-'ederal Reserve's Monetary Policy Report to Congress made pursuant to the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978. I would like you to testify on the Report and related issues at a hearing to be held on Tuesday, February 26, 1985, at 10:00 A.M. in Room 2128 of the Rayburn House Office Building. As provided by the Full Employment and Balanced Growth Act of 1978, I would expect your testimony to address the outlook for the economy in 198$ and the Federal Reserve's oojectives for growth of money and credit in 1985. 1 would also anticipate that you would discuss the performance of tne economy and tne growth or money ana creuit curing 1984. In adoitton, I would like your testimony to focus upon wnat Cdn De done to ootain lower uneiiip I oyment with price stability. As you Know, the unefiip i oyment rate has fluctuated between 7.bX and 7,1% since May 1984, with only a small downward trend. Continued strong economic growth will De required to oriny oown unemp'l oyi.ient, ana mono wry policy will, of course, ae a rudjur determinant of tnat 91 ovah. Htjvjuver, oiner factors such as productivity growth, tne size ana trend of tne nuayei deficit, the strenytn ot the oollar in foreign exchange markets, the traoe ceTicit, and commodity and 1aoor market conditions will also affect how fast and now much uneuployment can fall witnout inflation accelerating. I would like yuu to diicuas wnat tne f-eoera I Reserve can ana will do to foster lower unemployment arid Staole prices in 1985 given tn«se constraints. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis As a part of this focus, I would therefore hope that you will address the following questions in your testimony: 1. In regard to the outlook for the economy, what rates of real growth does the Federal Reserve believe to be sustainable and noninf1ationary for the coming year, given productivity trends, current fiscal policy, and prospective international currency and trade conditions? What rate of unemployment would such real growth rates produce? 2. What are the prospects in 1985 for moderating the overvaluation of the dollar in foreign-exchange markets and reducing the U.S. trade deficit? What impact would a modest or a steep decline in the dollar's value have on U.S. inflation and unemployment? What emphasis wi 1 1 the Federal Reserve give to achieving a more sustainable value for the dol 1 ar? 3. What relative weight will the Federal Reserve in its conduct of monetary policy during 1985 give to the growth of the monetary aggregates vis-a-vis economic and financial market conditions? What relative weight will the Federal Reserve give to reducing the unemployment rate and to reducing the inflation rate? Please plan to testify before the Subcommittee on Tuesday, February 26, 1985, at 10:00 A.M. in Room 2128 of the Rayburn House Office Building. Inasmuch as these hearings will take the place of the previous Full Committee hearings on the conduct of monetary policy, please provide the Subcommittee with 150 copies of the Monetary Policy Report to Congress of the Board of Governors and 150 copies of your own testimony, so that all Members of the Full Committee as well as the Subcommittee will have copies. I would like to receive the Report in time to deliver it to Members on the day you testify before the other body. I would like to receive your testimony no later than 10:00 AM on Monday, February 25, 1985. If there are any questions concerning this request or your testimony, please contact Howard Lee, Staff Director, at 226-7315. I look forward to your testimony and thank you in advance for your efforts in support of our inquiry on the conduct of monetary policy. With kindest personal regards, I am Sincerely you ~ WALTER E. FAUNTROY C h a i rma n Subcommittee on Domestic Monetary Policy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis U.S. HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON DOMESTIC MONETARY POLICY COMMITTEE ON BANKING. FINANCE AND URBAN AFFAIRS NINETY-NINTH COWGHESS WASHINGTON, OC 20515 NOTICE OF SUBCOMMITTEE HEARING TO: Members, Subcommittee on Domestic Monetary Policy Members, Full Committee on Banking, Finance and Urban Affairs FROM: Walter E. Fauntroy Chairman Subcommittee on Domestic Monetary Policy DATE: February 19, 1985 RE: Monetary Policy Hearings Tuesday, February 26, 1985 10:00 A.M. Tuesday, March 5, 1985 10:00 A.M. TUESDAY The Humphrey-Hawkins Hearings on the Conduct of Monetary Policy will begin on Tuesday, February 26, 1985 at 10:00 A.M. FEBRUARY 26, 1985 in 2128 Rayburn House Office Building with the testimony of the Honorable Paul A. Volcker, Chairman of the Board of Governors 10:00 A.H^ of the Federal Reserve System, 2128 RAYBURN HOB In making this semi-annual report on the Conduct of Monetary Policy, Chairman Volcker has been requested to focus particularly upon what can be done to reduce unemployment while maintaining price stability. Additionally, in light of the fact that the growing trade deficit is one cause of persistent high unemployment, especially in manufacturing and agricultural sectors, the Subcommittee has also requested comment on what monetary policy might be able to do about the high interest rates and the high value of the dollar in international currency markets. TUESDAY, MARCH 5, 1985 On the second day of hearings, which will be held on Tuesday, March 5, 1985 at 10:00 a.m. in 2128 Rayburn House Office 10:00 A.M. Building, the Subcommittee will take testimony from four former Presidential economic advisors in assessment of the 2128 RAYBURN HOB policies which the Federal Reserve will have announced at the earlier hearing. The four witnesses who will testify at that time are: WITNESSES: Dr. James Tobin, Professor of Economics at Vale University, was a Member of the Council of Economic Advisers under President Kennedy and Nobel Laureate in Economics in 1981. Dr. Alan Greenspan, President of the Townsend-Greenspan Company, was Chairman of the Council of Economic Advisers under President Ford and chaired the National Commission on Social Security Reform in 1982-1983. Dr. Charles L. Schultze, Senior Fellow at the Brookings Institution, was CEA Chairman under President Carter. Dr. Hilliam Poole, Professor of Economics at Brown University, was a Member of the Council during President Reagan's first term. PLEASE NOTE: ALL MEMBERS OF THE COMMITTEE ARE WELCOME AND ARE INVITED TO ATTEND AND PARTICIPATE IN THESE HEARINGS. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chairman FAUNTORY. Before we begin, I will yield to my col- league and friend, the ranking member of the subcommittee from the State of Florida, Mr. McCollum, for any remarks which he may wish to make at this time. Mr. McCoLLUM. Thank you, Mr. Chairman. I am delighted to have this opportunity to be here with you today. We have with us today the ranking member of the full commit- tee, Mr. Wylie of Ohio. I would like, before I make my statement, to yield to him to let him make a few remarks, if I might. Chairman FAUNTKOY. Without objection. Mr. WYLIE. Thank you very much to the gentleman from Florida for yielding for ihis opportunity, and thank you, Mr. Chairman, for holding these Hearings today. I compliment you in that regard. I, too, wain to welcome you, Chairman Volcker, to this timely hear- ing on monetary policy, after a too lengthy absence from this hear- ing room. I think the performance of the U.S. economy, in particular, the trends of production and employment, prices and interest rates, is a source of satisfaction to all of us, I am sure. And it seems to me that you and the membership of the Federal Reserve's Open Market Committee must have made a significant contribution to this favorable outcome and should be commended for your efforts and good judgment. And I do that at this time. Our present good fortune does not mean, however, that there are no clouds on the horizon, that all of us have been equally blessed. A major concern for policymakers, both from this body and in the administration, remains the size and growth of the Federal deficit and how oest to reauce it. While this is an issue for fiscal policy, its timely and effective resolution is of potentially great importance for tne monetary au- thority, as you, yourself, have repeatedly pointed out. Failure to lesoive it effectively and to get us back on track toward better budgetary balance is likely to generate enormous pressure on the Federal Reserve for undue monetary expansion, particularly if large financing requirements of the Government co- incioe with strong private sector demand for the necessarily limit- ed savings or the community. Yielding to such pressure could easily rekindle tne fires of inflation tnat are still glimmering under the surface. Effective resistance to sucn pressure, on tne other hand, could well mean higher interest rates ana a measure of Disinflation witn vviueiy felt ramifications, ooth in this country aau aoroad. The general dilemma nas a numuer of dimensions. Pressure for monetary expansion couia come from representatives of export in- dustries who oeiieve easy money is a way to lower interest rates and tnus, reauce tne excriange rate or the aollar. Syrnpatnetic as I am, ana I am sure we all aie, to tne difficulties of tnese mausunes, I feel tnat pumping up tne money supply is not going to be necessarily effective in lowering interest rates, nor do 1 thiiiK tnat inteiest rate differentials are tne Oiiiy, or even the uom- inanc, explanation of the miei national capital movements which account for the strength of tne aoiiar. Anotner ramification of tne poncy dilemma oi tne monetary au- thority, as I see it, is the still fragile financial state of many debtor Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis nations, although I should add that some of them appear to have made remarkable strides toward fiscal health. Similarly, on the domestic scene, Continental Illinois appears to be making a very significant and satisfactory progress toward li- quidity, and other troubled institutions are reportedly holding their own, if not improving, their positions. Gratifying as this is, trie fact remains tnat to regain their full financial health, a number of domestic institutions in foreign na- tions need a continued stable monetary climate in the United States. So it seems to me, therefore, that the federal Reserve, auring the year ahead, and despite our present general prosperous circum- stances, faces an extraordinarily delicate test of monetary manage- ment. I look forward to your testimony and the plans you and your col- leagues have for the conduct of monetary policy in 1985 and beyond, Mr. Chairman. I ask unanimous consent to revise and extend my remarks. Chairman FAUNTROY. Without objection. Mr. MCCOLLUM. Thank you. If I might reclaim my time, I appre- ciate the ranking member's remarks. I will be very brief with mine in light of that. Mr. Volcker, we are delighted that you are here, as everybody has said. We are always intrigued by what you have to say because it is of such great importance to us. We are charged with the responsibility on this subcommittee of the oversight of the conduct of monetary policy and its effect on the economy. We are presently blessed, as has been stated, with the strongest economy and economic recovery in some 35 years. GNP grew at a rate of just a shade under 7 percent in 1984. Infla- tion for the last 12 months has been under 4 percent. More Ameri- cans are employed than ever before. Unemployment has decreased from record mghs in 1982 to a level of 7.4 peicent. And the dollar has set a new record high many times in the past lew months. However, as we commence these hearings, we realize that in order to continue this economic prosperity and obtain the long- term economic health, Congress must act swiftly, as you have ad- monished us so many times, to put an end to runaway Federal defi- cits and make fundamental changes in our tax laws to encourage greater capital formation and economic growth. At the same tune, we are mindful that a responsible and consist- ent monetary policy is equally important. And monetary policy is the primary concern of this subcommittee at this hearing. While monetary policy and monetary restraint played a major role in bringing inflation under control, there are no signs that in- flation is likely to reignite in the near future. And while still being mindful of the possibility, the immediate concern of monetary policy, m my judgment, should be focused elsewhere. Strong eco- nomic growth over the next few years should be a primary concern. Sustained economic growth at a level of o to 6 percent of GNP or better annually requires a sure and stable availability of money through America's banking system. Furthermore, with the relative value of the dollar at all time highs and America's economy more dependent than ever on the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis influx of foreign capital, monetary policy must be concerned with the potential harm that might be caused if the dollar continues to rise at an excessive rate or if the dollar fell too rapidly. Barring the imposition of more rigid standards, the open market committee members are called upon to exercise discretion within the bounds of responsible economic principles and common sense. Since it is difficult to get any agreement on either, the difficulty of the task is fully appreciated, Mr. Chairman. And we look forward to hearing now how that task is being accomplished. Thank you, Mr. Chairman. Chairman FAUNTROY. Thank you, Mr. McCollum. We will now proceed to take the testimony of our distinguished witness, the Honorable Paul A. Volcker. Mr. Chairman, we are pleased to have you. STATEMENT OF HON. PAUL A. VOLCKER, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. VOLCKER. Thank you, Mr. Chairman. We look forward to a constructive dialog on the issues. I will not make any elaborate opening statement. I have deliv- ered to the subcommittee a rather lengthy statement, outlining both developments last year and our plans for 1985. It is the same statement that I submitted to the Senate last week. I could summa- rize it very briefly by repeating what you gentlemen have already said. We have had a good deal of progress, but there are some very real problems in the economy. There are several imbalances in our budget, in our trade position, in particular, that, unless corrected I think will over time, undermine all that progress that we have made. So far as growth in money is concerned, which is always the focus of these hearings, developments last year were generally in line with our intentions and targets, although when one looks at the broadest monetary aggregates, and particularly at the debt, you can see that it is running quite high, partly under the pressure of the Federal budget deficit. I think that, in itself, raises some warning flags for the future. The targets that we have set forth for 1985 are very close to those that we tentatively adopted and agreed to last July. The Ml target is exactly the same—4 to 7 percent growth this year. Some small adjustments were made in some of the other targets, but the broad thrust of policy is not affected by those rather technical changes. We certainly will continue to implement policy against those guidelines we have set for ourselves in the context of what is going on in the economy, in the financial markets, and I would spe- cifically include what is going on in foreign exchange markets in that connection, which a number of you have mentioned. There are very clear challenges for monetary policy, as for all economic policy. That performance of the dollar which is related to enormous capital inflows, on the one hand, has helped us balance our internal financial markets—enabled us to finance the deficit and rising investment at the same time. But, inherently, it is ac- companied by a growing trade deficit, which is a point of concern that, I think, illustrates the kind of problems we have. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis There are some things that monetary policy can do: we certainly have an important role in sustaining demand at appropriate levels in the economy. But there are some things that monetary policy cannot do: we can't very well deal with all the sectoral problems that develop in the economy, except by contributing to a prosper- ous whole. I do not believe we can safely substitute money creation for savings that is inadequate to meet the demands we are placing on the economy, both through investment and deficits. If we are going to have balanced growth, we have to look toward other tools of economic policy as well. Just a few words on the questions that you raised, Mr. Chair- man, about the outlook for employment and for unemployment. Several of you have already mentioned the remarkable growth during this expansion period. Employment is up about 7 million people. Unemployment is down about 3 percent. We, in fact, have about 60 percent of the population at work, which is a very high level historically. So all those indicators after the last couple of years, certainly look favorable. But I am also aware that reduction in unemployment came from a very high level. And when you have an unemployment rate that is currently well over 7 percent, it is certainly indicative of the fact that we have some distance to go before anyone can be satisfied. In some sense, the basic aim of policy is to promote the sustained growth of the economy and along with that, unemployment as low as practical. The forecast projections made by committee members, I would point out, look toward some modest further reductions in unemployment this year in a context of no deterioration in the in- flationary picture, and perhaps some progress in the inflationary picture. I don't think we can feel that that kind of unemployment projec- tion is totally satisfactory or in any sense that it is the end of the road. But I would emphasize here, as I have often done before, that I think success in dealing with unemployment over a period of time—not looking at the maximum improvement in the next few months, but the best improvement over a period of time, improve- ment that can be sustained—must rest on a solid rock of stability in the economy, reasonable stability in financial markets and rea- sonable stability of prices. We have had enough recent experience of the difficulties and pain and unemployment that results when inflation accelerates and gets out of control. And I think it's that stability side of the equation that must attract a good deal of our attention while mon- etary policy, as all of economic policy, is aimed at growth in em- ployment as well. When you look at the current unemployment picture or, indeed, the employment picture, you are inevitably struck by several char- acteristics. Manufacturing employment still hasn't reached the levels that it had before the last recession. I think that is one re- flection of the pressures on the heavy industry sector of the econo- my which, in turn, go back in good part to the trade picture that we have as well. We have alarmingly high rates of unemployment among minori- ties and among youth. I think in those areas, as well as, to some degree, in the manufacturing area, we face what we conveniently Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 call structural problems. Again, monetary policy has its part to play in creating an overall environment for growth. But I don't think that monetary policy can in and of itself, deal with all the structural problems. That requires a variety of answers, including, as you well know, those things that are very easy to talk about but very difficult to accomplish—the education of the labor force, the changing nature of the labor force, the mobility of the labor force, the discipline of the labor force, among other factors. But as far as the general tools of policy are concerned, and spe- cifically including monetary policy, we certainly have the strongest kind of interest in seeing this expansion continue, and continue in a way that promises further gains in the future, and promises to be sustainable. With that much introduction, Mr. Chairman, mayhe we can turn more specifically to what is on your mind. Chairman FAUNTROY. Thank you so much, Mr. Chairman. With- out objection, we will enter at this point in the record your state- ment, in its entirety, and the report. [Chairman Volcker's prepared statement on behalf of the Board of Governors of the Federal Reserve System and the "Monetary Policy Report to Congress" pursuant to the full Employment and Balanced Growth Act of 1978 follow:! Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 Statement by Paxil A. Volcker Chairman, Board of Governors of the Federal Reserve System I appreciate this opportunity to appear before you to present the Federal Reserve's monetary policy objectives for 1985. In accordance with the Humphrey-Hawkins Act, the semi- annual report of the Federal Reserve was transmitted to you earlier. That report reviews in detail economic develop- ments and monetary policy in 1984, and sets forth for 1985 the plans for policy by the Federal Open Market Committee. This morning I would like to discuss the Committee's decisions and the outlook for the economy in the context of some important unfinished business facing all of us responsible for economic policy, The Economic Setting The familiar objective of monetary policy is to foster sustained economic growth and employment in a context of reasonable price stability. Stated so generally, that objective can hardly be challenged; it indeed encompasses the broad goals of economic stabilization policy generally. Measured in those terrns, there is clear reason for satisfaction in the performance oE the economy last year. In summary, with real gross national product up by 5-1/2 percent over the year, and by about 12 percent in two years, we have en-joyed ttie strongest expansion since the Korean War period. On top of the gains in jobs in 1983, emnloyment increased by over 3 million last year. The unemployment rate fell one full percentage point to 1.1 percent at year-end. Real i ncomes for the averaqe American are up. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 Prospects for sustained growth and productivity over time rest importantly on success in achieving and maintaining an environment of greater stability of prices and financial markets. In that light, it is encouraging that, contrary to widespread earlier expectations, the strong growth of 1984 took place without inflation increasing appreciably from the sharply reduced levels of 1982 and 1983. Specifically, the consumer price index increased around 4 percent last year, little changed from the previous two years, and prices of most goods (in contrast to services) at the wholesale and retail levels rose by less than that. While the evidence is less tangible, there are also encouraging signs that chronic expectations of future inflation have been damped. The behavior of actual prices and nominal wages, which by soroe measures rose more slowly in 1984 than in 1983 despite expanding demands for labor, may in some part reflect those changes in attitude. Businessmen and workers no longer seem so preoccupied with a need to anticipate inflation in their pricing and wage decisions. And declines in bond yields after midyear seemed to reflect, to some degree, less fear of future i nf1ati on . To be sure, d number of factors that may not be lasting have helped to hold price increases down. The continuing appreciation of the dollar and strong competition from imports have placed strong pressures on prices and wages in some manufacturing and mining industries. Widespread declines in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 commodity prices cannot persist indefinitely. Unemployment is still higher than we would like to see. But it is also true that progress ayainst inflation, as it is prolonged, can potentially feed or. itself by encouraging res train ed price and wage behavior. As we start 1985, the immedi ate economic outlook appears reasonably favorable in these respects. Projections of Federal Open Market Commi ttee members that I will be reviewing later in my testimony broadly parallel those of the Administration, the Congressional Budget Office, and many other observers; economic growth is expected to remain strong enough in 1985 to produce some further decline in unemployment, with little if any pickup in inflation. But we must not be beguiled by those tranquil forecasts into any false sense of comfort that all is well. If the enormous potential of the American economy for growth and stability -- not just for 1985 but for the years beyond -- is to become reality, we need a sense of urgency, not of relaxati on. For one thing, with the general price level still rising in the neighborhood of 4 percent a year -- and with prices of services that today account for so much of the economy rising more rapidly than that -- we should not confuse evidence of progress against inflation with ultimate success. Indeed, the more favorable price expectations I noted a few moments ago Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 could prove fragile -- highly vulnerable to any Indications that public policy is prepared to accept and accommodate to inflationary forces. That must be of particular concern in the conduct of monetary policy. Perhaps more immediately, despite the strength of the overall expansion, some important areas of the economy are under strain and there have been recurrent international and domestic credit problems. Those strains and pressures are aggravated by underlying imbalances that, unless dealt with effectively, will undercut the long-term outlook. One of those imbalances was highlighted by the slowdown in GNP growth we experienced in the third quarter. Such a "pause" is not an unusual feature of an expansion period. Demand does not grow smoothly, and occasional inventory imbalances will develop that require production adjustments. What was unusual last summer was that the slowing of demand growth was accompanied by a surge in imports, magnifying the effects on domestic producers. That summer import surge was reversed by year-end, but the underlying trend toward higher imports is clear. Our trade deficit increased to about $110 billion in 1984, far higher than ever before, and the entire external current account deficit -- counting both yoods and services -- has deteriorated by about $100 billion since 1982. The sustainability of that trend, politically as well as economically, is, to say the least, questionable. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 The rising trade deficit fields account for the failure of a number of important sectors to participate at all fully in the expansion. Agriculture, heavy capital equipment pro- ducers, and the metals industry, all of which face difficult structural problems in any event, are examples. They are further pressed by interest rates that, as you know, remain historically high, both in nominal terms and relative to recent inflation. Looking abroad, growth in many industrial countries remains sluggish amid continuing high levels of unemployment, and depreciation of their currencies vis-a-vis the dollar seems to be one factor inhibiting more expansionary policies. Important developing countries are still struggling to restore stability and maintain growth while laboring under heavy debt burdens. In this interdependent world, these difficulties feed back on our own prospects. It is no coincidence that the record external imbalance and continued high interest rates have been accompanied by large federal budget deficits -- deficits that according to project!ons of both the Administration and the Congressional Budget Office will only deepen in the years ahead in the absence of decisive corrective action. Government deficits can be relatively benign and even useful in boosting incomes and purchasing power in the slough of recession and when private investment and credit demands are weak. It is also true that our growing volume of imports Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 over the last two years has provided an impetus for growth in other countries when other expansionary forces were weak. Moreover, the kind of obvious squeeze on, or "crowding out" of, domestic housing and investment that many anticipated as the expansion has developed has not been apparent. We have been able to reconcile high deficits, sharply rising imports, and strong investment mainly for one reason: we have been able to attract an enormous amount of savings from abroad to supplement our own. The net capital inflow approached $100 billion last year, and it will probably need to be still larger this year. Domestic net savings -- by individuals, businesses, and state and local governments -- are running at about $325 billion, so the supplement from abroad adds close to a third to net savings generated internally. The net capital inflow was equivalent last year to more than half of the budget deficit. That same inflow of funds has encouraged a very strong dollar. The strong dollar, in turn, contributes importantly to the huge and growing trade deficit. Our policy dilemma i s simple but perhaps not fully understood. We cannot logically welcome the capital inflow from abroad in one breath and com- plain about the trade deficit in the next. They are two sides of the same coi n. We are managing to finance the deficit and maintain housing and investment expenditures with the help of imported Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 capital. At the same time, the exporter, those competing with imports, and the farmer are being "crowded out." Looking ahead, the stability of our capital and money markets is now dependent as never before on the willingness of foreigners to continue to place growing amounts of money in our markets. So far, they have been not only willing but eager to do so. But we are in a real sense living on borrowed money and t i me. It is up to all of us to make constructive use of both the money and the time. In essence, that is the challenge for all of us -- for monetary and fiscal policy, and for all the other policies that can contribute to a productive, growing economy. Monetary Pol; ic_y_ i n 1984 As you will recall, the economy was expanding particularly rapidly during the early part of 1984, and demands for money and credit -- and for bank reserves to support monetary growth - were also strong. By early spring, data available at the time showed Ml increasing at rates well into the upper portion of its range for the year, which targeted growth at 4-8 percent.* At the same time, driven by the financing needs generated by rising levels of private spending and by the Federal Governiient, *The data in this testimony for the monetary aggregates reflect recent seasonal and benchmark revisions. While the changes for the year as a whole were small, the revised data for Ml for the first half of the year are lower, and the second half higher, than reported earlier. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 M3 and non-financial credij. were expanding around or above the upper end of their long-term ranges. The strong expansionary forces in the economy were re- flected in some limited upward movements in interest rates in February and March, and early in the spring the Federal Reserve began to exert some additional restraint on reserves being supplied through open market operations. Consequently, deposi- tory institutions were forced to rely increasingly on borrowing at the discount window to satisfy demands for reserves. With credit demands and the economy continuing to expand strongly, and with markets concerned about the possibility that infla- tionary forces might reassert themselves as the period of strong expansion lengthened, interest rates moved noticeably higher in the spring. In April tne Federal Reserve increased its discount rate 1/2 of a percentage point to 9 percent to bring this rate into better alignment with market rates and to discourage reserve adjustment at the discount window. In May, a liquid!ty crisis developed in one of the largest commercial banks in the country, growing out of continuing concerns over weaknesses in its loan portfolio. The Federal Reserve, the FD1C, and the primary supervisor of the bank, the Comptroller of the Currency, worked closely together to support the orderly functioning of the institution while more permanent recapitalization and other elements of a long-term solution could be developed. Nonetheless, that incident, together with continuing concerns about international debt problems, for a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 time contributed to uneasiness in banking markets, and interest rates on short-term private credit instruments rose appreciably above those on government securities." Demands for money slackened after midyear as tne economic expansion slowed. Long-term interest rates oegan to drop from the nigher levels reached in the spring as inflation concerns mo aerated. With tne problems of the Continental Illinois Bank contained and progress made toward restructuring the aeots of some important developing countries, tne abnormal interest rate spreads began to narrow, but trie money markets as a whole remained unoer some pressure. By late August and September, with Ml growth moving toward the midpoint of its range and M3 expansion slowing toward the upper end of its range, and with some evidence tnat economic growth had slowed, the Federal Reserve began to ease pressures on reserve positions. That process continued through the fall, and borrowing at the discount window fell steadily from September through January. Late in the year, total and nonborrowed reserves began to grow rapidly. Short-term interest rates declined between 2-1/2 and 3-1/2 percentage points over the last four iTiontns of tne year. Reacting to tnese declines, and to an extent facilitating tnem, tne Federal Reserve in two half-point steps reduced the discount rate to 8 percent, the lowest level since 19 7 8 .« *Attacn merits i 4 II summarize tnese and related developments and tne Federal Reserve response, more fully. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 Several additional factors influenced judgments about the appropriate degree of easing of reserve positions during the fall. The dollar remained exceptionally strong in foreign exchange markets, potentially increasing pressures on some sectors of the American economy and a source of growing concern among some of our trading partners experiencing depreciating currencies vis-a-vis the dollar. At the same time, relatively favorable incoming data about prices and wages tended to all ay concerns about actual and potential inflationary pressures. In fact, prices of many sensitive commodi ties were falling appre- ciably. In these circumstances, reserves could be provided more liberally, and growth in the money supply more actively supported without providing a basis for a destructive rise in inflation expectations. The fall in interest rates and the more generous provision of reserves in the context of some increases in economic activity led to a rather strong revival of HI and H2 growth around year- end, bringing both aggregates relatively close to the mid-points of their respective ranges. As monetary and credit growth continued at a relatively rapid pace into January, the easing process came to an end. Unlike the pattern during much of 1982 and 1983, when Ml grew more rapidly than nominal GNP (that is "velocity" slowed), the income velocity of HI rose 4 percent last year. That is broadly in line with cyclical experience in the past, taking Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 into account both the pattern of interest rate movements and income growth. M2 velocity also increased, rising around 1-1/2 percent following two yearly declines. These developments provide some support for the view that velocity trends over time, as well as cyclical changes for these aggregates, may be returning to patterns more along the lines of earlier experience. In contrast, in 198Z and 1983, during a period of rapid transition to deregulation of deposit interest rates and substantial economic uncertainty, those earlier patterns had been disrupted and velocity had declined appreciably. The rise in M3 and credit during 1984 exceeded expecta- tions at the start of the year, and both measures exceeded by a considerable margin the upper limits of their ranges over the year as a whole. In fact, credit increased at its most rapid pace over the entire post-Wo rid war II period, both in absolute terms and relative to nominal liNP. Debt growth of this magnitude would appear to be much faster than consistent with the long-run health of our economy and financial system. It reflects to some degree the imbalances in our economy I emphasi zed earli er . For example, the budget deficit led to expansion of federal debt of 16 percent, an unprecedented rate of growth in the second year of a business cycle. The growth of the debt of non-federal sectors, at nearly 13 percent, also was Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 high relative to past experience. A portion of this growth in private debt -- perhaps around 1-1/2 percentage points -- can be attributed to a huge volume of mergers, leveraged buyouts, and stock repurchases t>y businesses wnicn had the effect of substituting debt for equity. Despite some sizable sales of new stock, non-financial corporations on balance retired about $70 billion of stock last year. Whatever ttie circumstances and justification for the particular companies involved, a financial structure that tends toward more debt (and shorter debt) relative to equity becomes more vulnerable over time. More cash flow must be dedicated to debt servicing, exposure to short-run increases in interest rates is magnified, and cushions against adverse economic or financial developments are reduced. Tnese are factors that prudent lending institutions should take into account in evaluating new credits, and reports suggest that some banks did in fact review their policies toward mergers and leveraged buyout financing as the year wore on. While the effect cannot be isolated, the rapid growth of dent relative to GNP may also reflect tne fact that domestic s_ p_e ri q_i_nj[ increased appreciaDly faster than ouinestic prociuct ion , which is wnat the GNP measures. A new machine, for instance, will require financing, whether purchased at home or aDroad, and snarply increasing amounts OT capital equipment have in fact been imported. As I indicated earlier, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 directly or indirectly, that fi nanci ny may be supplied from abroad, alleviating the pressures on our market. But the debt burden inevitably rests with the borrower. Monetary Po I i cy_ J_n_ 1985 Ac its meeting last weeK the FUMC agreed to some smal1 changes in some of the ranges for the monetary and deot aggreyates tentatively sec out last July. The modifications are in response to analysis of inf onnati on now available and do not represent any change in policy intentions. As shown on the attacned taole, for Ml, trie Committee reaffirmed tne lower tentative range it adopted last July of 4 to 7 percent growth from the fourth quarter of 1984 to the fourth quarter of 1985. M2 is targeted to grow between 6 and 9 percent, the same range as ustu in 19 B4. The upper end of that range was increased Dy 1/2 percent from tne tentative range for 1985 set in July. That small adjustment reflects a technical judgment -- based on assessment of recent developments -- that M2 could expand more in line with income growth this year, in keeping with the historic record of little trend growth in its velocity. Tne upper end of tne new M3 range of 6 - 9 1/2 percent wai also sec 1/2 percent higner than tentatively ayreea in Juiy, 1 ne associated monitoring range for credit was set at 9 io I'l pec cent, a percentage point aoove the 1984 range. Aaj ubinient s in ootn target ranyes still contemplate a cotisider- aoie slowing in these two aggregates from wnat actually occurred Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 in 1984. Even so, credit growth, fueled in part by the budget deficit, is expected to be quite strong, significantly exceeding the rate of expansion of GNP for the third consecutive year. The Commi ttee does not anticipate that growth of debt within the targeted range would necessarily pose significant new risks for the economy or the financial system in the year immediately ahead. However, a healthy financial structure will in time require more restraint on borrowing relative to the economic growth that, in the last analysis, provides the wherewithal to service the debt. One continuing problem in that respect is the extent to which the current tax structure tends to favor debt rather than equity financing, a point addressed in the Administration's reform proposals. The ranges for growth in money and credit are expected by FOMC members and non-voting Reserve Sank Presidents to support another year of satisfactory economic expansion without an acceleration of inflation. Forecasts of real GNP growth centered around rates of 3-1/2 to 4 percent from the fourth quarter of 1984 to the fourth quarter of 1985 -- rates antici- pated to be sufficient to reduce the unemployment rate to around 6-3/4 to 7 percent by year-end. Inflation, as measured by the GNP deflator, was expected most frequently to be in a range of 3-1/2 to 4 percent over the year, about the same rate as prevailed in 1984.* *T ne s e ~p~r o j e c t i ons, now regularly set out in our Humphrey- Hawkins Reports, should not be interpreted as indicating "targets" for real growth or inflation in the short or longer run. As discussed in Attachment III, the Committee does not target a specific long-range growth path for the economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 In view of the necessarily tenuous nature of any judgment about the outlook for exchange rates, FOHC members in preparing their projections assumed that the dollar would fluctuate in a range encompassing its level of recent months. They also assumed that the federal budget deficit would be reduced sig- nificantly in fiscal 1986 relative to base line projections, a development that would help damp both interest rate and infla- tionary expectations. Obviously, those assumptions suggest some of the important risks Inherent in the outlook. As I indicated in discussing 1984 developments, we enter- ed 1985 with the various monetary aggregates growing relatively rapidly. The targets for this year take, as usual, the actual average for the fourth quarter of the previous year as a start- ing point (or "base"). Consequently, we are starting the year with the levels of the aggregates above the target ranges as they have been conventionally illustrated -- that is by so- called "cones" start ing at a point late the previous year and widening through the current year. (See Charts I to IV.) That conventional and widely used "picture" is essentially arbitrary. Interpreted rigidly (and wrongly}, the narrowness of a cone in the early part of the year -- literally narrower than some weekly fluctuations in the money supply -- would attach policy importance to levels or movements in the various aggregates that in fact have no significance. We have sometimes considered, and others have suggested, a better "pictorial" approach would be to illustrate the targets Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 by a different (but also necessarily arbitrary) convention -- parallel lines drawn back from the outer bounds of the specified fourth quarter target ranges to the base period, as shown in the charts attached. The target range is then portrayed as maintaining the same width throuahout the year. The current levels of the aggregates, as you can see on the charts, are within such parallel lines.* As a matter of economics and policy, rather than graphics, the Committee is not disturbed by the present level of Ml. and M 2 relative to its intentions for the .year. It contemplates that, as the year progresses, growth will slow consistent with the target ranges . Consistent with that approach, as I indicated earlier, the progressive process of easing reserve positions undertaken in the latter part of 1.984 ended. The provision of reserves through open market operations is currently being conducted a bit more cautiously to guard against inadvertent "overshoots" in supplying reserves. Any further change in approach will, as always, deoend uoon assessments of the trend of monetary growth in the period ahead, evaluated in the context of the flow of information on the economy, on prices, and on domestic credit and exchange markets. The annual target ranges for Ml and M2 assume that trends in velocity are returning to a more normal and predictable *AttachmentIV addresses the different but related questions of the appropriate "base" used in setting and illustrating targeted growth ranges. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 pattern. However, there is some analysis that suggests the trend of velocity over time may be a little lower than the trend of 3 percent or so characteristic of much of the postwar period when interest rates were trending higher. Should deuel- opments during 1985 tend to confirm that somewhat lower velocity growth, and provided that inflationary pressures remain subdued, the Committee anticipates that those aggregates might end the year in the upper part of their ranges. The lower part of the Ml range would be consistent with greater cyclical growth in velocity than now thought likely. As usual, these ranges will be reviewed at mid-.year, in accordance with Humphrey -Hawk ins Act procedures. Tje _C_ha1 lenge Ahead The approach toward monetary policy that I have outlined for 1986 is designed to promote, as best we can, our common objectives of sustained growth and stability. We can build on the strong progress of 1983 and 1984. There is forward momentum in the economy. The public at large seems to sense a greater degree of control over inflation than for many a year -- and 1 sense some chance of further progress toward price stability tnis year even as the economy grows. Happily, despite the strength of the economic advance and the financing of a huge deficit, interest rates are today little above those of two years ago. The threats of financial dislocation growing out of the debt problems of much of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 developing wo rid, or from more purely domestic financial pres- sures, nave been well contained. Points of strain will, with- out doubt, require continuing attention this year. But, in the context of a healthy economy, they are capable of resolu- tion. By encouraging appropriate growth in money and credit, in discharging our supervisory responsibilities, in performing when necessary the essential functions of lender of last resort, and in our general surveillance of the financial system, the Federal Reserve can help build on that progress. We aim to do so. But it is equally important to understand clearly what monetary policy and the Federal Reserve cannot do. The progress against inflation, the strength of the dollar and the competition from abroad, and some margins (if diminish- ing) of capacity and manpower have provided a certain degree of flexibility in the conduct of monetary policy. But that limited flexibility would be abused at our collective peril. Credibility in the effort to deal with inflation is a precious thing. The lesson here and abroad, now and through history, is that, once a sense of price stability is lost, it can be restored only with pain and suffering. The Federal Reserve can theoretically run the modern equivalent of the printing press -- we can create more money. But more money is not the same as correcting the gross imbalance Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 between our ability to generate real savings and the demands for those savings posed by housing, by investment and by the federal deficit. To create money beyond that needed to sustain orderly growth would be to invite renewed inflation -- damaging incen- tives to save in the process. In contrast, to encourage savings from income would be to provide more of tne real resources we need for future growth -- and it would Help spur productivity and reduce price pressures in the process. If that route isn't open to us -- and as a practical matter we probably can't do much right now to change ingrained savings behavior - - then the only constructive alternative is to attack the problem from the other side of the ledger by reducing the federal deficit. For the time being, capital from abroad has been readily available to close the grow ing gap between our domestic savings and the demands upon them, moderating pressures on interest rates. Indeed, the money attracted partly by perceptions of our strength has come so freely we have an exceptionally strong dollar. But that same strong dollar contributes to a massive trade deficit that strains key sectors of industry and our agriculture, aggravating structural problems. No doubt bad_ monetary policy could drive the dollar down -- a monetary policy that aroused inflationary expecta- tions, undermined confidence, and drove away foreign capital. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 But then, how would we finance our investment and our budget deficit? Nor is the process of money creation adapted to relieving particular sectoral strains within our economy. We can and will, in our administration of the discount window and in our actions as lender of last resort, protect the essential finan- cial fabric by supporting credit-worthy depository institutions faced with extraordinary needs. But the evident, problems of particular sectors, in the last analysis, will yield only to measures that support their efficiency and broaden their markets. That in itself is a large agenda, for government and those involved alike. And the process will be much easier if we at the same time address the basic imbalance between our capacity to save and our need to invest and to finance the government that I have emphasized today. Conclusi on I fully appreciate the difficulties of the decisions before you as you collectively approach those excruciating budgetary choices. As you do so, I know that you are aware of the priority that progressive reduction of the deficit deserves. That, indeed, would provide the most fundamental kind of reassurance that growth c_aj^ be sustained in an envi- ronment of greater stability. For our part, in the conduct of monetary policy, we in the Federal Reserve will be sensitive to both the ooportunities and the dangers before us. We believe the approacn I have out- lined with respect to the monetary targets and our implementa- tion of policy sensibly reflects and balances the concerns I am sure we share. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ml Target Ranges and Actual Billions of dollars 600 I I I I I I 1 I I I _ . I O ND J ^ M A WJ J A E O ND I F M A MJ J Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chut 2 M2 Target Ranges and Actual Billions of dollars 2600 9% s I—I 2550 2500 — 2450 CO 2400 — 2350 — 2300 — 2250 — 2200 2150 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ctian 3 M3 Target Ranges and Actual Billions of dollars 3300 9V*% 3200 00 00 3000 2900 I I I I I I I I I 1 I I I I 1 1 I I I I 1 1 I I I I 12600 O N U J F M A MJ J A S O ND J F M 6 M J J A S O ND 1983 1984 1985 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Debt Monitoring Ranges and Actual Bi'.lions of dollars 6800 6600 6400 6200 CC 6000 Actual Debt 5800 \ — 5600 — 540C 5200 I I I I I _ I I I II I 500C O f * D J ( - M A MJ J i S O ND J F M A MJ J 1983 1964 198E Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 jVtt acnmunt 1 The Imp 1ications tor Monetary Pol icy of tne Near of the ContinentalIllinois Bank The condition of the Continental Illinois Bank -- the seventh largest in tne United States at the o e g i n n i n g of 1984 -- had Dee rt a matter of concern to regulatory authorities and ma rnet participants for some time, particularly after the failure of the Penn Square Bank In the middle of 1982 b r o u g n t to light large loan losses and weaknesses in credit policy. Continuing profit and loan problems culimnatea in rumors of passiQte initial nq failure and a liquidity crisis in May 1984, involving withdrawal or failure to renew oillions of dollars of deposits in tne bank over a few days. The FOIC, the Federal Reserve, and the Comptroller of the Currency, witn tne cooperation of a group of major banks, d e - velopea arrangements to provide temuordry capital ana 1i qui m ty support pending more permanent solutions and reorganization. Tne Federal Reserve -- acting as 1 erider of last resort -- pro- videa large amounts of funds through the discount window to maintain the bank's liquidity. That lending rose irregularly from around $3 billion during most of May to a peak of mere than $7 billion in August. During the autumn the amount of outstanding loans declined to mucii reduced levels. Provision of funds through the discount window nas the effect of expanding total bank reserves, and unless otherwise offset, tne lending to tne t-anK would nave had the effect of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 expanding the money supply well beyond targeted ranges. To maintain consistency of reserve provision with FOHC intentions , essentially equivalent amounts of reserves were absorbed by open market operations. While the large borrowings necessarily i nvolved some added technical difficulties and uncertainties in the conduct of open market operations, the Commi ttee was able to achieve its reserve objectives. At the same time, nowever, the liquidity crisis of Continental Illinois Bank, particularly in an environment in which international debt and other credit problems were attract- ing attention, generated concern about possible threats to the stability of other financial institutions. As a result, inter- est rates on banking liabilities rose appreciably relative to interest rates on Treasury securities during tfie spring. More cautious funding and lending policies by a number of banks appeared to have some effect on maintaining short-term interest rates at higher levels than might otherwise have been the case. The extraordinary concerns in the marketplace dissipated as the year w.ore on, reflecting some sense of progress in deal- ing with both the international debt situation and points of domestic financial strain. Strong liquidity pressures at one of the largest savings and loan organizations during the late summer and fall, requiring sizable liquidity support by the Federal Home Loan Bank System, had lesser effects on market attitudes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 The experience of 1981, together with supervisory efforts and the strong continuing pressures on some sectors of the economy have underscored for depository institutions the importance of adequate capital and prudent lending policies, and other means of assessing and controlling risk. Substantial efforts have been made by many of the larger banking organizations to in- crease capital ratios and to review credit standards. In time, in the environ ment of a growing economy, these efforts should be reflected in stronger institutions and a reinforced banking system. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Attachment 11 The International Pebt__Si_tu_ati cui 1 n_J^984 At times during 1984, concerns aoout the external aebt prooI ems of key borrowing countries continued to De an i mpor- tant factor affecting attitudes in financial markets. As tne year- began, markets had substantial doubts about the viability of the Brazilian adjustment program, trie programs of tne new Venezuelan and Argentine governments were unknown, ana there was some sense of weariness among tne borrowing countries and their creditors. Tensions were aggravated by increases in dollar interest rates in tne spring and early summer. Subsequently, concerns in financial mar nets receded some- what as interest rates moved lower, clear progress was recorded in narrowing some countries' external imoalances, and plans for long-term deot restructuring were developed for some of tile 1argest Borrowers. The improvements in external accounts in Mexico and Venezuela in Latin America, and in Yugoslavia and Hungary in Eastern Europe, produced current account surpluses last year. Brazil's current account deficit was essentially eliminated, ana a nuinner of other- countries had reduced deficits. Tnis progress Was taci Hated in many cases oy significant increases in exports, particularly to the United States, and in most cases was accompanied by a recovery -- or at least a slower rate of decline -- of imports. Sucn developments, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 vtitn continued moderate capital Inflows, contnouted to sizable increases in trie i nternat lona I reserves OT many ol tnese countries and to tne prospects of reduced demands for extraordi- nary external financing in tne future. At tne same tune, most of tnose countries manayed to acnieve domestic growth. Against tnis oacKgrouna, several of tne major oorruwing countries were a o I e to move on to a second pnase in t n e i r adjustment and financing programs. One important iniative, wnen warranted by progress in adjustment, has oeen planning rur longer-term or multi-year restructuring of outstanding atsuts on terms tnat reflect stronger creditworrmriess ana penint plann- ing on a more assured oasis tor the future. Sucn arrangements have been agreed in principle between tne commercial banks and Mexico and Venezuela; serious negotiations nave Degun witn Brazil and Yugoslavia; and tne financing pacKage prepared for Argentina contains some longer-term e I e merits . However, it is also evident from developments in 1984 and tne first montns of 198B tnat the process of adjustment wni ch began in 19&2 i5 far from complete, particularly on the internal side. Financial markets will remain sensitive to indications of progress or the lack thereof. Cooperation among our-rowing countries, commercial oanks, multilateral institutions, and creditor countries will continue to oe required. Tne need for imaginative and constructive solutions to the proolems faced by individual countries is not yver. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 Attachment III Target 1ng Real Growth Questions sometimes arise as to whether the Commf ttee's forecasts for real GNP growth or prices are in the nature of short-run targets toward which the Federal Reserve "fine tunes" policy, or whether the Committee has preconceptions about just how rapidly the economy can and should grow over the medium or longer run. The answer to those questions is no. Monetary policy is, of course, broadly directed toward sustaining the yrowth process in a non-inflationary environment. But the Commi ttee as a group has no preconceived notion as to just how rapid growth can or should be over a particular period of time, with- out straining our resources or giving rise to price pressures and imbalances that would make it ultimately unsustainable. Our capacity for growth over time depends on such vari - ables as the trends in productivity, in the labor force, in incentives to save and invest, and in other factors over which monetary policy has essentially no direct or long-run influence, There are other policies, public and private, quite outside the purview of monetary policy that will influence both our growth potential and actual growth paths over time. There are debates in and outside the Federal Reserve as to some of these factors that affect economic growth, but annual monetary targets and operational decisions do not, and need not, rest on such as sump- tions for the long run. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis For instance, the Committee would presumably welcome faster growth than predicted for 1985 if that proved consistent with moderating inflationary forces, and indeed, less inflation than anticipated would tend to encourage greater growth, con- sistent with our monetary targets. Indeed, the relationship between money and economic growth at any point in time is sufficiently "loose that many other factors bear upon actual performance. In sum, policies are periodically reassessed in light of incoming information about prices, output, exchange rates and other variables bearing on our growth potential and prospects for inflation. In practice there is sufficient flexibility in our targeting procedures to accommodate information that might suggest greater or lesser growth potential over time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 Attachment I V The Base for Monetary Target Ranges Some questions have been raised concerning the "base" used by the Open Market Committee in deciding on targets for the monetary and credit aggregates for the calendar year. Consistent with the Humuhrey-Hawkins Ar.t pro cert urns, the Committee's target ranges are specified each February as a range of growth from the fourth quarter of the previous calendar year to the fourth quarter of the current calendar year. The convention that is usually used, is that the beginn- ing point -- or "base" from which growth is measured -- is taVefJ to be the fourth quarter average growth of a particular monetary or credit aggregate. Other "bases" could be used and occasionally have been used -- if the conventional base period is seriously distorted, by institutional change or otherwi se. During its recent meet ing the Committee, as it ft as from time to time, discussed the issue of the desirability of r.hoop- ing a base for 1985 for one or more of the aggregates other than the conventional one. It concluded that none of the fourth quarter averages for the targeted aggregates were dis- torted in a manner that strongly suggested the desirability of depart ing from the usual convention, and that such a departure might indeed confuse communication of the Committee's inten- tions. It also noted that the average level of both HI and MZ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 during the fourth quarter of 1984 was reasonably close to the mid-point of the previous year's range, an alternative base suggested by some. M3 and credit ran significantly above the 1984 ranges. Rebasing those aggre gates at the mid-point of the 1984 ranges would thus have imolied a wrenching adjustment in the levels of those aggregates, a result that would he contrary to the Committee's intentions. Essentially, such a change would nave imolied a substantial tightening to bring the growth of those aggregates into the new ranges, or, alternatively, a specification of ranges of growth for 198S that would have been extraordinarily high and quite out of keeping with longer range intentions. More broadly, a decision to regularly target growth from the mid-point of a previous year's range would seem to imply the continuing validity of a judgment made a year earlier that the mid-point of a previous range is in some sense a uniquely "correct" level of a monetary aggregate. The Committee does not share such a conviction. Instead, it believes that the aporopriate trend of each aggregate needs to be judged in the light of evidence as to velocity changes and other factors as ttioy emerge over time. In setting targets for any year, the Comm it tee is, of course, aware of the base level of the aggregate. Adjustments in the new target ranges themselves, or in the conduct of policy within those ranges, can take, account of any modest distortions in the hasp. Such considerations are reflected in the discus- sion of policy in the testimony. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 Growth Ranges for the Aggregates for 1984 in Comparison with Actual Growth {QIV to QIV} Percent Increases Actual Ran 9 e s Growth Ml 4 to 8 5.2 M2 6 to 9 7.7 M3 6 to 9 10.5 Domestic Nonfinancial Debt 8 to 11 13.4 Growth Ranges for the Aggregates Adopted for 1985 in Comparison with Tentative Ranges and Those for 1984 (QIV to QIV) Percent Increases Adopted Ranges Tentative Ranges for 1985 Ranges for 1985 Set in Mid-1984 for 1984 Ml 4 to 7 4 to 7 4 to 8 6 to 9 6 to 8-1/2 6 to 9 M3 6 to 9-1/2 6 to 9 6 to 9 Domest i c Non- financial Debt 9 to 12 8 to 11 8 to 11 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 20, 1985 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES. The Board of Governors is pleased to submit its Monetary Policy Report to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Paul A. Volcker, Chairman Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 TABLE OF CONTENTS Pat<e Section 1: The Outlook for the Economy In 1985 Section 2: Tt\t> Federal Reserve's Objectives for Honey and Credit In 1985 Section V. Thfi Pprformance of the Economy In 1994 12 Section 4: Monetary Pollr.y and Financial Oevel opfflents in 19*>4 23 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 Section 1: The Outlook for the Economy In 1985 Nineteen eighty-four was another year of substantial economic growth in the United States. Production and employiaent gains were large, making the expansion of th« past two years—with growth in real gross national product averaging 6 percent per annum—the strongest cyclical upswing since the early 1950s. Moreover, continued vigor of the economy was accompanied by signs of some further lowering of inflationary expectations. Aggregate price measures rose around 4 percent last year, about the same as during the two preceding years. While prices of services continued to rise by 5 to 6 percent, prices of many goods were relatively flat, and underlying wage trends seemed to be taorierating. Economic growth had been extraordinarily rapid in the first half of 1984, and then slowed abruptly around midyear. Although some slowing in growth was widely anticipated, the abruptness of the change raised some question about the continuing strength of expansionary forces. However, during the last few months of the year, output and employment were clearly rising, though at a more moderate pace than earlier in the ye»r. The strong gains in overall activity during the year drew attention away from a number of continuing problems, but those problems are nonetheless real and serious. The overall rate of unemployment is still unr.omfortably high and the ioblessness among certain groups—for example, teenagers and blacks— remains well above the average. Sectors of the economy facing intense compe- tition from abroad, such .is agriculture and certain mining and manufacturing industries, have not participated in the rapid economic expansion overall, and have been under strong financial stress. Strains also remain evident among financial institutions: a number of depository institutions have experienced Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 a deterioration of the quality of their loan portfolios, and the earnings of thrift Institutions remain constrained by low-yielding assets accumulated in earlier years. While it has not been an Impediment to economic expansion to date, growth in credit has been exceptionally rapid and many households and. businesses have accumulated substantial Indebtedness, often in short-term ot variable-rate forras that make them especially vulnerable to unexpected economic developments. Also, despite the impetus from strong U.S. demand, growth in economic activity has been limited in a number of Important industrialized countries, and many developing countries, In Latin America and elsewhere , are still struggling to restore satisfactory growth. While progress was raade in stabilising the external finances of sonie of the largest of those countries, that progress can only be secure la the context of greater stability in their own economies and of sustained growth in the industrial I zed wo r Id . Many of the problems afflicting particular industries have causes and complications that at least in part must he dealt with In direct and specific ways. But it is .-ilso evident that the enormous imbalances In our federal fiscal posture anrt in our trade and current account position have aggravated the problems and made constructive solutions much no re difficult. In an expanding ecoii ~-'ny requiring more private credit, the need to finance the large federal rteficits has contributed to the pressures that have held real interest ral?s at historically high levels. The failure to deal with budgetary deficit-; also has sustained doubts in the ralnds of the public about the ability of the government to continue to curb inflation over the run. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 The large federal deficits are mirrored in our external Imbalance. Many foreign investors have been attracted to the comparatively high real rates of return offered on dollar-denominated assets, and U.S. lending abroad has been reduced. Other forces stimulating capital Inflows have been at work as well, Including political and economic uncertainties in other countries and the relative stability and vigor of our economy. The shift in capital flows has supplemented domestic saving and helped finance the federal gov- ernment deficit and private investment. But, at the same time, the strong demand for the dollar has driven its value on foreign exchange markets to extremely high levels. As the dollar has appreciated, the demand for our exports has suffered arid our purchases of Imported goods have increased dramatically, resulting in strong competitive pressures on the marmfacturi'M, raining, and agriculture sectors and leading to calls for protectionist Treasures. Moreover, the capital inflows lead to mounting financial claims of foreigners that the nation must be prepared to deal with In future ye<jr% through reduced imports or Increased exports, in either case lowering doTiei.t i •- consumption. The Economic Projections of the FQMC Notwithstanding the risks associated with the doraestic and iTterna- tional problems just outlined, the weight of the evidence points to reasonably favorable near-term prospects Eor aggregate economic performance. In recent raonths, personal income growth has been strong, reflecting continuing substan- tial gains In eraploynent and helping to support consumer spending. Over- building of multlfamlly residential units and offices in •some parts of the country may pose questions about the outlook in these areas, but the lower Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 interest rates that developed over recent months suggest tViat single-family homebuilding may strengthen. Surveys of businesses indicate plans for continued growth In plant and equipment spending in the coming months, though at a slower pace than last year; meanwhile, some imbalances in business Iuvert tot tea that developed during 1984 appear to be well along in the process of correction, and in some sectors inventories are quite lean relative to sales. Many states and localities are experiencing an improvement in their finances, which portends further support to the expansion from that sector. And, at ttie tedetal level, there continues to De a strongly stimulative thrust from fiscal policy. tlie smallest increases in nominal wages and compensation in more than a decade have been accompanied by an improvement In productivity and downward pressures on energy and commodity prices. These developments help support the possibilities of continuing restraint in price increases. Also, in the content of an economy expanding at a sustainable rate, tney are con- sistent with continuing growth in average real income. Taking account of the above factors, the members of the Federal Open Market Committee (as well as Federal Reserve Rank Presidents who are not at present FOMC members) now foresee the probable continuation of the economic expansion through its third year, although dt a more moderate pace than in the first two years. The central tendency of the members' forecasts indicates the probability of an increase in real GNP of between 3-1/2 and 4 percent this year. The unemployment rare is expected to decline in 1985 to a level of between 6-3/4 and 7 percent by the fourth quarter. At the same time, most members expect general measures of price Inflation to remain close to recent trends. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 Economic Flirt*;" Members <uid otner t'KB Presidents Adminia- Ce_nt ral tendency t rat ion CBO hange, lourth quart to fourtn quarter Nominal GNP 7 to 8-1/2 7-1/2 to 8 Real CNP 3-1/4 to -*-i/4 3-1/2 to 4 GNF deflator 3 t.o 4-3/4 3-1/2 to 4 Average unemployment rate in the fourth quarter (%) 6-1/2 EO V-l/4 b-J/4 to 7 f>.9 Wtien considering the gisneral outlook for 1985, members oE the HJMC recognized that persisting problems could be^oroe aggravated tor particular sectors of the economy, ana r.hat ttiere ace ilsits for the economy as a whole. Clearly, there is growing distress in many farm communities. Incomes from farming have been low, land prices are falling, and many producers face heavy debt burdens• In tne iiouaetiold and business sectors, higher levels ot indebtedness are unlikely to forestaH further gains In spending, but unless moderated, they would in time add to linancial pressures. PavoiaBle prlue performance has oeen encouraged by the strength of the dollar In the exchange markets. A snarp and large reversal of that strength could he reflected in at least; temporarily stronger inflationary pressures- Greater conridence in prospects for price stability is, of course, dependent over time on suitably restrained growth in the money supply, and that necessary approach, and more monecate real interest rates, would be facilitated by effective action to reduce substantially the size of federal budEet deficits in ttie upcoming and suosequent fiscal years. Action to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 restate balance in the government'B fiscal position is Important to the achievement of an environment conducive to stable, strong economic growth. In their forecasts, the Committee members assumed that the exchange rate would remain within the range of recent months and that effective fiscal action is in prospect. The "central tendency" forecast of the FOMC members is broadly consistent with that of the Administration, as indicated In the Economic Report of the President, and that of the Congressional Budget Office. The Administration's projections for both real GKP growth and inflation do fall, however, toward the upper part of the ranges of Committee members' forecasts, while the CBO's estimate of real growth is a bit lower than the FOMC central tendency range. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 Section 2: The\_Federal Reserve's Obecelves for Money and Credit in 1985 At lea meeting of February 12-13, the POMC set monetary and credit growth ranges for 1985 designed to be consistent with further sustainable economic growth and progress toward reasonable price stability over time. Specifically, the Committee (t) set a growth range for Ml of 4 to 7 percent from the fourth quarter of 1984 through the fourth quarter o£ 1985, the same as that tentatively selected last July; (2) established target ranges of 6 to 9 percent and 6 to 9-1/2 percent for M2 and M3, respectively, one-half percentage point higher at the upper end of the range than tentatively set in July; and (3) set an associated monitoring range of 9 to 12 percent for the debt of domestic nonflnanclal sectors, one percentage point higher than tentatively indicated. The upper end of the range for Ml is one percentage point below that of 1984, and the range for M2 is the same as last year's. The upper end of the target range for M3 is slightly above that for last year. That increase, as well as the upward adjustment in the associated monitoring range for the debt of domestic nonfinancial sectors, reflects analysis of developments during 1984 suggesting that growth somewhat greater than anticipated earlier may be consistent with Committee objectives for the year. Expansion within these ranges would represent a significant decelera- tion in the actual growth of M3 and debt from the experience of last year when the target ranges were exceeded. In formulating these objectives, the Committee assumed that no new statutory or regulatory developments would be enacted that would appreciably influence the behavior of the monetary and credit aggregates in 1985. Although at the beginning of the year the minimum denomination of super NOW Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 and money market deposit accounts was reduced from 52,500 to 51,000, to uatc the promotional activity accompanyIng tuts engage tias Deen minor, and it appears that Ml and M2 have not been affected significantly. On average, the benavior of Ml velocity—nominal GNP divided by the money stock—during 1984 was broadly consistent with previous cyclical patterns. Together with other evidence, this development suggests that the factors responsible for the highly unusual velocity Behavior over 1982 and early 1*983 have receded. Nonetheless, a range of uncertainty inevitably remains about the trend of Ml relative to nominal GNP in light of recent deposit deregulation and other financial innovations that have affected the funding policies of banks and the cash management practices of Che public. On balance, it appears likely that the process of deposit deregulation will lead to a trend rate of increase in the velocity of Ml that may be somewhat lower than in the pdst- Woild IJar 11 period as a whole. However, in view of the multiplicity ot changes in financial instruments and practices that Influence the behavior of all the monetary measures, interpretation of all the aggregates will continue to Ise raade within the context of the outlook for economic activity, inflationary pressures, and conditions in domestic and international financial markets, including the strength of credit deicands. The new it-to-7 percent target range for Ml encompasses growth in Ml consistent with velocity expansion over the coming year approximating that of last year, and also higher Ml growth that would be needed snoul'i velocity gro« at a rate approximating the reduced trentf suggested above. The movements in velocity during 1984 occurred in a context 'if moderate increases In interest Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 ralet* over much of tne year; however, velocity lias slowed suostantially lu recent months In the context o£ an appreciable rise In uoney growth and following declines in interest rates. In all the circumstances, a somewhat hignei- race of money growth Chan implied by straight line projections from the tourtti quartet 1984 base to the targets for the fourth quarter of 1985 may be appropriate early In the year, but growth of Ml would be expected to slow, ana velocity growth to rise, as the current adjustments are completed. Tims, as the year progresses, growth of Ml would be expected to move gradually towaiu ana into tne FOMC's target range. Depending upon developments with respect to velocity and price benavior, growth in Ml and the other monetary aggregates in the upper pacts ol tneir ranges may DC appioprtace over the year as a wnole. Those developments will, of course, be closely monitored over the year. Like Ml, growth of M2 and M3 have been particularly strong in recent ninths, reflecting the unusually favorable yield spreads in favor of monetary assets that emerged temporarily toward the end of last year; open market Interest rates dropped more swiftly than rates offered by depository institutions on retail deposits and returns on money market mutual funds. In addition, M3 growth has reflected substantial issuance of large CDs by thrift institutions to support their lending in mortgage and consumer loan marKets. Growtn of tne oroaaer monetary aggregates is influenced, as well, by th« pattern of international capital Inflows associated with the riuge current account deficit. Domestic banks may condone to borrow sizable amounts of Eurodollar funds from their foreign branches and unaffiliated foreign banss; such borrowings are not included in the measured monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 aggregates. By reducing the need for funding through other managed liabilities included in M2 and M3, these inflows tend to restrain measured monetary growth in relation to growth of bank credit and credit generally. Moreover, many domestic borrowers. Including the federal government and private corporations, may continue to tap overseas securities markets directly, reducing the need for credit expansion by U.S. intermediaries. Given the federal budget deficit as projected by the Administration for 1985—as well as a likely expansion of spending by domestic sectors in excess of nominal GNP growth, as part of that spending flows abroad—the Committee contemplates that domestic nonflnanclal debt may continue to increase more rapidly than nominal GNP. Still, actual growth of debt in 1985 should be markedly less than in 1984, as nominal GNP growth and over- all credit demands moderate. Growth within the debt range for 1985 assumes also a slowing in credit for mergers, leveraged buyouts, and other financial restructuring. Such credit led to some erosion in corporate equity cusMons last year, and a more cautious approach Is anticipated this year. The outlook for financial conditions generally is again expected to be affected importantly by current and prospective federal budget deficits, which will remain enormous In comparison with experience in previous economic expansions. This massive federal borrowing will compete for available domes' tic savings with the strong private credit demands accompanying further growth of economic activity, keeping interest rates and exchange rates higher than they otherwise would be. Such relatively high interest rates and exchange rates limit expansion in those sectors that are most sensitive to the cost of credit and impair the competitive positions of domestic import-competing and export industries. Decisive and credible actions to reduce federal budget Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 deficits would have favorable effects en investors' expectations and help to lower Interest rates, especially longer-term rates, evert before these reduc- tions become fully effective. Such actions would work to relieve the imbalances and strains within the economy, contribute to further abatement of Inflationary expectations, and so reinforce the prospects for continued growth and stability. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Section 3:The Performance of the Economy in 1984 Thft economy recorded major gains in 1984, with the real gross national product up 5-1/2 percent and the unemployment rate down more than 1 percentage ootnt: over the year. The growth In output and employment was exceptionally strong In comparison with exnerlence in other oost-forean War expansions. But even more striking, In terms of Its departure from past norms, was the ejrt.raordinary rise in domestic spending, which again appre- ciably outstripped growth in domestic production. Over the course of the year such spending rose about 6-3/4 percent in real terms. Consumers and businesses purchased greatly increased quantities of Imported goods, whose relative prices were lowered by the appreciation of the dollar in exchange markets, and the U.S. trade deficit reached record proportions. Last year's economic gains were achieved without a pickup In Inflationary pressures, in part owing to the rise in the exchange value of the dollar. Aggregate Indexes of prices rose about 4 percent or less, stmilac to rates of inflation recorded In 1983. Ample availability of tnd«Rtirl;il capacity here and abroad helped to contain price increases. Labor cost pressures also were limited, as wage Increases actually were slightly Inwer than a year earlier. Labor markets continued to reflect the still consider- able unemployment in the economy as well as the adjustments of w^ges In STHC sectors to thp realities of forces associated with deregulation and foreign competition. Wage changes also reflected the favorable feedback effect of lower inflation on anticipatory or catch-up pay deioands. Although the nation as a whole has marte substantial progress In the past two years toward the goals of sustained growth and high enploynent Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Real GNP Percent change, Q4 to Q4 urn 1980 1982 1984 Real Gross Domestic Purchases Percent chanpe, Qi to Q4 irar 1980 1984 Unemployment Rate Percent — 6 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 along with price stability, important segments of the economy have continued to experience considerable difficulty. One symptom of continuing imbalances has been interest rates that, relative to the prevailing rate of inflation, have remained exceptionally high by historical standards. However, after moving upward during the first half of the year when economic expansion was especially brisk, interest rates retraced their advances in the second half of the year. At year-end, they were, on balance, a little lower. Federal government tax and spending policies have provided substantial stimulus to aggregate demands for goods and services, but in credit markets the deficits have added strongly to the demands for funds and have been one important force keeping interest rates high. Moreover, there is general agreement that, unless legislative measures ace enacted, budget deficits are likely to increase further, even in the context of a reasonably growing economy. This prospect, with its implication of continuing pressures on the supply of savings, has been a factor in the rise in the foreign exchange value of the dollar and the attendant emergence of enormous deficits in our trade and current accounts with other nations. Although, as noted above, the sharply higher value of the dollar has been an important factor In the movement toward price stability, inflationary pressures could become more apparent If the U.S. dollar wete to decline sharply—a risk th«t could in- crease as fundamentally unsustainable fiscal and external postures are extended. The Household Sector The household sector continued to benefit last year from the economic expansion. Adjusting for inflation, the rise in disposable in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 from the fourth quarter of 1983 to the fourth quarter of 1984 was 5-3/4 percent, surpassing the large gain in 1983. This strong increase in income supported a rapid rise in spending for consumer goods even as the personal saving rate rose. Household sector outlays in this expansion have been tilted more toward durable goods than has been typical. In the 1980-82 period, a time of relatively slow income growth and high unemployment, consumers had curtailed discretionary purchases of household goods. Since the end of 1982, however, strong employment and income growth and rising consumer confidence have been translated into an appreciable restocking of household durables. The strength of automobile purchases in 1984 was a part of this restocking process. As the stock of existing autos has aged, replacement demand has grown. Most recently, reductions in gasoline prices have lowered operating costs. Automobile sales in 1984 rose to 10-1/2 million units, the highest level since 1979. The foreign share of the market declined, owing in large part to the impact of limitations on Japanese units during a period of expanding sales. Indeed, demand for domestic autos proved to be so strong that producers had difficulty supplying many of the more popular models, even though auto companies operated some factories at near full capacity over most of the year. Total auto production was up 14 percent from the preceding year, despite brief strikes in the autumn. Spending for new homes slowed over the course of 1984, with rising mortgage interest rates through midyear a factor reducing housing activity. However, there were some Initial signs of improvement In the housing sector at year-end, associated with earlier declines in interest rates during the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 fall. From the fourth quarter of 1983 to the fourth quarter of 1984, residen- tial construction outlays, in real terms, were up 3-1/2 percent after an extremely rapid advance in 1983. For 1984 as a whole, 1.7 million new housing units were started. This was below the peak rates in the 1970s, but a marked Itnprovetuent over the performance of the first years of the 1980s, as housing demand continued to be supported by favorable demographic factors and ex- panding incomes. Moreover, relatively stable house prices and the growing use of adjustable-rate mortgages made home purchases more accessible for many households. The second year of strong growth tn income and spending was accompanied by significant changes in household balance sheets. Late in 1983 and in the first half of 1984, financial assets declined relative to income— owing primarily to the sluggish performance of stock prices—retracing a portion of the strong gains made earlier In the recovery. However, the sub- sequent rise in equity prices helped to restore household asset positions to their previous high levels, and since the turn of the year, with stock prices up sharply, asset positions have improved further. Meanwhile, growth of household indebtedness picked up noticeably last year, and consumer Install- ment debt as a share of disposable income moved to near its previous peak in the late 1970s. Despite the rise in indebtedness, there were few signs of increased financial stress In the household sector. The Incidence of payment difficul- ties on consumer installment debt remained historically low and home mortgage delinquency rates were about unchanged for the year as a whole. Nonetheless, the proportion of problem loans in the home mortgage market has not receded from Its recession high, and there is some special concern about future Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Real Personal Income And Consumption Percent change, Q4 to Q4 QJ] Real Disposable Personal Income Real Personal Consumption Expenditures 1 JL I 1980 1982 1984 Total Private Housing Starts Annual rate, millions of units 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 prospects In thia area owing to the added risk exposure of homeowners who took on mortgages carrying adjustable features, especially those made with sizable initial interest rate concessions. The sustained high level of mortgage loan delinquencies appears to date attributable not so much to adjustable rate loans as to a combination of still high unemployment and more stable real estate prices than some borrowers had anticipated. The Business Sector The increase in business spending for plant and equipment was greater in 1984 than in 1983. In fact, the rise in gross business capital outlays over these two years combined was much larger than in any other post-World War II economic expansion. Profits In the nonfinanctal corporate sector were up substantially In 1984, although by year-end the level had fallen back a bit owing to the slowing in sales growth. Growth in business fixed investment spending was strongest in the first half of the year, but continued at a double-digit pace in real terms in the second half. For the year as a whole, large gains were registered for both equipment and structures outlays. The ebullience of total spending reflected a number of factors, including the more favorable tax laws enacted in 1981, the desire to take advantage of technological advances, and the further narrowing of the margin of unused factory capacity under strong demand growth. Continued competitive pressure from foreign producers pro- vided additional Impetus for rapid modernization. At the same time, many U.S. producers of capital equipment, especially outside the "high-tech" area, did not fully benefit from this spending. Instead, foreign manufacturers captured an increasing share of capital goods purchased by U.S. firms; for Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 domestic equipment spending, this share—approximately 25 percent—was nearly twice that experienced in the late 1970s. Businesses accumulated inventories in 1984 after reducing stocks in the preceding two years. In real terms, business inventories rose $24 billion, an historically large gain. Those gains were concentrated largely in the first half of the year, alongside the rapid pace of the expansion of final demand. When sales growth slackened in the summer and autumn, businesses quickly cut back on orders and production to avoid severe Imbalances. In order to finance the combined increase in capital spending and Inventory investment, businesses relied heavily on external sources of credit. Nonetheless, gross Issuance of new equity weakened as stock prices declined early In the year and then failed to surpass earlier highs when they rallied In the summer. After accounting for the retirement of equity associated with merger activity and share repurchases, the net issuance of stock was decidedly negative. Shorter-term borrowing was favored by business as in the first half of 1984, as firms elected to finance mergers initially through bank loans and commercial paper, and the high level of long-term interest rates discouraged bond issuance. In the second half of the year, merger financing slowed and the decline in interest rates contributed to some movement toward longer-term debt Issuance. Even so, the traditional balance sheet ratios used to assess aggregate business financial strength worsened over the year: the ratio of loans and short-term paper to total debt of nonflnancial corporations rose, as did the ratio of debt to equity. Severe financial strains, in many cases related to the high exchange value of the dollar, persisted in some of the nation's basic Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 Real Business Fixed Investment Percent change, Q4 to Q4 Producers' Durable Equipment Structures 20 Jffl 10 1980 1982 1984 Change In Real Business Inventories Annual rate, billions of 1972 dollars 20 10 HDJ unr 10 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 industries. Farmers continued to face Less favorable export conditions than in much of the previous decade, land prices fell further, on average, and farm Income remained depressed. As a result, farmers with large voiuues (it dene ictuainlng from trie late 1970s continue to face serious deat-servicing pi u Hi ems. 1'tie metals, agricultural implements, and some equipment Industries alftu continue to face significant problems. Tria Government Sector Ttie expanding economy lifted federal gwvernifltfiic racei^cs In 1*84. At tMe sams time, outlay growth was Limited by furtner declines In recession relateu expenditures and by a drop in agricultural support payments. None- theless, the federal budget deficit remained enormous, more tnan 5 percent of GNP and larger than total domestic personal saving. Moreover, at the end of the year the deficit was again riaing. Fedeial goverunient purchases of goods and services, trie component of the budget that directly adds to GNP and comprises aoout a third of" total federal outlays, rose strongly last year. Excluding changes in Commodity Credit Corporation farm inventories, federal purchases were up nearly 5-1/2 percent, after adjustment for inflation. A major tiirust to federal purchases came from defense spending, wnicfi increased almost 7 percent in real tei/ms. Ac tie acace ana local government level, real putcnases of goods aria tieivJ-teH lose 3-1/2 percent in lyU^, following two years ot no ciiaiige. Trie ttsiifc-ec. giotftn in sucn spfendiiig toliofced an appteciaDLe improvement in this sector's fiscal position: state and lot:al governments experienced a sltaole operating and capital surplus In 19B3 and early 1984 owing to the eftects ot the economic recovery aa well as increases in tax rated. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 Federal Government Deficit Billions of dollars Fiscal Years, Unified Budget Basis 200 150 100 50 1980 1982 1984 State And Local Governments Billions of dollars Operating And Capital Budgets, NIA Basis 10 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 The Foreign Sector The appreciation of the dollar over the past four years directly contributed to the imbalance between exports and imports in 1984. On a trade- weighted average basis, the dollar climbed a further 12 percent during the course of the year, bringing the cumulative appreciation since the end of 1980 to about 65 percent, and the rise has continued into 1985. Part of the dollar's strength in the first half of last year may have been generated by a widening of the differential between real interest rates in the United States and real rates abroad; however, the influence of this factor appears to have been reversed in the second half of the year. The relative dynamism of the U.S. economy and success in curbing inflation helped attract capital from abroad. Conversely, relatively slow economic growth elsewhere and economic and political uncertainties in various countries also may have contributed co the dollar's appreciation throughout the year. Notwithstanding a further weakening of the international competitive position of U.S. firms owing to the dollar's appreciation, and despite the sluggishness of foreign economies, the volume of U.S. merchandise exports increased by 9 percent In 1984. Exports to Canada, some of which are relm- ported after further fabrication, accounted for about a third of the rise, with Western Europe and Mexico receiving moat of the remainder of the increase In exports. Economic growth in many developing nations, oil-producing as well as others, was limited by their debt servicing problems, and demand by those countries for U.S.-produced goods remained generally depressed. The vigorous expansion of the U.S. economy and the strength of the dollar pushed the volume of merchandise Imports sharply higher. Consucner Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 Exchange Value Of The U.S. Dollar Index, Marcn 1973 = 100 150 125 100 1960 1982 1984 U.S. Merchandise Trade 19bO 1982 1B84 U.S. Currum Account* Billions or collars 1UO 19BO 1982 19B4 *1964 la partially eatlmaiM Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 goods, materials, and capital equipment shared in the Increase. The merchan- dise trade deficit roae to about $110 billion. In addition to the growing trade deficit, net service receipts were reduced and the current account deficit was about $100 billion in 1984, compared with $42 billion in 1^83. Labor Market Developaienta Developments In Labor markets continued to be favorable during Che second year of expansion. Reflecting the strength of activity and iiapruved employment prospects, growth of the labor force picked up last year. But the number of new jobs expanded even more rapidly, and the unemployment rate was 7.2 percent in the fourth quarter, more than a percentage point beluw the rate at the end of 1983. Indeed, since the recession low in late 1982, nonfarm payroll employment haa Increased by nearly 7 million, the largest two-year gain In three decades. In 1984, employment growth continued to be widespread across industries. The trade and service sectors each added rare than one million jobs. And there was a gain in construction employment, owing in large part to a rise in nonresidential building. Government employment was up a quarter of a million, reflecting the rise In spending by state and local units. The manufacturing sector, which haa borne the brunt of Increased foreign competition, registered a large increase of almost three-quarter million In 19H4; even so, the level of manufaccurlng employment teiaai.ied below its pre-recession peak. Wage developments in 1984 were more favorably to the control of inflation; even though labor marfcet slack was reduced Substantially further during the year, wage rates Increased leas than in 1983. The employment Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 Employment Cost Index* Percent change, December to December 12 1980 1982 1984 Union Settlements And Aggregate Wage Change Percent change from year earlier First-Year Adjustments 12 In Union Settlements Average Hourly Earnings Index* 1980 1982 1984 * Private nonfarm business sector Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 cost Index, a comprehensive measure of change in wages and benefits, rose just 4 percent in 1984, nearly one percentage point less than the year earlier. Moreover, major collective bargaining agreements during the year showed no acceleration in nominal wage rates, even In those industries with improved economic conditions. These wage developments suggest that inflationary expectations continued to moderate this past year; to an Increasing degree, workers and managers now appear to be focusing on improving job security and on enhancing productivity! often in an attempt to remain competitive with foreign producers. Productivity increases in 1984 were substantial In the first half of the year, when output grew rapidly, and helped keep overall cost pressures down. Over the course of the year, labor productivity increased 2-1/4 percent, partly reflecting a cyclical adjustment to higher levels of output as well as appar- ently some improvement in the underlying trend rate of growth from the very low pace of the 1970s. The combination of moderate compensation Increases and favorable productivity developments held down cost pressures on prices; unit labor costs rose 2 percent over 1984, less than a fifth of the rate experienced in 1979 and 1980. Price Developments^ Over 1984, the consumer price Index rose 4 percent and the implicit deflator for the gross national produce 3-1/2 percent. The increases In these broad indexes represent little change from Inflation rates that have prevailed since the beginning of the expansion. The producer price index for finished goods, which excludes the prices of services, rose less than 2 percent last year; basic commodity prices, which had advanced more Chan 30 percent early In 1983, fell during most of 1984. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Nonfarm Payroll Employment Millions of persons 95 90 1980 1982 1984 Compensation Per Hour Percent change, Q4 to Q4 Nonfarm Business Sector 12 1980 1982 1984 Output Per Hour Percent change, 04 to Q4 Nonfarm Business Sector 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 GNP Prices Percent change, Q4 to 04 10 1980 1982 1984 Consumer Prices Percent change, December to December 15 10 1980 1982 1984 Producer Prices Percent change, December to December 10 1980 19fl2 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 The relative softness of demand in world-wide markets and the strength of the dollar against foreign currencies played a large role last year in holding down prices of basic commodities. Importantly, energy prices, which have been a major factor in inflation rate (soveweftts for more than a decade, moved down. The weakness of demand during the recession and early recovery period restrained energy prices in 1981 and 1982; moreover, conser- vation measures and additional oil production capacity in many countries have continued to relieve energy price pressures. Food prices at the retail level rose about in line with overall prices in 1984. Early in the year, food prices jumped sharply because farm supplies were limited by the 1983 summer drought and a winter freeze. How- ever, supplies again became plentiful as the year progressed, reflecting more favorable harvests and sagging export volume. Apart from the food and energy areas, consumer price inflation was little changed from a year earlier. The rise in consular goods prices slowed appreciably, owing in part to the relatively small increase in prices of imported goods, as well as the accompanying competitive pressures on domestic products. Service prices rose more rapidly over 1984 than in 1983, although the rate of inflation in the sector remained well below those recorded In the early 1980s. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 Section 4: Monetary Policy and Financial Developments in 1984 Monetary policy in 1984 aimed basically at supporting sustainable economic growth within the context of long-term progress toward price stability. The target ranges for the monetary and credit aggregates chosen by the Federal Open Market Committee last February, and reaffirmed in July, called for growth rates 1/2 to 1 percentage point below those set for 1983. Measured from the fourth quarter of 1983 to the fourth quarter of 1984, the target ranges for the monetary aggregates were 4 to 8 percent, for Ml, and 6 to 9 percent, for M2 and M3. The associated monitoring range for the debt of domestic nonfinanctal sectors was fixed at 8 to 11 percent. Underlying these objectives was the Committee's expectation that the special factors distorting monetary growth rates in 1982 and 1983 would be less important in 1984, and that relationships among the msnetary aggregates—particularly Ml—and economic activity and inflation would be more consistent with historical trends and cyclical patterns. Portfolio adjustments associated with the previous introduction of new deposit accounts and with the steep drop in interest rates during the 1982 recession appeared to have ended. Furthermore, the economic expansion seemed to be reducing uncertainties about employment and Income prospects that earlier had boosted demands for liquid precautionary balances. Over the year, increasing evidence suggested that Ml was in fact behaving more in line with historical experience. As a result, this aggregate was given m>re weight in policy implementation than had been the case during the latter part of the cyclical downswing and early phase of the economic recovery. However, all of the monetary and credit measures continued to be Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 Ranges and Actual Money Growth M1 Billions of dollars Rate Of Growth RanpB Adopted By FOMC For 1983 (W To 1984 Q4 1983 04 To 1984 04 570 5.2 Percent 560 550 5-10 530 520 1983 1984 M2 Billions ot dollars Rate Of Growth Range Adopted By FOMC For 1983 04 To 1984 04 1983 04 To 1984 04 2*00 7.7 Percent 2350 — 2300 —' 2250 — 2200 1983 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 Ranges and Actual Money and Credit Growth M3 Billions of dollars Rate Of Growth Range Adopted By FOMC For 1983 04 To 1984 04 1983 Q4 To 1984 Q4 10.5 Percent 3000 2900 2800 2700 1983 1984 Total Domestic Nonfinancial Sector Debt Billions of dollars Rate Of Growth Range Adopted By FOMC For 1983 Q4 To 1984 Q4 1983 Q4 To 1984 Q4 13.4 Percent — 6000 — 5750 5500 5250 1983 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 evaluated in light of the outlook for the economy and domestic and Interna- tional financial markets. Money, Credit, and Monetary Policy The actual growth rates of Ml and M2 over 1984 were well within the target ranges established by the Federal Reserve, with MI expanding 5.2 percent, somewhat below the midpoint of its range, and M2 Increasing 7.7 percent, a bit above its midpoint. As had heen anticipated in the mid- year policy report to the Congress, growth of M3 and domestic nonflnancial debt, at 10.5 percent and 13.4 percent, respectively, exceeded their ranges.* The relatively wide divergence between M2 and M3 growth rates reflected mainly substantial issuance of large CDs and other managed liabilities by thrift institutions and commercial banks in the face of heavy credit demands. Credit growth last year was the most rapid on record, and much stronger relative to GNP expansion than historical trends would suggest. An unusually large volume of mergers and related activity, including "leveraged buyouts," involving nonfinancial corporations accounted for about 1 percentage point of the growth of overall debt. Around S75 billion of equity was liquid- ated In this process, with much ot it replaced, at least for a time, with short-term debt. In addition, more than $10 billion of equity was retired through corporate share repurchases, frequently In defensive maneuvers to ward off unfriendly takeover attempts. 1. The figures cited herein for the monetary aggregates are based on recent benchmark and seasonal adjustment revisions. Before those revisions, the 1984 Increases were measured at 5.0 percent for Ml, 7.5 percent for M2, and 10.0 percent for M3. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 Even after allowance is made for the unusually large volume of merger-related borrowing, It la clear that total credit demands were exception- ally strong last year. Federal debt expansion, at more than 16 percent, was unprecedented for the second year of an economic expansion, both in absolute terms and in relation to income. Private domestic nonflnancial debt grew about 11-1/2 percent (abstracting from growth of merger-related debt Issues), also faster than, but much closer to, comparable stages of previous recoveries. The behavior of Ml velocity in 1984 was broadly consistent with past cyclical patterns. In contrast to the unusual weakness of the previous two years, over 1984 Ml velocity increased 4 percent, only a little above the average rate of growth during the second year of previous economic expansions. M2 velocity increased 1-1/2 percent, reversing two consecutive yearly declines. The strengthening of velocity over 1984 apparently reflected, in part, some unwinding of the precautionary and other motives that had swelled demands for liquid assets in 1982 and early 1983, as well as the rise of short-terra interest rates in the first part of the year, and, in the case of M2, the abatement of dramatic Inflows to money market deposit accounts (MMDAs) associated with the initial authorization of these accounts. Demands for Ml balances, and for bank reserves to support deposit growth, were robust early in the year as the economy expanded rapidly. Credit demands also were very strong, and market interest rates began rising even as the Federal Reserve, through open market operations, was keeping the degree of pressure on bank reserve positions unchanged. In early spring, with credit and money demands continuing unabated,* and with economic growth continuing I. Annual seasonal and benchmark revisions to the monetary aggregates subsequently lowered somewhat the growth of Ml In the first half of 1984 relative to what was estimated during the period. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 GROWTH OF MONEY AND CREDIT^ Percentage changes Domestic nonf inancial Period Ml M2 M3 sector debt Fourth quarter to fourth quartet 1979 7.5 8.1 10.3 12.1 1980 7.5 9.0 9.6 9.6 1981 5.1 (2.5)2 9.3 12.4 10.0 1982 8.8 9. 1 10.0 9.1 1983 10.4 12.2 10.0 10.8 1984 5.2 7.7 10.5 13.4 Quarterly growth rates 1984-Q1 6.2 7.2 9.2 12.9 Q2 6.5 7.1 10.5 13.1 Q3 4.5 6.9 9.5 12.7 Q4 3.4 9.0 11.0 12.7 revisions made In February 1985. 2. Ml figure in parentheses Is adjusted for shifts to NOW accounts in 1981, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 at an extraordinary pace, the FOMC adopted a sontewnat more restraining posture toward supplying reserves, and both short- and long-term interest rates rose further as banks relied more heavily on discount window credit to loeet their reserve needs. Borrowing tor adjustment and seasonal purposes Inci'tased to aromw $1 billion In Marcn and April after averaging aouut i>b50 million during the first two months of the year. In April, the discount rate wad raisec 1/2 percentage point, to 9 percent, to bring tnis rate Into Oecter alignment with suort-term market rates. Ijespite tne absence of any further tightening ot reserve availability oy t:ie Kecerai Reserve, pressures on private short-term Interest rates Inteiisl- fteu arount! early May in reaction to the well-publicised liquidity prooleuis of Continental Illinois Bank.' Uncertainties related to the international debt situation also added to market concerns. In this environment, quality dif- ferentials between yields on private money market instruruents and Treasury securities widened sucstaiitially. While Ml growth early in the year remained in the upper part 01 tne FCHC's target range, M2 increased at a pace slightly below the midpoint of Its range even as the economy expanded rapidly. Growth in M2 relative to income may have been damped by substantial inflows to IRA and Keogh accounts, wnich are excluded from the monetary aggregates. Also, as market interest races firmed, sl^aoie spieaos developed between these rates and ylelas on it:i.all depuuits aim luuucy vuai-Km: mutual tunas, liKeiy encout<iging some invcsLoLa to place ruiius diiectiy in credit rnatnet Insttuiuents. MJ, meaimnlle, pusued 1. L&igc dJ.acouiit wmao«r botrowing by Continental Illinois bauic, Oeglunli in May, was ottset in tenns of Its Impact on overall reserve supplies thiougn open raarKet operations. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Short-term Interest Rates Percent Federal Funds 18 14 10 3-month Treasury Bill 1980 1982 1984 Long-term Interest Rates Percent Home Mortgages Fixed Rate 18 14 10 30-year Treasury Bond 1980 1982 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 Reserve Aggregates Billions of dollars Snaded Area Is Adjustment And Seasonal Borrowing' 1983 1984 Excludes borrowing by Continental Illinois Bank beginning n May 1934. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 above its longer-run range, as banks and thrift institutions issued large CDs and other managed liabilities to accommodate rapidly rising credit demands. After midyear, economic expansion slowed markedly, particularly during tne summer, tending to reduce transactions deraands for uioney. Uruwt in M3, thougn remaining somewhat above tne upper limit of its range, aiso modetatea as demands for short-term business credit slackened and as soine banks adopted more cautious lending and funding policies in lignt or the strains on financial markets. Initially, tne slowing in Ml was not resisted, as it reversed a bulge that had brought MI growth well above the midpoint of tne fr'OMC's target range. However, by late August and early September, as evidence appeared of much slower economic growth, with financial tensions high and with the dollar rising rapidly on foreign exchange markets, the Federal Reserve moved to lessen tne degree of restraint on banK. reserve posiciuns. That process continued through much of the rest of the year. Borrowing at the discount window receded, reaching levels of around S575 million by late in 1984 and dropping further to around $340 million, on average, during January 1985. Total reserves and nonborrowed reserves, wnlcti had siiown little expansion since June, increaaed markedly in Che final two muncha of the year and Into early 1985. Mil tuning t'ie easing of reserve niarnet couaiCLoiis, suoii:—teem intfeiesc races oroppea considerably rrom tneir iate-suhiiuer nigns. iiuteu.^r, quality spteaQs on vaiious money marxet Instruments returned Co wxenlu iiunud ranges aa the strains related to trie problems of Continental Illinois liuiik Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 remained contained and progress was made In Latin American debt negotiations. Responding to the provision of reserves and the reduced rates on alternative outlets for liquid funds, Mi-type balances rose rather sharply In late 1984 aini early 1985. Growth of M2 also was very rapid, aa open martcec interest rates tell below average yields on MMDAs , small denomination time deposits, and money martcet mutual fund stiares. Tne eaaing in financial raarKets during the second naif of iy84 was reflected In, and to an extent encouraged by, two successive reductions In tne discount rate, tirst to 8-1/2 percent In Movemoer and tnen to 8 per- cent in uecemoer. By year-end, short-term interest rates were 2-1/2 co 3-1/1! percentage points lower than they had been during the summer, and 3/4 to 1-1/2 percentage points below their levels at the beginning of the year — in some cases near their cyclical lows of early 1982. Long-term interest rates also declined in the second half of the yeai , 1" part reflecting some moderation of Inflationary expectations. flut for the year as a whole, most long-terra rates declined by less than 1/2 per- centage point, and remained above their earlier cyclical lows. The still relatively high level of long-term rates appears to be influenced by the continuing budgetary uncertainties, current strong demands for total credit, and lingering, though lessened, fears of inflation. Otliei lievelopments In Financial ^arketa foieigH savings iniaiieea a large snare oi tne aouiestic borruwiiig in 1984. fret inflows of capital trom aoroad were ncre than double tne already adv&imeu puce of 1983, thus supplementing domestic saving and enaoiiiig clua financing of the maaslve federal deficits at tne same time that private Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis investment expanded rapidly. Banks continued to intermediate substantial amounts of these inflows, and sales of Eurobonds by U.S. corporations reached record levels. Direct investment in the U.S. also was very strong, reflecting several large takeovers of domestic firms by foreign corporations. Much of the credit raarfcet borrowing—particularly that related to merger activity—was at short term. Commercial paper debt of nonfinancial businesses surged more than 50 percent, offsetting two consecutive years of runoffs. With strong loan demands in business, real estate, and consumer areas, total loans at commercial banks grew nore than 14 percent. Given only moderate inflows to core deposits in the face of this brisk loan growth, commercial banks Increased their outstanding CDs In 1984 by more than 14 percent, after having allowed a large volume of CDs to run off during 1983. Credit growth at banks was especially rapid during the first half of last year, reflecting a wave of bank-financed mergers. The bulk of the CD issuance was concentrated In this period and likely would have been even greater had not banks also borrowed heavily from their foreign offices. In the second half, loan expansion slackened appreciably, and large time deposit growth tapered off, as some earlier merger-related loans were repaid with the proceeds from issuance of commercial paper and other debt obligations and from selective sales of assets of the merged companies. Strains on some sectors of the economy, as well as the effects of overly aggressive lending policies by some institutions, continued to be reflected in relatively high levels of non-performing and other troubled loans In a number of depository institutions. As the year wore on, there were signs of more forceful efforts to deal irttn these problems and their consequences. Loan loss provisions were significantly increased and steps Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 are being taken to correct weaknesses In credit standards. The largest bank holding companies generally improved their capital positions over the year, partly in response to supervisory guidelines to raise capital ratios. These approaches will take time to bear full fruit, and progress in strengthening balance sheets will he dependent on reasonable profitability as well as on developments external to the banking system. In that connection, the strains in agricultural areas, on heavily indebted foreign countries, and in sectors of the energy Industry pose continuing challenges. In long-term markets, municipal bond offerings achieved new highs in 1984. Tax-exempt offerings were relatively light over the first half of the year as authority to Issue single-family housing revenue bonds lapsed and as the market anticipated the Imposition of retroactive ceilings on issuance of industrial revenue bonds (IDBs). But volume rebounded in early summer after passage of the Deficit Reduction Act, which reauthorized housing bonds and stimulated a flood of issues toward year-end to avoid stricter rules for IDBs and student loan bonds—effective January 1, 1985. Financial and non- financial corporations also raised record amounts through bond offerings; however, the maturities of new issues tended to be much shorter than in previous years, and many offerings carried provisions that essentially transformed these obligations into short-term or variable-rate debt. Variable-rate instruments exhibited increasing popularity within the home mortgage sector as well. Adjustable-rate mortgages (ARMs) accounted for almost two-thirds of the number of conventional first mortgages on homes at major institutional originators in 1984, up considerably from only one- quarter of such originations the previous year. Thrifts, in particular, preferred to acquire ARMs rather than fixed-rate mortgages in an attempt to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 reduce their already acute exposure to interest rate risk. The widespread acceptance of ARMs by consumers wag attributable partly to substantial initial rate advantages offered on ARMs compared with fixed-rate mortgages, as well as ta other features that limited borrower exposure to higher future interest payments, at least for seve.ral years. Large initial rate discounts became less prevalent after the adoption of somewhat tighter standards both for purchases by federal credit agencies and for the underwriting of ARMs by private mortgage insurers. Yet, despite the shift toward ARMg during 1984, and Increased consumer and business lending, the assets of thrifts remained heavily concenfrated in relatively low yielding instruments. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 Chairman FAUNTROY. We all agree that, in the long run, we ought to have both low inflation and low unemployment. However, in the short run, it is clear we cannot have both. In the coming year, for example, it would be great if we could reduce unemploy- ment to 5 to 6 percent, or inflation to 2 to 3 percent, with further reductions in the years thereafter. But your projections do not show such improvement and it would probably be unrealistic to hope for them. What can we realistically achieve? It seems to me that the realistic choice this year, with some reasonable favorable developments on the deficits and on the trade fronts would be this—we could either see a reduction of inflation to, say, the 3-per- cent range, at the cost of continued unemployment at, say, the 7 percent range, or we could see a reduction in unemployment to somewhere around 6 to QVz percent, at the cost of continued infla- tion at or about the 4 percent rate that we have today. My question, Mr. Chairman, is which of these choices is the Fed trying to achieve through its monetary policy? My reading of your testimony suggests that you are aiming at the second choice. But the improvement in projected unemployment is so modest, that you could be trying for the first. Mr. VOLCKER. I think our actual numbers are somewhat between your choices. I don't know whether I would accept fully the realism of your choices—whether it is really possible to achieve in combina- tion some of the numbers that you suggested. But I don't know that for sure. I would look at it perhaps in a somewhat more qualitative way. I don't think that we can just look at numbers in isolation for a par- ticular year and say what is achievable in 1985. I would be very interested in what is implied in terms of the directions and the threats, as well as the benefits, let's say, toward the end of that year, with one of those extreme protections or another. If we drove for, in some sense, maximum reduction in unemploy- ment this year, you presumably would increase the money supply further and increase the liquidity of the economy. You might or might not be successful in the space of 12 months let us say, in get- ting the unemployment rate lower than you otherwise would have it in that particular period. But would you end up with the kind of forces at work in the economy that immediately jeopardized the outlook in 1986 or 1987; would you end up with unemployment a bit lower in 1985, but with a much more threatening situation as you looked out into the future? When one approaches problems with that kind of tradeoff set of mind, the risk has been, historically that one pushes for maximum growth in unemployment in the short run at the risk of inflation and you set up, inadvertently, forces in the economy that end up with more inflation and more unemployment. It may not be true in year 1, but it would be true in year 2. 3, and 4. I think that is the history of the 1970's. We have projections here for a year, but we try to keep a longer term perspective in mind. It is in that context that I think the im- portance of keeping one very clear eye on the inflationary forces in the economy, actual and potential, is extremely important. Chairman FAUNTROY. Let me try to be a bit more specific. What would it take in your view to get unemployment down to, say, 5 or Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 6 percent during the next 2 or 3 years? If we mandated that as a goal for monetary and fiscal policy, what would be the risks? Mr. VOLCKER. One kind of answer I could give you is that those chances—let's say to get to 6 percent—are going to be maximized over a time period of 2 or 3 years to the degree that we are success- ful on the price side. Let me, for purposes of discussion, assume that monetary growth on the order of magnitude of our targets for this year is appropriate, and should probably be something lower than that, as time passes, to be consistent with stability. If you are given that kind of a framework, the less prices increase, the more successful we are on the inflation side, almost arithmetically, the more room you have for growth. If you think of the money supply as setting some limits—and they are very loose limits—on nominal GNP, then it is in our inter- est to see that as much of that turns out to be real growth and as little as possible of it turns out to be inflation. That would be the favorable result we can get. I'm always hesitant about presenting these projections because they may imply a degree of certainty about the future that isn't possible. We would be delighted, I am sure, if growth turned out to be higher in 1985 and unemployment lower, provided that is in a con- text that makes it look sustainable. Again, one important element is what's going on in terms of prices, not only currently, but pro- spectively. Chairman FAUNTROY. The Board recently forwarded to the Con- gress a study on margin regulations which study included some leg- islative recommendations. What priority should we place on this? Mr. VOLCKER. I don't think it is the most urgent matter before the Congress in terms of all the matters you have before you. We have lived with these margin regulations for a long time. I wouldn't put it high on the priority list of problems in the econo- my. But with the development of new and different markets for fu- tures and options, problems have arisen in terms of consistency and equity of margin requirements for stock and other markets. In the interest of simplifying regulations wherever possible or going back and seeing whether they are necessary, that study reflects work that has been going on, in fact, for 5 years or more within the Federal Reserve System. We have concluded that margin require- ments, as they have traditionally been operated since the 1930ls, are probably no longer necessary. They may be delegated. One main option is to give authority over margin requirements to self- regulatory bodies with some kind of Government oversight. I think that suggests also that, within the context of the present arrangements and the present law, one might say the present margin requirement of about 50 percent could logically be reduced some. We have been a little hesitant about doing that for fear that it might be misconstrued as a monetary policy action, which it would not be, or construed otherwise during a period when the stock market is strong. But I think the logic is—and the board has looked at the matter as a kind of interim measure—to reduce that margin requirement from the 50-percent level that it's been at for many, many years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 Chairman FAUNTROY. I am tempted to have you discuss a con- cern which I have on the trend in mergers and acquisitions, but I am going to resist that temptation and yield now to the distin- guished ranking member for his questions. Mr. McCoLLUM. Thank you, Mr. Chairman. Mr. Volcker, for the past couple of years when you have testified, I've inquired about the factors that the members of the open market committee use in making judgments to loosen or tighten the money supply Two or three years ago, you responded that the M's were being distorted because of the money market factors and other things and that besides the M's and the ranges that had been adopted by the committee, you were looking at price baskets and maybe unemployment and several other factors. Last year, as I recall, you expressed confidence in the M's again and the money supply as a guiding standard of major concern and Mr. VOLCKER. Relative confidence. Mr. MCCOLLUM. Relatively. But you indicated that very little or no emphasis was being placed on other factors like price commod- ities and so on during that testimony. I am curious—over this past few meetings of the monetary open market committee, what factors the members are looking at, if any, besides the range of the M's. Are they looking at price bas- kets? I noticed in your report, the growth of debt has been of con- cern. Or is the primary focus still on the ranges, the target ranges, of the M's, in making the decisions to loosen or tighten? Mr. VOLCKER. Let me try to be careful in answering because, whatever I say, I find it sometimes gets interpreted in a manner that I don't fully recognize. I do not recall deemphasizing other fac- tors last year. I do think that we feel that so-called velocity move- ments may be more normal than they were, let's say, in 1982 and the early part of 1983, anyway. In that sense, we have somewhat more confidence in setting out targets and feeling that they are ap- propriate. But we allow a margin for flexibility within those targets, as you well know. In conducting policy we do look at the targets in the context of other indicators. I don't think we have mechanical indi- cators like, let's say, a basket of commodities, or some arithmetic, mathematical kind of rule that we try to weigh into our decisions. But if you ask are commodity price movements, for instance, a very interesting piece of evidence that is brought to the table to show the degree of inflationary or disinflationary forces in the economy, they certainly are. One element that has, I think necessarily and appropriately, at- tracted increasing discussion and weight in our decisions within the general context of appropriate monetary growth is what has been going on externally, particularly with the exchange rate. That certainly affects our judgments currently as to how to conduct monetary policy, within the general framework of the monetary targets that have been set out. Mr. MCCOLLUM. Well, now, you have got the monetary targets listed in your report and, in addition, you have got target ranges for what is referred to as domestic nonfinancial debt, I suppose technically. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 Mr. VOLCKER. Yes. Mr. McCoLLUM. It appears that in 1984, the target ranges for the debt were exceeded by quite a bit. Mr. VOLCKER. That is correct. Mr. MCCOLLUM. The actual growth of debt was quite a bit more. Mr. VOLCKER. That is correct. Mr. McCoLLUM. In your testimony, you have indicated that with regard to setting the new targets and raising them slightly on debt, that even so, you say credit growth, fuelled in part by budget defi- cit, is expected to be quite strong, significantly exceeding the rate of expansion of GNP for the third consecutive year. The committee does not anticipate the growth of debt within the targeted range would necessarily pose significant new risks in the immediate year ahead. But you go on to say that a healthy financial structure will in time require more restraint on borrowing relative to the economic growth that, in the last analysis, provides the wherewithall to serv- ice the debt. Am I reading correctly into this that if the debt continues to grow at this kind of excessive rate, that the open market commit- tee is going to, despite the fact that the M's may be in line at the time, put more reliance on this debt factor? Is that what we're to expect or anticipate and there may be more tightening as a result of that? Mr. VOLCKER. I think that that may be overstating it, that is in the sense of looking at that one variable. I think that that is one that tends to go in that direction, frankly. If we are looking at nothing but the monetary numbers and the debt number—and if the debt continued to rise very rapidly—this would weight, let's say, toward the lower part of the ranges of monetary growth, all else equal. All else isn't equal, I quickly say. and we do look at the other indicators that I just mentioned. Mr. MCCOLLUM. And one of them is the question of the value of the dollar abroad; is that correct? Mr. VOLCKER. Yes. Of course, we look broadly and inevitably make the best assessment we can of what the economy itself is doing in the broadest sense. What are the growth patterns in the economy? How sustainable do they appear to be? What is the degree of momentum in the economy? You can get fooled in that analysis: monetary policy is not just a process of trying to assess and fine-tune what's going on in econom- ic growth; quite the contrary. You certainly look at that. Mr. McCoLLUM. But the emphasis, Mr. Chairman, still is on the M's. That is still the target, the primary emphasis. Is that correct? Mr. VOLCKER. That is the point of departure, I think. Mr. McCoLLUM. Thank you. Thank you very much. Chairman FAUNTROY. Thank you, and I yield now to the gentle- man from North Carolina, Mr. Neal. Mr. NEAL. Thank you, Mr. Chairman. Chairman Volcker, we are now operating under an economic plan that has doubled the national debt in about 4 years and, if un- changed, will triple the national debt within another 4 or 5 years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 I have to ask a broad sort of question. There are several parts to the question. In a very broad way, what is going to hanpen to the economy if we don't change this economic plan that we are follow- ing? And what will the pressures he on the Fed to pump out exces- sive amounts of money? As I understand from what I can read in the popular press about the supply side argument these days, I think it sort of hoils down to the fact that these deficits don't really matter and that we will grow our way out of them. And in any case, if we don't, it's the fault of the Federal Reserve System; that is, because the Federal Reserve System is not pumping out enough money. I don't mean to be unfair to the supply-side argument, but that is the way I read it and if I am correct I very much disagree. I think if the Fed does again start to engage in excessive money creation, inflation will be sure to follow and it does appear to me that the pressures on you are going to he very strong to do just that if we don't get our fiscal policy in order. Would you comment on these points? Mr. VOI,OKER. As to what happens if nothing's done about the deficit, I don't think that anybody can creditably give you a very precise scenario. I think you can look at what has been happening and raise, to me, unanswerable questions. What has been happening is that we have been managing to fi- nance this deficit, along with rising housing and private invest- ment, with the help of an increasing net flow of capital from abroad, which has now reached about 2 Vz percent of the GNP. That 2V2 percent of the GNP happens to supplement our net domestic savings on an order of magnitude of something like a third. It is a very significant quantity. We save something less than 9 percent net of our GNP domestically, and now we're supplementing it by 2% percent from abroad. That has not meant low interest rates in the United States, but it certainly kept them lower than they oth- erwise would have been and permitted the private economy at home to move ahead consistent with this deficit, contrary to many expectations a year or so ago. The other side of the coin necessarily is that huge and rising trade deficit which reached more than $100 billion last year and looks like it's still trending higher. That creates a severe distortion in the economy in and of itself. It helps depress the manufacturing sector of the economy. But looking ahead, I think you have to ask yourself, is that sustainable? And I would answer, "No." I don't know how long it's sustainahle. We have had a number of developments going on that have helped to track this capital, in- cluding relatively high interest rates. It contains the seeds of its own destruction, if nothing else. The more you borrow, at some point people are going to become a little suspicious and they are not going to be so willing to put money in the United States. The dollar can't go up forever, and fear that the dollar will go down in itself would tend to shut off that capital inflow. Ask yourself what happens when that day comes? We no longer have this crutch from abroad to support our domestic financial markets. Then the squeeze comes back on the internal markets, ac- companied perhaps by a rapidly falling dollar reversing the recent, or at least part of the recent rise, which gives you both pressures Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 on our domestic market and inflationary pressures at the same time. One pressure at that point in time might well be what you sug- gest; that somehow, we in the Federal Reserve must solve that problem by creating more money. But creating more money isn't the same as creating more savings. Money, as you point out, will, in the end, create inflation. More savings do the opposite; they re- lease real resources for investment, for the Government deficit, if we have one, for the improvement in the trade balance, offsetting the decline in the capital inflow. If you don't get the increased sav- ings, you have got a real problem, and I don't think there is any reasonable prospect that you can expect savings to jump up con- veniently. The savings rate has been quite steady within a channel for many, many decades. It reflects some very deep propensities and habits of American individuals and businesses. That's not a very happy prospect, to say the least. It is a prospect that will both undermine the progress on inflation and the progress of the economy itself. The prudent way to prepare for that is, I think, by doing what we constructively can do, which is reduce the demands from the budget deficit, If that's not done, I think this rather high risk, bleak scenario is there. I can't predict the timing, and I can't predict just how it would come about. Looking at the shape of the American economy now, with those huge trade defi- cits, I think you have to sense that you're not in a fully sustainable position. Mr. NEAL. I would like to followup, if I can. Again, I quite agree with you. I don't see what would drive foreign capital from our shores at this point, either. I mean, the economy is booming right along and interest rates are certainly attractive. But I have this uncomfortable, uneasy feeling that precisely what you suggest could happen. Mr. VOLCKER. I well understand your uneasiness and every day brings it closer. But we've had a remarkable performance in the past year, with rather strong increases in capital inflows—net cap- ital inflows. If you look at what's been happening in the last 3 years or so, a large part of that net increase is in reduced growth in the outflow, particularly by banks. They are not lending abroad the way they were before. So, it is not just that our economy has been attracting a lot more money. It has been attracting some more money from abroad. But we are not sending it out at the rate of speed that we were. The sending-out side has pretty much come to a halt. What we are doing is living off the continuing inflow, which has been expanding and using all that money at home instead of recy- cling it, as was the case earlier—recycling all of it, sometimes more than all of it, to the rest of the world. There is less attraction for bank lending abroad, for obvious reasons. Mr. NEAL. It seems to me that if we don't take this deficit situa- tion seriously, we are going to do enormous damage to the over- whelming majority of the people in this country. And a less painful way to deal with it would be to cut spending and increase some taxes as a part of a plan to deal with it, and the pain of that to the economy at large and to individual people will be much less than it Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 will than if wo continue to ignore the problem. Would you agree or disagree with that? Mr. VOLCKER. I certainly agree that taking action now to deaf with what seems to me so evident a problem—even though, on the surface, it is obscured by the general prosperity of the economy—is what is called for. That is the only prudent, reasonable approach. How you go about that, of course, is a very controversial matter and it involves many considerations outside the strictly economic. I have often said that if you are looking at this purely as an economist—you forget about national security and you forget about Social Security and forget about all those considerations—you look at it purely from an economic standpoint, the question is: How do you reduce that budget deficit with minimum impact on incen- tives? Maybe maximizing some incentives, giving maximum scope for the private economy and the growth of investment- You attack it from the expenditure side. I think that's what the economics call for. That's excluding all these other objectives. You have got to rec- oncile all those other objectives and, in the last analysis, if you can't do it on the spending side, then you have to look to the reve- nue side. Chairman FAUNTROY. Thank you. Mr. Wylie? Mr. WYLIE. Thank you very much, Mr. Chairman. May I say that I am not one of those who is quite that sanguine, quite as sanguine as some of the economists who feel that we don't have to worry about the Federal budget deficit, that with proper incentives from the Fed, that the economy will grow fast enough that we can grow our way out of it. So, I was glad to hear what you had to say in response to Mr. Neal's question. Something that has been a concern of mine, Mr. Chairman, is the haphazard way in which the delivery of financial services has been developing in this country. I think it has some ramifications on the conduct of monetary policy and is therefore an appropriate question for this hearing, because I think a stable financial system would help you in the conduct of your job. But may I ask you for the record today, Chairman Volcker, about the need for, and the urgency of congressional action on banking regulation-deregulation issues which were left over from last year. Mr. VOLCKER. Let me say as flatly as I can, I find the present situation totally unsatisfactory and disturbing from a variety of viewpoints. You mentioned that it could impinge upon monetary policy. It certainly will impinge, in some respects, on the safety and soundness of the system. Most broadly and clearly, you are dealing here with the appropriate evolution of the banking system and fi- nancial system generally. What kind of a system do you want to see? What we have is a circus going on of every bank lawyer in the country, and I guess more lawyers want to become bank law- yers Mr. WYLIE. Yes. Mr. VOLCKER [continuing], Reexamining every law that is on the books to see what sunshine is seeping through gaps in particular pieces of legislative language and how they can move in new and different directions and directions that, by common assumption, the legislation prohibited in the first place. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 You see it in the nonbank bank area, a so-calied loophole where- by the basic congressional policies to separate commerce and bank- ing can be violated. You see it in the interstate area, where inge- nious theories are advanced as to how banks can move across State lines against what was thougnt to be the doctrine of banking law. You see a great rush by the States to provide all sorts of powers for their financial institutions, banks ana savings and loans, certainly not consistent with any interpretation of what Federal policy has been in tiie past. If Congress doesn't move, trie world is going to move. The world is moving. The question is wnether it is moving in directions that you would like to see or tnat anyone would like to see in terms of taking a comprehensive view of the system. It is moving by default and it is moving in awKward ways trirougn peculiar channels be- cause it Has got to move around the oostacies of present law. It seems quite evident to me that if you want to exert any influ- ence over this process, you had better move to legislation; that is urgently needed. I know that you have introduced legislation that constructively deals with some aspects of this. Mr. WYLIE. Yes. Mr. VOLCKKR. Mayoe I ougnt to put it this way: Congress is acting by not acting, because the world out there is moving. If you want to exert some public policy direction over tnis movement, now is the time to uo it. I will tell you, we, as regulators, as one set of regulators, are constantly put in a position of interpreting constitu- tional issues tnese days; we are, in effect, wnatever way we act, making Damdng policy. We would like some instructions from the Congress aoout which way you want us to go, oecause we don't think tnat we should be doing this througn interpretations of out- moded, existing law. That is not at all to say tnat some of the directions in which events are moving are not constructive. Take the interstate issue. I think tiiat there ought to be some liberalization tnere. But forcing it tnrough some peculiar criannefs of doubtful legality seems to me to have notning to be saiu for it. Mr. WYLIE. I think I appreciate your encouragement ana admoni- tion that Congress should act fairly early on to establish some better guidelines in the delivery of financial services. As you stated a little earlier, Mr. Chairman, this country has been incurring enormous deficits in its traue with its foreign partners. How is it that the U.S. locomotive and its importation of foreign goods has not been more effective in generating more of a recovery, particu- larly in the countries of Western Europe? Mr. VOLCKER. I think the premise of your question, and I think it's quite proper a premise, is that wiiat stimulus we have seen aoroau—arm we nave seen some growtn aoroad—nas oeen in con- siderable part directly related to the fact tnat tney have such fa- voiaDie export marKets in trie United States currently. That has been constructive. Your question is why don't they have a little bit more home-grown growth. Mr. WYLIE. Yes. Mr. VOLCKER. Ana tnat is a question that I have asKea myself repeatedly over this period of time. I think we nave to recognize, p&vchoiogically and otherwise, a. situation in which the United Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 States is attracting so much of their capital, which is reflected in a depreciating exchange rate for those countries vis-a-vis the dollar, is a factor inhibiting them in some instances, rightly or wrongly, from applying more stimulus at home. More broadly, they have all been struggling with inflationary problems inherited from the past. They have all—I speak general- ly—place a lot of priority on bringing down inflation with very con- siderable success, even in the face of depreciating currencies. Our success in inflation is made easier by the fact that we have an ap- preciating currency. They have, at least vis-a-vis the dollar, a de- preciating currency. That's made it more difficult. But they've had a high measure of success. They have fairly uniformly thought their budgetary deficits were too big as a structural matter, so they have been making great efforts to reduce their budgetary deficits and, in the process, there hasn't been much stimulus. Monetary policy is certainly affected by the condition of their currency. They have been trying to reduce budgetary deficits. They have a capital outflow, so they haven't been operating, I think it's fair to say, in the most favorable environment. Nonetheless, I think your question is a very relevant one, and it does seem to me that there are opportunities in some of those countries, particularly the coun- tries with the strongest external positions—Japan, Germany, to some extent—perhaps to take some stimulating action, perhaps by way of reducing taxes. Some of them have some plans for reducing taxes. The question arises, could they be speeded up? They have a certain amount of preoccupation with structural problems in their labor market. I don't think there's any question to the extent they can deal with those, work on those, get a more flexible economy, they will be assisted. Those measures take some time. I don't think they offer any immediate remedy. So we are left with a situation where the prospects for growth in most of the industrialized world is reasonable, if you just look at the percentage growth numbers. Bui those percentage growth num- bers by and large are not big enough to reduce unemployment levels that average much higher than our unemployment levels now—historically, very high levels of unemployment. Mr. WYLIE. Thank you. Thank you, Mr. Chairman. Chairman FAUNTROY. The time of the gentleman has expired. Mr. Cooper. Mr. COOPER. Thank you, Mr. Chairman. I would like to welcome Chairman Volcker as well and I appreciate hearing1 your testimo- ny, getting a chance to ask you a few questions. Probably the most publicized economic circumstance of the last couple of weeks has been the farm crisis. I have heard figures men- tioned as high as $150 to $180 billion of liabilities out there in the farm sector. 1 have heard talk from the farm credit system that there could be circumstances under which they would not be able to survive economically. How would you categorize the threat of a real farm crisis? Most farm debt, as 1 understand it, is not Farmers Home; it's commercially financed by banks and other institutions. Assuming trie worst happened, how close do you think we are from a farm crisis? How serious do you think it would be? What impact do you think it would have? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 100 Mr. VOLCKER. For many farmers, it is a crisis. I don't think there is any question about that. They are under enormous financial pressure and strain, if they are heavily indebted. It's almost as simple as that. Let me put it that way, because the value of the asset is going down—if they went into this period with a debt ratio of upward of 50 percent, it is very hard to service that debt without simply borrowing more money and driving the ratios still higher and digging yourself in a deeper hole. A certain important fringe of farmers was heavily indebted, is heavily indebted, and is under ex- treme pressure. The numbers that come to my mind are about $200 billion of agricultural debt, of which the farm credit system has something short of $80 billion. Their assets may be close to $80 bil- lion, but their debt holdings are less than that, as I recall it. The Farmers Home Administration, which, of course, is a Gov- ernment agency, has, I think, something on the order of $40 billion. The actual commercial debt in the banking system is by compari- son only between $40 billion and $50 billion. Life insurance compa- nies, individuals, and others, hold the remainder. Obviously, this is a threat to some rural banks that have heavy exposure in this area; it is a very serious problem, not only for those banks, but po- tentially for the communities that they serve. I do not believe that this necessarily sows the seeds of a more general banking problem. These are mostly small rural banks that are pretty much fully insured by the nature of their business—as far as the depositors are concerned. In many cases, even if the bank failed, other banking resources would be developed in those communities. That may not be the case in some of the smaller com- munities where it becomes a community problem if the bank goes out of business. We are in the very fortunate position that these rural banks, his- torically, have been among our strongest. They are well capitalized. They have been profitable right up until now, more profitable in relation to their assets than the bigger banks. They will experience some pressures and, undoubtedly, there will be some failures, as there were last year. But they do come into this period with a sub- stantial financial cushion. And I think the same thing can be said about the farm credit system which has a high capital ratio. The weakest loans tend to be the ones—and this is a matter of degree—in the Farmers Home Administration, which, of course, is a Government agency. However, it doesn't raise the same problems of financial threat that would be present in the private markets. Mr. COOPER. Well, I hope, certainly, that the situation does not turn out to be one that spreads and can be confined to isolated, smaller banks. And I hope also, as you point out, that the smaller banks do have adequate capitalization. The second question—regarding full employment. When I was in school, not too long ago, we were taught that full employment was 3 or 4 percent. Today, it seems to be substantially higher than that, and I can understand that. I just want to know, from a theoretical standpoint, what structural changes do you think have taken place in the American economy that might mean that for the foreseeable future, that full employment would be at the level of 5 or 6 per- cent? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 101 Mr. VOLCKER. I think the changes that many analysts have pointed to in the past, perhaps most particularly during the 1970's, was the enormous growth in participation of women in the labor force. Also during that period there was enormous growth in the labor force and in the population, which meant a lot of young people who tend to have, at that stage, less permanent attraction to jobs, and more movement, more difficulty in getting jobs in the short run. There were some rather basic demographic forces at work in the 1970's that most people think were pushing up what I might call the natural rate of unemployment. Some of those forces may be reversing themselves. It may be that during the decade of the 1980's, the analysis that suggested that reasonable full employment used to be 4 percent, has now risen to 6, to 6J/2—I suppose some people might say 6 to 7—may be going back down in the other direction. I haven't got any fixed and firm view about that. I think that is something that we find out over a period of time by experience. Chairman FAUNTROY. Thank you. Mr. COOPER. Thank you, Mr. Chairman. Chairman FAUNTROY. Mr. Hiler? Mr. HILER. Thank you, Mr. Chairman. Chairman Volcker, I think it was maybe when you testified before the other body's Banking Committee, that you indicated that the easing of money which had started in the fourth quarter of last year Mr. VOLCKER. It started in the third quarter. I interpreted it as less pressure on bank reserve positions. Mr. HILER. Starting during the third quarter, that less pressure was going to—those instructions were going to be changed possibly to maintaining the current pressure and basically to stop the easing, but maintain the current pressure. Mr. VOLCKER. I would repeat what I said last week. That is not the equivalent of tightening. Mr. HILER. Without saying whether that is tightening or loosen- ing, what caused you to make this determination? I mean, what was it that you saw, that the Board saw, that you felt justified Mr. VOLCKER. Let me cite several of them. One, quite clearly, in terms of taking the monetary targets as a basic point of departure, is that since November, the money supply in all its measures, and debt as well, has been rising rapidly, at a rate that, if sustained— that's a big if, but if it were sustained—would produce results over a longer period of time well in excess of our targets. The committee has not been alarmed, if that's the right word, as I said last week, by the current level of the various M's. But the trajectory has cer- tainly been a fairly rapid increase in recent months. At the same time, I think if one looked at the broad economic indicators, there was some evidence of renewed strength—greater growth in the economy—so you were not dealing, it appeared, against a weakening economic situation. One factor that I think has gone in the opposite direction through this period has been the performance of the dollar in the exchange markets. That has been a moderating influence on any tendency to go in the other direction, which we haven't done. Mr. HILER. So that if I can try to extrapolate from what you said, that it was the appearance that the economy was growing a little Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 102 bit better and that the growth rate of Ml in the period of the last part of the year had been picking up steam and Mr. VOLCKER. I would say all the M's; yes. Mr. HILER. All the M's, and taken over a year, that the M's growth rate higher. 1 am curious. The Ml growth for the year was 5.2 percent. So that when you took the 12 months overall, that is all that it went up. There were periods there where—in fact, I think for the last 6 months, Ml has only gone up about 3.2 percent or so, hasn't it? Mr. VOLCKER. You could probably find some 6-month period. However, if you began at the beginning of the year, there was never any time that it was that low, but you can probably find the 6-month period during the year; yes. Mr. HILER. Well, I was thinking that the last economic indicators book from the Joint Economic Committee indicated that the last 6 months have been in the low 3 percents for Ml growth. Mr. VOLCKER. I don't recall the exact figure. But if you took June as a starting point, which is a relatively high number, there was basically no growth or very little growth for 4 months, following a high figure. That is right. Mr. HILER. What impact does—in other words, when the Board meets and they look at things like what is happening with com- modity prices to include metals and gold and other metals, look at land prices, what impact do the falling commodity prices, falling land values, have on the determination of the proper Ml or where to try to hit within the target of the M's, so that you corne up with the sustainable, however you might deiine that level of growth, consistent with some stability? Mr. VOLCKER. 1 don't honestly think I can answer that question in a really satisfactory way, because you are asking me to read the minds of 12 members of the FOMC and how they weigh this kind of thing. I am puzzled about that myself sometimes. Mr. HILER. Since we are not in on the meeting and hear about it quite laie after the meeting takes place, you are the best one we have to ask. Mr. VOLCKER. I will try and answer, but I will tell you, I can't answer you with great precision. There is no equation and no for- mula out there, and I am sure different people do weigh it differ- ently. In general terms, the kind of events that you recite—falling commodity prices, falling land prices, and so forth—I interpret them, anyway, as reducing short-term risk of a reignition of infla- tionary forces and as a sign that attitudes, behavior patterns, ex- pectations are changing, and that's got favorable, as well as other aspects to it. So, if you just look at that, that is not so much, although it could affect intelligent people's thinking, but I would think it affects less the kind of targets for the year that are set in a longer term per- spective than it does the tactical decisions, the implementing deci- sions within the year as to how much to restrain or ease at any particular moment in time. Mr. HILER. If I might just conclude, Mr. Chairman, my lime has expired. So that maybe you could answer in a word, yes or no. Then it would be the Board's opinion that the commodity prices, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 103 land prices, et cetera, fall not due to aspects of monetary policy, but extraneous to monetary policy—— Mr. VOLCKER. No; 1 dun't think that is an either/or. They cer- tainly react to monetary policy as well. They certainly do. Mr. HILER. Thank you. Chairman FA UN TROY. Thank you. Mr. Carper. Mr. CARPER. Thank you, Mr. Chairman. Welcome back to this subcommittee, Mr. Chairman. I'd like to just start off by saying that recently, in his Stare of the Union Message, President Reagan seemed to signal that he was in favor of the notion of tax reform, tax reform that would promote economic growth, presumably lowering unemployment, presumably reducing Federal budget deficits. Subsequent to that speech, in an interview with the Wall Street Journal, he also apparently sig- naled that he didn't really understand that part of the Treasury tax proposal that called tor increasing taxes on businesses, while lowering, generally lowering taxes for individuals. We understand he is not a real oetaii man. [Laughter.] I don't know what your reputation is as a detail man or not, but I want to just ask you some questions, if you don't mind, about Treasury tax proposals, particularly those that relate to capital ac- cumulation, some aspects of the proposals that deal with changes in investment tax credit and ACRS and capital gains. Have you had an opportunity to think through any of those proposals and how they may or may not affect pur economic expansion? Is that the kind of tax reform that you believe is likely to lead to stronger economic growth? Mr. VOLCKER. I certainly have not looked at those in detail. I don't consider myself a tax expert particularly. It is clearly out of my area of responsibility, so I'm not going to give you a very full answer. I can say that the general thrust of the tax reform effort to broaden the base and lower the rate seems to me cesirable. There is only one point of detail, if it is detail, that I would comment on from the standpoint of my responsibilities, and that is 1 do not like all this movement toward indexing. 1 think that that has unfavor- able connotations for long-term policy. A lot of countries have gotten themselves into an immense amount of difficulty by think- ing that they can cure problems by indexing things instead of by dealing with the basic inflationary problem. As a matter of general philosophy, I would rather adopt econom- ic policies that provide some reasonable assurance we are not going to have inflation; that is, that we not go running around trying to index everything. Mr. CARPER. All right. Thank you. A couple of my colleagues have already talked about the strong dollar and what tiiat does with regard to our ability to export and to sell abroad. Some of us believe that large budget deficits have an effect on strengthening the dollar. There are other factors that also affect or lead to the overvalued dollar. Could you just assess for us in your own judg- ment what are the factors that have led to the overvaluing of the dollar and maybe set them in some kind of priority? And finally, if 1 could just add, which of those do you think we in the Congress can and should do something about? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 104 Mr. VOLCKER. I think the answer to the last part of your question is quite clear. To the first part of your question, 1 can only answer that there must be a great many factors at work. The classic fac- tors of what your current account is doing and what your trade balance is doing I don't think are absent, but certainly the move- ment in the market is quite contrary in direction to what you would normally expect from a weakening trade balance in the short run. The other factor that is typically cited and that you can measure is interest rates. Our interest rates are relatively high in nominal terms and in real terms and that undoubtedly helps attracts cap- ital and keeps American capital here, as well as attracts capital from abroad. But that also, I would think, is clearly not the only factor at work, and it may not even be the absolutely dominant factor during this period. We had some very substantial declines in nominal interest rates at least during the fall and the early part of the winter. And, during that period, the dollar on balance contin- ued to rise. I think there is a sense that because of the stability of the Amer- ican economy, because of our political stability, because of the ap- parent opportunity for profits, flexibility, there is a lot of emphasis recently now placed upon the United States as a good place to have your money or your capital in real form. But I think I have to emphasize also that everything is relative in this business, and there's a certain amount of pessimism about prospects elsewhere. That could change, consistent with the same prospects in the United States that would tend to shift these flows. Certainly, the absence of bank lending abroad, on balance, in any real size, is a reflection of distress in other parts of the world, as much as anything else. You raised the budgetary question in this context. I would say it is against the background of a good deal of confidence and growth in the United States where the budgetary deficit, by helping to keep pressure on our interest rates and our financial markets, has contributed to the capital inflow. And the capital inflow, in turn, has helped to finance that budgetary deficit. There is kind of a symbiosis between the two; they live off each other. Unfortunately, I think the end of that road is not a very pretty picture, as I dis- cussed earlier with Mr. Neal. You asked me what the Congress can do constructively. You can do various things to get the dollar down. We could run a bad mone- tary policy, an inflationary monetary policy. That will get the dollar down, quicker than anything else, maybe, but it's not a very constructive action. I could imagine some actions that you would take that would not be very constructive, and because they were considered destructive, the dollar would go down. The question is what constructive things you can do. What is consistent with the health and growth of our own economy? And the answer to that seems to me crystal clear: you can deal with that budgetary prob- lem. Mr. CARPER. Thank you very much. My time has expired. Chairman FAUNTROY. Thank you. Mr. Leach. Mr. LEACH. Mr. Chairman, last week, in your conversations with the Senate and the President's press conference, some comments Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 105 were made that have been widely reputed to have caused the dollar to go up. Would you care to say anything this morning to cause the dollar to go down? [Laughter.] Mr. VOLCKER. It's certainly risen a lot, and the danger of all mar- kets is that what rises excessively at some point may fall. Mr. LEACH. I understand. Let me comment a bit parochially from my State of Iowa's perspective. You mentioned earlier, and I think a little bit glibly, that lower monetary growth may be consistent with stability. I'm not sure that's true for all of America, and it's certainly not true in the heartland. I mean, we know that a lower monetary growth has caused the value of the dollar to rise, if one assumes the value of the dollar is determined by supply and demand and as the dollar goes up, the price of corn and soybeans goes down, as occurred pre- cisely last week. And for other relationships, the price of hogs and cattle are going down as well. One of the offshoots of monetary policy, as well as the fiscal policy, that is pro-import and anti-export, is that it has been very good for the large money center banks that have lent abroad be- cause the only way they can be paid back is if other countries are able to export more than they import. I would stress that the problem in rural America is very much like that of a developing country, and that if one were to look at Iowa today, one would be looking at a State that should be seen as part of the Third World. The terms of trade have turned against us. Our banking system is in chaos. The farm credit system is about to reach comparable chaos. And the only way that we are going to be able to bailout our banks, bailout the farm credit system, is if we increase the return on investment to American farmers. That means, in essence, to bring stability to an Iowa farm economy. It very likely means to have a little more stretch in monetary policy. So the question I would have is is the Federal Reserve Board pre- pared in its policies to be as sympathetic in looking at a State like Iowa as a Third World problem as it has in looking at Third World problems? You know, 80 years ago a great midwestern populist sug- gested that the rural heartland was being nailed to a cross of gold. And I'm not sure that today, we are not seeing our farmers nailed to a cross of the inflated dollar. Mr. VOLCKER. I think it is considerably more complicated than that, if I may say so, Mr. Leach. First of all, you commented that the borrowing countries have to, in a sense, export their way out of the problem. There is a lot to that. I agree with that. But to avoid any misunderstanding, in terms of our own trade position, increas- ing exports from those countries count for a relatively tiny propor- tion of our problem. The overwhelming rise in imports has been from countries that are not underdeveloped, countries like Japan, Canada, and Western Europe. That is where the disequilibrium is so great. Mr. LEACH. I share that perspective and that is precisely why one brings dramatically into question whether the Federal Reserve Board is correct in assuming that stability will be enhanced by lower monetary growth, which I think I am reflecting precisely—— Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 106 Mr. VOLCKER. Let me get to that question and the awkwardness of our position. You can have as much monetary growth as is con- sistent with a trend toward stability in our economy. If we violate that precept, then you might get a declining dollar in the short run. but you are not going to get lower interest rates. You then have to ask yourself how we can finance this budget deficit? Now taking your question, if we do nothing but ease money, in effect. Suppose we no longer get this capital inflow from abroad precisely because foreigners think the Federal Reserve is now em- barked upon a more inflationary policy. You might argue that that environment would help farmers in Iowa. It is not going to help the homebuilder or the homebuyer or those looking to make invest- ments in areas of the economy that are already under strain. It would simply reshuffle the problems from one sector to another sector. That is why I do not think that that problem is susceptible to any easy or, I might say, difficult monetary measure taken in and of itself. You would have quite a different situation if, at the same time, we were operating in a direction to reduce those de- mands from the budgetary side, but that is not the situation that we have. Mr. LEACH. Well, I share your concerns. But one of the things— there isn't terrific economic consensus on this issue—a number of economists are arguing that a little greater monetary expansion will lower, not increase, interest rates. Mr. VOLCKER. Since the beginning of time, a lot of people have argued that inflation is the solution for every problem. But I think we have learned a pretty hard lesson on that score recently. Mr. LEACH. Well, I hear what you are saying to some extent. But I would also share that what is good for some parts of the economy is not good for all. And one of our problems right now is equity today. Mr. VOLCKER. I do not disagree with that point. You can always debate, at least marginally, whether the policy should be tighter or easier. I accept that point, too. But I would simply urge that the unevenness in impact is very real and extreme in the economy at present. I do not for 1 minute minimize those problems in the farm sector. They are very great—and basically stem from some imbal- ances in policy. You have to come back, I think, to the imbalance in the deficit. I do not know how the problems can be cured with- out curing that underlying imbalance. That is the basic thrust of my statement submitted this morning. Mr. LEACH. Well, I will not prolong this, other to say that I think most members of this committee are in sympathy with your issue on the deficit and we accept that, although it's unclear that lower- ing the deficit necessarily will cause the United States to become a less attractive place for foreign investment. It could become the very reverse. Mr. VOLCKER. I cannot predict the market. The dollar has obvi- ously gotten quite high. But you could tell me that if suddenly the deficit was reduced, people might have an added dollop or more of confidence—maybe more than a dollop—and that the short-run impact might be to send the dollar higher. I would say then that I think that is not the way the basic economic forces operate over a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 107 period of time and, at that point, your question about monetary policy becomes much more relevant. I can't respond to that situation because of the basic underlying imbalance that will shift the problem from one sector to another and that would have been taken care of if you did enough. Mr. LEACH. I appreciate your comments. Mr. VOLCKER. You have quite a different setting. Mr. LEACH. I would only conclude by saying, we are going to deal with a farm bill in the next few days in the Congress. It is of trivial consequence compared to what you decide at the Federal Reserve Board. And all I am suggesting is that we from the farm States are hopeful for a great deal of concern reflected in Federal Reserve Board decisionmaking. Thank you. Chairman FAUNTROY. The time of the gentleman has expired. Mr. Erdreich. Mr. ERDREICH. Thank you, Mr. Chairman. Chairman Volcker, I appreciate your appearing before us again. I am trying to get some perspective on where we are to get some idea of what we should be doing. Would you give me some guidance as to what, in your view, are the specific policies enacted by Congress over the last 3 or 4 years that have been a driving force toward the recovery that we are now experiencing? Mr. VOLCKER. I suppose I would have to say that, while it reflect- ed no single act, or even deliberate act, on the part of the Congress, that deficit pours out a lot of purchasing power. When you start in the middle of a recession, it gives some driving force to the econo- my. Carried into the prosperity phase of a cycle, it gives rise to very considerable distortions in the economy. Mr. ERDRETCH. So you are saying that if you look back over the last 3 or 4 years, the major activity of Congress in producing these huge deficits is what has pulled us into recovery? Mr. VOLCKER. That is not the only factor. Mr. ERDREICH. Is that the major one, though? Mr. VOLCKER. It is a factor. There are natural forces in the econ- omy. I hesitate to give monetary policy credit, but it has been per- forming during this period, too. Mr. ERDREICH. Correct, however, I am just looking for legislative acts of this Congress over the past few years. Mr. VOLCKER. Correct. Mr. ERDRKICH. I would agree that monetary policy has been a part of that force, and it is why we are where we are today in 1985. I am trying to get some sense, though, of what you would suggest that Congress should do as far as legislative action to assure con- tinued recovery beyond what, I agree is the necessity to push the deficit down. Are there any other specific acts that you would urge that we proceed upon besides the deficit reduction as legislative acts of this Congress? Mr. VOLCKER. Certain things, I must confess, and let me take the opportunity to say them, come to mind as to what you should not be doing, such as yielding to protectionist pressures. That is an- other kind of short-run response you can make to this basic imbal- ance. But I think it would be totally counterproductive over a period of time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 108 I think what you can do to work toward improving incentives in the economy and improving efficiency in the economy. Both are always helpful. It works over a longer period of time. The tax reform proposals go in that direction. I think that they can be of assistance in a very basic way toward a stronger economy in the future. I don't think the economy needs any other actions I can suggest. Compared to reducing the deficit and dealing with some of these basic tax issues, I think other suggestions pale in significance in terms of impact on the growth and health of the economy over a period of time. Mr. ERDREICH. Last year, you told us that foreign capital in-flows would be about $80 billion. What was the actual amount last year, and what are your expectations this year? Mr. VOLCKER. I probably expected $80 billion last year. It turned out to be $100. I suppose our expectation on the present trajectory would be somewhat above that. I don't have any particular figure in mind. It is still rising. Mr. ERDREICH. So that would be better than half. Mr. VOLCKER. What you are running into now, even if the trade balance stabilized, and I do not think it has yet, is that you will begin paying the interest on all the debts that we incurred last year. Thus the current account will get worse faster than the trade account gets worse, and it is the current account that's the meas- ure of the overall capital inflow. So you are at $100 billion and moving higher. Mr. ERDREICH. Do you expect that that will then finance about half our deficit? Mr. VOLCKER. If you just offset one against the other, yes. Mr. ERDREICH. Do you also expect the value of the dollar to stay about at its current level this year? Mr. VOLCKER. I have no particular expectation on that score. Any expectation I had a year ago would have been wrong, and I will not make any prediction this year. It has gotten very high, as you know. Mr. ERDREICH. All right. Thank you, Mr. Chairman. Thank you, Mr. Chairman. Chairman FAUNTROY. Mr. Chandler. Mr. CHANDLER. Thank you, Mr. Chairman. Chairman Volcker, you have alluded throughout your testimony to the foreign invest- ment and the $100 billion that came in last year. I would like to focus on that and, again, your opinion of what potential is there for that foreign investment to diminish or go away; in other words, for that figure to become perhaps even a negative. And, if it did trend in that direction, what would be the result of that occurring to our economy? Mr. VOLCKER. Let me distinguish between two events, if you will. The incentive to put money in the United States could in time prove to be quite fragile because, it is dependent, probably encour- aged in part, by expectations of a strong dollar. If those expecta- tions change, if something arises either in the United States or abroad to change the relative assessments of where it is best to put your money, this thing could change rapidly. And, if the dollar began declining, expectations would run against you. We do, obvi- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 109 ously, operate from a position of considerable strength. There is a good deal of confidence in the United States. I also would not expect in the foreseeable future conditions where our banks or others will begin investing large amounts abroad again, as they did during the 1970's, which is part of the reason the net inflow is so large. But when you ask about actually slowing down the capital inflow or actually turning negative, let me say we cannot do that in the short run. The only way we can export capital is by running a cur- rent account surplus. That is the only way that we can finance, on balance, the capital outflow. People might try to take their money out, but, on balance, they cannot unless they are also willing to take our goods. And it takes a while for the trade balance to change. Even in the most favorable circumstances, it changes rather sluggishly. So, in effect, we are hostage to or hooked on for- eign capital for a while. When y,ou ask about the motivations to send in the foreign capital, you are really raising a question as to what is the price? What is the price in terms of the exchange rate and what is the price in terms of the interest rate? Quite clearly, it seems to me, one of the hazards we are running, is that if those motivations changed importantly and we didn't so easily get the increasing amounts of foreign capital that we are going to need, the impact on interest rates could be quite decided and then the pressures come back on the domestic market and you get the squeezing and the crowding out that people feared on do- mestic investment. That is precisely the risk. Mr. CHANDLER. That was the answer I was interested in and I very much agree. Now, you stated earlier that there tends to be a disincentive be- cause of the lack of confidence abroad. Yet, you said that some of those governments are taking steps to turn that situation around. Also, if the United States does deal decisively with its deficit, that would, in effect, have downward pressure on the strength of the dollar. Then does that, in a sense, create this disincentive to invest here that you referred to? Or are we chasing our tail here? Mr. VOLCKER. But that is in a quite different setting, ideally. It would be wonderful if things worked out that smoothly. However, if you had reduced demands on our internal market from a reduc- tion in the budget deficit, moving along more or less in line with reduced capital inflow and a stronger trade position, a reduced trade deficit, then you do not have these adverse implications for the domestic financial market because you are relieving the pres- sures on the one side as they are being potentially increased on the other side. That is precisely my argument. That is why I urge that you get prepared for this situation. Mr. CHANDLER. So that the bottom line is, deal with that deficit or face higher interest rates, or depend upon an increasing flow an- nually of this Mr. VOLCKER. Precisely. And I cannot predict when that flow might stop. But in the best circumstances, it is an aggravation of what we have now. The economy looks all right in some overall sense, but it's increasingly dependent upon foreign capital inflows, which is the same thing you are saying: bigger trade deficits with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis no increased strains on all those sectors of the economy that are relat- ed to trade, including agriculture. Mr. CHANDLER. Yes. At some point it's going to go "sproing." Mr. VOLCKER. It will not if we took the right actions. Mr. CHANDLER. But without it, it is going to say "sproing." Gee, I wish you'd let me get quoted there, Mr. Chairman, saying ''sproing." Mr. VOLCKER. "Sprawling" was the word you used? Mr. CHANDLER. "Sproing," like a spring going— sproooooiiinnngggg. [Laughter.] Mr, VOLCKER. It's an increasingly uncomfortable situation. We are putting ourselves at unnecessary risk, in my judgment. Chairman FAUNTROY. Thank you. Mr. Frank. Mr. FRANK. Thank you, Mr. Chairman. I want to ask you if you would address some of the criticisms that have heen leveled at your work. There have heen some gains, but there also are some critics. Recently, within the last year, we were told that the Federal Re- serve Board's destabilizing actions have to stop and that we need coordination between fiscal and monetary policy, timely informa- tion about Fed decisions, and an end to the uncertainties people face in obtaining money and credit. Does that seem to you a fair criticism? What can we do about it? Mr. VOLCKER. It is a little too general for me to respond. Which aspect would you like me to address? Mr. FRANK. I am reading from the Republican platform from 1984 on which President Reagan ran. So it is a little hard for me to supply more specifics. Perhaps my colleagues on the other side who also ran on that can give you some of those specifics. [The "Text of the 1984 Republican Party Platform on Monetary Policy" under unanimous consent by the subcommittee was insert- ed in the record hv Congressman Frank at this point:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Ill Text of 1984 Republican Party Platform f ECONOMIC FREEDOM AND PROSPERITY It I,H- (.,'-. -HI,! ihii mi-r" mii-i h.,:t Moilplaiv Pdlitv PRFA MBLE l^*n, *"'^:.*^™<^,^ mf.^ 3^," "C'M ',',' ^ in- ,,t r,,. An-..-r r.'i' [,v,,:,:r ml! df^a(> n- .1!. -l^t flt „ 'I hptreai !»-!<- ,,< (Mmiui^ii.n iv.u-i he |jrouivl*<,rl( for ., ^' »ra ..f n-,-|iPriH aimirmlissu.fi 11,111 '•>, t,p,nif win. t n-e ami rctiiifuie mlVunin „ ,,,-K il,5 f,r,t -n-n :n i,|i|)iM..nirk IP- all ,,,h,-i, H all human H-u-Nnnn'-nt sr,,,,,ld hf- »'..-i h a fin'lar in 'h- ful'iri; Tin- fiiint-. Er. .>i';-. (MM Er'>.i-k F'rr-idfiv nh.i *,,uii<ipd In ,"> .,-a-m „„],„' IlrnpK ,nf(,r:iis1 i.m abi>iit F-d de(.i- u,nip- pn.jjt-« walkfd h,- uss inr,, a hosmtsl and r;-."rr- sl(1r,s and an end 1' the kinrirtamtirs pe(> I..IK a-ujpd ihf Mii-1.1 NIHI lit .mil In- pic tare in chlaimns: rrmnev and m-di! The Thi^ is n.,I t;.rT.e al,.'i i, I l.ini LM ]• .- tounm »,.ula nH bi Oi-lfrred trinn Ilitir f.olrf Mandard ma\ lie a useful mechanism pmljlein-. no matte: h.™ dilf.,'1.1. , .,- uunlnan Tlallorrn jupnil n-.tai-.ir.i; and needed to instasn pn.-f stability li- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 112 Mr. FRANK. We do have a situation where the Republican plat- form says that your destabilizing actions have to stop you and your colleagues. It says that we don't have coordination between fiscal and monetary policy. We don't have timely information about your decisions. And we have too many uncertainties that people face in obtaining money and credit. It seems to me that that's a criticism from a fairly substantial source and we ought to get some response to it. Mr. VOLCKER. You all understand I did not write the platform. I'm not an expert on Mr. FRANK. No, I understand that. But you realize, objective rules Mr. VOLCKER [continuing]. The exegesis of what it means. Mr. FRANK. Objective rules—we don't only have to ask you about things you said. Mr. VOLCKER. I understand. But I would like to understand the question. We'd better take it up in parts. What is part No. 1? Mr. FRANK. Is this the first time you have addressed this? I mean, the Republican national platform on which the President runs makes this solemn statement in August and it is now Febru- ary of the following year. It seems to me that I would have expected, frankly, a little more attention. I know party platforms are not holy writ, but they ain't chopped liver, either. I think you ought to pay a little attention to them. The first part is that your destabilizing actions must there- fore stop. Have you stopped destabilizing our economy? [Laughter.] Mr. VOLCKER. I have to deny the premise. [Laughter.] Mr. FRANK. Let me ask you in general, and I'm disappointed, frankly, that you are not going to join this issue. It is a serious issue. We have the President's party. They are in office making some fairly substa itial criticisms. Some of those have continued. You are aware that there have been criticisms. I think we may be having a situation where some people want to have their cake and eat it, too. They want to take credit for a tight monetary policy having reduced inflation, but they want to blame that same tight monetary policy because there are other problems. Those are questions that I think ought to be addressed. Mr. VOLCKER. I will try to address it, but I address it with some trepidation, not knowing quite what you refer to. Destabilizing—there has been a lot of criticism. It is a rather hoary old question about stabilizing the money supply month to month or quarter to quarter. The money supply was actually fairly stable last year. We have a relatively stable money supply relative to foreign countries. I do not, myself, think that stabilizing the money supply from month to month or quarter to quarter is the be- all and end-all of policy. Indeed, I think that could produce an un- stabilized economy, and I'm interested in stabilizing the economy more than I am in the money supply. Is that an answer to that question? Mr. FRANK. I think it's a reasonable answer, although, again, I am a little puzzled that you seem to think that somehow you are surprised to be asked to respond to some fairly fundamental criti- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 113 cism. Have you asked some of the people over there what they are worried about? Let me put another one because the answer probably is no. There have been criticisms voiced publicly—I assume you have heard some of them privately from some people in the administra- tion—that you have been too tight in the monetary policy at vari- ous parts of the year. Your own Vice Chairman, Mr. Martin, has indicated some of that. I wonder if you would care to respond to that. Let me just ask you a specific question. Is it your impression that the administration, specifically the President, has been supportive of your monetary policy actions in these past couple of years? Have there been a series of—and have there been any disagreements and what were they? Mr. VOLCKER. Obviously, there is some disagreement. But if you ask me, broadly, are they supportive of the general thrust of the policy Mr. FRANK. No, I didn't ask you broadly because you don't like broadly. I asked you specifically. Mr. VOLCKER. Specifically, I'm aware that criticisms have been made from time to time. You are aware of them, too. Mr. FRANK. Yes. Well, you have only read them? Have people not communicated them to you privately? I mean, we read in the paper suggestions, assertions, that mone- tary policy has been too tight, that the slowdown last year that we had Mr. VOLCKER. In fairness to me, and maybe to them, a lot of the articles I have read in the newspapers has been a concern that it might be, rather than it has been. Mr. FRANK. So you have not been told by the President, the Sec- retary of the Treasury, past or present, or Mr. Sprinkle or other major economic officials of the administration that you have been too tight and that the slowdown was in part caused by excessively tight monetary policy? No one has communicated that to you di- rectly? Mr. VOLCKER. I am not going to discuss all my conversations with the President. But I would think, basically, the answer to that before the event is "No." Mr. FRANK. So that representations we have had, I would infer from that, that some of these slowdowns weren't, therefore, be- cause you were out there independently doing monetary policy, are inaccurate. I think that's an important point because we get people—— Mr. VOLCKER. You get a different question as to whether people looking backward have a different view. Mr. FRANK. Oh, all right. Well, then, let me ask you a different question. Have they after-the-fact told you that you made some mistakes and did they on those occasions differ from your own analysis? Obviously, people make mistakes after the fact. Mr. VOLCKER. I do not think as directly as that. Mr. FRANK. OK. So that neither prospectively, nor retrospective- ly Mr. VOLCKER. You have read the statements in the paper, appar- ently, as much as I have. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 114 Mr. FRANK. Mr. Volcker, if all I wanted to do was read the paper, I would be at my office right now. 1 mean, I'm asking you to comment on these things. Mr. VOLCKER. I read the papers, too. We both read the papers and that is our common ground, then, as to what they said about our policy. Mr. FRANK. Well, all 1 can say, Mr. Chairman, is 1 am worried Will Rogers wasn't around if I just wanted somebody who all he knew was what he read in the papers. I suppose we might have had him to ask as a witness. I am disappointed, Mr. Volcker. There is a political point here, but there's also a substantive point. We have gotten suggestions, and more than suggestions, from the platform and elsewhere, that there are some differences between the administration and yourself on monetary policy. I think they ought to be discussed. I think your refusal to discuss them by saying, well, read the papers, isn't helpful. Mr. VOLCKER. I think you have to be a little more specific. I think there are differences in views in the administration as to what monetary policy should be. Mr. FRANK. I couldn't have been more specific when I asked you about the President, the Secretary of the Treasury, Mr. Sprinkle. And what you told me was, well, you're not going to discuss your conversations. I could read it in the papers. I mean, if I am too specific, that is no good. If I am too general, that is no good. So I give up. I am out of categories. How can you expect me to ask you questions? [Pause.] Chairman FAUNTROY. The time of the gentleman has expired. Mr. FRANK. Thank you. Chairman FAUNTROY. Mr. McCandless. Mr. MCCANDLESS. Thank you, Mr. Chairman. Mr. Volcker, I would like to shift gears for a minute, if I may, into another subject area—the mechanics of the banking, savings and loan industry from Chairman Volcker's point of view of the Federal Reserve Board. Do you see some things here in the area of, priority areas of policy change that we here in the Congress should be looking at as far as the mechanics of the industry are concerned? Mr. VOLCKER. Yes. Mr. MCCANDLESS. And if so, could you share some of those with us? Mr. VOLCKER. I think there are a series of issues that the Con- gress began to deal with last year that are still very much relevant and we so urgently need congressional guidance. We need guidance on this question of the loopholes that I touched upon a bit earlier with Mr. Wylie, the nonbank bank issue, for one. We clearly need some action there. It is not just a question of the banks, it is of the thrifts, too; a similar problem exists there. We urgently need, I think, some guidance about where the bal- ance of Federal and State authority is, where we have so many States going out providing very wide-ranging authorities. Indeed, at the extreme, saying a banking institution can do virtually any- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 115 thing, or a thrift institution can do virtually anything; what is public policy there? We clearly need movement on the interstate banking area and the powers area. It was among those developed last year. I think it's a logical and necessary complement to some of these other problems and needed legislation. There is a very sizable agenda that I think urgently needs action, because, as I said earlier, probably before you came in, that action is taking place. The only question is whether it's going to be through loopholes, as lawyers find their way through it, through uncoordinated regulatory decisions, or whether it's going to reilect some cohesive sense of congressional direction. That is what's lack- ing now. Mr. McCANDLESS. There appears to be, at least in my part of the country, a proliferation of institutions, both banking and savings and loan, new charters which bring about obvious things, such as eager management, higher interest payouts, easier loan policy, from the Federal Reserve point of view. Do you find this to be a problem? Mr. VOLCKKR. Sometimes, I find it to be a particular problem if there is a proliferation of semibanks or nonbanks, or whatever, that are operated outside the general framework of banking regula- tion and violate what I have always taken to be some basic pre- cepts of public policy. I think a mere variety of financial institu- tions can be a good thing if they come within some general frame- work of appropriate regulation and surveillance. Mr. MCCANDLESS. Are enough regulations on the book currently, in your opinion, to address this? Mr. VOLCKER. We have got lots of regulations. The question is whether Mr. MCCANDLESS. Policy, then. Policy, rather than regulation. Mr. VOLCKER. I think we need some policy decisions. There is a great deal of confusion out there as to what will be allowed in the future. People are going now where they think they can go, rather than within present law, which may be outmoded. That law needs to be liberalized in some instances. But it is very hard to defend what is going on now—that is institutions going through the cracks rather than doing what makes sense from the standpoint of either the private markets or public policy. Private markets are motivat- ed to go where they can go or think they can go legally. Some very novel interpretations of established banking policy are put forward. Mr. MCCANDLESS. And finally, Mr. Chairman, if I may, I would like to ask your opinion on how you think this foreign loan portfo- lio is maturing on a scale of 1 to 10. Mr. VOLCKER. Is one guod or bad? Mr. MCCANDLESS. 10 is a 10. Mr. VOLCKER. 10 means it is all solved? Mr. MCCANDLESS. Yes. fPause.] Mr. VOLCKEK, Six or seven, I don't know. There is progress both in the sense of improvement in the economic conditions and bal- ance of payments of the borrowing countries. It was very hearten- ing. There is progress in the sense of negotiation of some long-term restructuring agreements that I think are very positive. But I Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 116 think it would be a mistake to say that that progress last year means the problem is behind us. We have had some developments recently that illustrate very vividly that the problem is not behind us, that there are still many difficulties that could arise before I would be willing to give this a 9 or a 10, in the sense that you don't have to worry about it. It is going to be a continuing concern for these countries to achieve and be able to achieve—not only economically, but in a stable political context—a sustained pattern of growth and external equilibrium that you have to achieve in the end to put this problem behind us. There is a lot of short-term progress but a lot of long-term effort is still going to be required. Mr. MCCANDLESS. Thank you, Mr. Chairman. Chairman FAUNTROY. The time of the gentleman has expired. Mr. MCCANDLESS. Thank you, Mr. Chairman. Chairman FAUNTROY. Thank you. Before yielding to Mr. Vento, a member of the full committee, I yield for a unanimous-consent re- quest. Mr. FRANK. Mr. Chairman, thank you. I ask unanimous consent that the text of the Republican platform from 1984 on monetary policy be inserted in the record at the point at which I raised my questions. I am sure that none of my colleagues on the other side object to enshrining their party platform in the record of the hear- ing. Mr. HILER. Will the gentleman yield? Mr. FRANK. I will yield to the gentleman. Mr. HILER. Will that be as a dissenting view or a supplemental view? Mr. FRANK. It will simply be as an illustration to the public. Chairman FAUNTROY. Without objection, so ordered. [The text of the Republican platform from 1984 on "Monetary Policy," under unanimous consent by Congress Frank may be found of p. 111.] Chairman FAUNTROY. The gentleman from Minnesota, Mr. Vento, is recognized. Mr. VENTO. Thank you, Mr. Chairman. Mr. Volcker, the dollar value increases that have been going on obviously are causing serious difficulties. Do you have any plan to meet with your central bank counterparts in other parts of the world in the next weeks or months to address this particular con- cern? I note that there has been some intervention. I think in the past you have said that if there is a disorderly and unstable situation, that that would necessitate involvement. Is this disorderly and unstable? What are you going to do with regard to dollar imbalance, if anything? Mr. VOLCKER. I cannot tell you precisely what we are going to do. Do I have any special meetings scheduled or contemplated? The way I interpret your question, the answer is "no." But do we meet from time to time? Are we in frequent contact on the telephone? The answer is "yes." There is no shortage of ability to get together. Mr. VENTO. Have recent actions been coordinated with you or have you been aware of recent actions Mr. VOLCKER. Yes. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 117 Mr. VENTO [continuing]. To try and buoy up the various curren- cies? Mr. VOLCKER. Yes. Mr. VENTO. Have you got any reactions to those initiatives or ef- forts? Have they been helpful or harmful? Mr. VOLCKER. The proof of the pudding is in the eating. I cannot say whether there has been any dramatic success from recent ac- tions. I think there is a question of whether actions were taken forcefully enough, including any interventionary actions. Mr. VENTO. Did you discourage? Encourage? How would you characterize your response or advice to those that said they were going to take action? Did you take any action yourself or recom- mend that the Treasury of the United States take any action? Mr. VOLCKER. From time to time; yes. Mr. VENTO. You have recommended that the Treasury take action? You have encouraged the action of other central bankers? Mr. VOLCKER. You said recommended that Treasury take action. I do not know what action you are thinking of. There are two kinds of action that other countries have taken. Some of them have taken policy actions in the sense of monetary policy or other kinds of policy. And there has been intervention in exchange markets. Mr. VENTO. I am thinking of intervention. I am not thinking of their basic economic programs. Mr. VOLCKER. I am not sure that they are separable because I think intervention can be a useful tool at times. It certainly is a tool, in my opinion, that ought to be in our armory for use on suit- able occasions. At the same time, I do not think intervention is likely to be the answer to these problems standing alone. It has to complement more basic actions and more basic directions. Mr. VENTO. What happens if there is some decline in the value of the dollar, or rather, you know, almost as dramatic an increase in value or decrease in value as there has been increase in value with regards to the import question and inflation, Mr. Volcker? Mr. VOLCKER. I think some decline in the dollar would be of no concern in that sense. The dollar has gone up very rapidly recent- ly. If we retrace those grounds, I do not think that is a source of any disturbance. In the long run, it would moderate the adverse impact of this higher dollar in our trade position. If it began moving beyond reversing recent movements, it depends upon the rapidity of the move. It also depends upon the surrounding circum- stances, including that question of the deficit that we discussed ear- lier. But that is one of the risks in the outlook for inflation; I do not think there is any question about that. I know the FOMC mem- bers, in setting forth their projections this year, for instance, decid- ed, rather arbitrarily, to say, "We'll assume no important change in the dollar one way ov another in making these projections." Mr. VENTO. They are already wrong. Mr. VOLCKER. And particularly on the inflation side. Mr. VENTO. They are already wrong. Mr. VOLCKER. They are already wrong on the up side. That is right. Mr. VENTO. On the up side; yes. Mr. VOLCKKK. I think they were probably more worried at that time about the down side. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 118 Mr. VENTO. Doesn't this indicate, especially in this short period of time, a certain amount of volatility that is unacceptable from a standpoint of our economy? If this were to continue, this particular trend, over the next few months in terms of driving up the dollar, it seems like they're saying there's no ceiling in sight. Isn't this really going to necessi- tate a different response to intervention here, I assume in coordina- tion with other central bankers and coordination with the Mr. VOLCKER. I think that is a question that is constantly re- viewed. I do not like what has been going on in the markets and the volatility or necessarily the direction at this point. If I knew an easy answer to it, I would either apply it or recommend it. Mr. VENTO. 1 don't think there are any easy answers. I don't think an easy answer is the deficit or changes in the economy. I think this thing is getting out of hand and I'm concerned about it. I want to express that particular concern to you, and I realize the answer Mr. VOLCKER. 1 understand the concern. Mr. VENTO. You talked about the banks and the problem with Continental Illinois arid its liquidity problems. Can you give me any answer to the question of quantifiably, how much money is being raised now on a liquidity basis every day by U.S. banks in the international marketplace? Mr. VOLCKER. I cannot give you a figure offhand, but it is a very large amount. Mr. VENTO. What is the effect of that in the dollar imbalance question, Mr. Chairman? Do you attribute or ascribe any problems to the liquidity issue and the money being raised Mr, VOLCKER. It is related in the sense that banks go to the international market to raise money as a matter of course. They will press that money-raising process more strongly the more they need money at home, the higher interest rates are at home. In that sense, it is certainly related to the overall imbalance on our mar- kets at home, where we have an excess of demand relative to sav- ings. Banks raising money abroad is part of the process by which we balance out the internal economy. So, there is that underlying relationship. Mr. VENTO. I would like for the record an answer, the quantifi- able one, and I guess that one brief question is do you think that the tradeoff in terms of the higher interest rates has been a good tradeoff in terms of our economy? Is that a good tradeoff, the higher interest rates and deficit issue? Mr. VOLCKER. It is a tradeoff that we have been forced to live with. It is not desirable in the sense that I would rather have a different result, the lower deficit arid lower interest rates. I think that thai would be much more desirable in terms of the sustainable growth of the economy. Chairman FAUNTKOY. Thank you. The gentleman from Connecti- cut, Mr. McKinney, a member of the full committee. Mr. McKiNNEY. Thank you, Mr. Chairman. 1 just want to apolo- gize to the chairman. I had to be at another hearing. Since I wasn't here, 1 certainly don't want to take up his time. I also want to con- gratulate him on doing what I consider an absolutely superlative job. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 119 Mr. VOLCKER. Thank you. Chairman FAUNTROY. Thank you. In that regard, as we prepare to go to a second round, we did note, Mr. Chairman, that during the Humphreys-Hawkins hearing in the other body, Senator Prox- mire expressed the hope that you would remain as Chairman for the full duration of your term. Inasmuch as you have not given any indication of your intentions, despite the various press comments from time to time, I would like to express a similar hope—that you will serve your full term. While we have made much progress in our economy, there is still much work to be done and many hopes to be fulfilled and needs to be met. Thus I encourage you to contin- ue to take this challenge arid remain at your post. Mr. VOLCKER. Thank you, Mr. Chairman. 1 wonder whether I could mayoe give you an even more apropos quotation that Senator Proxrrnre had at that hearing when he quoted Disraeli. You may appreciate it at this point in the hearing: "The thing that has driven more men mad than love is the currency question." Chairman FAUNTROY. I see. Mr. Schumer. Mr. SCHUMER. Thank you very much, Mr. Chairman. 1 can tell you, Mr. Chairman, that love has driven me far more crazy than the currency question. [Laughter.] Mr. VOLCKER. I see where your priorities are. [Laughter.] Mr. SCHUMER. I hope so. [Laughter.] I am riot saying which has made me happier or sadder in my life. [Laugnter.] In any case, I have two questions. Before I do, I would just like to add my sentiments to those of Chairman Fauntroy. I think you've been an outstanding Chairman. I hope you will stay on. I think much of the credit that is given to 1600 Pennsylvania Avenue for this economic recovery belongs over at the Federal Reserve Board, not where it is being given. 1 have two questions. The President has put us in an almost im- possible position here in Congress, sticking to his increase in de- fense spending, wiiich we know will be dropped some, insisting that COLA's for social security be given, and then saying that we can reduce the deficit by totally eliminating some programs, which you and I know is politically nothing short of a joke because it just won't happen. That leads me to the conclusion that if we are going to reduce the deficit by $50 billion, which is the number that you have stated is required and all of us seek to do, we are going to have to have some kind of revenue increase, because we just will not eliminate the 17 or 18 major programs that the President has proposed. So our choice is really to increase revenues or reduce the deficit by less. If that were the only choice available to us, decrease the deficit by approximately $JJO billion or decrease the deficit by $50 billion with, say, $20 billion in revenues from an oil import tax or a corpo- rate minimum tax, which would you prefer? I am riot asking which taxes, but just the overall. Mr. VOLCKER. I do riot want to be pinned down on precise arith- metic, but I have expressed for many years the opinion—and I did it again this morning—that the more you can do on spending, the better from an economic standpoint. Do it all on the spending side. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 120 If you can't do it on the spending side and do some minimum mass, then I think you have got to turn to the revenue side. I don't want to get into a discussion of particular revenues, but to the extent that it can be done in a way that least hampers in- centives, I think the better off you will be. I also think the present tax structure, the present income tax structure, in particular, is very heavily strained with its relatively high marginal rates and lots of exemptions and all the rest. It's hard to put more pressure on that structure in its present form. That, I suppose, introduces the relevance of tax reform. Mr. SCHUMER. What would you think, without commenting whether you're for it or against it, but just giving us some param- eters to judge against, something like a 25-percent minimum tax on all gross income for all individuals, all corporations whose income was above $100,000? Mr. VOLCKER. I simply don't have the competence to Mr. SCHUMER. Fine. I didn't think you would. The second area of questions is IMF. In today's New York Times, there was a headline stating: "Rekindling Is Seen of Latin Debt Crisis." It leads me to two questions. First, do you think that the debt crisis is being rekindled? Do you think we have major problems ahead of us because of the failure of the banks to agree to the plans that have been offered and, it seems, the bucking by some of the Third World countries of the type of austerity demanded by the IMF. Even Mexico, which is in the best shape, has undergone a pretty severe recession, and may say they don't want to retrench any longer. Mr. VOLCKER. Mexico is growing again, which is a very favorable development, and I think Mexico will reach agreement on this third year IMF program and that restructuring will go through. But you ask, is the problem being rekindled? I would prefer not to use the word, "rekindled" because it was never out. I don't know whether the word, "crisis" is appropriate Mr. SCHUMER. There was a headline a few weeks ago that said Mr. VOLCKER. There have been fluctuations of opinion and com- mentary about this, but the problem has persisted. There has been some real progress. But a feeling of euphoria that the problem was over was never justified. We see some evidence of that now in a number of Latin American countries where they still have a real struggle in restoring the kind of domestic stability and equilibrium that is necessary, even to support the progress they made in the past. There has been dramatic progress in Brazil externally. There has been very considerable progress, I think, in improving the flexibil- ity of their internal economy, pricing policies, reduction in the budgetary deficit, for a period of time. At the same time, inflation has been rising. So long as that is the case, there's going to be a feeling of uncertainty about the permanence of some of this im- provement. For example, Argentina is still at a much earlier stage than these other countries and is clearly having difficulties in deci- sively moving through stage 1, so to speak, that Mexico and Brazil have been through. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 121 Mr. SCHUMER. The amendment that we passed to the IMF bill last year and all the other parts of the legislation, have basically been short-run solutions. Do you think it is about time that people like yourself, who I think deserve more of the credit than anybody else for seeing that this crisis hasn't blown up out of proportion, start looking at long-range plans. Don't you think that before the countries balk, if some of the little and then medium-size banks start balking, that we ought to have some long-range plan? What if the banks start saying that they don't want to put up more money to repay themselves? Mr. VOLCKER. I have no particular problem with what the banks have been doing. You have problems with individual banks some- times that are not in the cooperative spirit in arranging some of these programs. They tend to be isolated instances. When one looks more broadly at the financing side, I think a great deal of progress has been made, at least conceptually. None of them is fully in effect yet, but I think some of them will be shortly, in truly long-term restructurings at reduced spread. It seems to be directly along the lines of the approach that you were so strong in urging. I think there has been a good deal of progress on that side. When you look toward longer run solutions, I would like to think that we are doing that all the time. But it depends, basically, I think, on those countries getting their own economic policies in shape so that, in fact, they can look forward to sustained growth consistent with much reduced external needs for funds. They ought to be able to do that at that stage against the back- ground of a long-term restructuring so that they have a basis for planning ahead with some knowledge of what the external require- ment is. I think that side of the process has gone pretty well in the past year. Chairman FAUNTROY. Thank you. Mr. SCHUMER. Thank you, Mr. Chairman. I appreciate your let- ting non-subcommittee members ask questions. Chairman FAUNTROY. Certainly. We invited all of the committee members and I am pleased at the number of members of the full committee who have joined us or will be joining us for the remain- der of this hearing. Thank you. Mr. Chairman, on another subject, as you know, I have been con- cerned for some time with some of the trends in mergers and ac- quisitions, especially where it does not appear that the mergers result in improved efficiency or financial strengths. More recently, a trend has developed where various high-yielding, but unrated, notes or securities are used to finance some of these takeovers. Is this a healthy trend, in your view? Shouldn't financial institutions exercise some greater care in accepting these securities and in fi- nancing mergers or buyouts generally? Mr. VOLCKER. All these mergers are different and have different justifications and different financial characteristics. But to respond to your question, I have had some concern that in the midst of this process, insufficient attention may be paid to maintaining a strong financial structure, both from the standpoint of the surviving busi- ness and, more directly from my concerns, the point of view of the stability and strength of the financial institutions making the loans. My sense is, while it is very hard to judge in any specifics, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 122 that in the course of the last 12 months or so, there has been a somewhat more cautious approach by banking institutions, at least toward the dimensions of this financing, not just in mergers, but even more directly, in terms of so-called leveraged buy-outs and other restructurings of existing companies, where it has become quite the fashion in a number of cases to substitute debt for equity. This development has been important enough so that you can see it very apparently in the gross figures for both debt and equity. We had net retirement of equity last year by American corporations of something on the order of $70 billion, if I recall the figure correct- ly. There was some issuance of equity, of course. It suggests how much was retired. The other side of that is debt/equity ratios that get thinner, increasing when one looks at the overall shape of the financial system, its vulnerability to uncertainties, the inevitable vicissitudes of fortune. Chairman FAUNTROY. According to your economic projections, you assume that the Federal budget deficit would he reduced sig- nificantly in fiscal year 1986 relative to the baseline projections. I wonder what would be the effect of your projections if there is little or no deficit reduction? Mr. VOLCKER. I think it would increase the risk of the projection. I can't respond in quantitative terms. The presumption was that action would be taken, as you said, to reduce the deficit in 1986. That is beyond a period, except for one quarter, that's even covered by these projections. The assumption was that the climate of financial markets might be favorably affected, or at least not unfavorably affected by the failure to take action. If there is no action, 1 simply think it in- creases the risk during this period of some of the contingencies that I was talking about earlier, about the permanence of the cap- ital inflow, the possible consequences for domestic interest rates and the rest. The impact has to be expectational and psychological this year and, therefore, not definable. Chairman FAUNTROY. If reducing the deficit would be so advanta- geous, why is it that inflation and unemployment would show so little improvement in your projections. Mr. VOLCKER. Again, I suppose everything is relative. But I think most people would assess those as rather favorable projections, some reasonably substantial economic growth in the third year of expansion and no backtracking on the inflation progress and maybe some improvement on the inflationary picture—it doesn't look too bad for the third year of expansion. Chairman FAUNTROY. Mr. Salomon, who is now the former presi- dent of the New York Federal Reserve, said in a recent article, and I quote him, "The case can also be made that in the short-run, at least, the economic restraint exerted by actions to reduce the defi- cit should be actively offset by speeding up the money growth." Do you agree with his statement and do you view the open market as Mr. VOLCKER. I have to ask "speeded up" from where in the first instance. It has been pretty fast recently. But I would not make that presumption ex ante. I could imagine circumstances in which that might be appropriate. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 123 Chairman FAUNTROY. You also said that the open market projec- tions for the economy assume a stable, but high exchange rate for the dollar and substantial reductions of the deficit. Are these two assumptions consistent? For example, I believe the Fed's position has been that a substantial reduction in the deficit would help bring down the exchange rates of the dollar. Mr. VOLCKFR. Right. Over time, yes. Chairman FAUNTROY. Are you saying that reducing the deficit will not moderate the dollar's value, but simply—- Mr. VOLCKER. I think you may be reading a little bit too much into that assumption. The assumption about the dollar I think was simply an arbitrary assumption. It said there was an important movement that could have a significant impact on prices. Let us make a common assumption, and the most neutral assumption in some sense was saying, let us assume it is roughly in the area that it has been in recent months. I don't think it was meant to convey any economic policy content, or any judgment about the effects of deficits or the absence of deficit reduction action. It was an arbi- trary assumption. Chairman FAUNTROY. Am I correct in my interpretations that the Ml aggregate has been returned to its former place as the first- among-equals for the committee? Mr. VOLCKER. I think it often gets interpreted that way, but there has not been any formal action by the FOMC in that respect. Chairman FAUNTROY. In the report, there is quite a bit of discus- sion about the Ml velocity, including a projection that Ml velocity growth would be likely to be somewhat lower than the Mr. VOLCKFR. The current growth, yes. Chairman FAUNTROY. For this reason, it is suggested that the growth, and I am quoting you now, "growth in Ml and other mone- tary aggregates in the upper parts of their ranges may be appropri- ate over the year as a whole." Does this mean that the committee will be paying careful attention to the nominal GNP growth rela- tive to Ml growth and adjusting Ml growth as appropriate for the desired path of outgrowth? Mr. VOLCKER. We certainly look at real growth and the prospects thereof and we certainly look at price trends. You put those togeth- er and you are looking at the nominal GNP, but we do not have a particular target for the nominal GNP. As you know, our projec- tions came out with the nominal GNP on the order of TVs to 8 per- cent in the central tendency. If you had monetary growth in the upper half of our 4 to 7 percent range, to look at Ml, say the GVz- percent area, that would be consistent with very little growth in velocity over the year as a whole. Chairman FAUNTROY. I know that in the past, you objected to proposals that the Federal Open Market Committee specify its ob- jectives for nominal and GNP growth on the grounds that the Fed has too little influence over the growth of such objectives to be meaningful. I would, however, note that the growth of nominal GNP from the fourth quarter of 1983 to the fourth quarter of 1984 was 9.3 percent, almost precisely in the middle of the central tend- ency of the Federal Open Market Committee's projections for growth of 9 to 10 percent made in February of 1984. Not only that, but we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 124 Mr. VOLCKER. I think we did worse in July, didn't we? Chairman FAUNTROY. You certainly did. Mr. VOLCKER. It looked all right in our February projection. We should have stuck with it. Chairman FAUNTROY. Based on the record, either the Fed has been pretty lucky in your forecasts or it has had a greater degree of influence on the nominal GNP growth than you have admitted. I wonder which it is. Mr. VOLCKER. I don't think you would find that result in all ear- lier years. But I suppose, looking at the average, if we are reason- ably on course on money supply and, there are not unusual devel- opments with respect to velocity, you are going to find it falling within some general range close to our projection. I prefer to look at it as separate projections of real growth in prices because I think a lot depends upon the composition. Contrary to the expecta- tions we put down here, if one could imagine that we had a much better inflation performance than that central tendency suggested, it is not necessarily true that you would want to have the same nominal GNP growth, or vice versa. Indeed, as I said earlier, that might be a circumstance in which the total climate would suggest that you could have more real growth, but I would not attach any particular importance to hitting that particular target for nominal GNP growth. Chairman FAUNTROY. Thank you. My time has expired. I yield to the gentleman from Florida, Mr. McCollum. Mr. MCCOLLUM. Thank you, Mr. Chairman. Mr. Volcker, the target ranges that you have given to us in the back of the statement that you have delivered today indicate a couple of different ways of looking at target ranges. In fact, you al- luded to them in your statement—the cone method, supposedly, or the parallel or the band method. Mr. VOLCKER. Right. Mr. McCoLLUM. Some concern has been expressed to me about the results of following the two different methods and how they might vary in terms of the monetary policy. If you follow the cone method, you are following a pretty strict system. Mr. VOLCKER. Certainly in the early part of the year. However, there is not a substantial difference in the latter part of the year. Mr. MCCOLLUM. Right. But if you did follow the cone method more severely, rather than allowing things to go on for a while and then changing course, what would that do to the economy? In other words, do you believe this wider latitude is necessary? Mr. VOLCKER. Let me comment first that we have conventionally drawn these cones, and it has always aggravated me because they are very narrow at the beginning of the year. If you interpreted them literally, you would have to follow a very strict policy, as you put it. It would be a policy which is beyond our capacity—to keep money within that narrow a cone in the early part of the year. In fact, we have not done that. But you get a lot of commentary as to whether we are in or outside that precise cone. Maybe the best answer is some compromise between the two. I think this chart is another reasonable way of looking at it. It doesn't show that same implied, but maybe wrong, discomfort of being outside the cone. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 125 You ask what the consequences would be of following that very strict policy within the cone? One of the difficulties is it is different in the first part of the year than in the second part of the year when the cone is wider. You would be following a more rigid mone- tary targeting approach, as I say; I think, in fact, beyond our capac- ity. But you would have to be willing to give total priority to hit- ting, or trying to hit, a rather precise monetary number. You only have leeway of $3 or $4 billion even now within that cone. That is less than the fluctuation in some weekly figures. You are not going to hit it every week. But if you were absolutely bound and deter- mined to try to keep the monthly figure, let's say, within the cones, you would have to discard any other consideration in the imple- mentation of policy in the short run. Mr. McCoLLUM. Well, you would be adjusting every time you met as a committee and then maybe some on the telephone, too; right? Mr. VOLCKER. You would probably change your procedure. In our present procedure, we would have to have some method of meeting very frequently to change pressures on reserve positions. Mr. McCoLLUM. What impact would that have, for example, on the fluctuation of interest rates? Mr. VOLCKER. Extreme. Mr. McCoLLUM. So they would really fluctuate. Mr. VOLCKER. Yes. Mr. McCoLLUM. One other question I have related to the target- ing. You have targeted the Ml growth at 4 to 7 percent as a range for this coming year. And you have indicated, at least the commit- tee members apparently feel, that the estimated real GNP growth will be in the area of 3Va to 4 percent. Obviously, the real GNP growth is a very important part of any consideration of money policy. I am sure you would agree. Mr. VOLCKER. Correct, Mr. McCoLLUM. If this growth is at the higher end of that range or perhaps even exceeds the 4 percent this coming year, would you feel that the committee would revisit the targets? Mr. VOLCKER. No, I don't think that those projections are set forth as targets. And I could well conceive, hypothetically, of a situ- ation in which you got more real growth and everybody would be quite happy and it would be quite consistent with these monetary targets. That was not the best guess of FOMC members. But if things developed in a favorable way during the year, that is quite possible. Mr. McCoLLUM. So if you had a better real growth, that would not necessarily—in fact, it wouldn't—encourage the open market committee members to reexamine the targets and maybe making them broader—— Mr. VOLCKKR. Not necessarily. We always reserve the right to look at the targets and change them, and circumstances could arise in which that would be appropriate. But suppose you were getting more real growth. You were getting growth above 4 percent, maybe even comfortably above 4 percent. The price situation was develop- ing very well. The monetary growth was more or less on target. Let me throw in another one: the Congress has acted on the budget and the outlook there looks better. There is nothing that is going to make you uncomfortable about that situation. We are certainly not Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 126 going to tighten up on the targets when everything is going well, under that set of circumstances. Mr. McCoLLUM. What about loosening up on them if everything is going that well? Would that help bring interest rates down at that point and not inflate? Mr. VOLCKER. I don't know. If things are going all that well, we might just leave them alone. [Laughter.] Don't interfere with paradise. You could imagine circumstances in which you would want to change the targets. Let us take the same assumptions, but growth is doing not very well, velocity really seems to be declining; if we are wrong in our judgment about velocity, interest rates are high, then I think those are the circum- stances in which you might think about raising the targets. Mr. McCoLLUM. Thank you, Mr. Volcker. Mr. Chairman, I yield. Chairman FAUNTROY. Thank you. Mr. Leach. Mr. LEACH. Some say that one of the problems, with Congress is that people get elected and break their campaign promises, and that is what is wrong with the system. But I have found around here that the problem is we keep our promises; that is, that we don't rethink when we should rethink. Maybe the Fed ought to give as much attention to defending America's trade position as is given to defending the value of the dollar. One of the problems in the Farm Credit Administration is the possibility that the farm credit system bonds may come under pres- sure in the weeks or months ahead. And let me just ask, specifical- ly, in that regard, is there any indication that the Fed might buy farm credit system bonds in order to keep their price lower? Mr. VOLCKER. We hold some Farm Credit Administration bonds now. We were able to buy them. Let me emphasize that I have seen no signs in the marketnlace of the kind of strain you alluded to currently with respect to the farm credit system. I should also say that the Federal Reserve has authority to lend to elements in the farm credit system. Mr. LEACH. You are absolutely correct. At least as of last week there has been no evidence of gain in the bond selling end of it. And in terms of the portfolio management, I think, frankly, as we look at the next several weeks, we are going to have a donnybrook around March 1 that could indicate a great many more problems in agricultural lending in general. And as we look at Congress' response—and traditionally, I think the monetary authorities look to Congress for response first—it should be stressed that what is beine discussed in terms of helping farmers both on the Senate and House sides is still a wave in the ocean. It is not very significant. Therefore, the underlying problems in agricultural lending are great. And, beyond that, if we look at the prices which farmers are going to get on returns for the products they have produced, they don't lend any particular confidence that they will be able to pay back their loans if all that is done is put out more credit. Mr. VOLCKER. If they are far enough in debt, I agree with that, and 1 think that is the heart of the problem. Mr. LEACH. Well, there are discrepancies, obviously. A given per- centage of farmers have virtually no debt and another percentage Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 127 have higher. We are looking at conflicts between young and old, to a degree, a large and small, although those discrepancies aren't quite as significant as might be suspected because about the same number of large farmers are in difficulty as small farmers. But it is a situation that we in the Midwest are very concerned about and in addition just simply basic American manufacturing is obviously in enormous jeopardy. I look around my area of the coun- try and Caterpillar is moving jobs to Korea and France and Scot- land, as is Tenneco. And we are looking at the prospect of a coun- try that doesn't make anything. In this regard, I think people historically have lent different weights to different factors in economic growth. But I would sus- pect, that if there is any change in factors that the Fed should he considering at this time, it should certainly be our trade competi- tiveness. It's pretty clear that Congress is going to look at other kinds of solutions to our trade deficit problem that might be even less ac- ceptable, whether they be protectionism, whether they be some sort of arbitrariness that may be introduced into the economy. And one of the attractive aspects of the value of the dollar issue is that it isn't as discriminatory as other types of responses in the sense that with protectionist legislation, one has to make one deci- sion for automobiles and another decision for corn, and another de- cision for textiles. And if we just had a more reasonable dollar relationship, a lot of inefficiency that would be introduced into the economy by specific exceptions, I think, won't have to he dealt with. Mr. VOI.CKER. If I can respond, I agree with virtually everything you are saying except the applied remedy. Where I see that we are stuck is that the economy as a whole is dependent upon a strong capital inflow to balance our accounts. That has produced a strong dollar, and your part of the economy has gotten squeezed from two directions. I don't think there is any question about it. Monetary policy is just a tool that can affect the overall environment. It cannot be directed toward your particular sector. We are forced to ask the question, if we did that, let's say, and took your applied advice as to somehow getting the dollar down—I presume by a much easier monetary pol icy—would we inadvertently, presum- ably—but I suppose with foreknowledge, simply be transferring that problem elsewhere, because the basic imbalance is not one we can deal with with monetary policy? I think, in time, we can make it worse. But you are just feeling the effects of tbis huge imbalance we have in our trade accounts, which I think is inextricably related to the huge imbalance we have in our budgetary accounts, and there's nothing that can be papered over by monetary policy. Mr. LEACH. Well, I don't think tbere is massive disagreement on Congress' responsibility. I am not at all sure though that the type of policy that is currently being run puts the kind of pressure on Congress that I think might have been perceived to be the case 2 or 3 years ago. In addition we have the new assessment that the re- verse effect might occur, that with a reduction in the deficit, we might cause more dojlsr inflow rather than less, which is exactly Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 128 the opposite of what everyone was assuming until very, very re- cently. Beyond that, it looks as if we are approaching a structural change of rather dramatic significance. If this country can't manu- facture anything that's competitive of large size, if our rural econo- my is flat on its back for as long as we can see, that means the next 4 or 5 years, we are looking at a country that's going to have a very different composition in the very near future. Mr. VOLCKER. I do not disagree with that, but there are sectors of the economy, as you know, that are doing very well. The whole service sector is booming away; the defense sector is doing very well; high-tech areas are doing just fine. Overall, the economy is doing well. It is unbalanced and you have got the wrong end of the imbalance. I am not arguing there are not modifications of policy that you can legitimately debate. We have been giving more weight to the international situation. You can argue with whether we give enough. But I do not think we can dramatically change the situa- tion by our own tools, given—and it's a rather basic point—that it is not in the interest of the economy as a whole and is not even in the interest of the farm sector, in my opinion, to go back to an in- flationary environment. That's what got them into trouble in the first place. Mr. LEACH. Let me just conclude that for 20 years, the Fed and the Treasury have welcomed foreign investment in debt instru- ments, and that certainly has kept some interest rate costs down. On the other hand, it has served as probably the single most effec- tive vehicle for other countries, particularly Japan, to devalue their currencies. The question arises as we look at this, do we want to rethink the relative importance of these factors. On the one hand there are obvious pluses in keeping interest rates down, but on the other, there are obvious minuses about lack of ability to compete internationally. It could well be that this is a time for very serious reassessment of Fed policies. I am not sure that old-line reasoning is particularly relevant at this time. And if we don't do some new reasoning, the only thing that's obvious is that, structurally, this country is going to become a service-orient- ed economy in which nobody does anything for anyone else except rub their back. What about our capacity to compete in internation- al trade and our capacity to maintain a strong country? And econo- my? Mr. VOLCKER. I think you raise some very real problems and my answer that I do not think monetary policy can answer them all is not very satisfactory, because I think they are very real problems. Chairman FAUNTROY. I thank the gentleman. Chairman Volcker, there are a number of questions which mem- bers of the committee would like to have you answer, and I am going to submit them to you in writing and would appreciate a timely response. Mr. VOLCKER. We will answer as soon as possible. Chairman FAUNTROY. I yield now to the ranking minority member, who will close the hearing out with a question. Mr. McCoLLUM. Thank you. Chairman Volcker, earlier my colleague from Massachusetts was doing what I call flyspecking the administration's criticism of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 129 Fed. One of the criticisms a few years ago was with respect to the accounting procedures, and I know you have done some changing in that, measuring the money supply growth by now using the so- called contemporaneous accounting procedure. Could you tell us how this is going, how it's working out? Mr. VOLCKER. Plus and minus. I think, mechanically, it is work- ing all right. I have sensed it has been accompanied by somewhat more volatility in interest rates in the very short run. I'm talking about the Federal funds rate over the course of a 2-week period, and since that sometimes bears back on the rest of the environ- ment and the markets in the pretty shortrun prospectus, you prob- ably have a little more volatility with it than without it. There is a lot of speculation the market would accommodate to this in a way you would have smoother interest rates, or at least as smooth in the very short run. I do not see much evidence of that. They tend to bid strongly in the first part of a reserve period and have excess in the latter part or vice versa, without any systematic pattern. But there are quite a lot of fluctuations. We not only made the reserve requirement period more nearly contemporaneous, but we lengthened it from 1 week to 2 weeks, and maybe it's that lengthening that gives the result that I mentioned. Mr. McCoLLUM. Do you anticipate continuing the current proce- dure for the foreseeable future, or there plans to adjust them or change them? Mr. VOLCKER. It is difficult to change these, and we wouldn't foresee changing them. There are certain costs involved in making the change. I should say we are not using a technique of monetary technology. We do not use a technique which would maximize the potential effectiveness of the contemporary reserve requirement in keeping the money supply stable. That's not the same as keeping interest rates stable. Mr. MCCOLLUM. Right. Mr. VOLCKER. So one could argue if the objective is stability of the money supply, and that is the prime objective, we ought to change our techniques. I alluded to that earlier by saying if we really wanted to stay in that cone, we have to change the tech- niques, and contemporaneous reserve accounting would make it easier to adopt a different technique; theoretically it remains to be seen, like the interest rate question. Theoretically, it would make the money supply respond a little more quickly to what actions we take, if we used a different technique. But we have not been using that technique, because we didn't think it was necessary or desira- ble under all circumstances. Mr. MCCOLLUM. Chairman Volcker, in closing out the hearings from my end of it, I just want to commend you for your personal involvement and truly studious conduct of monetary policy. I think we would all be a lot more restless in our sleep, if we didn't have your balanced experience and analytical thinking at the helm. Mr. VOLCKER. Thank you very much. We will keep trying. The answers are not easy, but we will keep at it for a while. Chairman FAUNTROY. Thank you, Mr. Chairman. We appreciate your candid and straightforward answers to many of the questions the members have raised with you. I hope you will take note of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 130 fact that there seems to be unanimous agreement on both aides of the aisle here that we would like to see you complete your term. Mr. VOLCKER. Thank you. Chairman FAUNTROY. With that, we bring to a close today's hear- ing on monetary policy. [Whereupon, at 12:50 p.m., the hearing was adjourned, to recon- vene at 1U a.m. on Tuesday, March 5, 1985.] [Tiie following written questions were submitted to Chairman Voieker by Members of the Committee on banking. Finance and Urban Affairs with additional questions submitted by Congress- woman Marcy Kaptur. Chairman VoiCKer's answers are attached to the questions.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 131 U.S. HOUSE OF REPRESENTATIVES N OOMtSTIC MONETARY POLICY C&MMI I I Et ON BANMNti, MNArtL't AND UHBAH NiNtTT-IMtnlH LUttlaflESS WASHINGTON, UC 20513 Trie honoiaofe I'aul A. Wolcker Cfiairman •- Board of Governors Federal Reserve System 20th and Constitution Avt-nue tJ.W. Was tiington, D.C. 20^il Dear Paul: Following your testimony on Tuesday, February 26, 1985, Mf.mbers of the Committee on Banking, Finance and Urban Affairs submitted the following quesLions which were not asked and for which answers would be appreciated as boon as possible: 1. BOLII 111 your statement and in the Monetary Policy Report you express consider able concern arrout the rapid rise ol debt, not only by the Federal government, but by the private sector. You also make an elliptical remark about Che Administration's tax reform proposals. I wonder if you could be clear. Are you suggesting that the Treasury Department's tax reform proposals and similar ones by Mr. Bradley and Mr. Cepnardt, and Mr. Keirip and Mr. Kastf;n, would be beneficial in terms of reduced credit demand and lower interest rates? What are your views on the need ior and value ol major tax reform along iinese lines? 2. On I'rfK^ iy ol your staLeuieiit, you reier to "growth 01 debt wit Inn ii_b ta* gei_eo range.'1 Ear J ier, you naci leterreO to a 'moni t ur ing1' I ange for cieait, which is tne i-ay in Liie past trie FOMi; lisa ti.eai_ea cue deot aggregate. Is your statement a slip, 01 does rt indicate a cnange in tne scaLus of the cieDt aggregate? J. In an aj-jieiioix to >oui tebLimony, you olicuss now trie anility of me economy to jJiow wimout inllatloo "aepeiids on sucn vrtiiaolcb as me tr.enas in pioauctlviry, in me iaour toruc, in incentives LO save and invest, ana in oiner lacLors i>ver whicn montcary policy nab t: b-i tut i ally no Oiiect or long-run influence." however, you tneii say tliat "annual monef .iry tai gt;ts rtiia opti a tioual Decisions on not, ana neea not, rtisii on sucn assumptions tgr me long jun.' Tne problem ot coui &e is tnaii, ab Loid Kejnes said, "in trie -loiig run we ait; all atad. is ;t not tne cane mat trie luipcict ot Eionetary policy on tne econoiay in tne snort run vill depend Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 132 cri L icii] ly upon trends In productivity, in labor force growth, and incentives to K;WC .ind invest, because rliese factors will dttcruiine whether a given rate of money and economic growth translate into more real growth and less inflation, or less real growth and more inflation? Therefore, could you tell the Subcommittee what trend growth in productivity the FOMC is assuming? What trend growth in the labor force? Whether the incentives to save and invest will be increased or decreased by a continuation of current fiscal policies, or by adoption of the Treasury's tax reform proposals? 4. It is generally recognized that the U.S. economy must grow at an annual real growth rate of somewhere between 4.0 and 4.5^ to maintain reasonably full production and employment, and even higher than those levels in order to acnieve these goals when tbere is large economic slack. Since annual growth rates of GNP have been extremely deficient over the last 20 years (i.e., 3-2% during 1966-1969; 2.8% during 1969-1984, and only 2.17. during 1979-1984, for instance), how serious is this chronic diminution in the rate of real economic growth, in light of the fact that economic growth is the basic vehicle for creating a stable domestic and international economy? 5. When, we look, at the inadequate rate of growth over the last thirty years, it has been estimated by some economists that as much as 19.5 trillion 1984 dollars worth of GHP have been forfeited and more than 118 million years of unemployment, in excess of the full employment goals mandated in law, have been suffered due to inadequate growth. In view of these staggering losses in production and employment opportunity, how high of a priority does the Fed attach to the rate of real economic growth and levels of employment: and unemployment? 6. When we look at the real growth rate in the non-Federally held money supply, (as opposed to the nominal rates), on an historical basis, we have had close to thirty years of little, negative or no real growth. When you add this lack of real money supply growth to the decades of less than adequate economic growth, and the large deficits in production and employment opportunities, how can current Fed policies be justified? And what defense can be given to the charge that Fed money supply policies have actually become an aggressive and patent factor in the decline of our economy? 7. If it is the Fed's position that inflation is the primary "excuse" for these past and current policies, how does the Fed a) measure the relative weight to be attached to inarginal decreases in the growth rate of inflation against the weight to be attached to staggering losses in CNF and employment opportunity and b) how does the Fed explain the fact that the periods of higher real economic growth and low unemployment have been accompanied by low and declining rates of inflation, while periods of stagnation and recession have usually been marked by rising inflation? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 133 8. Tt is clc-arly in vogue these days for virtually everyone to be urging deficit reduction. H;we you considered the effect the Fed's more repressive than ncrossary monetary policy has had on the growth of the deficit? 9. You have stated that the deficit must he greatly reduced before it will be practical or desirable to bring about larger reductions in interest rates and larger Increases in the money supply. Further, you, among some others, call most vigorously for sharp reductions in domestic spending programs as the so-called "best" way to reduce the deficits. Is it not putting the cart before the horse to say this, because is it not true that reductions in the deficit can only come about from a sustained period of GN? real growth and larger reductions in unemployment, and this can't really happen until the money supply is eased and there are appreciable reductions in interest rates? 10. How can Fed policies be changed so that the mandated goal of reaching 4% unemployment, as called for in the Full Employment and Balanced Growth Act of 1978, and 3% inflation, are attainable simultaneously? 11. Tn a recent New York Times article, former New York Fed President Anthony Solomon was quoted as saying that "...ideally in the long run I would like to see commercial banks permitted to do pretty much what investment banks do and vice versa." Any comment? 12. President Solomon also said in that same article "...T have a lingering feeling that it is too dangerous to live in a fully deregulated world of banking...the risks are probably too great." Any comment on this statement? 13. The President's Economic Report has suggested that rather than basing the target growth rates of the monetary aggregates on the average of the fourth quarter of the preceding year's ^c_tu_al^ growth (giving rise to base drift) the growth rate of the money supply should be measured from the mid^point of the previous year's target range. Any comment? Walter E. Fauntroy, Chairman Subcommittee on Domestic Monetary Policy Committee on Banking, Finance and Urban Affairs Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 134 BOARD OF GOVERNORS FEDERAL RESERVE SYSTEM March 19, 1985 The Honorable Walter E. "Fauntroy C tiaii man Subcommittee on Domestic Monetary Policy Committee on banking, Finance and Uroan Aiiairs House of Representatives Washington, D.C. 20515 Dear Walter: In response to your letter of March A, I am pleased to enclose my responses i:u t.i .• written questions suoraittied in connection with the htetfj.tijr tieid on February 26. I hope this information will be useful to the Subcommittee. Please let me know if I can be of further assistance. Sincerely, Enclosures Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 135 Question fl: Botn in your statement and in the Monetary rolicy keixiEt you express consideranle concern about the rapid rise of oent, not. only by the federal government, but by the private sector. You also maKe an elliptical remark about the Aehiinistratior.'s tax rtftonn prujjosals. I wonoer it you could be clear. Aie ytAi ftugyestirjg tnat trie 'ireas>ui.y LfcparUiient's tax leionn pi-upi-wcils ana similar ones oy Mr. WdJiey ana Mr. Gepiiatdt, ara Mr. Rsaip arci Mr. K.0yten, would ce ccrieficial in temns or reduced cteoit aeuiara ata lo^er inteteat ^ates.' What ai.e youc views on tie neeo tor ara valua ot nwjor tax twroim ijlory these lines? natk or. tax r«totin addressea a cor(c*ji.r. aixxit tfits s^x-tssive use ot aeot ratfwr trtir: ajuity aa <j stxii.ce or cotpotate fiuaiioa. Tne preference fun cfeot finance is encouraged uy tax cude piovisionsj that allow the deduction of intetest ex.pense Out permit no deduction for dividend payments. The 'ircosury tax lelocm protJObal UNJJICI yrouiae a paiti_al i enitscly to the tinanclng bias introduced by tnese provisions Dy allowiuy Lucpurcicicjiii to deduct 50 percent of dividends paid to shareholders. Corporations which, as a result, relied more on equity and less on debt finance would be less vulner- able to interest rate and other econontic fluctuations. Tile potential impact ot tie Treaauty piar: tanen aH a wlioLe, ur other tax retorm prufjoSiila , on ci.«iit deraarris ana intutt;st tdtea is; vviy difficult to predict because of the broad scope and overall ccmplexity of these plans. Individual provisions such as limits on the deductibility of interest could tend, other things equal, to lower nominal interest rates. TT>e case for tax reform should not Da seen, however, as hinging ijr. ttiese questions — otter cons ioe ratio ns are at lyast as important , it not in.ua so. The dciiroDi J ity ot particular rerocin paCKayes r.eeds to »; asa^Saed mjaLiisit LfK NiiJoitr ii.Ty±ifjjriorL!i of the ptotjoiidis tor aiiocdUi^« etticier.ijy, io/: ciie cofeti o£ carif iiu,v,-e arxi admir.iaunti.oi', stxt r<jtr tfte taiznttss at tin? bj'.ii.ri). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 136 Question If 2: On page 19 of your statement, you refer to "growth of debt within its targeted range." Earlier, you had referred to a "iron i tor ing" range for credit, which is the way in the past the FDMC had treated the debt aggregate. Is your statement a slip, or does it indicate a change ir, the status of the debt aggregate? made to the "monitoring range for credit" for 1981). Wo have not changed the status of the debt aggregate. My reference to a "targeted range" for the debt aggregate shewld r.ot he so understood. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 137 In ar. appendix to your test irony, you discuss how the ability of the economy to grow without inflation "depends or. such variables as the trends ir. productivity, in the labor force, ir. incentives to save and invest, and in other- factors over which monetary policy has essentially no direct or long-run influence." However, you then say that "annual monetary targets and operational decisions rto not, and r.etid not, rest on such assumptiors for the long run." The pi oblem of course is that, as I/lid Keynes said, "in the lorxj run we are all dead." is it r.ot the case that the impact of monetary policy on the economy in the sl-ioit tun will depend critically upon trends ir. productivity, in Ijbor force growth, ar.d incentives to save and invest, because these factors will determine whether a given rate of money and economic growth translate into more inflation? Therefore, cculd you tell the Subcemittee what trend growth in productivity the row is assuming? What trend growth in the labor force? Whether the incentives to save and invest will he increased or decreased by a continuation of current fiscal policies, or by adaption of the Treasury's tax reform proposals? variables and the actual short-run performance. They need not be, and generally are not, the same. As I indicated in Attachment III of my statement to the Banking Ccfiinittee, year by year monetary policy decisions need not depend on the long-run trend growth of such factors as productivity, labor force participation, and capital formation—although clearly enough money has to be provided over time to accommodate the econony's real growth potential, after allowing for the tiend in the velocity of money. Of course, the actual short-run performance of productivity growth, labo: force participation, capital formation, price and wage decisions, as well as many other structural arri behavioral features of the economy will influence tow the economy responds Lo monetary policy over the near-term. The predictions of real GNP, prices, and the unemployment rate made by members of the Open Market Qjimittee take into account prospective near-term developments in those respects. I canr.ot tell you what individual Committee members assumed for each of the large numbers of romnir.etary factors that go into their forecasts. In general, it is jcobable that a slowing was assumed in productivity growth from Che relatively rapid pace of the past two years, as normally occurs after the initial surge in growth as the economy recovers cyclically, should more favorable productivity growth develop, and wage pressures remain low, we could see less inflation ami more growth ir. 1935 than was projected, However, a weak productivity performance without a centrensurate slowing ir. wage growth would exert upward pi essures; on prices and restrain real growth. No special effects on saving and investment incentives from the Administration's tax reform proposals were assumed in part because they ate not likely to be implemented early er,n.igh to affect significantly the year 1985. It was assumed that fiscal policy was represented by the Administration's budget program, and that the financing of the budget deficit woulcl again strain the capacity of domestically generated saving to accommodate both domestic private investment and the needs of the federal government. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 138 Question *4: It is generally rer: rani zed that the U.S. e^onrmy mist arow at an annual real growth rate of somewhere between 4.0 and 4.5 percent to maintain reasonably full production and emoloyment , and even higher r.har. those lewis in order ro achieve these ooals when there is laroe economic slack. S'rce annual growth rates of GNP have been extremer! v deficient over the last 20 years (i.e., 3.2 percent dun no l%6-69: 2.8 percent during W*-V)Rd, and only 2,1 petce.r.t. during 19TS-VW4 , for \nstPinraj), now serious is tMs nhronic dirairjition in the rats of real economic growth, in Jiaht of Mie fact that econonit; orowth is the basic vflhio!e for creatirq a st=>h!e domestic snd international economy? We can all aqrf^e th^f. tt^ere h^s bueri a slowing in the trend real rate of growth in recent decades, but it should also he pointed out that excorhs in the field do not necessarily agree on the orowth rate of potential (W, differing in part on estimates of productivity cfnwth. Ind^irf , the 4 to 4-1/2 percent nuntjers you cite tcrrt to he high in the range of major estimates. Setting asirte the technical issue of the measurement of potential output, however, there is no dcMbt aboMt tte importance of achieving sustained economic growth at the nation's full potential. An expanding economy raises living standards at home and contributes to an improvement in the world ecoiTomy. The critical question is how to create the con- ditions most likely to yield that result. Experience of the past decade has shown that sustained economic growth can best be achieved in an environment of reasonably stable prices; the slowinq of real orowth in the decade of the 1170's coincided, not colnci denial lv in my vi«>w, with a marked acceleration of inflation. But an environment of stability, while necessary to sustained growth, is not sufficient to assure that the rate of growth and productivity will return to the earlier, more rapid tterri. Whether it does, or the extent to which it does, will depend nr. surti factors as the public's preferences for saving and investment, the rate of technological innovation, attitudes of the labor force, and the organizational skills of business. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 139 guestign_*5; When we look at the inadequate rate of growth over the last thirty years, it has been estimated by some economists that as much as 19,5 trillion 1984 (toilers worth of GNp have been forfeited and note than 118 million years of unemployment, in excess of the full employment goals mandated in law, have been suffered due to inadequate growth. In view of these staggering losses in production ar.d employment opportunity, how high of a priority does the Fed attach to the rate of real economic growth and levels of employment and unemnloyment; Answer: The Federal Reserve can affect short-run movements in aggregate demand and output, but over the long run, such as the thirty-war time horizon referred to in this question, the growth of the economy depends essentially on structural ard behavioral factors affecting the productive capacity of the eoono-ny that are independent of monetary policy, including the rate of productivity growth, capital formation, ar.d technological innovation. Our policies are aimed at encouraging over time the conditions in which the economy can achieve its full growth potential and highest possible employment on a sustainable basis. We believe that can best be acccmp]ishpd in an environment of stability, including reasonable price stability. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 140 Question |6; Wheri we look at the real growth rate in the non-Federally held money supply, (as opposed to the nominal rates!, on an historical basis, we have had close to thirty years of little, negative, or no real growth. When you add this lack of real money supply growth to the decades of less than adequate economic growth, art) the large deficits in production and employment opportunities, how can current Fed policies be justiEied? fyncl what defense can te given to the charge that Red money supply policies have actually becone an aggressive and potent factor in the decline of our economy. Answer: It needs to be understood in response to this question that over the long-run, the Federal Reserve does not have control of the real money stock. It can control only the nominal money stock. Should it turn out that the amount oE noninal money provided be more, for instance, than the public warts to hold in real terms, prices will rise—as the public attempts to buy mare goods and services with the "surplus" rroney—and the real money stock will fall to the level that satisfies public demands. Thus, one cannot sinply conclude frcsn a 30-year trend in real money anything about the appropriateness of past Federal Reserve policies, much less current policies as suggested in the question, in any event, over tte 31-year period from 1952 to 1984, inclusive, the real money Stock on average increased about 1/2 percent, about what would be expected from estimates of potential growth in real output over the period and the impact of financial innovation ard other factors that tended to increase growth in velocity of nor.ey. I do not believe that our money supply policies have becone, as the question avers, an "aggressive and potent factor in the decline of our econooy." The recovery and expansion following the recent reces- sion has beer; the strongest of the past three decades and, with continued progress in containing inflation and assuming action to cut the federal twdget deficit, may also prove to be the meet enduring. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 141 Question #7; If it is the Fed's position that inflation is the primary "excuse" for these past ard current policies, how does the Fed a) measure the relative weight to be attached to marginal decreases in the growth rate of inflation agairst the weight to tfi attached to staggsrirg losses in GtJP and employment opportunity and b) how (toes the Fed explain the fact that the periods of higher real economic growth and low unemployment have been accompanied by low and declining rates of inflation, while periods of stagnation and recession have usually Keen marked by rising inflation? Answer: I believe the experience of recent decades demonstrates that we canr.ot simply trads off inflation against unemployment, we are not, in other words, faced in practice with assessing the costs and benefits of mare or less inflation vs unemployment ES posed in part (a) of your question. Achievement of over-all stability, including reasonable price stability is in our view the most likely route to attaining sustainable econonic growth at the nation's potential. The fact that there have been sustained periods of lew growth and high inflation, as pointed out in part (b) of your question, is evidence that one cannot simply stimulate growth by adding rrore and more money to the economy. Depending in part or. the extent o£ unutilized, resources in the ecorajny, thare ate times when additional money cculd lead to sane increase in real growth for a while, but accelerated noney expansion would, as continued, soon lead to price increases, strengthened inflationary expectations, and in the end to distortions and disturbances that retard the econony rather than encourage productive investment and growth. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 142 Question f B; It is clearly in vogue these days for virtually everyone to he urging deficit reduction. Have you considered the effect the Fed's more repressive ttiar: r,ecess^ry monetary policy has had on the growth of the deficit? Answer: We certainly do not believe that monetary policy is "more repressive thar. necessary," or that it is worsening the nation's basic budgetary deficits, if the economy had grown Easter in the past two years, it is true that the budoet deficit would have been lower. Rut in fact the econcmy grew more rapidly than in any cyclical recovery of the past thre" decades, still, its rate of growth raiqht have heen even greater if so much of the spending by domestic sectors had not teen made abroad. This diversion of spending to foreign sources took place tiecause of the high evcharae value of the dollar. That in turn was partly an indirect effect of the strongjy expansionary fiscal policy— which by keening interest rates here higher than they otherwise would have tv"?n, led to increa-wd demands for dollar assets by foreigners. In any case, the structural budget deficit—abstracting from current economic conditions—remains exceptionally large. Monetary policy cannot remedy this structural imbalance. Efforts to do so by rapid money exparsion, for instance, would sooner or later lead to ir-creacpil inflation and to risirq interest rates. Recent Congressional Budget office estimates show that the effect on the deficit of an increase in inflation that, is matr-hfd txiir.t for point by increased interest rates—as could likely accompany a less restrained monetary policy—wculd fe vmcfrtain. It discretionary appropriations are not adjusted upward in sten with inflation then sane small improvement in the deficit wnjld occur. However, if discretionary appropriations are adjusted for inflation then, according to CEO estimates, higher inflation and interest rates would result in a higher deficit over the 1985 to 1990 period, faxi the economy would also te bearing the costs and distortions of an inflation "tax." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 143 Questinn 19: You have stated that the deficit must be greatly reduced before it will be practical or desirable to brinq about larger reductions in interest rates an) larger increases in the money supply. Further, you, among some others, call most vicprously for sharp reductions in domestic spending programs f>s tht? so-called "best" way ro reduce the deficits. Is it rot putting the cart before Che horse to say this, because is it not true that reductions jr. the deficit can or.Jy (xme about fron a sustained period of GNP real qrowth and Larijer relict lews ir, uriesnployrferit. and this ran't t^ally happen virt.il the money supply is eased and there are appreciable reductions in interest ^jtes? Answer; Growth is important, and we are committed to a policy of fostering an environment conducive to healthy, sustained grovjth. However, the consensus view seems to he that a vf=ry sizable deficit would remain ever, if the econctw grew rapidly er.ounh to reattain full employment in the next, few years. Indeed, the Onrigressional Budget office's meagre of the st-ruotiji-a! deficit rises rrore over the 198*, to 1990 period than its estimate of the actual teseline deficit. More rapid productivity growth than has been assumed by tie CEO would allow higher growth rates and a lower deficit whe--. full employment is attained; but sizable structural deficits still would remain, if productivity growth stays within the range of our post H^rld War T! experience. I would add that monetary policy essentially has no direct influence on productivity growth trends. I should also note that the initial sentence of the question suggests a more mechanical relatiorship between monetary and fiscal policy than i think exists. T do teJieue, however, that decisive action to reduce the deficit would help relieve the pressures holding rates up ard, as such action helps to dampen inflationary expectations and forces, provide ar. environment with nore flexibility for monetary policy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 144 Attainment of these two '.joals simultaneously it: the shoit cur probably is not j.iossible because of structural conditions in the economy, ami no change in Federal RPSGCVS policy car, alter: that. It may be—anil this is the "iew of many respected analysts—impossible to maintain an. unemployment rato of 4 lucent in today's economy, qiven the demographic characteristics of Lh.o labor form arxi other structural factors. Mici oeconcmic policies may be n«xted to improve the skills of out workforce and increase its mobility if 4 percent unemployment is to bs a realistic goal in the future. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 145 Ir. a recent >ew York Times article, former New York Fed President Ar.thor.y KolcriDn was quoted as saying that ". . . ideally in Lhe long run I would like to see coitnercial tanks permitted to do pretty much what investment har-k1? do and vice versa." Any eonnent? An gyre r: The Board has for sane tin*; supported the view that certain changes are desirable in the current framework for separatircj comtercial and ir.veStinent banking, but it has not felt that differences between the two should !>e oanpieteiy removed. Reasonable changes wculd need to be structured .ind iropiemt-ntfiid so as to stimulate competition for both types of financial instiLjtions, without jeopardizing either the stability of the banking and financial system or encouraging the exploitation of potential conflicts of interests. Tn addition, the Board believe? tnat such fundamental changes should te hrought about by legislative action, and not by the independent actions of regulators. Given the importance of these issues, iir is probably desirable that any changes be gradual and occur over the longer term. With these ideas in mind, the Board has supported legislation to authorize Dank holding companies to sponsor, control, and distribute the secur- ities of mutual funds, as well as to underwrite ami deal ir mjricipal j-evenue tonds, 1-4 family residential mortgage-backed securities, and com,ercial papet. In addition, the Boa^d has ut-ged that to the extent that canne»cia' hai'.king [•>owci;s we;t? to !*-.• granted to investment banks, investment bar.k:, n>ust to the same extent :>e subject to the rules and regulations that crmnercial M'-ks operate under. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 146 Question 112: President Soloron said in a recent New York Times article "... I have a lingering feeling that it is too dangerous to live in a fully deregulated world of banking . . . the risks are probably too great." Any corment on this statement? Answer: Mr. Solcnwn was probably expressing concern with the possibility that banking organizations may expand into certain nonbank activities to such a degree that it would increase risk for the tank. This is a reasonable concern in view of the crucial role of coimercial banks as the transmission belt for monetary policy; a source oE credit for most consumers and business; the pri- mary holder of the savings and transactions accounts for the vast majority of Amecicars; and the Key indicator, at hone arid abiuadr of trie health and sound- ness of the U.S. financial system. Under trie circumstances, as we move forward with deregulation with respect to the products and services tanks may offer, it will be essential to move judiciously anrJ prudently yet at the same time avoid unnecessarily con- straining the opportunities for banks in new areas. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 147 Trie President's Econonic Report has suggested that rather than basing the target grcwtn rates of the nonecaty aggregates or. the average of tne tourth quarter or tile preceding year's actual growth (giving rise to oase drift) tne growtn race or tne noney nuppiy Srtcjuld 1x3 measured trom tne mitj-point or tne prey j._QU!a_ year 's target ufige. AT.y cuiuiitrnt? Tins isaut was discubsed in AtJ^Criinent IV Ot my stdtfairiuriL to Lrit= riiriking CQnnLtcce. Ttje conucucior-. ot basing tre current year's Ceangs;s on the itvel ir, t.lie touxi,n quditei ot tne [jctrvious year is coiitjist-criiL with tne nuiiipriLcy-n<JWKlr.s Aft picji,tsauL''-B3 Lfiat nave tter, toliowetl tor atite time; a^pflttuifS nave (jJCuLLed 01'j.y wtiu:- Lite coijvmiLioriaa rase level has teen btjrlousily cistuttsfl. l also r.ot-wa on t-jye IV-3 or my stdteiier;t tnst rtsjuirtely taiyecmj niowcn tnjtn cue Kim-point ot a p^t^ious yfear's rarxje seans to imply tnat cnt; growth it-un year to yoai. at the raid-point is in sane sense a uniquely correct Ltend for a mir.etary aggregate. I cannot agree that such a rigid pursuit of the raid-point, based on an earlier judgment, should be adhered to uhsn emerging evidence on factors sucn as velocity shifts suggests that a deviation rrun the uiapoii'.t is tequited it UK br unotrr goais ot su&tainaiile econcinic grij~r.li and pruyitsss cuwaiQ yr n.e staoility a;e to Le achieved. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 148 MARCY KAPTUR Congress of the United States HOME of UcprEstntattoEs Washington, B£ 20515 Walter E. Fnimtroy, Chairman Subcommittee on Domestic Monetary Policy Committee on Banking H2-J09 House Office Building, Annex 2 Washington, DC 20515 In response to your gracious concern that Members be allowed to have al 1 their quest ions regarding Federal Reserve Policy answered in a timely manner and the liniled time of our recent hearings with Chairman Volcker, please find attached a number of additional questions 1 had for Chairman Vol e.ker. Sincerely, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 149 BOARD OF GOVERNORS FEDERAL RESERVE SYSTEM WASHINGTON,!]. Z. 2Q55I March 20, 1985 PAUL A. V[ CHAIR I. The Honorable Marcy Kaptur House of Representatives Washington, D.C. 20515 Dear Ms. Kaptur: In his letter of March 8, Chairman Fauntroy asked that I respond to written questions you had in connection with the Monetary Policy hearing on February 26. I am pleased to enclose my responses to your questions. Please let me know if I can be of further assistance. Sliinnceerely, ,/ Enclosure cc; The Honorable Walter E. Fauntroy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 150 Chairman Volcker's response to written questions from Congresswoman Kaptur: (2/26/85 hearing) Question fl: Is our "real business fixed investment" for Fv 1983(refer to page 16, graph page 18) an indication that industrial and commercial capital investment is occurring at a growing rate that will result in long-term growth? Recently in another session with Memoers of Congress, Mr. Volcker stated that foreign capital, which is being used to finance puDlic and private sector borrowing, was being used primarily to finance short-term consumption, not long-term investment? Answer; business fixed investment has risen rapidly in the current expansion after falling sharply during the 1981-82 recession. Most observers expect some slowing in tne rate of growth of capital spending this year and next. Nonetheless, the capital stock should continue to rise over the next few years, with beneficial effects on both labor productivity and potential output growth. The recent rapid growth in investment has occurred despite very large government budget deficits, which had been expected by many observers to "crowd-out" private financing for investment. There are two reasons for this. One reason is that corporate cashflow has risen substantially in the past two years, as a result of both the 1981 business tax cuts and the strong economic recovery. The rise in casnflow nas riaanceii a good deal of tne increase in investment. In addition, net foreign capital inflows have risen considerably, thus supple- menting private domestic savings as a source or financing for both the deficit and private investment. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 151 However, the funding sources that have supported investment may not continue to be as readily available in the future. As the economic expansion has matured, growth in CorpuidLe casntlow nas slowed, and external financing needs of corporations nave grown. Continued growth in investment tnere- fote will require more corporate borrowing than in tne past two years, leading to greater competition between government and private sector needs. An increase in the amount of foreign capital would relieve surae of this pressure. However, large and growing foreign capital inflows are not sustainable arid this source of funds is not a permanent solution to domestic imbal- ances. If the net inflow of foreign capital were reduced, domestic saving would have to rise — current consumption would have to oe cut--to finance the same amount of private invest- ment, absent a reduction in the Federal deficit. But the prospects of such a significant rise of domestic saving in relation to income are not strong, given historical experience. Thus, a decline in the Federal deficit is the most likely source tot sustaining growth of private investment at a satisfactory pace. Quest ion 42-. Can we grow our way out of this deficit? Itt) Please explain Cased on recent trends. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 152 Answer; I do not believe that we can grow our way out of the current federal budget deficit. The very rapid economic recovery and expansion that has occurred over the past two years has lowered the deficit from its 1983 peak of $208 billion (on-budget plus off-budget) only to $185 billion in 1984. The Administration projects the current services deficit to rise again this year and to remain above $220 billion throughout the next five years. As you know, CBO's estimates of the baseline deficit are slightly lower than those of the Administration in the early years of the projection period, but rise later in the period to levels above the Administration's projections. A part, but only a relatively small part, of the difference in the later years is attributable to CBO's projection of slower growth. Federal Reserve staff estimates suggest that one percentage point faster growth in real and nominal GNP would lower the deficit, by 1990, by a bit more than $100 billion from the Administration's estimates, if all other key economic assumptions were the same. Such an acceleration night be associated with a more rapid rate of productivity growth, which would allow spending to expand more rapidly without incurring the danger of inflationary pressures in labor and product markets. In this regard, it should be noted that the Admini- stration's assumptions about productivity, and the other factors Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 153 that contribute to a trend growth of output at the k percent rate they have incorporated in their budget calculations, tend toward the high end of ranges of many economic forecasters. Nevertheless, even sustained growth of real GNP at 5 percent over the coming five-year period would only do about half the job of closing the budget gap by 1990. Question j>3; What can be done to encourage increased "savings by U.S.citizens? Answer: Economists have long debated the effectiveness of special tax incentives for raising the rate of private saving. One idea that has been suggested is replacing the present income tax system with a consumption-based tax. This would tax only the proportion of income that is spent. However, economic research generally is inconclusive on the question of whether increasing the rate of return on savings actually causes individuals to save significantly more. It is therefore not certain that exempting savings from taxation would appreciably raise the overall saving rate. Another possible way to encourage more saving would be to increase the present limits on contributions to individual retirement accounts. Again, the evidence as to whether this would increase total saving is mixed. Since IRA's were introduced in 1981, it appears that individuals generally have Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 154 shifted savings from ordinary income accounts into IRA's rather than adding new saving. However, the Treasury Department has estimated that about half of the people who invest in IRA's invest the maximum amount. It is therefore possible, although not proven, that individuals would save more if the IRA ceiling amounts were higher. Question fjt: On page 25, paragraph 1, federal and private debt expansTon are discussed. Why is it that federal debt expansion of 18 percent in a second year of recovery is unusual? What is problematic about this when private domestic nonfinancial debt grew at a fairly normal historical rate? Answer_; With regard to the magnitude and impact of federal debt expansion in 1984, this growth was a postwar record for the second year of a recovery both in nominal terms, 16.9 percent, and in real terms (based on the GHP deflator), 12.8 percent. The increase was similarly unprecedented when U.S. government debt is measured in relation to income: while growth of GNP normally exceeds that of federal debt in the second year of a recovery--by about 3 percentage points, on average — last year this ordering was reversed, with federal debt expansion actually surpassing GNP growth by more than 7 percentage points. Other measures of federal borrowing, such as the federal budget deficit divided by GNP, also convey basically this same message, that federal credit demands last year were well above those in comparable periods of earlier expansions. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 155 A major problem with heavy federal borrowing demands so late into a recovery occurs as these credit demands, together with rising private investment and credit demands accompanying the economic expansion, press against the available domestic saving. Even though growth of domestic nonfinancial debt last year was in line with past recoveries, one consequence of the contending public and private credit demands is higher interest rates than would prevail otherwise and slower expansion in those sectors most sensitive to the cost of credit. Furthermore, large prospective deficits raise market concerns about future inflationary and credit market pressures, concerns reflected in current levels of long-term interest rates that remain high relative to historical experience and to recent rates of inflation. Relatively high U.S. interest rates, in turn, have encouraged substantial inflows of capital from abroad that, while supplementing domestic saving by a third and permitting the financing of the federal deficit and private investment, have contributed to a dramatic appreciation of the dollar on foreign exchange markets. The mirror images of these capital inflows and the appreciation of the dollar are the unprecedented deficits in our foreign trade accounts and a deterioration in the competitive positions of domestic import-competing and export sectors, in effect a "crowding-out" of domestic firms from international markets. 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 CONDUCT OF MONETARY POLICY TUESDAY, MARCH 5, 1985 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON DOMESTIC MONETARY POLICY, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met, pursuant to call, at 10:00 a.m., in room 2222, Rayburn House Office Building, Hon. Walter E. Fauntroy (chairman of the subcommittee) presiding. Present: Representatives Fauntroy, Neal, Barnard, Cooper, Carper, McCollum, Hiler, and Ridge. Chairman FAUNTROY. The subcommittee will come to order. This is the second day of our hearings on the conduct of mone- tary policy. Last week we received the testimony of the Chairman of the Federal Reserve Board. Today we will hear evaluations of the Federal Reserve's report on monetary policy and its proposed policies from several prominent economists. As I noted last week, we are confronted with both evidence of great progress in the economy and signs of serious troubles either already present or looming on the horizon. As many observers have noted, this has been an unbalanced recovery. We have made re- markable progress on inflation—indeed, inflation is now at the lowest rates in the last 20 years. But the unemployment rate is still well above 7 percent—higher than the unemployment rates we have seen at the same stage in prior recoveries. Some sectors of the economy—services, defense production, high-tech manufacturing, and retailing—are booming, while other sectors—agriculture, natu- ral resources, and traditional manufacturing—are languishing. The trade deficit is steadily worsening, driven by the continued rise in the dollar's value. Most of us recognize that the largest threat to the economy and the major source of most of the imbalances in the recovery is the enormous budget deficits we are generating under current fiscal policies. We also accept the importance of restructuring those fiscal policies in order to bring down the deficit. But we need much great- er and more flexible leadership from the President if we are to do this without creating new problems. Still, monetary policy, with or without prudent fiscal policies, will greatly influence what happens to the economy, to inflation, and to unemployment. Monetary policy will also affect the value of the dollar and what happens to the balance of trade. We have heard from Mr. Volcker about what the Federal Reserve's assump- tions, plans, and objectives are for monetary policy this year. Today, we will want to get some independent evaluations of those (157) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 158 assumptions, plans, and objectives. Are the Federal Reserve's eco- nomic projections and assumptions reasonable and realistic, given the stage of the cycle and the underlying conditions? Are the Fed- eral Reserve's relative priorities for the reduction of unemploy- ment and inflation appropriate? What can and should the Federal Reserve do with regard to the exchange rate of the dollar? Should the Federal Reserve be paying more attention to the monetary ag- gregates, or to the overall behavior of the economy? To help us address these questions, we have assembled before us a most distinguished panel of economists. Let me welcome Dr. Alan Greenspan, president of the Townsend-Greenspan Co.; Dr. William Poole, professor of economics at Brown University; and Dr. Charles Schultze, senior fellow of the Brookings Institution and professor of economics at the University of Maryland. Dr. James Tobin, who was also scheduled to testify today, unfortunately had to cancel be- cause of the death of a friend and colleague whose funeral is being held today. However, he has submitted a written statement, which will be included in the hearing record. [The letter of invitation to the witnesses and the notice of the subcommittee hearing follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 159 LETTFR OF INVITATION TO WITNESSES US- HOUSF OF RFPRFSENTATIVES SURCOMMITTFF O" POMFSTIC. MOMF/raHY PfH.ICY (IFTHf CQMKJITTFF f" paM"inf5. FINAWCF ANn URRaN 4FC4IRS WASHINGTON. DC 20515 January 30, 1985 At the request, of the Chairman of the Cnmmitt.ee on Banking, Finance and Urban Affairs, the Subcommittee on Domestic Monetary Policy will hold hearings on the Conduct of Monetary Policy and the Federal Reserve's Monetary Policy Reoort, pursuant to the Full Emoloymnnt and Balanced Growth Act of 1978. In evaluating the testimony that the Subcommittee will hear from the Honorable Paul Volcker, Chairman of the Board of Governors of the Federal Reserve System, on Tuesday, February 26, 1985, the Subcommittee will receive testimony on Tuesday, March 5, 1985, from other individuals on the Federal Reserve's Monetary Policy Report and how well the proposed policy addresses the problems that will be faced this year and in coming years. I would like you to testify at the hearing on March 5. 1 would hope that in your testimony you would provide the Subcommittee with your appraisal of the outlook for the economy in 1985 comnared with the Federal Reserve's projections, and with your views on the Federal Reserve's objectives for growth of money and credit in 1985. A copy of the Monetary Policy Report will be sent to you on or about February 20 to aid you in that undertaking. Additionally, I would like you to keep in mind that the Subcommittee is particularly interested in what the Federal Reserve can do to foster lower unemployment and stable prices in 1985 and future years, given current productivity trends, unchanged fiscal policies, and likely cormodity, labor, and currency market conditions. I have asked Chairman Volcker to address this issue in his testimony,- and would like you to cor.ment on his responses in your oral remarks, if not in your written statements. A copy of his testimony before this Subcommittee will be sent to you immediately after the hearing on February ?6. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 160 In preparing your written testimony, I would therefore hope that your discussion of the rOMC's economic projections and money and credit objectives for 1985 would address the following specific questions: 1. In regard to the outlook for the economy in 1985, what are the prospects for further reductions in unemployment without a reigniting of inflation? Should the Federal Reserve attach greater priority to reducing the unemployment rate in the coming year, to reducing the inflation rate, or to some combination of these objectives? In regard to the outlook for the economy in 1985, what are the prospects for moderating the overvaluation of the dollar in foreign exchange markets, and what can and should the Federal Reserve do to help achieve such moderation? What should the posture of monetary policy be in regard to the international value of the dollar, and what role, if any, should direct Federal Reserve intervention in foreign exchange markets play to moderate the dollar's value? In regard to the Federal Reserve's objectives for money and credit growth in 1985, what should be the relative weight given to the growth in the monetary aggregates vis-a-vis economic and financial market conditions in the FOMC's conduct of monetary policy? What specific variables do you believe the Federal Reserve should be using as targets for monetary policy? Please plan to testify on these issues at 10:00 A.M., on Tuesday, March 5, 1985, in Room 2128 of the Rayburn House Office Building in Washington, D.C. Committee rules require that 100 copies of your written testimony be made available to the Subcommittee the day before the hearing for the use of the Subcommittee Members and staff, and for distribution to members of the press and the public who may be in attendance at the hearing. However, the Subcommittee Chairman may waive or modify this requirement if circumstances make it difficult for you to comply. If you have any questions about this or any other aspect of your testimony, please feel free to contact Howard Lee or Andrew Bartels of the Subcommittee staff at 202-226-7315. I look forward to your testimony on March 5, and thank you in advance for your assistance to the Subcommittee. Sincerely yours , J.-^^vS^^ ^ Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 161 U.S. HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON DOMESTIC MONETARY POLICY COMMITTEE ON BANKING. FINANCE AND U3BAN AFFAIRS NINETY-KINTH CONGRESS WASHINGTON, DC 20515 MUJ£E..QE ROOK CHANGE TO: DATE: RE: The second day of hearings on the Conduct of Monetary Policy will be held on Tuesday, March 5, 1985 at 10:00 A.M. in 2222 Rayburn House Office Building. The Subcommittee will take testimony from four former Presidential economic advisors in assessment of the policies which the Federal Reserve announced at an earlier hearing. The four witnesses are: Dr. Alan Greenspan, President of the Townsend-Greerispan Company, was Chairman of the Council of Economic Advisers under President Ford and chaired the National Commission on Social Security Reform in 19R2-1983. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 162 Chairman FAUNTROY. Gentlemen, I am pleased to welcome you to this hearing. You nave all served on the Council of Economic Advisers under various past and trie current President, 1 point that out because 1 tniriK it is important tor everyone to Know that there are still some of us in Wasnington wno value mat institution and are pleaseu \vitn its continuing survival. Before we oegm, nowever, let me yield to my distmguisned friend and ranking memoer of this suocommittee, Congressman McCol- lurn of Floiiua, ibr any remarks wnicn he may wisii to raise. Mr. McCoLLUM. ThaxiK you, Mr. Chairman. We are very pieased to nave tttis panel of distmguisned econo- mists wicn us touay to discuss trie issues tnat are at nand oil mone- tary policy. I tnink tnose 01' us on our siae of tne aisie understand that we are in a period of great economic growth, but we are dis- tre&beu uy tne continuing aeiicits tnat tnis country nas saltered, la- boieu under for so long. We know arid understand that because of foreign investment and capital tnat is coming' into tins country, this deficit nas not nad tne impact it otneiwise would iiave. So we are very concerned aoout tne future in tne fiscal area. But we are equally concerned auout monetary policy, especially in light of tne fact tnat we are in sornewnat uncnarted water with this kind of hign value of the dollar, high foreign investment and hign deficits. We are looKing lorward to nearmg from tnis distin- guished panel in their review of monetary policy in tne context of today's situation. Thank you. Chairman FAXJJNTJIO^. i tnaiiK you. Unless tne panelists iiave an- other preference, we will proceed in the order listed on tne nearing notice, Dr. Greenspan first, Dr. Schult/e, tnen Dr. Poole. Let me note that your statements, in their entirety, will be included in the record. STATEMENT OF 1)R, ALAN GREENSPAN, PKESlUEJNT O>' THE TOWNbEND-GKEENSPAN & CO. Dr. GKiLt.NbPAN. Tnamc you for your Kina remarKS, Mr. Chair- man. 1 would like to review brieily tne economic OUUOOK and excnange rate of tlie dollar and presumaoiy leave for tne question period a number of the details, wnicn I am sure will remain unanswered. The near-term OUCIOOK is fairly optimistic. The lacK of imbal- ances suggests tnat tne normal economic growin will taKe iioid and carry us until imbalances are created. Accordingly, the FOMC's economic projections of roughly 4 percent real growth in 1985, mod- erate inflation at around 4 percent, and an unemployment rate below 7 peicenc uy yeaienu appear reasoiiaoie. They could be ac- conmiuuuieu uy tne reueial Reserve's announced monetary caigets. Wnne sucn an outcome is most desirauie and may nave the prooaoility of any alternative scenario, ic is uy no means . Tnere are a numoer of ditr'erent events wnicn migiit uerail it, puling serious prooiems for tne Fed. Economic expansion could piuve to have gieater momentum man now anticipated. Consumer buying rmgnt ue stronger, and norneuuilding and capital spending Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 163 more vigorous. This could generate an excessive surge of demand built on large inventory accumulation. Such economic buoyancy generally quickens monetary growth and heightens inflation pressures. Under these circumstances, the Federal Reserve probably would be impelled to keep tightening credit, even if this eventuality produced a recession. The Fed un- doubtedly would want to appiy the minimum and least disruptive tightening necessary to achieve its purposes. Such judicious control of credit tightening, dampening the economy into a presumed soft landing, is not easy, however, without the benefit of hindsight. The problem is complicated by the time which generally must elapse for the impact of Fed policy on the economy comes out of it. These time lags create a tendency to carry policy further than might in retrospect be absolutely necessary. Thus, there is a danger that initial attempts by the Fed to accommodate the accel- erating expansion, so as not to endanger employment, could reig- nite inflationary expectations and eventually inflation itself. The result would then inevitably be a recfcssion, either from the inflation-induced reaction or from the anti-inflation policies adopt- ed by the Fed or a combination of both. This problem does not appear to threaten at present. The danger of excessive monetary ease relative to the economy's requirements appears to have been allayed by the announced cessation of the policy of progressive easing prepatorily, presumably to a moaest renewed tightening when arid as appropriate. Moreover, severe tightening does not appear to be contemplated or necessary at this time since the economy shows no signs of over- exuberance at the moment. The tremendous pulling back of com- mitments to a near hand-to-mouth basis is reflective of a virtual elimination of inflationary expectations, at least in the short term. There is, therefore, apparently little reason to accumulate invento- ries for potential capital gains. The Fed is presumably keeping an eye on long-term interest rates as a gage of inflation expectations. Should these show signs of beginning to rise steeply, the Fed could be expected to respond ex- peditiousiy with policies focused more heavily on fighting inflation. A more likely scenario is an eventual weakening of the dollar, which could develop into a speculative downturn in the exchange rate. This would, in turn, put short-term interest rates higher and stifle further economic growth. It is difficult to assess the probabili- ty of this occurring in the short term despite the indications that the current exchange rate, now probably close to 30 percent over purchasing power, is being driven by dollar demands which are un- likely to be sustained indefinitely. History suggests that there is little that the Federal Reserve can do to nudge the foreign exchange value of the dollar lower in an orderly fashion. The attraction of the dollar as a safe haven vehicle appears to outweigh the effects of relative interest rates. As was evident late last year, lowering interest rates on dollar denominat- ed assets, relative to those denominated in other currencies, does not necessarily cause the dollar to fall. Moreover, should the Fed try to push U.S. interest rates down significantly to weaken the dollar, the monetary expansion which would be required to achieve this under piesent economic condi- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 164 tions could intensify inflation pressures and inflation expectations. This, in turn, would raise the inflation premium in long-term inter- est rates causing yields to move higher. In short, the ultimate outcome of an excessively easy monetary policy aimed at pulling down the dollar would be to raise, rather than lower, interest rates, presumably enhancing the attractive- ness of the dollar on foreign exchange markets. This suggests that an overly easy money policy by the Fed might not be of much help to the dollar and could be counterproductive. If investors in the rest of the world feared inflation in the United States, this could trigger a steep decline of the dollar, as occurred in 1978 and 1979. If interest rates were not the primary determinant of a foreign ex- change value of the currency, U.S. interest rates would have to climb sharply in order to attract the funds needed to cover other current account deficits. The detrimental impact on the economy is clear. As for central bank intervention in the foreign exchange market, it too appears to have little sustained effect when there is strong movement toward currency. Such intervention may temporarily disconcert speculators and discourage speculation in the currency for a while. Resources available to central banks are limited, and repeated massive intervention simply is not feasible. Once the markets recognize that intervention is limited, its impact on exchange values does not last very long. It then begins to take greater and more frequent intervention to achieve even that limited effect. In short, it is easier to point to techniques which will not be too effective, such as excessive monetary ease or sporadic intervention than cite the things which the Federal Re- serve might do to effectively bring down the value of the dollar. It would appear that the best thing that the Fed could do is to be patient, awaiting the emergence of market forces away from the dollar. That is likely to occur sometime this year, although it is very difficult to pinpoint the actual timeframe. The reason, basical- ly, is that we are covering ground in the international financial markets now which I don't believe we have traversed previously. When we observe the particular flows of funds, what comes across most clearly is that while in the early stages of the dollar rise, that is 1980 through 1982, the major force which was driving it was largely the movement of dollars in the Eurocurrency mar- kets and the advent of a very major acceleration of dollar flows into the United States by foreigners. Since 1982, however, a significant shift has occurred in the sense that, one, the net flow of dollars from other countries in the Euro- currency market has stabilized, and two the flow of dollars by for- eigners into the United States, while very large, has also stabilized. The only switch in the capital flows which are pushing the dollar higher is the dramatic slowdown in net investment by U.S. resi- dents, especially banks in foreign countries. In 1982, for example, aggregative purchases of foreign assets by U.S. residents accumu- lated to $111 billion, most of which was lending by U.S. commercial banks to foreigners directly, in large part Latin America, and to Europe largely through the branches of American banks also sug- gesting significant flows of loans to Latin America and other devel- oping countries. With the debacle in the international credit mar- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 165 kets initiated by the near default by Mexico, this lending contract- ed very sharply so that by mid 1984 it was essentially zero. Margin- al evidence since, suggests there is actually liquidation going on. So what we have seen is not a significant acceleration in the pur- chases of dollars by foreigners, either directly in the United States or through the Eurocurrency market, but a dramatic decline in the purchases of foreign currency by U.S. residents with U.S. dollars, which obviously has the effect of essentially strengthening the dollar by weakening the demand for other currencies in terms of dollars. That process cannot continue indefinitely. At some point we are going to find that the rate of liquidation of portfolios by U.S. com- mercial banks will come to a halt, and presumably some increase in lending will then ensue. At that point, the upward pressure on the dollar will come to a halt and presumably turn it downward. It is not possible for us to make judgments as to when that will happen because we are, as I indicated earlier, tracing new ground. It is very difficult to use historical experience to determine when this particular process will take place. Nonetheless, the dollar is es- sentially a short-term phenomenon. The longer term problem clearly is the budget deficit. The deep- est shadow, which crosses our otherwise benevolent economic sce- nario, is cast by the structural aspects of that budget deficit. There can be little doubt that the markets do not expect expenditure cuts ranging up to $100 billion or more annually by fiscal year 1988. That dimension, is a number which many budget deficit reduction programs contemplate. Should the cuts be enacted into law, cur- rently, in a manner which is credible to the financial community, long-term interest rates are likely to fall by at least two full per- centage rates with short-term rates falling even more. Thus, even the sharp reduction in purchasing power implied by such a major contraction of the Federal deficits, that is the so- called fiscal drag, would surely be overridden by increases in effec- tive demand generated by the market decline in interest rates and cost capital. The economy clearly would benefit longer term if the budget problem is addressed. It is an immediate imperative as well, howev- er, achievement of the Fed's economic projections rests upon the validity of the asssumptions back of these projections. Four percent real economic growth, with inflation still at only 4 percent, as- sumes that interest rates will increase only modestly. This, in turn, requires some reduction in the Federal deficit as part of an ongoing Federal deficit reduction package, although I must say it does not contemplate the tremendous reductions which are involved either in the President's budget or those that are currently surfacing in the Congress. The forecast also assumes no precipitous decline in the exchange value of the dollar and a monetary policy which successfully keeps the monetary aggregates within the Fed's targets. If any of these assumptions are not realized, the delicate balance required to achieve the projections would be in jeopardy. Appropriate mone- tary policy requires a weighing of the various relevant financial and economic developments, but above all, the inability to judge Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 166 the vagaries of credit demands requires stable growth rates in the monetary aggregates. Thank you. [Excerpts from the statement of Dr. Greenspan follow:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 167 Excftrpts trom the Tesc.mony ot Alan Grfs-i Ocnrie.sc ic Stints i. •* cy Qt cne Committee on Bdnmi>g, ^'induce ana _iro<n.i Attair.. House ot 'Kepi.esnntdt i ves Mat(.n 5, While the preponderance of evidence suygtscs a fairly ouoyant pat- tern o£ economic activity in cne montns immediately an«ad, deep shadows hovec over the longer term out LOOK. Tna cement pause in economic growth was a see.ningLy natural aftecsiacn ot tne solia pac- tecn ot expansion during tne £ irsc cwo y«idcs ot c^ijovef y . This slowdown appears eo oe over, and a quic-cening pace ot dec iv icy uiy is deveiop ing. The iitipiGving oucioot concinuea in tn« taca ot est^^ocn inacy sttentjth of cne U.S. dollar on foreign excn^nge mdcKets. By crHac- ing ptice aduantag«a tor foteign-proriuced jooos, cne strong aollaC has signLticancly incieaseo tne average anaca oE imports to doraest.i.c demand it\ recent quactwrs. It ^aa aVao aiverted U.S. pur- chasing power co foreign producers and, at Inast in tne simple first approximation, cose American production ana JODS. But cnac Eicst apptoximdtion is tar tiom tne wnom stury. irie nea^y de.-naiid foe U.S. dollars naa also lufc interest taees Lower thari cney otherwise would have often and nas clearly cont;iouted to a Lower rate oi inflation. ICnese, in tutn, nave r«auc«d cne sense ot in- stability and risk associated witn capital invescaieiit. It is tnu3 unclear, on Daiance, now mucfi ot a JOD loss, i£ any, tne strong dollar has produced. What ic has ptoduced, without question, is a paccwrn ot economic activity whicti is unique to tne pose World War II period and, per- haps, for a good deal ot U.S. history Before that. For tne first time in many generations, out domestic output and ^nipioy.tienc d;-a beir.g significantly impautea oy events wnicn originates oucsian our b AD o C i . d e G v c 3 e a ens _ p _ an i _ s Pre _ s _ i dent olTTb _ w _ n _ s _ f __ t _ n _ S _ - _ S _ r _ e _ e _ n _ s _ p _ a _ n _ _ "s _ _ ^ _ a _ . _ , . i .. n . c. Townsend-Cpeenspan & Co., inc. 12U W»il Street New to". NY 100U5 21c.-b4J-y;i15 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 168 The impact of international trends was particularly pronounced last year. The tremendous expansion in consumer expenditures, which was triggered by pent-up demand in the summer of 1983, was finally ex- hausted by the summer of 1984. This inevitably brought with it a slowdown in economic growth. Growth in domestic purchases in real terms, that is gross national product minus net exports, slowed Erom a near 9% annual r^te tor the first six quarters of this recovery to a less than 61 annual rate in the third quarter of 1984. But the growth rate in domestic production, that is the gtosa national product, fell from 7% to less than 2% annually over the comparable periods. The additional slowing of GNP growth was a reflection of a greater volume share of imported goods -- presuma- bly ordered earlier in 1984 -- arriving on our shores in time to displace a significant amount of domestic supply, production, and employment last summer. The marked slowing in production, coupled with the weakness in dollar-denominated international commodity prices, also created a major squeeze on profit margins which, in conjunction with the dol- lar translation of foreign affiliate earnings of U.S. corporations, brought the rapid acceleration of profits in the first half of 1984 to an abrupt halt by the summer. Whereas after-tax corporate prof- its during the first quarter of 1984 were a staggering 47% over Che first quarter of 1983, it looks as though the current quartet's level of earnings will come in below those of a year ago. All of this created a tendency on the part of American business to adopt a somewhat defensive posture. The result was a dramatic contraction in purchases for inventory, and a sharp decline in Che average lead time on the deliveries of materials ffrom basic suppliers. In fact, with production materials being quoted with a lead time of only 50 days in December 1984, purchasing patterns were back to their levels of the beginning of the 1993 recovery. This is an ex- traordinary phenomenon since a more typical pattern is one of con- siderable tightening of supply two years into a business recovery, prompting slowed deliveries, spot shortages, and rising commodity prices. Whatever one may say about the end of 1934, it was charac- teristic more of the beginning of a business recovery than its later stages. The reason the late 1984 pause in economic activity did not degene- rate into another recession is that inventories remained ex- ceptionally low by historical standards and capital investment was expanding. The period was scarcely describable in terms of an un- sustainable boom, nor were there the clear credit stringencies which typically predate the beginnings of a recession. Thus, it was just a matter of time before the reduction of commitments — the fall in new orders, the weakness in commodity prices, and the general compression in the timeframe of business decision-making -- would run out of room to contract. The normal forces of economic expansion would then reassert themselves and, indeed, this appears to be what is currently in progress. Real GNP growth through, the first half of the current quarter seems .to be tracking at something in excess of a 4% annual growth rate. This implies continuation of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 169 the moderate inventory accumulation rate which is now apparently under way. IE the inventory pace should accelerate, it is quite possible to get a much higher, say 6%, GNP growth rate for the cur- rent quarter. Monetary policy contributed to the revitalization of the expansion. When the sluggishness in the economy became apparent last fall, the Federal Reserve responded with a marked easing in credit policy, indeed, it reduced borrowed reserves (excluding extended credits) from a high of S960 million last October to S345 million in January, one of the sharpest such contractions in recent history. This was reflected in a rising ratio of seasonally adjusted nonbor- rowed to required reserves, which advanced from .9832 on November 7th, piercing 1.0 in the two weeks ended December 5, 1984 and remaining above l.Q until the present. Thus, the Fed has been quite accommodative, supplying more nonborrowed reserves than required for the past three months. As a result, short-term interest rates are now approximately 300 basis points below their levels of last summer. Accordingly, the near-term outlook is fairly optimistic. The lack of imbalances suggests that normal economic growth will take hold and carry us until imbalances are created. Accordingly, the FOMC's economic projections of roughly 4% real growth in 1985, moderate inflation at around 4%, and an unemployment rate below 7% by year- end appear reasonable. They could be accommodated by the Federal Reserve's announced monetary targets. If realized, the twin objec- tives of unemployment reduction and inflation containment would be attained without requiring the Fed to make crucial decisions which might jeopardize one of these aims by giving it less of a priority. while such an outcome is most desirable, and may have the greatest probability of any alternative scenario, it is by no means assured. There are a number of different events which might derail it, pos- ing serious problems for the Fed. The economic expans ion could prove to have greater momentum than now anticipated. Consumer buy- ing might be stronger and homebuilding and capital spending more vigorous. This could generate an excessive surge of demand built on large inventory accummulation. Such economic buoyancy generally quickens monetary growth and heightens inflation pressures. Under these circumstances, the Fed probably would be impelled to keep tightening credit even if this eventually produced a recession. The Fed undoubtedly would want to apply the minimum and least dis- ruptive tightening riscessary to achieve its purposes. Such judi- c ious control of credit tightening, damping the economy into » soft landing, is not easy, however, without the benefit of hindsight. The problem is complicated by the time which generally must elapse before the impact of Fed policy on the economy becomes evident. These t ime lags create a tendency to carry policy further than might in retrospect appear absolutely necessary. Thus, there is a danger that initial attempts by the Fed to accommodate the accelerating expansion so as not to endanger employment could Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 170 inflation expectations and eventually, inflation itself. The result would then inevitably be recession, either from the inflation-induced contraction in real, purchasing power, or from the apt-i-inflation policies adopted by the Fed, or a combination of both. This problem does not appear to threaten at present. The danger of excessive monetary ease relative to the economy's requirements appears to have been allayed by the announced cessation of the policy of progressive easing preparatory, presumably, to a modest renewed tightening when, and as, aooropriate. Moreover. severe tightening does not appear to be contemplated or necessary at this time since the economy shows n.o aiqns of over ex- uberance at the moment. The tremendous pul1 ing back of commitments to a near hand-to-mouth basis is reflective of a virtual elimina- tion of inflationary expectations in the short-term. There is, therefore, apparently little reason to accumulate inventories for potential canital gains. The Fed is keeping an eye on long-term interest rates as a gauge of inflation expectations. Should these show signs of beginning to rise steeply, the Fed could be expected to respo'nd exped itiously with policies focused more heavily on fighting inflation. More likely is an eventual weakening of the dollar, which could develop into a soeculative downturn in the exchange rate. This would, in turn, push short-term interest rates higher and stifle further economic growth. It is difficult to assess the probability o£ this occurring in the short-term, despite the indications that the current exchange rate, now probably close to 30% over purchas- ing power parities, is being driven by dollar demands which are un- likely to be sustained indefinitely. History suggests that there is little that the Federal Reserve can do to nudge the foreign exchange value of the dollar lower in an orderly fashion. The attract ion of the dollar as a safe haven vehicle appears to outweigh the effect of relative interest rates. As was evident, late last year, lowering interest rates on dollar denominated assets relative to those denominated in other cur- rencies does not necessarily cause the dollar to fall. Moreover, should the Fed try to push U.S. interest rates down significantly to weaken .the dollar, the monetary expansion which would be required to achieve this under present economic conditions could intensify inflation pressures and inflation expectations. This, in turn, would raise the inflation premium in long-term interest rates, causing yields to move higher. Tn short, the ultimate out- come of an excessively easy monetary policy aimed at pulling down the dollar would be to raise, rather than lower, interest rates, presumably enhancing the attractiveness of the dollar on foreign exchange markets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 171 TO is suggests tnat an overly easy money policy by the Fed might not be much help to the dollar and could be counterproductive. If in- vestors in the rest of the world feared inflation in the United States, this could trigger a steep decline in the dollar as oc- curred in 197B and 1979. IE interest rates are not the primary determinant Q£ the foreign exchange value . o£ a currency, U-S. interest rates would have to climb sharply in order to attract the funds needed to cover our current account deficit. The detrimental impact on our economy is clear. As for central bank intervention in the foreign exchange markets, it too appears to have little sustained effect when there is strong movement towards a currency. Such intervention may temporarily dis- concert speculators and discourage speculation in a currency for a while. The resources available to central banks are limited and repeated massive intervention simply is not feasible. Once the mar- kets recognize that intervention is limited, its impact on exchange values does not last very long. It then begins to take greater and more frequent intervention to achieve even that limited effect. in short, it is easier to point to the techniques which will not be too effective, such as excessive monetary ease or sporadic inter- vention, rather than cite the things which the Federal Reserve might do to effectively bring down the value of the dollar. It would appear that the best thing the Fed could do is be patient, awaiting the emergence of market forces away from the dollar. The deepest shadow which crosses our otherwise benevolent economic scenario is cast by the structural budget deficit. Unless the laws of arithmetic are repealed, interest cost accumulation on top of S200 billion plus deficits must inevitably crowd out private in- vestment and economic growth. However, it is not a short-term prob- lem. Temporary market adjustments might £end it off for several years, but the process of deterioration is inexorable. While the strategic purpose of reducing the deficit is to prevent long-terra excessive absorption of private savings and a crowding out oE private investment, the short-term tactical purpose is to create, in law, a fiscal policy which the financial markets per- ceive as sufficieatly credible to drive long-term interest rates down. There is no need for a pact with the Federal Reserve stipulating that, if Congress reduces the deficit, the Fed will ease money supply. The markets work very efficiently by themselves. If the average cynical bond trader begins to perceive that indeed a budget reduction package is not phoney, the desire to turn a profit can be counted on to drive bond prices sharply higher and long-term interest rates correspondingly lower. There is clearly a difference, however, in the way bond traders and other participants in the world markets view a reduction in the deficit. A deficit reduction package which is heavily weighted toward tax increases is less likely to induce a marked decline in interest rates than one heavily or solely weighted in the direction Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 172 of expenditure cuts. There is the strong presumption in the finan- cial community that an increase in tax rates could just as easily become the base for increased expenditure programs, as for reducing the deficit. The argument that the Congress has not in the past employed tax increases to finance increased expenditures is apparently unpersuasive to the financial community. The past is likely to tell us little about the future behavior of the Congress when confronted with pressures from constituencies. It is true that Presidents and the Congress continuously cut tax rates through the 1970s as inflation pushed most taxpayers into progressively higher tax brackets. Hence, federal receipt's as a percent of the GNP or of taxable incomes has remained relatively steady during the past couple of decades, it is argued, therefore, that increased tax receipts have not been the basis for financing new outlay programs. The critical consideration, however is spend- ( ing, which rose as a ratio to GNP, increasing the structural deficit. Unless the upward pressure on spending is reduced, tax in- creases will eventually be triggered; deficits can't increase in- definitely. In that event, taxes would be supporting increased spending programs, albeit with a time lag. There is also clearly a difference in the way markets will react to the mix of federal budget cuts between defense and entitlement pro- grams. Leaving the politics of entitlements and the very serious question of defense adequacy aside, so far as the economy is con- cerned, does it make any difference where the cuts are made? The short answer is that it does. Entitlements: social security, Medicare, civil service, military retirement, etc., depend to a significant extent ot\ population growth, especially among the elderly. As the base of expenditures expands, reflecting the growth in population, changes in the law today have a much larger impact on outlays ten years from now than they do, say, three years from now. Defense, however, is another matter. A goodly part of defense ex- penditures are involved in building up our military asset base. Once' we reach the requisite number of F-16 wings, carrier task forces, ammunition stores, etc., procurement outlays will fall back to maintainance levels, which are significantly lower in real terms than the huge budget outlays required during the period of military build-up. Hence, cuts in defense over the next three years are not translatable, as they are in entitlement programs, into very much larger cuts in the years 1990 and beyond. Accordingly, the financial markets are surely likely to credit, on a dollar-for-dollar basis, short run cuts in entitlement programs with far more long-term anti-inflation impact than equivalent cuts in defense outlays. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 173 There can be Httle doubt that ing power implied Dy such a major contraction ot tie reaerai deficits, i.e., so-called fiscal drag, would surely be overridden by increases in effective demand generated by the marked, decline in interest rates, and cost oE capital. Most immediately, homebuiIding would rise quite significantly, in- creasing from recent levels of 1.7 million housing starts annually to well in excess of 2 million and perhaps as high as 2.2 million units annually, at least for: awhile. But the more important and lasting impact would occur in the capital goods markets. The ex- ceptionally high cost of capital which has prevailed in recent years has led to a disproportionate emphasis in investment in short-lived assets, i.e., those with guick cash payoffs. Lowered long-term interest rates would surely propel stock prices higher, and lower the cost of equity capital. The combination of lowered costs of equity and debt would increase the incentive to invest in plant and other long-lived goods. Considering the pent-up demand for long-lived investments at lower costs of capital, the expansion could go on for years. This would be especially helpEul to those depressed areas ot the American economy which build long-lived facilities or the materials which go into them — steel, heavy equipment, etc. Thus, the economy clearly would benefit longer run if the budget problem is addressed. It is an immediate imperative as well, however. Achievement of the FOMC's. economic projections rests upon the validity of the assumptions back of these projections. Four percent real economic growth with inflation still at only four per- cent presumes that interest rat«s will increase only modestly. This, in turn, requires some reduction in the federal deficit as part of an ongoing federal deficit reduction package. It also assumes no precipitous decline in the exchange value ot the dollar and a monetary policy which successfully keeps the monetary aggregates within the Fed's targets. If any of these assumptions are not realized, the delicate balance required to achieve the pro- j ections would be in jeopardy. Ours is a highly complex economy, closely interrelated with economic and f inaneial developments throughout the world. No single monetary or credit aggregate has an invariant relationship with the diverse economic and financial strands of our society. Therefore, no single monetary or credit aggregate can stand alone as the sole target of monetary policy. The various monetary and credit aggregates require monitoring and targeting, as the Fed is now doing. Moreover, the growth rates of the monetary aggregates can only be interpreted and evaluated in the context of economic and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 174 financial cond it ions. Accordingly, it is not possible to specify in pdvance the relative weights which the Fed should assign at any given time to these diverse factors. Since the broader monetary aggregates, such as M2 and M3, can pro- vide the basis for transfer of deposits into transactions accounts, it is important that these broader aggregates be kept within their targets. It may be very difficult to hold down Ml if funds are be- ginning to be transferred into it from these other accounts. Con- sequently/ the fact that Ml is low relative to its target must be weighed against the potential problems which could evolve if the broadec aggregates remain cons is tently above target for a period of t ime. Nevertheless, the Fed must be free to conduct monetary policy on the basis at a.n assessment of the forces which appear crucial at any particular time. Clearly, when the economy is faltering, it is necessary to maintain credit and monetary growth. But if the economy and money supply appear to be accelerating in an un- sustainable manner, they must be reined in before a new inflation wave is generated. Appropriate monetary policy requires a weighing of the various relevant financial and economic developments. But above all, the inability to judge the vagaries of credit demands requires stable growth rates in the monetary aggregates. Chairman FAUNTROY. We thank you, Dr. Greenspan, and we will return for questions as soon as we complete the presentations of the other panelists. We now turn to Dr. Charles Schultze. Dr. Schultze, it is a pleasure to have you here again. STATEMENT OF CHARLES L. SCHULTZE, SENIOR FELLOW AT THE BROOKINGS INSTITUTION Dr. SCHULTZE. Thank you, Mr. Chairman, and members of the subcommittee. I will try to abridge my formal statement liberally as I go, to save a little time. Your letter of invitation to testify asked me to discuss a number of specific questions about the economic outlook and the monetary policy objectives for 1985, which Chairman Volcker recently pre- sented to the comuiittee. Let me introduce my answers to those questions that you have asked by summarizing my assessment of the Federal Reserve's basic objectives and operating techniques. Despite all the attention still given to monetary aggregates and its semiannual reports to the Congress, the Fed, since about the middle of 1982, has not, I think, been pursuing an essentially mon- etarist course. You might describe the Fed as about 20 percent monetarist, or if you prefer, maybe 30 percent. It has been pursuing, and I believe will continue to pursue, two principal objectives. It has, on occasion, modified or ignored its tar- gets for the monetary aggregates and will do so again if necessary to meet those principal objectives. Faced with the huge and con- tinuing pump priming stimulus from the Federal budget deficit, the Fed's first objective has been and is an anti-inflationary one— to keep a lid on the growth of national spending and output. It will do whatever it feels it has to do by way of restrained growth and bank reserves and the accompanying higher interest rate to pre- vent, an excessively rapid economic expansion from overheating the economy and generating new inflationary pressures. Its commit- ment to this objective was amply shown in May of 1983 when only 5 months into the new recovery, it began to tighten monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 175 policy and let interest rates move up sharply. Such an early move toward rightening was unprecedented. The Fed, however, also, in my judgment, has no desire to see an- other recession. Unlike its actions in 1981, 1982, it will not deliber- ately put the economy through the wringer of recession in order to get inflation down further. It will, at least for the time, live with the inflation we now have. So long as inflationary pressures remain moderate, the Fed will not stand hy and watch the econo- my go into recession. If it appears that monetary restraint has gone too far, that economic growth is slowing too much, as appar- ently happened late last summer, the Fed will move to ease mone- tary policy and lower interest rates, which it did last fall and early winter. And real interest rates are still so high, even after their de- cline of last fall and winter, that the Fed has very large scope to use monetary policy, if it does so responsibly and cautiously, to cor- rect any mistake or to offset any softening in the economy. I said that the Fed was perhaps 20, or if you want, 30 percent monetarist. It apparently doesn't pay much attention to very short- run deviations of money growth from its targets. But in the medium-run, the Fed, quite properly, does look at the combination of monetary growth rates and interest rates as a useful, although occasionally fallible current indicator of the likely strength of demand and spending in the economy. Unexpected and sustained growth of the money stock over some months, combined with stable or rising short-term interest rates, suggests either that economic activity is accelerating or that veloci- ty is falling below expectations. To the extent that incoming data ultimately confirmed the second hypothesis about velocity, the Fed has been willing to diverge from its money growth targets to ac- commodate the changed velocity. But for the interim, in deciding on the amount of bank reserves to supply, it does pay attention to sustained deviations of money supply growth from its targets. I find the basic approach that the Fed has settled into in the last several years to be highly sensible and commendable. It has en- abled the Federal Reserve reasonable economic stability and growth in an environment made very difficult by the huge struc- tural deficits in the Federal budget. Mr. Chairman, let me try to answer some of your specific ques- tions. You asked about the 1985 outlook, However, short-term eco- nomic forecasting is not my bag. In any event, the economic out- look for 1985 will not solely be determined by outside events. It will be determined by the specific course that the Federal Reserve, itself, takes as the year progresses. For what it is worth, I think the prospects for the year may be a shade more optimistic than the Federal Reserve's own forecast, given the current status of policy. A fall in the dollar could give rise to higher inflation than the Fed forecasts, but unless that happens within the next 3 months or so, the time lag between the change in the exchange rate and the con- sequent change in prices would keep the effect in 1985 rather small. More important than these particular forecasts, which probably aren't worth very much, is the attitude of the Federal Reserve, as expressed by Chairman Volcker. The report indicates that the Fed would do nothing to prevent the above pattern from developing. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 176 Economic growth of the amount the Fed predicts or even a shade higher would apparently fal! within the safe limits to which, under objective No. 1, the Federal Reserve is committed. Your letter of invitation asks about the appropriate priority that the monetary authority should place on the reduction relative to reduction of inflation. Let me start with inflation. The inflation rate is now about 3.5 to 4 percent, but the rising dollar is contribut- ing a percentage point, or probably slightly more, to that low rate. With a stable dollar, the underlying inflation rate would probably oven be in the neighborhood of 4.5 to 5 percent. It has been a major accomplishment achieved at very great economic cost and human suffering to halve the underlying inflation rate from 10 to 5 per- cent. At the present time I agree with the Fed's apparent willingness to live with the inflation we now have rather than to put the econ- omy into a new period of stagnation and recession in order to pull inflation down further. On the other hand, the Nation's capacity to produce apparently continues to grow at a modest 2.5 to 3 percent a year. All of the evidence on the growth of manufacturing capac- ity, the expansion of the Nation's capital stock, the cyclically ad- justed growth of productivity, seems to confirm that judgment. There is still some slack in the economy so that the growth of output can, for a short while, safely proceed somewhat faster than capacity is growing. But if the 4-percent forecast for GNP growth in 1985 is approximately reached, we will, by the end of the year, have used up half of the remaining spare capacity. In terms of unemployment, it will be only one-half to three-quar- ters of 1 percent above the level at which unfortunately we have to begin to worry about generating new inflationary pressure. Given the human suffering and costs that are incurred during an infla- tion, once it gets started, and the impossibility of the Fed finetun- ing the economy, it would be unwise, I think, for the Fed to pursue a substantially nr re liberal monetary policy in 1985 than it now appears to have in mind. In short, I agree with the Fed's apparent objectives for the year, especially in the light of its demonstrated willingness to change the preannounced course of money growth if that becomes recessary, to keep the economy on the middle course between incautious expansion and unneeded stagnation. You ask whether I think the Federal Reserve can or should redi- rect its monetary policy toward moderating the overvaluation of the dollar in foreign exchange markets. The esential answer to that question ought to be a resounding no. Some time ago, the Fed, quite properly, made the choice not to let the massive pump-prim- ing stimulus from the structural budget deficit lead to excessive growth in national demand and spending. The inevitable consequences of that decision were that other in- terest-sensitive activities in the economy had to be squeezed out to make room for Federal borrowing. Surprisingly, it was the trade balance that overwhelmingly got squeezed rather than domestic in- vestment, and housing construction, and business plant and equip- ment. At least it was a surprise to me and most of my honest friends. It is indeed a serious problem that the budget deficit distorts the structure of our economy so as to penalize severely the Nation's Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 177 farmers, manufacturing exporters, nnd import compering iiniis. But the Fed cannot avoid the unpleasant, consequences of the budget deficit. It can only change them from one unpleasant hum to another. It could sharply ease monetary policy, in my judgment, engineer for a time a large drop in short-term real interest rates. ;.) depreciation of the dollar, and ultimately a shrinkage of the t'.S. trade deficit. But the cost of such excessive expansion after a period of time would be renewed inflation, and if history is any guide, a subsequent reversal of policy leading to recession. At the margins, the Federal Reserve may occasionally find it useful to modify its monetary policy a bit in periods when specula- tive fever seems to be particularly prominent in driving the dollar. But in a fundamental sense, I don't think the Federal Reserve will, or more importantly, should try to substitute the pains of inflation and subsequent recession for the less severe pains of an oven allied dollar and a large trade deficit. The third question in your letter of invitation asked our views on the relative weight the Fed should give to various monetary aggre- gates vis-a-vis the financial market conditions as targets for policy. I think, Mr. Chairman, in the process of answering your earlier questions, I have already given my own views about this last one. Finally, I would like to emphasize that the important choices about the future of the American economy must now be made not by the Federal Reserve but by the Executive and the Congress. If you do not soon act to slash the budget deficit drastically, the Fed will more and more be restricted to choosing which of several forms of economic cost it must impose upon the country. There are several alternative scenarios that might play themselves out should the budget deficit continue essentially unabated over the next sev- eral years. Each of those scenarios will pose major problems for the conduct of monetary policy. But far more important under any of them, the long-term growth, stability and vitality of the American economy will suffer severely. The final section of my testimony, Mr. Chairman, which I will skip in the interest of brevity, goes through what I consider to be the three major scenarios that might happen with respect to the Federal Reserve's policies and actions if you don't do anything about the budget deficit. The testimony points out that in any of those scenarios, some a little more than others, but in any of the three, the Fed is put in a real bind and so is the country. Finally, Mr. Chairman, my reading of budget numbers and politi- cal realities suggests that there is only one feasible package of defi- cit reductions large enough to do the job that must be done to avoid the consequences that I have spelled out. And, that is a pack- age which attacks all the elements of the budget: reduce defense spending, cuts in Social Security benefits, and increased taxes, in addition to the cuts in other civilian programs, which the President has asked you to concentrate upon. Thank you, Mr. Chairman. [The prepared statement of Dr. Schultze follows:! Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 178 Statement of Charles L. Scnuitze* Brookings Institution before the bubconimi ttee on Doraestic Monetary Policy U. S. House ot Representatives Maten 5, 1985 Mr. Chairman and members of the ConuaiLtee: Your letter of invitation to testify asks me to discuss a number of specific questions about the economic outlook and the nujfieLary policy objectives for 1985 which Chairman Volcker recently presented to this Committee. I will do so briefly. Since my views about the economic outlook and about the specific questions you have posed depend heavily on an assessment of the underlying objectives and the control techniques the Federal Reserve is now pursuing, let me start by summarizing that assessment. Despite all the attention still given to monetary aggregates in its semi-annual reports to the Congress, the Federal Reserve, since about the middle of 1982, has not, 'L think, been pursuing an The author is a Senior Fellow at the Brookings Institution. The views set forth here are solely those of the author and do not necessarily represent the opinions of the trustees, officers, or other staff members of the Brookings Institution. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 179 essentially monetarist course. One might correctly describe the Fed as about 20 percent, monetarist. The Federal Reserve has been pursuing, and I believe will continue to pursue, two principal objectives. It has on occasion modified or ignored Its targets for the monetary aggregates and it will do so again if necessary to met those principal objectives. Faced with the nuge and continuing pump-priming stimulus from the federal budget deiicit, the Fed's first objective is an antilnflationary one — to keep a lid on the growth of national spending and output. It will do whatever it feels it has to oy way of restrained growth in reserves and the accompanying higher interest rates to prevent an excessively rapid economic expansion from overheating the economy and generating new inflationary pressures. The Federal Reserve's commitment to this objective was amply snown in May 1983, wnen only five months into tne new recovery, it began to tighten monetary policy and let interest rates move up sharply. Sucn an early move towards tightening is unprecedented. It showed its determination again, in the first half of 1984 wnen it engineered a 200 point rise in shorc-term rates to damp down an excessively rapid growth in GNP. The Federal Reserve, however, also has no desire^ to see another recession. Unlike its actions in 1981-82, it will not deliberately put the economy through the wringer of recession in order to get inrldtion down furtner. It will live with the inflation we now nave, as Chairman Volcker implicitly indicated in his testimony before the full House Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 180 Banking Committee on February 20, when he said that "The [1985] ranges for growth in money and credit are expected ... to support another year of satisfactory economic expansion without an acceleration of inflation" (underlining supplied). So long as inflationary pressures remain moderate the Fed will not stand by and watch economy go into recession. • If it appears that monetary restraint has gone too far, that economic growth is slowing too much — as apparently happened late last summer — the Fed will move to ease monetary policy and lower interest rates, which it did last fall and early winter. • Real Interest rates are still so high, — even after their decline of last fall and winter — that the Fed has very large scope to use monetary policy to correct any mistake or to offset any softening in economy; more so than usually, the Fed is now In a good position to provide counter-recessionary assistance for the economy, should that be necessary to avert a recession. I said thac the Federal Reserve was perhaps 20 percent monetarist. It apparently does not pay much attention to very short-run deviations of money growth from its targets. But in the medium run the Fed, quite properly, does look at the combination of monetary growth rates and interest rates as a useful, although occasionally fallible current indicator of the likely strength of demand and spending in the economy. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 181 Unexpected and sustained growth of the money stock over some months combined with stable or rising short-term interest rates suggests either that economic activity is accelerating or that velocity is falling below expectations. To the extent that incoming data ultimately confirm the second hypothesis the Federal Reserve has been willing to diverge from its money growth targets to accommodate the changed velocity. But for the interim, in deciding on the amount of bank reserves to supply, it does pay attention to sustained deviations of money supply growth from its targets. I find the basic approach that the Fed has settled into in the last several years to be highly sensible and commendable. It has enabled the Federal Reserve to preserve reasonable economic stability and growth in an environment made very difficult hy the huge structural deficits in the federal budget. One way to describe the current economic scene is that, withtn some moderate range, monetary'policy has been determining the overall level and growth of national output. The size of the budget deficit determines the internal composition and structure of national output. With the federal deficit equal to about 5-1/2 percent of GNP, the Federal Reserve has to squeeze out enough interest-sensitive spending to make room for federal borrowing of that amount. For the past two years it has been the foreign sector of the economy — our export and import-competing industries — which have mainly been squeezed. If, as, and when overseas Investors become less interested in pouring Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 182 foreign saving into the United States it will Chen be interest-sensitive domestic activities that will have to be squeezed out. With cue led more or less successfully targeting the overall level of demand and spending, the damage done to the nation by the huge structural budget deficits, is not so likely to come in the form of recession or inflation. Rather it will come from the distorted internal structure that the budget deficits are forcing on the economy. Let me turn to your specific questions. You ask aoout the 1985 outlook. Snort-term economic forecasting is not my profession. And, In any event, the economic outlook for 1985 is not solely determined by outside events. It will be determined by the specific course that Federal tteserve policy itself takes as trie year progresses. For wnat it's worth I think the prospects for the year may be a snade more optimistic that the Federal Reserve's own forecast, given the current status of policy. Growth over the year of 4 to 4-1/2 percent, with unemployment falling to 6-1/2 to 6-3/4 percent might be a good midpoint. All of tne current signs point to continued moderate inflation. JUSL as in the Federal Reserve's forecast a fall in the dollar could give rise to higher inflation, but unless that: happens within the next three months or so, the time lag between a Change is the exchange rate and tne consequent change in prices would keep the effect in 1985 rather small. More important than tnese particular forecasts — which are prooably not worth very much — Is the attitude of the Federal Reserve as expressed by Chairman Volcker. I read him as Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 183 saying tnat the V'ed would do nothing to prevent the above pattern from developing. Economic growth of ttiat amount would apparently tall within tne "safe" limits to wtilch, under objective number one, the Federal Reserve is couimicted. Your letter of Invitation asks about tne appropriate priority that Lhe monetary autnorities should place on the reduction of unemployment relative to tne reduction of inflation. Let me start with inflation. Tne inflation rate is now about 3-1/2 to 4 percent. But tne rising dollar is probably contributing a percentage point, or maybe a little moie, uo that low late. With a stable dollar, the underlying inflation rate wuuld prooaoly be in tne neighborhood of 4-1/2 to 5 percent. It haa been a major accomplishment, achieved at very great economic cost and human suftering, to halve the underlying inflation rate trom 10 to 5 percent. At tne present time I agree with the Federal Reserve's 1. There is a passage In Chairman VoicKer'a testimony of February 20 (p. 24} where he can be read as saying the Ved is in some sense targeting a nominal GNP growth tn tne neighborhood of 8 percent. After Saying tnat the trend of velocity growth in 1985 may be a "little lower" than the norinal 3 percent, the Chairman went on to say, "Should developments during 1985 tend to confirm that somewhat lower velocity growth, and provided tnat inflationary pressures remain suodued, the Committee anticipates that [ttie] aggregates might end up in tne upper part ot ttieir ranges." But over a period as long as a year, the Fed Itseli can control tne giowth of the aggregates. I tase the statement to mean, tueieiofe, that the Fed, given evidence of Ml velocity growth slowing to say, 2 percent, will deliberately grow tne Ml money supply near ttie upper end of tne target range, say 6 percent, wnich is consistent with an 8 peicent nominal GNT growth. I do not mean the Fed can tine tune this closely. But the statement does seem to indicate that Ml growth will be adapted in the light of observed economic growth, in a way designed to move the economy towards a GNP target. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 184 apparent willingness to live with the inflation we now have — rather than to put the economy Into a new period of stagnation or recession in order to pull inflation down further. On the other hand, the nation's capacity to produce apparently continues to grow at a modest 2-1/2 to 3 percent per year. There is still some slack In the economy so that the growth of output can, for a short while, safely proceed somewhat faster than capacity is growing. But, if the 4 percent forecast for GNP growth in 1985 is reached, we will by the end of the year have used up half of the remaining spare capacity, and in terms of unemployment will be only 1/2 to 3/4 of a percent above the level at which, unfortunately, we have to begin worrying about generating new inflationary pressures. Given the human suffering and costs that are incurred to wring out inflation once it gets started, and the impossibility of the Fed fine-tuning the economy, it would be unwise for the Fed to pursue a substantially more liberal monetary policy in 1985 than it now appears to have in mind. In short, I agree with the Fed's apparent objectives for 1985, especially in the light of their demonstrated willingness to change the preannounced course of money growth to the extent that becomes necessary in order to keep the economy on the middle course between incautious expansion and unneeded stagnation. You ask whether I think the Federal Reserve can or should redirect its monetary policy towards moderating the overvaluation of the dollar in foreign exchange markets? The essential answer to that question is Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 185 a resounding "No." Some time ago the Fed quite properly made the choice not to let the massive pump-priming stimulus from the structural budget deficit lead to excessive growth in demand and spending. The Inevitable consequence of that decision was that other interest Sensitive activities in the economy had to be squeezed out to make room for the deficit. Surprisingly, it was the trade balance that overwhelmingly got squeezed rather than domestic investment in housing construction and business plant and equipment. It is indeed a serious problem that the budget deficit distorts the structure of our economy so as to penalize severely the nation's farmers, manufacturing exporters, and import competing firms. But the Fed cannot avoid the unpleasant consequences of the budget deficit; it can only change them from one unpleasant form to another. It could sharply ease monetary policy, engineer for a time a large drop in short-term real interest rates, a depreciation of the dollar, and ultimately a shrinking of the U.S. trade deficit. But the cost of such excessive expansion, after a period of time, would be renewed inflation ana, If history is any guide, a subsequent reversal of policy leading to a recession. At the margin, the Federal Reserve may occasionally find It useful to modify its monetary policy a bit in periods when speculative fever seems to be particularly prominent in driving the dollar. Chairman Volcker told this Committee last week that the Federal Reserve may now be doing a little of this, in the sense of pursuing a slightly easier monetary policy than It would otherwise desire. But in a more Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 186 fundamental sense I do not think the Federal Reserve will or should try to substitute the pains of inflation and subsequent recession for the less severe pains of an overvalued dollar and a large trade deficit. The third question In your letter of invitation asked our views on the. relative weight that the Federal Reserve should give the various monetary aggregates vis-a-vis an array of economic and financial market conditions as targets for policy. I believe, Mr. Chairman, that in the process of answering your earlier questions I have already gl«en ray views about this last one. Finally, I would like to emphasize that the import-ant choices about, the. future of the AtBe.rican ec.onoray nvnst nou be marte TIOT. by T.he Federal Reserve but by the Executive and the Congress. If budget deficits of 5 to 5-1/2 percent of GNP are allowed to continue, then — even more than in the recent past — the Federal Reserve will be called upon to make choices between various unwelcome forms of economic pain. There are three alternative scenarios that describe how economic event? might play thernselves out over the rest of this decade, assuming no radical reductions in tVie budget deficit. Under the. first, and possibly thp roost likely scenario, foreigners will eventually begin to lose snwp of their desire to buy dollars, as their portfolios become increasingly top heavy and risky with dollar-denominated pssets. The dollar — possibly later rather than sooner — will begin to fall. After a lag, exports will strengthen and Imports weaken, The inflow of foreign saving, which now indirectly finances over half of the U.S. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 187 budget deficit, will start to dry up. The 5 to 5-1/2 percent of GNP which the federal government borrows will then have to be financed out of our limited domestic saving. In order to meet its primary objective of avoddlng an overheated economy the Federal Reserve will, therefore, havp to engineer a new surge in interest rates In order to squeeze out domestic, investment in housing and business plant and equipment. No one can be sure, but recent history under financial deregulation suggests that the rise in rates might have to be very large. Yet they would only be the symptoms of underlying economic loss — namely the long-term reduction in American economic growth that would result. A second, less likely but still possible scenario, is that foreigners continue for a long time in the future to find dollar assets attractive, despite the cumulative increase in their holdings. £fter all, most of us sharply underestimated the foreign appetite for dollars over the last several years; perhaps their appetite for dollars will continue to surprise us. In this scenario foreign saving continues to supplement domestic saving in a large way. The dollar remains high; thp trade balance stays huge; farmers, exporters and inmort competitive industries continue to suffer. But the 5 to 5-1/2 percent of RNP going t" the feHpj-al budget deficit can continue to be financed at roughly current interest rates. The economic cost to the nation in this case takes the form not of reduced domestic Investment and lower productivity growth, but an ever mounting foreign debt, the payment of debt service on which Increasingly erodes the growth of the nation's Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 188 living standards. In one way this is the worst of all scenarios. No crisis and no surge in interest rates intervenes that might force action on the budget deficit. The day of reckoning is postponed, while, in the meantime, the eventual tax burden required to service the federal debt steadily mounts. The third scenario, also less likely but not impossible, is a crisis scenario. Suppose that when the dollar starts to fall speculative fever takes over so that it falls not gradually but very swiftly and far. Import prices would rise steeply, and the price of import-competitive goods produced domestically would follow suit. Temporarily, at least, the U.S. inflation rate would rise significantly. In a strong economy, with low to moderate unemployment and high capacity utilization, the sharp increases in import prices might set off a new price-wage-price spiral and turn a temporary rise in inflation into a long-term one. The Federal Reserve would be faced with a dilemma — continuing to accomodate economic growth would require validating a new inflation. Suppressing the inflation could set off a new recession. My guess is the present Fed would choose recession. The purpose of spelling out these scenarios, Mr. Chairman, is to drive home the point I made earlier that at this juncture in history the critical choices to be made are in the hands not of the Federal Reserve but In those of the President and the Congress. If you do not soon act to slash the budget deficit drastically, the Fed will more and more be restricted to choosing which of the several forms of economic costs it will impose upon the country. A reading of budget numbers and political realities suggest in turn, Mr. Chairman, that the only feasible package of deficit reductions large enough to do the job Is one which attacks all the elements of this budget — defense spending, social security and taxes in addition to the other civilian spending programs which the President has chosen to concentrate upon. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 189 Chairman FAUNTROY. Thank you, Dr. Schultze. Dr. Poole. STATEMENT OF WILLIAM POOLE, PROFESSOR OF ECONOMICS, BROWN UNIVERSITY Dr. POOLE. Thank you, Mr. Chairman, and members of the sub- committee. I am certainly delighted to be here. I must say, though, that when I took a walk after breakfast, I almost decided to call in sick and pack up my suit and go for a walk along the canal. It is such a beautiful day. But here I am anyway. I hope you have a copy of my written statement in front of you. I will be referring to some of the charts in that statement in the course of my oral presentation. Let me begin by just very briefly touching upon the three ques- tions posed to me in the chairman's letter of invitation to these hearings. Then I will run through my ideas on monetary targeting with somewhat greater attention to detail. As for the economic outlook, I believe that the administration's economic assumptions are sound. The administration, the Federal Reserve and the CBO forecasts are all quite similar. It should be emphasized, however, that we must interpret all forecasts as having a range of error attached to them. Forecast errors for both real GNP in the inflation rate average in the neighborhood of 1 to 1.5 percentage points for a four-quarter-ahead forecast. That is our experience historically. Second, the performance of the economy will depend importantly on the future policy actions of the Federal Reserve, the administra- tion and the Congress. It is not easy to forecast what the Govern- ment is going to do, and the discipline of economics is not of much value in improving these forecasts. To forecast the Government, it is probably better to pull out a crystal ball than a bundle of eco- nomic text books. In relation to Federal Reserve policy toward inflation, as shown in the chart on page 2 of my statement, with a lag that has aver- aged about 2 years in the United States, more rapid money growth brings more rapid inflation and vice versa. The relation between swings in money growth and the business cycle is shown on page 3 of my statement. Money grown generally declines before and during recessions. These charts, by the way, have been reproduced from this year's economic report of the President. If money growth declines gradually over time, I believe that the administration's forecast has an excellent chance of being realized, at least in broad outline. The forecast also depends on the assumption that our Federal finances are put on a sound basis. My only quarrel with the administration's outlook is that I believe that real rates of interest remain unusually high so long as the Govern- ment follows policies that support high real rates of return on new business investment. Reducing the budget deficit will help to reduce interest rates but not by a large amount, in my view. Now, let me turn to the value of the dollar. The U.S. dollar is high, but not overvalued in any proper sense of that term. The dollar will fluctuate in value, but I do not believe that it will de- cline sharply under our current policies, even assuming that the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 190 budget deficit is brought down significantly through spending re- ductions. However, reducing the deficit through tax increases that reduce the rate of return on new investment could well leave us with lower real interest rates and a lower dollar. Such policies would also leave us with lower investment and a lower rate of real GNP. To those who predict that the dollar will fall if the Federal budget deficit is reduced, I raise this challenge. Find me an exam- ple from history of a country that has put its fiscal affairs in sound order and found itself with a depreciating currency. Large-scale direct intervention in a foreign exchange market is unlikely to have much effect on the exchange rate except possibly to increase the short-term volatility of the rate. According to this morning's Washington Post, intervention by various governments last week may have amounted to about $4 billion. Intervention of that scale continued for a year would amount to $200 billion, and yet might only hold the dollar a few percent below where it other- wise would be. Intervention policy just doesn't look very promising. Chairman Fauntroy's third question concerned the proper role of monetary aggregates and financial conditions in Federal Reserve policy. I note first—and here I agree with Charlie Schultze, that Federal Reserve policies are not today very monetarist, Especially in the short run. They are, in my view, the functional equivalent of its policies before October, 1979. The pre-1979 policies involved an explicit short-run peg to the Federal funds rate. The peg was ad- justed from time to time. Policy today involves what the Federal Reserve calls maintaining a certain degree of pressure on bank reserve positions. The reserve pressure is adjusted from time to time. But if a man or a woman from Mars dropped down here today and looked only at the data, studiously avoiding reports, speeches and testimony, that person would have a hard time distinguishing present open market policy from the policy before October 1979. Let me now turn to monetary targeting issues. The purpose of monetary targeting is to improve the performance of the economy, to stabilize the price level, to obtain maximum employment and growth, and to foster stable and efficient financial markets. Noth- ing is less inherently important than green pieces of papers with numerals and nicely engraved portraits of Presidents. Money is a tool. We must be its master and not its slave. My views on mone- tary management reflect my best efforts to help us master money and to explain why my suggestions for policy should be helpful. I am well aware that economists have much to be humble about, and I hope my analysis will be taken in that perspective. One issue in the design of monetary targets concerns the so- called wedge or cone, as it is sometimes called, versus the band. The chart on page 11 of my written statement, reproduced from the 1985 economic report, illustrates the difference between these two approaches. I first advocated the hand approach in a 197t! paper published in the Brookings Papers on Economic Activity. One reason for adopt- ing this approach is illustrated nicely by the chart on page 12 of my written statement. That chart, reproduced from Chairman Volcker's recent testimony, shows that the money stock has al- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 191 ready surged above the target wedge. At the beginning of the year, the wedge is simply too narrow to reflect the inherent fluctuations of money on a short-run basis. Rather than leave the financial markets, and the Congress, with uncertainty about exactly what the wedsre means, T believe that the Federal Reserve should define its targets explicitly in terms of a band. A seconn problem with the wedge apnroach arises when one year's target is linked to the previous year's target. Take the chart on page 12, and add one more year to it, as shown on page 13 of my statement with a chart that I drew rather crudely with a pencil and ruler, adding to the previous chart. Now, for the sake of illus- tration, suppose that the Large! range for 1986 is 4 to 7 percent growth for M1, the same as 1985 targets. Referring to the chart, if the money stock in late 1985 reaches point x at the end of the year, then the target, wedge for 1986 will look like the upper one in that chart on page 13. Conversely, if the money stock finishes 1985 at point y, then the target wedge for 1986 will look Like the lower one in the chart. The Federal Reserve's practice of basing the target for a year on the actual level of the money stock in the fourth quarter of the previous year produces this result. The band approach, illustrated on page 14 of my written state- ment, chows how the two approaches differ. In the band approach, the target for 1986 will be tied to the target for 1985 and not to the actual 1985 outcome in the fourth quarter at a point like x or y. This issue is taken up in attachment 4 of Chairman Volcker's testi- mony. Here is a quote: "More broadly," he said, "a decision to regularly target growth from the midpoint of a previous year's range would seem to imply that continuing validity of the judgment made a year earlier, that the midpoint of a previous range is in some sense a uniquely correct level of a monetary aggregate. The committee, meaning the FOMC does not share such a conviction." ; Am I to interpret this passage to mean that the FOMC believes that, as a normal matter, the actual level of the money stock in the fourth quarter of each year is the uniquely correct base? The Fed has often talked of the vagaries of short-run money growth and of money stock measurement and control problems. The Fed has warned us over and over again not to pay much attention to money in the short run. Why does the Fed want to base its money growth targets on what it itself views used as such a will-o'-the-wisp as the actual level of the money stock in a particular quarter? As a matter of simple arithmetic, the wedge and band approach- es could be specified in such a way year by year as to be absolutely identical, but the two specifications had different implications as to what is to be done as a normal matter. The wedge aoproach im- plies that a high or low level of the money stock in the fourth quarter of 1 year will ordinarily be built into the targets for the next year. In the band approach, the normal expectation is that a high or low level of the money stock in the fourth quarter will be reversed over the quarter of the next year. When I wrote on this subject in 1976, I could only speculate on how the alternative systems would work because the monetary tar- geting announcements had only started in 1975. But now we have substantial experience with this system, as summarized in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 192 chart on page 15 of my written statement. Here we can see that money growth exceeded the target wedges in 1977, 1978, and 1979 as inflation became a more and more serious problem. In 1981, money came in at the bottom of the target range as the economy sank into a deep recession. The target for the recession year of 1982 was based on that low level of M1 in the fourth quarter of 1981. The proposal that monetary targets be stated in terms of a band is, therefore, supported by 9 years of experience with monetary tar- geting. The proposal is designed to provide a sound longrun mone- tary policy plan. Federal Reserve officials, in my view, should not come before the Congress with urgent statements of the impor- tance of a longrun fiscal policy plan when they are unwilling, as at present, to commit themselves to a monetary policy plan extending more than lOVa months in the future. The policy proposals discussed above have often been described as rigid and doctrinaire. Many observers believe that wise policy must be flexible policy. I am not arguing that we should, or can, enact today a monetary policy good for all time. I am instead argu- ing for a policy built upon experience that is good until there is clear and convincing evidence that a different policy would be better. That is what flexibility ought to mean. Actions based on what seems best day by day cannot be regarded as flexible policy. Unless those actions reflect some principles or standards, flexible policy is no policy at all. Thank you. [The prepared statement of Dr. Poole follows:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 193 STATEMENT OF WILLIAM POOLE PROFESSOR OF ECONOMICS, BROWN UNIVERSITY BEFORE THE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS SUBCOMMITTEE ON DOMESTIC MONETARY POLICY U. S. HOUSE OF REPRESENTATIVES MARCH 5, 1995 STATEMENT Mr. Chairman, Members of the Subcommittee, I am delighted to be here this morning to discuss monetary policy and related issues. These hearings, and others like them, are a sign of the growing Congressional and public interest in monetary policy. We have come to take that interest for granted; the damage that can be done by monetary instability is obvious to everyone. Only ten years ago the potential for monetary policy to disrupt the economy was not nearly so well understood. Difficult economic conditions — severe recession or sustained inflation — were attributed to other causes. But everyone now knows that the Federal Reserve has the power, with one decision of the Federal Open Market Committee (FOMC), to set o£f a raging inflation or a deep recession. Congressional oversight of the Federal Reserve's use of its powers is one of the very most important responsibilities of this Committee and o£ every member of the Congress. The first three sect ions of my statement are devoted to the questions posed by Chairman Fauntroy in his letter inviting me to testify at these hearings. Issues concerning the specification of money growth targets are taken up in the fourth section. in a final section I offer some observations on Congressional oversight of monetary policy. The Economi c Outlook The administration's outlook for economic growth and inflation over the second half of this decade is sound and sensible. The 1985 part of this forecast path for real GNP accords quite closely with the forecasts from the Federal Reserve and the Congressional Budget Office. Most of the commentary on these forecasts has emphasized that the administration's forecast is on the high side of the others, but I am personally convinced that the administration's optimism is fully justified. Arguing about these small forecast differences is, in any event, a waste of time. Attached to anyone's real GNP forecast over the four quarters of 1985 should be a range of error in the neighborhood of 1.0 to 1.5 percentage points. The administration's forecast should really be stated as 3.0 to 5.0 percent real growth over the four quarters of this year. The Federal Reserve's forecast might be stated as 2.75 to 4.75 percent real growth, and the CBO forecast as 2.5 to 4.5 percent real growth. What is most interesting about these forecast ranges is the extent of their overlap and not the extent of their differences. To provide a better understanding of forecast accuracy, this Committee might want to request CBO to conduct a study of the accuracy of economic forecasts. Forecasting inflation is subject to similar hazards to forecasting real growth. Over a span of 4 quarters the inflation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 194 foiecast ill sujj ject. to errors of aoout tue same magnitude as tfie teal GNP torec<a.= t. Over tne longer run, inflation is determined primarily hy tne rate ot mon«y growth. To illustrate ttiis tact, I have reproduced below a chart trom the 198j Economic Repgrt _g£_ the. FLfcai6ent. ifi" Gruwin u:uj iey (jruwm ^niyeo U Uuuit_-." Given the close connection between monetary policy and inflation, inflation to-recasting errors over tf.e longer run are policy forecasting errors. Tlieae totecaating ei tors are not ttie fault ot the toreyasters. There is no cm tig in tne traditional discipline on econumics ttiat helps economists to roiecast what trit; E'eaeral Kessefve is go±ng to ao, ot wnat ptessutes the Congitiss will uring on tne Feaeral Keaerve tu oend it's luoiLecary policies. WriaC ecoiio.discs ca.i say is cms; _i_t_ money gio-vcn fails uver tiu.c, _trifei_i_ tne tienu rate ot iti£iatiun will also rail, aituouyn tne timing aim exacc ex cent of tne tall ate suoject co SaDS^an^ial pieoiccioii etrors. it is up co trie t'eaerai Deserve ai'Li tne Cor.gj.ess co oe tetmi ne waecner tnat 'if cifauat; ia a tacr >iai or a count err actual one . C no it man Voj.ci-.er, in nis rtcent test imu.iy , placed yteat w-sigjit OP tlie impoi tance oi: continuing to t educe trie ta'ie or iri nation. I ^mpliat icdlly suppo1"1" tnat position . Inrla t ion and OUL society's reaction co it wete tne main educes ur tnd ptuttacteu 1991-B2 recession. Looking uacK, tne sa.iic pact.et n wa; Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 195 evident in the recessions of 1974-75, 1969-70, and 1957-58. I urge you, sometime, to review those periods of history by going to the library and pulling out microfilm for the jJew York Times, the Washington_Post_, the _Wall__Street Journal, and any other newspapeFs that might interest you. Read the news stories and, especially, me editorials to see now long into triese recessions inflation was viewed as tne "numoer one proDlem" tor our economy. These attitudes lead to an undesiraoly tignt monetary policy for coo long into recession, dragging tne economy into a fat deeper slump tnan necessary. The chart below, also £rom the 1985 Economic Report, shows that money growth has typically 'dVciTned before and/or during recessions. Money Growtn ana tjie Business Cycle mil lillliii liliUiiiiilimiliimirilliiliiilEhiiiml jliiilinliiilhi luBI jiiliu Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 196 Our Nation cannot, however, pursue a monetary policy that is sometimes easier and never tighter. If money growth rises but is never brought down for fear of triggering or exacerbating a recession, then it is a simple matter of arithmetic that the average rate of money growth will rise over time. Under this monetary policy the rate of inflation would become higher and higher and higher. That is not a desirable policy. Nor is it one the American electorate will accept. If recessions are to be avoided by avoiding sharp decelerations of money growth, and ever-rising inflation is to be avoided by preventing an ever- rising rate of money growth, then a sustained period of higher money growth must not occur. This conclusion is a matter of logic and not of my own personal preferences. I can emphasize my concern that we maintain a long-run policy perspective in another way. Who on this Committee remembers the state of the economy in the second quarter of 1976? Who remembers how the economy differed in the second guarter of 1977? What happened in the second guarter of 1980 that did not happen in the first quarter of 1980? My economist friends will be able to answer those questions, but few non- economists will be able to do so. Nor will they care. It doesn't matter whether the rate of inflation began to rise in the first quarter of 1977, or in the third quarter. The fact is that the rate of inflation did rise for a sustained time in the late 1970's, and the exact timing is not important. Questions about the 1985 economy should always be imbedded in a longer-term outlook. Some economists are now forecasting a new recession to begin late this year or in 1986. There is no professional basis for such a forecast. Some base the recession forecast on the fact that by the end of this year the present business cycle expansion will be about as old as the average length of a postwar expansion. If that fact were highly relevant, then we should expect that all business cycle expansions would be of about the same length. In fact, business cycle expansions differ greatly in length. To understand this important point, consider a simple coin- tossing analogy. We know that in repeated trials the number of heads will be about 50 percent. Suppose you are exploring the laws of probability by tossing a coin and recording the results. If you happen to see three tails in a row, should you expect heads on the next toss? The answer, of course, is "no". The coin has no memory, and each toss is independent of the previous outcomes. A business cycle expansion has about the same properties. The probability that a recession will begin in any particular quarter is independent of the length of the previous expansion, at least as a close first approximation. I take issue with one part of the administration's economic outlook. In my view, we should expect real interest rates to remain high as long as we pursue policies that encourage economic Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 197 growth by maintaining a high rate of return on new business investment. Tax and regulatory policies, low inflation, and a healthy labor market environment free of unusual discord or an abnormally high level of strike activity all contribute to a high rate of return on new investment. That high rate of return on investment, so long as it exists, will hold up the rate of return on competing financial assets. Under the administration's announced economic policies, business investment should continue to be profitable and the rate o£ return should continue to be high for the forseeable future. Under these policies, I expect that the real rate of interest will decline only slowly, A substantial reduction in the budget deficit, which is highly desirable, will not reduce real interest rates very much if tax and other incentives to business investment remain intact. The__Value of the Dollar The dollar is high but not "overvalued." The issue is not just a matter of semantics. Under the Bretton Woods system of fixed exchange rates from 1945 to 1971, "overvalued" had a reasonably clear meaning. Governments intervened in the foreign exchange market to maintain the fixed exchange rates. An overvalued exchange rate was one where there was a persistant imbalance between the private demand for and supply of the currency that required governments to buy up excess supplies of the currency on a sustained basis. To maintain the overvalued exchange rate, a country had to run down its foreign exchange reserves and/or borrow abroad. In the flexible exchange rate world in which we now live, a currency cannot be "overvalued" in the Bretton Woods sense, unless a country is intervening heavily to support its value. Today, no country is intervening heavily in the foreign exchange market to support the value of the dollar. Intervention is going in the other direction; some governments are attempting to hold the dollar down rather than hold it up. The second sense in which the dollar might be "overvalued" is the same in which any asset might be "overvalued." A common stock, a piece of real estate, an ounce of gold, or a currency might said to be overvalued in the sense that the speaker is predicting that the value will decline in the future. It is obvious that the average market opinion cannot be that the dollar is overvalued today. If that were the case, the value of the dollar would be lower than it is now, just as would be the price of IBM stock if the average market opinion were that it is priced too high. The dollar may fall, but there is no reason to believe that it must Inevitably fall. Those who believe that the dollar must fall are making the same mistake as those who sold their "overvalued" IBM stock in 1955. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 198 There are two basic questions concerning the high value of the dollar. The first concerns why the dollar is sc high, and the second the possible public policy actions to change the value of the dollar. This second question has two parts. First, would proposed policies in fact produce the advertised results? Second/ would tnose proposed policies be desirable considering all of their eftects? The dollar is high because o£ the great success of trie U.S. economy over recent years compared to our foreign competitors. Let me use an analogy. Within the United States, over the last twenty years, favorable economic conditions in tne sun-celt states pulled resources from the snow-beJt states. Because cn^se regions use a common currency — trie U,S, dollar — tne strength of tne sun-belt could not show up in a strong currency. But if the regions of tne United States had Deen using separate currencies, along the lines of tne separate nations within the European common market/ then it is nighly prooable that the sun- belt currency would have Deen strong and the snow-oeIt currency would nave Deen weak. Because the fundamental cause of the strong dollar is the strong U.S. economy, the policy option available to us that would have the largest effect on the dollar would be to do whatever is necessary to weaken the economy o£ the United States. The dollar will fall if we pursue inflationary policies and raise taxes on business in order to reduce- .-."e incentive to invest in new productive capital. It mould be easy to aad to this list of destructive policies, I '.[•.--_,» of no one Who would advocate reducing tne value oi cue dollar by pursuing sucn approaches. Because the value of the dollar reflects the relative positions of the United States and foreign economies, what we should advocate is improvements in foreign economies rather than degrading the performance of our own. BL:L while we can advocate, we cannot control the economic policies of our friencls in Europe and Latin America. Those countries must find their own way. But we should insist that it is unreasonable for them to asK us to copy tneir own destructive policies th^t n^ve led to economic st cigna 5:1 on arid rising unemployment. Trie otner policy option taat is trecjuently a), scussed is dinect intervention in the foreign, exchange markets. It is atgued that we could lower tne foreig n currency price of the U.S. dollar through sustained purchases of foreign currencies, adding them to our international reserves. Tnose wno oppose en is policy, as I do, do not do so i_or reasons of ideology, as is so often cnarged. This is a matter of economic science, a.no ttiete is wucn. cacetul empirical '•.ork to support the proposition tnat activist foreign exchange policies simply will not cnanye tne value of tne dollar short 01 massive intervention. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 199 This empirical finding depends on the assumption that foreign exchange market intervention is of the "sterilized" variety. Sterilized intervention is conducted in sucii a way that it does not change the rate of growth of the domestic money stock. The exchange rate might, however, be affected by truly massive sterilized ir.teirvt.ntion --• inteivuntion an.ouaciay to scores of billions or doiiats p«r year. For reasons that go beyond the scope our discussions today, 1 believe that massive intervention would ue v«ty unu«sirar>le; all 1 want to ao at tnis point is to insist to you tnat intervention in the neighbornood ot ten to twenty Diliitm aollors per year will nave little noticeaoj.e efrecc on the average value of the U.S. dollar in tne toreign exchange markets. This Committee nughc want to asK CBO tor a compendium ot studied on this issue. Although limited intervention will not cnange tne average foreign exchange value or the dollar over tame, it may, as demonstrated last week, make ttie ejtcnange rate less staole. To market participants, government oehavior is otter not very predictable. Indeed, can members of this Committee predict what the Treasury's intervention policy will be next week, or wnat the German Government's policy will be? It is ironic that, in the abstract, advocates of intervention argue for timely buying and selling of foreign currencies to stabilize markets and that in practice intervention often has tne opposite ettect, and sometimes deJ ip^c?.tely so. Money and Finaiicia_l__Cg nd i tions In Eeaera i JKe s e r ve t-o 1 i cy Having just returned to academia from Washington, I air well aware of the benefits to all policy makers of fuzzing up certain issues. While in Washington, on occasion I had no choice but to do the same. But now that 1 am an academic once again, tay responsibility is to clarify and sharpen issues rather tnan the reverse. Over the years one of the most fuzzed up elements or bederal Risse^ve poXicy has been tiw rois o£ market i.-.merest rates in determining open market operations, Intetest rates are [jclj-^ically sensitive; neither the Federal tieserve nur dfijone else waats to take responsibility when interest rates rise, altnouyii I have occasionally neard political figures tat>.e ciedit whtJii interest rates fall. E'ederal Reserve attention no "financial conditions" is simply a euphemism for federal Reserve eftoits to innlutjiice interest nates — to make them fall wnen i-ney otrietwiae wuuld not, to keep them from rising as much as they otherwise would, and so on.. Over the years, and especially recently, numerous bills nave been introduced in Congress that would require the federal Reserve to target interest rates in some fashion or otntsr. I beLieve that interest rt.te targeting is highly unOesnable, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 200 am therefore an uncompromising opponent of such proposals. But I also believe that improved monetary policy over the long run requires improved public and Congressional understanding of what is now being done, and therefore I want to insist that the Federal Reserve is today targeting interest rates, although loosely. A major source of confusion is that in discussing monetary policy the Federal Reserve switches back and forth between the terras "reserves" and "reserve positions". The growth of bank reserves available to meet legal reserve requirements is very closely related to the growth of the money stock, especially Ml. In the short run, over several months or several quarters, reserves and money growth are essentially uncorrelated with changes in interest rates. Low reserves and money growth is sometimes associated with rising interest rates and sometimes with falling interest rates. The concept of bank's "reserve position" is entirely different. A bank's reserve position is the Difference between its nonborrowed reserves and its required reserves. This quantity can also be stated as the difference between a bank's excess reserves and its reserves borrowed through the Federal Reserve's discount window. When this figure is positive it is called "net free reserves" and when it is negative it is called "net borrowed reserves". Because the reserve position is the difference oetween nonborrowed and required reserves, the banking system's reserve position has no necessary connection to the rate of growth of total reserves and the money stock. If money growth is rapid, required reserves growth will also be rapid. If the growth of nonborrowed reserves keeps up, then the banking system's reserve position will not change. The banking system's reserve position, however, J.s_ closely connected to the level of market interest rates relative to the Federal Reserve's discount rate. Given the discount rate, rising market interest rates increase the incentive for banks to borrow at the discount window, and they commonly do so. Let me now provide some illustrations of these important distinctions. On page 28 of its Monetary Policy Report the Federal Reserve says that in late August and early September of 1984 it, "moved to lessen the degree of restraint on bank reserve positions." Statements of. that kind are interpreted by the Federal Reserve and by knowledgeable market participants to mean that the Federal Reserve eased interest rates down at that time. Barring temporary and anomolous blips in the data, I Know of no one who would say that the Federal Reserve could "lessen the degree of restraint on bank reserve positions" at a time when money market interest rates were rising substantially. A "lesser degree of restraint" is a euphemism for "lower interest rates." In the interest of clear thinking about monetary policy issues I urge you to treat the two terms as synonomous. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 201 Below is a chart reproduced from the Federal Reserve's Monetary Policy Report. The banking systems's reserve position is the shaded area between the two lines in the chart. Note that after the middle of 1984 total reserves fell while the reserve position "eased" — that is, net borrowed reserves fell. This was a period when money market interest rates were falling significantly and money growth was low. In testimony February 20, 1985, before the Senate Banking Committee, Chairman Volcker made a special point of arguing that the Federal Reserve did not target real economic growth. An attachment to his statement discusses that issue. The beginning of that attachment reads as follows: "Questions sometimes arise as to whether the Committee's forecast for real GNP growth or prices are in the nature of short-run targets toward which the Federal Reserve 'fine-tunes' policy, or whether the Committee has preconceptions about just how rapidly the economy can and should grow over the medium or longer run. The answer to those questions is no." I believe that the Federal Reserve ought not to target real economic growth, but am less convinced than this passage suggests that it does not target real growth, at least to some extent. Consider the following two passages from that same testimony. "The strong expansionary forces in the economy were reflected in some limited upward movements in interest rates in February and March, and early in the spring the Federal Reserve began to exert some additional restraint on reserves being supplied through open market operations." (page 11) "By late August and September, with Ml growth moving toward the midpoint of its range and M3 expansion slowing toward the upper end of its range, and with Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 202 some evidence that economic growth hart slowed, the Federal Resei-ve began to ease pressures on reserve uos it ions." (page 13) The juxtaposition of phrases concerning the performance of the real economy and adjustments in monetary policy in these passaaes, and m.iny others, leads rnarket observers, riqhtly or wrongly, to believe that monetary policy is adj::stad in response to observed short-run cnanges in the state of the economy. It is not surpri sing that market speculation on Federal Reserve responses to incoming data on the strength of the economy sometimes causes interest rates to change. Monetary Targets for 1985 and Beyond The purpose of monetary targeting is to improve the performance of the economy — to stabilize the price level, attain maxi mum employment and growth, and to Coster stable and efficient financial markets. Nothing is le^s inherently important than green pieces of paper with numerals and nicely engraved portraits of Presidents. Money is a tool; we must be its master and not its slave. The issue is how we can master money. Economists,- government officials, and others have fought over monetary issues for centuries. The fact that we continue to fight over monetary matters, as in these hearings, demonstrates that we have not yet mastered money. We are sometimes its slave. It hurts and we resent it. The views I present to you on monetary management reflect my best efforts to help our society master money, and to explain why my suggestions should be helpful. I am well aware that economists have much to be humble about, and I hope my analysis will be taken in that perspective. Following past practice, the Federal Reserve has announced 1985 targets for three measures of the money stock — Ml, M2, and M3 - Tn my vi ew. major weight should be given to Ml; the other two monetary measures should be regarded as distinctly subsidiary. Indeed, I believe that the predictability of monetary policy would be improved if the Federal Reserve would confine its targets to Ml. The behavior of the other monetary aggregates could be referred to in the process of justifying or explaining the Ml target. The existence of multiple targets creates unnecessary market uncertainty because the Fed may switch from one to the other. An episode that illustrates this concern occurred in 1981. Money as measured by Ml was coming in at or below the bottom of the target growth range. In August — which we now know was the first month of the 1981-82 recession — the Federal Reserve switched its policy emphasis to give more weight to M2, which was coming in at the high side of its range. The effect of this change of emphasis was to alter open market operations to keep interest rates from failing as rapidly as they otherwise would have at the beqinning of the recession. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 203 I believe that a careful examination of the targeting record since 1975, counting up the successes and failures from altering the target emphasis, would yield a count of considerably more failures than successes. In designing policy for the future we should try to learn as much as we can from this experience. A second important issue in the design of monetary targets is the "wedge" (or "cone") versus the "band." The chart below, reproduced from the 1985 Economic Report of the President, illustrates the difference between these two approaches. Alternative M1 Target Ranges for 1985 In his Senate Banking Committee testimony. Chairman Volcker offered the following observation on this matter. "We have sometimes considered, and others have suggested, a better 'pictorial' approach would be to illustrate the target by a different (but also necessarily arbitrary} convention — parallel lines drawn back from the outer bounds of the specified fourth quarter target ranges to the base period as shown in the charts attached." [Emphasis added.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 204 The choice between these two approaches is not arbitrary. Consider the chart offered in Chairman Volcker's testimony, shown below. A difference between the CEA chart and the Fed's chart is the choice of the base. The CEA chart is drawn with a base equal to the center of the 1984 target range whereas the Federal Reserve's traditional approach is to use the actual level of Ml in the fourth quarter of the year. In the Fed's chart the target range for 1985:IV is essentially the same under the wedge and band approaches. Mt Target Ranga* end Actual In the CEA chart the wedge and band, at the end of 1985, overlap to a very considerable extent, but not entirely. The reason the overlap is not complete is that the actual level of Ml in 1984:IV was slightly below the midpoint of the 1984 target range. Now look ahead to next year. Assume, for the sake of illustration, that the 1986 target is the same as 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 205 Suppose Ml ends 1985 in either the upper part of its target range, as shown by the point marked X in the chart below, or in the lower part of the range, as shown by point Y. The 1986 target wedges from points X and Y just barely overlap at the end of 1986. Should the 1986 target range use point X or point Y as a base, or would the middle of the 1935 range be better? Ml Target Rangai ind Actual 1986 This issue is taken up in Attachement IV of Chairman Volcker's testimony. "More broadly", he says, "a decision to regularly target growth £ron\ the mid—point of a previous year's range would seem to imply the continuing validity of a judgment made a year earlier that the mid-point of a previous range is in some sense a uniquely 'correct' level of a monetary aggregate. The Committee does not share such a conviction." Am I to interpret this passage to mean that the FOMC believes that as a normal matter the actual level of the money stock in the fourth quarter of each yea~r is" the "uniquely correct" base? The Fed has often talked of the vagaries of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 206 short-run money growth and of money stock measurement and control problems. The Fed has warned us over and over again not to pay much attention to money in the short-run. Why does the Fed want to base its money growth targets on what it views as such a will- o'-the-wisp as the actual level of the money stock in a particular quarter? Now, put the CEA and Fed targeting methods on the same chart, as shown below. Looking ahead to 1986, the wedge and band methods of specifying targets have major differences, and these differences are not simply "arbitrary". The Fed's procedure creates a large range of uncertainty about future monetary policy, and this range widens each year. MI T»r0et RinfMt *nd Actual Of course, as a matter of. arithmetic the 1986 targets stated according to the wedge procedure could be restated depending on whether the money stock ends 1985 at the top or the bottom of the range. Suppose Ml is at the top of its range in 1985. Would the Fed announce 1986 targets of 2.5 to 5.5percent money growth in order to offset a high 1985 outcome of 7 percentage growth? Or, if money in 1985:IV were at the bottom of its range, would the Fed would announce a target range of 5.5 to 8.5 percent to offset a low 1985 outcome of 4 percent? I belieue that the Federal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 207 Reserve is unlikely to art just its targets by such large amounts, fearing that it would be sending the wrong message to the markets, the voters, and ttieir representatives in the Cony cess. My concern about this needless uncertainty over the Federal Reserve's long-run policy reflects more than an academic's imagination. The chart below, reproduced from the JL9EJ5 Economic .Re£ort_, Shows how the Fed exceeded its targets repeatedly in the late 1970's, ana eacn year built the overun into the next year's target. Money growth accelerated as inflation rose. Was this a stabilizing monetary policy? In 1981 money growth fell short of the Fed's own targets, and this short-fall was built into the target range for 1982. was this a stabilizing monetary policy as the economy sank into the deepest recession since the Great Depression? Is this the tat get ing procedure the Federal Reserve wants to defend? Ml Money Stock and Federal Reserve Target Ranges The proposal that monetary targets be stated in terms of a band, with each year's band starting from the previous year's band rather than from a base level equal to whatever the actual money stock happens to be in the year's fourth quarter, is designed to provide a sound long-run monetary policy plan. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 208 Federal Reserve officials should not come before the Congress with urgent statements of the importance of a long-run fiscal policy plan when they are unwilling to commit themselves to a monetary policy plan extending more than 10 1/2 months in the future. The policy proposals discussed above have often been described as "rigid" and "doctrinaire." Many observers believe that "wise" policy must be "flexible" policy. We all know, however, that flexible policy can be aimless policy. Rather than attach labels, policy proposals should be examined on their merits. The proposals I have offered are based on my analysis of where and why mistakes have been made in the past and of what might be done to avoid repeating those mistakes. I am not arguing that we should or can enact today a monetary policy good for all time. I am arguing for a policy that is good until there is clear and convincing evidence that a different policy would be better. That is what "flexibility" ought to mean. Actions based on what seems best day by day cannot be regarded as "flexible policy." Unless actions reflect some underlying principles or standards, flexible policy is no policy at all. Congress ioria_]^_gvei:sight of Monetary Policy Congressional oversight of monetary policy, and indeed of government departments and agencies generally, suffers from the fact that government witnesses and outside witnesses do not appear at the same time. It is as if a defense attorney appears in court, states his case, examines his witnesses, and then takes all of them home before the plaintiff's attorney arrives. The plaintiffs attorney talks to empty chairs. There is a sense in which outside witnesses such as myself are asked to testify in Congressional heari ngs in the role of "plaintiffs." All of us believe that the give and take of open debate will illuminate the issues and lead to better public policies. I am not here as a "prosecutor" to to obtain a "conviction", but rather to support the Federal Reserve where I believe it is correct and to challenge it where I believe it is not. That role, I believe, could be better fulfilled if government and outside witnesses appeared together. In the absence of such arrangements, however, I propose that the following questions be submitted to the Federal Reserve. I should like the format of the answers to consist of a first paragraph of one word — either "yes" or "no". Additional paragraphs should explain the answer in the first paragraph. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 209 From what we now know, and all things considered, would it have been better for the U.S. economy if growth in Ml had been one percentage point lower than it actually was in 1977, 1978, and 1979? (Ml growth should be measured from the fourth quarter of one year to the fourth quarter of the next.) From what we now know, and all things considered, would it have been better if Ml growth in 1981 had been one percentage point higher than it actually was? Consider a hypothetical target for Ml for the fourth quarter for 1985. Suppose the target were a dollar level that is 5.5 percent above the level in 1984:IV, and that Ml is measured on a not-seasonally-adjusted basis. If all other considerations were ignored, would it be technically possible to hit that target with an allowable error of 0.5 percent? If the answer is "no", specify the technical reasons why such a target could not be reached. If the demand for bank borrowing through the discount window were a perfectly stable function of the difference between the federal funds rate and the discount rate, is it true that a borrowed reserves target, given the discount rate, is the exact equivalent of a federal funds rate target? If the demand function for bank borrowing through the discount window were highly unstable and unpredictable, would success in hitting a borrowed reserves target determined by the FOMC for the intermeeting period introduce undesirable volatility in the federal funds rate? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 210 Chairman FAUNTROY. Thank you gentlemen for your written tes- timony. Let me begin by posing to any and all of you the dilemma which is uppermost in my mind, and that is the Fed's relative effort to lower inflation versus lower unemployment. So far this year, as you know, the unemployment rate has been at 7.4 percent—up, I hope temporarily from the 7.2 percent rate in the fourth quarter of 1984. The inflation rate is still at between 3 and 4 percent and has been there almost 2 years. Granted that our ultimate objective is to have both low inflation and low unemployment, what should the Fed's priorities be this year: To try to keep inflation at the current rates and push unemployment down more; to try to push inflation lower at the cost of keeping unemployment at the current rates; or simply to avoid inflation and unemployment from getting worse? I would note that the FOMC's projections seem to suggest that it is following the first course, but those projections rest on the fairly optimistic assumption that the dollar will neither rise nor fall, and that the budget deficit will be substantially reduced. What weight should we be giving? Dr. GREENSPAN. Well, let me start off, Mr. Chairman. I think that the presumption that there is a simple tradeoff between infla- tion and unemployment is misguided. I think the evidence of the last decade has clearly demonstrated that lower inflation ultimate- ly brings lower employment if we endeavor to reduce inflation, reduce uncertainty and risk, and thereby increase the rate of cap- ital investment and general expansion, we will find, in the context of a 2- to 3-year period, that the more we can stabilize the price level, the more we can increase the underlying growth rate in the economy and, hence, reduce the unemployment rate ultimately. Any endeavor to engage in short-term fine tuning on either side of that presumed tradeoff, is destined to fail. So there is really only one policy. The policy which the Fed should pursue is to maintain a monetary growth rate which can, if possible, stabilize the price level. If we succeed in that, the unemployment rate will fall as low as we are likely to get for the longer term. A short-term endeavor to lower the unemployment rate can probably succeed, but only at the expense of significantly higher unemployment at a later date. Chairman FAUNTROY. Dr. Schultze? Dr. SCHULTZE. First, whatever you say about the long run, in the short run it is true that even though the Federal Reserve cannot forecast and predict it very well, that there is a tradeoff available. Now it isn't the kind of tradeoff the Fed can pick a target and say "We are going to hit it," But at the moment, if the Federal Reserve wanted to pursue the goal of price stability—not inflation stability but price stability—that is to get the current 3.5 to 4 percent rate of inflation down significantly further, it would have to reduce the rate of growth that is now programming for the money stock and bank reserves substantially. I don't think the Fed is going to do that. I don't think they should do it. I think that for the time being, while not trying to fine tune the economy, and not trying to do a very shortrun tradeoff, their fundamental proposition is that they will live with the rate of inflation we now have and will not deliberately put the screws tighter and tighter and tighter on the economy to pull it down further. I agree with that. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 211 Second, they also implicitly—again without fine tuning—have de- cided, on the other hand, they are not going to speed up the cre- ation of the money stock and the growth of bank reserves suffi- ciently to pull the rate of unemployment down except slowly. My guess is they would be quite satisfied if the money stock targets they have set forth would give them an unemployment rate falling to somewhere in the 6.75-percent range. You might quarrel a little bit bat since we are now corning close to the margin of spare capac- ity this economy has available, thus I find it hard to quarrel with the Fed within that kind of a range. So it seems to me they are targeting properiy. Given tne very difficult problem of keeping the lid on this economy with that huge budget deficit, they are target- ing moderate growth in the economy, slightly faster than capacity growth, consistent with rough stability in the inflation rate, given no major change in the value of the dollar. If the dollar, all of a sudden, starts to fall out of bed, the Federal Reserve will have a real dilemma on its hands, but at the moment it seems to me what they are targeting is about right. Chairman FAUNTROY. Dr. Poole. Dr. POOLE. I would like to emphasize that about 14 years ago, when the inflation rate was around 4 percent, just about where we are now, we adopted comprenerisive wage and price controls. Four percent inflation was regaraed as being intolerable at that time. Now, many people seem to be ratner relaxed about 4 percent. It seems to me that the problem is this: I would have no difficulty if I knew for sure that we could stay at 4-percent inflation. But I do not believe that that is a credible policy alternative. What are people in the markets going to say, when we get a disturbance—as will surely happen—that takes us to 5-percent inflation? Some day we are going to get an upward blip and I believe people are then going to say, "Well, if 4 percent is all right, what is wrong with 5 percent?" I do not think that that is a sound basis for long-term policy. In my view, we ought to have a steady, persistent monetary policy that is consistent with the return to full price stability over a period of years. We should not shove hard. We should not try to do it quickly, but that is where policy should be going. Chairman FAUNTROY. I thank you. I yield to Mr. McCollum. Mr. McCoLLUM. ThanK you, Mr. Chairman. There has oeen a lot of discussion among your testimony today, ab well as otners, over the value of the dollar, monetary policy and the deficits and all the interplay that goes on in them. Most of that discussion tnat I have heard is eitner centered on, or indirectly al- luded to, liquidity, the availability of capital in this country, which of course would be the major factor in interest rates not being higner at tne present moment, with the large deficits we have. There have also oeen indications—I haven't heard any of you dis- cuss toaay—tnat the high dollar and the trade imbalance actually for tne moment are good, in the sense that imports are aimost an absolute essential part, while we follow poor fiscal policy, of keep- ing inflation under control. The imports are cunently a major factor in tne steady inflation at tne present moderate level. I would like for you to comment on that. Do you think that if we see tne value of trie dollar decline or pernaps, Dr. Greenspan as you described, more American banks investing abroad, loaning Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 212 abroad and so on, that at that point in time, with the trade deficit coming back in line and less imports, that inflationary expectations are likely to rise? Dr. GKEENSPAN. Mr. McCollum, the level of interest rates and the level of inflation that we currently experience would be higher with a dollar which had not been rising at the pace of recent years. As a consequence of that, I think capital investment has been higher. So while we are clearly very aware of the job losses that are occurring as a consequence of the strength of the dollar and as a result of imports displacing some competing goods in the United States, it is by no means clear to what extent, if any, the strength of the dollar has, in fact, created a net job loss as such. There is no doubt that the extraordinarily large flow of funds either by foreign- ers or by Americans invested in the United States has been a sig- nificant factor in creating a much more tranquil environment in the capital and financial markets than would have existed without it. About a forth of aggregative savings are coming in from abroad, and that is an extraordinarily large number. There can be no doubt that were that not the case, the very heavy Treasury borrow- ings, which are now in place and will continue indefinitely, would eventually begin to squeeze the system and create very significant problems at the Federal Reserve. So while we may, in fact, be looking at the strong dollar as some- thing which is creating problems, I suspect that if the dollar were to turn around and go down, the problems that would occur as a consequence would make the problems of the strong dollar rather insignificant in comparison. Mr. MCCOLLUM. Dr. Schultze, would you care to comment on that? Dr. SCHULTZE. I guess I would change the emphasis, but not come to a substantially different conclusion. Let me just say the same thing another way. The Federal Government is borrowing an amount now equivalent to 5 percent of GNP, and it is going to do that out to the indefinite future unless you do something about the budget deficit. After allowing for depreciation, the Nation saves 8 to 9 percent of GNP, The Federal Resreve is keeping a lid on over- all economic output, letting it grow at a safe level. You have got to take that 5 to 5.5 percent from somewhere—it has got to come from somewhere. Either it comes from abroad, there is a big inflow of foreign savings, supplementing domestic savings, or if that is not available, you have got to squeeze the Federal borrowing out of savings available for domestic investment. The precious savings is diverted out of domestic deficit into financing the deficit. Neither course is costless. The first course, namely, a large net inflow of foreign savings, preserves our own domestic investment, but at the same time we, and then our children, are going to be paying the debt service on that foreign debt, thus lowering our growth of living standards. Conversely, if you did not have the inflow of foreign savings, we would be squeezing out domestic investment, and we and our chil- dren would pay the cost by having lower domestic productivity growth in the future. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 213 I end up where Alan does. If I have to have my choice of pains, and since I am not a farmer nor a rural banker nor an exporter, if I look at the whole national economy, I say, "Yes, you are better off to take our lumps the way we are now taking them than the way we are ultimately going to take them," because foreigners are not going to keep on pouring their savings into the United States. That is a complicated answer, but it says, "Yes," in that narrow, limited sense, the overvalued dollar is serving a purpose. Remem- ber, however, that it is simply the lesser of various evils. Mr. McCoLLUM. It is buying us some time for Congress to act is what you are really saying is the lesser evil. Dr. SCHULTZE. Let me be a little bit provocative and say one of the real tragedies of this budget deficit is that we are living with it too well. We might be better off if it generated a crisis. The tragedy is there is not a tragedy. To overstate this a little bit, it took the British 50 years to become a second or third-rate economic power. It wasn't a budget deficit that did it, but by not paying attention to some very longrun gradual economic problems. Thus, I agree with Alan, but every second day I think maybe we would be better off if the foreigners weren't supporting our credit card habits. Mr. McCoLLUM. Well, my time has expired, so I can't ask Dr. Poole the same question, but that is all right. I will yield back, Mr. Chairman. Chairman FAUNTROY. Mr. Cooper? Mr. COOPER. One thing here repeated so much is that our strong dollar is equivalent of a tax of 30 percent or a subsidy of 30 per- cent, and I have always wondered, are those two percentages addi- tive? Is there really a 60-percent difference, or is it the equivalent of one or the other? Dr. GREENSPAN. That percent comes from the rough calculations that the U.S. dollar in foreign exchange markets is approximately 30 percent above its so-called purchasing power parity. Purchasing power parity refers to those exchange rates that would exist rela- tive to the dollar, if a dollar, when converted into them would buy essentially the same types of goods and quantity in any country. The problem with the calculation is that, it is very rough, and that it presupposes that the U.S. dollar is not the reserve currency for which there is constant accumulation. So the exchange rate will always, under such circumstances, be above so-called purchasing power parity. The concept of the tax merely reflects the fact that people who are creating costs in other than U.S. dollars presumably have a cost advantage of a certain amount. Therefore, foreigners have the equivalent of their 30-percent subsidy, or we have a 30-percent tax. It is not additive. It is just different ways of looking at it. But I suspect neither is really quite correct. There is obviously a cost dis- advantage to American producers. It is significantly less than the 30 percent, which is what the purchasing power parity difference suggests. Mr. COOPER. Thank you. I was interested in your testimony, the part you added, I think, to your text, that the problem with the strong dollar is not only the extreme confidence that other nations are placing in our currency but our lack of investment or lack of confidence, our worries over Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 214 the rural debt problems or whatever, and that one day perhaps soon that imbalance could be corrected. I didn't understand, though, fully whether once American banks regain willingness to lend money outside this country, what effect that would have on our dollar as a currency. Would that lower the value of the dollar? Dr. GREENSPAN. Yes; other tilings equal, it would do precisely that because, remeiiiDer, that almost all of the lending abroad by U.S. commercial banks is converted into the local currency for pur- poses of business activity. In that sense it becomes a demand for deutch marks or British sterling or Swiss francs or Japanese yen in terms of U.S. dollars. That transaction thus lowers the dollar rela- tive to those otner countries. Should there be a significant increase in lending again by U.S. commercial banks abroad, that, in effect, would increase the demand for foreign currencies in terms of the U.S. dollar. Thai element alone would tend to suppress the dollar's exchange rate. Wheiher otner forces might be operating in the other direction, of course, is yet unclear. Mr. COOPER. I believe you said that in 1982 about $110 billion is the figure for net American lending and investing overseas. About what proportion, I believe you said the lion's share was lending. About what proportion of that would be investing abroad? Dr. GREENSPAN. Direct investment overseas in 1982 was $119 bil- lion, of which $111 billion was lending by commercial banks. It is important to note, also, that when you substract foreign investing in the United States, the net direct investment figure is negative. Mr. COOPER. Many, myself included, have been concerned about America's turn, perhaps this month or next month, into a debtor nation, and in those days ahead when we do regain our confidence, ability to lend and invest abroad, it doesn't seem like American in- vesting abroad will ever retake the rate at which foreigners are in- vesting in this country. So it looks to me as if, and I would like your view on it, whether the debtor status that we are about to assume will be a fairly long-term prospect for us. Dr. GREENSPAN. It is a prospect certainly for years immediately ahead, if for no other reason than it takes a while for the lags and the leads to work their way through the excnaage rate system. Second, the fact of the very suostantial accumulation of U.S. assets by foreigners guarantees an increase of fairly suustantial proportions in the net interest paid by U.S. residents to foreigners, which is an element in the current account balance which, in turn, has to be financed. It doesn't follow, nowever, that we are now and forever a ueotor nation in trie sense that our current account will be in ueficit in- definitely. Obviously, if the excriange rate were to fall quite signifi- cantly, that would, with a lag, close the traue aericit arid probably create a ne\v resurgence of our services surplus, wnich is rapidly diminishing. Thus I wouldn't say tnat mere is sume magic line that we cross and once crossed, creates an ability to come back. In fact, 1 would douot it. This episode of our ueuummg a ueoiur nation is probably a relatively snort-term aifair of 5 to 7 year-s. Thereafter, it is quite possible, indeed probably, that tne United States will fall bacK mco current account surpluses. Wriecrier or not ic can occur for a significantly long enough time to again reverse the lines is a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 215 good question, but we cannot say that there is certainly some struc- tural imbalance in our trade and foreign accounts which is similar to our internal Federal budget deficit in that it creates structural problems. That does not exist for the foreign account. The only thing which is intransigent is interest payments to foreigners on the debt previously accumulated. So I would say that it is sometning tnat is unlikely to be with us forever. Unlike the domestic budget deficit it is not in and of itself a problem. Remember that the United States, until 1914 was a debtor nation, and I don't recall that that created problems. Mr. COOPER. Well, my time has expired. Chair/nan FAUNTHOY. We have the time for Dr. Schultze to re- spond, and then we will yield to Mr. Hiler. Dr. SCHULTZE. I just want to add a codicil to Dr. Greenspan's answer. First, it is not simply that we are becoming a net debtor nation. We are liquidating our net asset position abroad to the term of over $100 billion a year. That is, we are going from having net assets abroad of $200 billion to zero, which is no better than going from zero to minus $200 billion, and we have been doing that. Second, when we were a debtor- nation in the 19th century, we were borrowing from abroad to invest in productive assets. Now, indirectly we are borrowing from auroad to invest in the Govern- ment deficit. It pays the country which can increase its productivi- ty through investment in productive assets to borrow from abroad. If you can borrow at 8 percent and get 10 percent return on your assets, it is good. But if you are borrowing from abroad to get zero on those assets, or whatever you think the Federal deficit is worth, it seems to me it is not a good deal. Thus I don't think it is a struc- tural position we can't get out of, but I think there is a big differ- ence being a net debtor nation to finance a budget deficit and being a net debtor nation to improve our own internal productive capac- ity, Dr. GREENSPAN, i agree with that. Chairman FAUJNTHOY. Dr. Poole. Dr. Pooi.E. Let's think aoouc saving in the United States as con- sisting of private saving and government saving which, of course, has been negative for some time, especially at the Federal level. So we have positive private saving and negative saving at the govern- mental level. We add triose two togetner and get the total national saving. In 1984, trie national saving, as a percentage of GNP, was about 15.7, compareu to the 1980 figure of 16.2. So we are down about nail a percentage point as a percentage of GNP. These num- bers bounce around. 1 picKed 2 years that have fairly similar unem- ployment rates, bui you get dilierent answers depending on now you ao trial. What troubles us aoout the foreign borrowing is, at least in part, tne view tnat we are borrowing in order to consume, as wiiri Doriuwnig lor trie financing of tne buuget deficit. That is nui nc-ct.rwsuriiy correct because it iy possible that private saving is financing tne buuget delicti in utct, you can't link a particular li- ability vviin a particular asset. Now, suppose that wnat we are doing is borrowing abroad to in- ciuaoO our investment. IT the foreign borrowing is increasing our productive capital and it ii will nave a rate of return that exceeds Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 216 the borrowing rate, then, as Dr. Schultze said, that is a good deal. If you can borrow at 8 percent and earn 10 percent, that is a profit- able thing for the United States to do. The issue here is that the investment opportunities in the United States are apparently so much better than they are in so much of the rest of the world, that it does not make sense for us to send funds abroad to earn 4 per- cent if we can invest it at 10 percent in the United States. And, it does not make sense for anybody abroad to keep money in Europe, let's say, earning 4 percent when he can send it to the United States and earn 8 percent. So the basic cause of this capital inflow is the difference in the rate of return, which I think is very impor- tantly related to the difference in the growth prospects, in the vigor of the economy of the United States versus the economies in Europe and Latin America. People do not get good returns when they send money abroad and, therefore, it is not sensible to send money abroad. The key is not to reduce our own growth prospects. We could reduce our capital inflow if we were to reduce the rate of return in the United States, but that is not a sensible thing to do. The key is for the Europeans and Latin Americans to have more vigorous economies with good prospects, good rates of return. That is not under our control. We can argue the case, but we do not vote in their elections. Chairman FAUNTROY. Thank you. Mr. Hiler. Mr. HILER. Thank you, Mr. Chairman. Dr. Poole, if we start out with the proposition, that monetary policy should be conducted in such a way to achieve long-term price stability, as you have mentioned, what should we use as an indicator of inflation? What should the Fed look to to determine whether, in fact, we are attaining long-term price stability or not? Dr. POOLE. The best thing that I know to look at is what is shown on page 2 of my prepared statement, where I have plotted Ml and the inflation rate side by side. There is a 2-year lag in this relation- ship. The inflation arrives a substantial time after the monetary impulse. This is the average experience in the United States. I know of no monetary measure that is a better predictor of inflation than this one. And you can see how good it is. It is not perfect, but you can see what you get out of it. It is because of this experi- ence—and we can run these charts way back before 1956—and ex- perience in other countries, that I am convinced that the best thing for us to do is to stabilize the rate of growth of money. The Ml defi- nition, I think, is the best of the ones we have. We should gradual- ly bring Ml growth down over time—not try to realize full price stability next year, but over a period of time. If we know we are headed in that direction, the financial markets know we are headed in that direction, I think it will be very constructive. Mr. HILER. Do you have any fears today of deflation taking place? Dr. POOLE. I think that the prospects for deflation—and by that I mean a decline in the general price level, not just declines in some prices—prospects for general deflation in the foreseeable future are, I believe, nil. Mr. HILER. What impact do you think that the deflation that is taking place in some parts of the U.S. economy will have? Do you Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 217 have any fears about that deflation that is taking place in commod- ities and land? Dr. POOLE. I would, if I were producing those commodities and owning that land. Mr. HILER. But you see no fear except an individual fear of the loss of asset base. For the economy, you don't have a fear of that? Dr. POOLE. No; the average price level in the Unitd States—and it has changed over time—is made up of an enormous number of individual prices, some of which are rising and some of which are falling more or less rapidly. We have a very difficult situation in these commodity sectors which you are talking about, especially the agriculture. I think that a lot of that difficulty comes because we had an enormous change in conditions from the late 1970's to the early 1980's. In the late 1970's, it was altogether the other way. Prices were rising, especially land prices were rising rapidly. Credit was readily available. That stipulation has flipped over in the last 5 years. Some people's expectations have been violated, and people have been put through very difficult times. I don't deny that. But it seems to me that we ought not to think about trying to regulate the rate of inflation for the economy as a whole on the basis of the very real difficulties of any particular sector of the economy. Mr. HILER. Do you believe that and since you mentioned agricul- ture, but I think you could go to almost any of the metals and see the same dramatic effect—not quite as many headlines, but cer- tainly copper, aluminum, and certainly other metals have gone down the tubes. Do you believe that the deflation that is taking place in those areas is in any way a result of monetary policy? Dr. POOLE. This is mostly a result of the very strong dollar. These are all commodities that are traded on world markets and the strong dollar has depressed the prices in the United States ex- pressed in dollars. What you have is that the prices abroad in the foreign countries have been rising somewhat. The prices in dollars have been falling and splitting down the middle with the exchange rate change. I think that the exchange rate is strong for the rea- sons that I have been talking about before because of the invest- ment returns in the United States. I would also mention one other thing. In the late 1970's the dollar depreciated quite clearly because of fears of inflation. That is, the markets of that kind that adjust quickly bring inflation future inflation forward into the present. I believe that part of what we have seen is that these markets have brought future good price performance up ahead in the same way. This is exactly the same proposition about what happened in the late 1970's, but going in the other direction. Thus, I don't anticipate the dollar confining to appreciate unless we have rapid reduction in the rate of infla- tion. That I think is not in the cards and is not desirable as a policy goal. Mr. HILER. I will ask this to any of the three gentlemen. How much of our current inflation today as measured by GNP price de- flator, Consumer Price Index or what ever you would choose to use? How much of that inflation is still an aspect of catching up with the inflationary pressures of the seventies by maybe erratic monetary policy, rises in the price of oil? Is some of our inflation Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 218 today still a catching up of the rest of the indices of prices that are flowing through the system? Dr. SCHULTZE. I do not think so. If you had never had inflation in the late seventies the inflation rate today would have been lower. That is, peoole now have come to expect—you pick your number, but let's say 4 to 5 percent inflation—and in the early sixties they were expecting IVfe percent inflation. If today they were expecting l¥z percent inflation we would have lower inflation. In that sense, maybe you are right, but in the more fundamental sense, that any significant part of inflation today represents an adjustment of long- lived processes to inflationary pressures which occurred 4, 5, or 6 years ago, I would say none of it. Mr. HILER. Dr. Greenspan? Dr. GREENSPAN. I agree with Charley's analysis but net his con- clusion. Indeed there is an anticipatory element in the price level which affects contracts, attitudes, and activities. When in 1969-71 inflation was rising from 2 to 4 percent, increasing concern was ex- hibited which was why political pressure rose and a lot of people were getting nervous. That was the reason, as Dr. Poole mentioned, we put in wage and price controls in 1971. I think we still have that residual con- cern, but it is gradually unwinding. It has not gone. It is still a re- sidual reflection of the past. Dr. SCHULTZE. To add a note of levity, I am reminded, when you asked about deflation and the probability of deflation, of a com- ment Pat Moynihan once made when asked a similar question. He said he put that 28th on the list of fears, the 27th being the fear of being eaten alive by piranhas. That is about where I put deflation. Chairman. FAUNTROY. Doug Barnard. Mr. BARNAPD. Thank you, Mr. Chairman. Gentlemen, we indeed welcome you to this very interesting and important hearing this morning on monetary policy. It seems we have digressed a little bit from monetary policy to some other things, but on balance, I would presume then that you see the problems of our trade imbalance as just as important as our deficit imbalance? Dr. SCHULTZE. I don't want to say yes or no. Mr. BARNARD. I was hoping to catch you there. Dr. SCHULTZE. I don't think Dr. Poole would agree, but in my judgment our deficit is important, but not solely responsible for our trade imbalance. Fundamentally our deficit and the necessity to borrow $200 billion a year with limited supply of private savings sets in motion a whole train of events which are major factors in causing the trade deficit. Thus it isn't that one is as bad as the other, one is the cause of the other or at least an important cause. Mr. BARNARD. Dr. Greenspan? Dr. GREENSPAN. First, our Federal budget deficit is a far greater problem than the trade deficit which will be cured by our currency turning weak. However, which is not something I look forward to with favorable anticipation. I am more inclined to agree with Dr. Poole on this question. I am not at all convinced that the extraordi- narily large credit requirements of the Federal Government is in and of itself creating a significant pull from abroad. It is certainly the case that somewhere uo to but not exceed.inu~ a third of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 219 strength in the dollar in the last couple of years is attributable to the differential interest rates amongst the currencies, but no more than that. The substantial part is a reflection of a general change in attitudes toward the United States as a safe haven in the sense that our political and regulatory atmosphere is such that foreign- ers are treated essentially the same as Americans, and in a favor- able way. Conseauently, the Federal budget deficit is something which is not significantly affecting our trade or current account deficit. However, the internal Federal Treasury deficit is an order of magnitude owing to the nature of the problems it created, which is many times more of concern than our trade deficit. Mr. BARNARD. But still—and I want to include you, Dr. Poole, in this—but still, as compared to our gross national product today, is our deficit that much of a problem and/or our national debt as in past history? Dr. GREENSPAN. The answer is most certainly yes. It is a very sig- nificant problem. In fact, at a hearing last week before the Joint Economic Committee, the chairman of that committee was—I think correctly—stating that his concern was that looking out 10, 15, 20 years with these deficits, the vast proportion of our expendi- tures would reflect interest payments on the debt. Arithmetically it is explosive. Mr. BARNARD. I think out of 260 deficits the interest on the debt would be 225 or something like that. Dr. GREENSPAN. All I can say is that that particular calculation which doesn't require very detailed arithmetic, should pretty much convince us that whereas we have a problem on our international accounts, it is not a big one in relative terms. The problem of our Federal deficit is best described as scary. Dr. POOLE. I don't know whether the trade deficit is only 10 per- cent affected by the budget deficit or 90 percent. I think it is more than 10, but I don't think it is very big. I wouldn't go to the wall on that as a professional matter, but I would insist that the Congress can do something that is within its direct control, that is to reduce the budget deficit. After all, you Members passed the appropria- tions bills and passed the tax legislation. You don't have-direct re- sponsibility for the trade deficit, so I would say, first of all, that given the responsibilities assigned—the market by and large takes care of the trade deficit and you take care of the budget deficit. Second, I agree that the budget deficit is a serious problem, but I would like to give equal billing to the level of Government spend- ing. The reason I say that is that Government spending has been growing for 50 years. My view of the political processes that drives that growth is that they are extremely difficult to get hold of. If you look at the economic stagnation in Europe today, it seems to me quite clearly to be a result of bloated governments and very substantially reduced incentives for growth and employment. Euro- pean governments have government spending as a share of GNP today in the 50 to 60, sometimes even the 65-percent range. They were where we are today—we are at about 35 percent for all levels of Government—only 20 years ago. The political process that is driving this growth is going to put us, I think, up where the Euro- peans are now in the space of a generation if we cannot control Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 220 spending. I, therefore put equal billing on spending and deficit problems. Mr. BARNARD. Let me just ask this question realistically. Time does fleet fast. Do you think that we ought to have a policy on our trade deficit. Should there be a Federal policy as to attacking our trade deficit, such as possibly—and of course this is coming from off the wall on this, but like an across the board tax on imports which would of course affect the deficits as well as our trade imbalance? Dr. POOLE. We ought not to have such a policy, but in addition to that, a tax on imports would be counterproductive. If you think his- torically of cases where countries have imposed taxes on imports, it has been in cases when they have depreciating currencies. They impose taxes on imports to keep the currency up. If we impose taxes on imports, we are going to make our currency stronger. I don't think that is what we want to do. It is counterproductive, will lead to retaliation abroad, and interfer with the progress that the world has made towards trade liberalization since the 1930's. Mr. BARNARD. Well, our chairman is very much concerned about inflation and monetary policy and what it has done to unemploy- ment. Now, if we would look at our trade imbalances, we would find some very, very direct relationships to unemployment. I know in my part of the country we have got ghost towns developing all in the area of Georgia and South Carolina and North Carolina be- cause of the textile industry. The textile industry is being taken away from us. I have always been an advocate of free trade. I am beginning to wonder now about between free and fair trade, and that is why I am concerned about a strong policy as far as trade is concerned. I guess when I take the total aggregates in trade you may not get concerned. But when you start dividing those up in the industries and you see automobiles, textiles, and steel and other things of that kind, it is devastating. Dr. POOLE. There are important impacts across different sectors of the economy from the strong dollar, but I come from a part of the country, New England, that was devastated, if you will, a gen- eration ago by the textile industry moving elsewhere. It turned out in this case that it didn't move outside the country but it moved south. Mr. BARNARD. Some folks think that is outside of the country. Dr. POOLE. I don't. It is exactly the same as a regional issue. In one case the industry went across State boundaries and in another case it went across national boundaries, but the economics are ex- actly the same. Mr. BARNARD. But we didn't have money flowing out of the coun- try because of that. Dr. POOLE. We had money flowing out of New England. Mr. BARNARD. But that is different than flowing out of the coun- try. Dr. SCHULTZE. Mr. Chairman, Mr. Barnard, again I think I differ somewhat from my collegues in the weight I put on it. Yes, there is a policy we ought to have about our trade deficit and that is get rid of the budget deficit. But in the other things, I think you are likely Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 221 to make matters worse. Most of the other proposals 1 have heard would make matters worse ultimately. Chairman FAUNTROY. The time of the gentleman has expired. Mr. Neal. Mr. NEAL. Thank you, Mr. Chairman. I would like some help from our panelists in understanding better this relationship between money, growth and inflation. I had come to think that there was a very good, predictable relationship over time, as is shown on this chart on page 2 of Dr. Poole's pre- pared statement. But sometime in 1982 we started having rather explosive money growth for a period of time and the rate of infla- tion has been coming down ever since and I don't understand it. Maybe you can help me to understand. Dr. SCHULTZE. We will confuse you, but we will try. Mr. NEAL. The question is this: We had explosive money growth in 1982 and if you look at that 2-year lag, you dont' find inflation soaring, you find it dropping, and I don't understand that. Dr. POOLE. That is right. I certainly predicted that we would have rising inflation as a result of that rising money growth, from past experience. We did not get it. It appears to me that there are several reasons for it. Part of it is that I think we probably had underestimated the technical terms, the interest elasticity of the demand for money. When the interest rate came down, people de- cided they wanted to hold more money balances, and we had a very sharp reduction of interest rates as you know, and I don't think that was well estimated in our past relations. Let me point out one other thing from this chart. If you look at this chart on page 2 of my prepared statement, there are periods when the inflation rate and the money growth rate run apart for a long period of time but by a relatively small amount year by year. Look at the period from roughly 1964 to 1969. There, money growth ran consistently ahead of inflation. Now, if it had run ahead all in one blip, then you might have seen something that was rather like what we have obtained now. It just took a while for inflation to catch up. The difference here was that money growth, instead of surging ahead all at once, kept creeping up. We had the same thing happen in somewhat the other direction, if you look at 1975 to 1980. There again we had inflation outrunning money growth, whereas in the late 1960's money outran inflation. So it seems to me that what we had was simply a large diver- gence between the two series. The divergence ordinarily is not very great, but we have had it all at once in 1982-83. That is not a very thorough explanation. Mr. NEAL. And over time though the relationship is good. Would you then predict as a result of that surge in money growth starting in 1982 a growing level of inflation? Dr. POOLE. No, I think that we are unlikely to have a substantial- ly higher inflation, provided money growth stays in the neighbor- hood where it is now. Mr. NEAL. So that was a free ride? Somehow we got a free ride? Dr. POOLE. It was a once over makeup. Mr. NEAL. And we don't have to understand it? Dr. POOLE. No, I think it is important to understand it, but I am saying I can't give you a precise explanation at this time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 222 Mr. NRAL, Can anyone? Dr. SCHULTZE. Well, I never expected it. That is the difference. Unlike Dr. Poole, I do not believe that the association in the medium term as opposed to the very long term between money and inflation is all that good. If you look at the chart I think what you will find is that in over 28 years the really good association is for a period of about 8 to 10 years. Look back at 1956 through 19(54— relatively stable inflation and fairly substantial changes in money supply. Similarly, if you look at 1968 through 1972, you do get a much closer relationship in the next 10 years. It seems to me the relationship between money growth and the consequent economic activity has particularly tended to be erratic in recent years be- cause we are going through a period of very substantial innova- tions in financial institutions, new kinds of instruments, the defini- tion of money changing, and the meaning of money changing. Even in the past, the relationship has had periods of being errat- ic. Right now, it seems to me the danger of being erratic are much greater. I think the 1982-83 period was one in which the relation- ship between money and economic activity shifted substantially, and I think you are likely to see that again, particularly as we complete this business of new financial instruments and financial innovations. So I am not surprised because I never thought the as- sociation was that close to begin with. Mr. NEAL. Dr. Greenspan, do you have a comment? Dr. GREENSPAN. There is a technical problem. Money supply should relate to aggregative nominal GNP and is divided into two parts: real growth, and the growth in price level or the rate of in- flation. That correlation requires a stripping out of it the long-term growth, that is the physical volume of activity. It doesn't change the correlation that much. Hence I would agree with Charley Schultze. Over the long run there is no question that unit money supply—that is money supply adjusted for the level of economic ac- tivity—and prices go hand in hand, They have as far back as our data go. It is not clear that the correlation is as close as that 2 year overlap suggest, however. My concern is that because that 2-year overlap has been used re- cently as a forecast of the relationship between money and prices, and since it clearly hasn't worked, that therefore the conclusion is that inflation is not related to money. I think that inflation is fun- damentally a monetary phenomenon. It is just that I don't believe it has that rigid a relationship. Mr. NEAL. My time has expired. Mr. COOPER. [Now presiding! Mr. Carper, do you have any ques- tions? Mr. CARPER. I would like to ask questions but not at this time. Will I have an opportunity later in the hearing? Mr. COOPER. Yes sir, I anticipate taking another round if that suits the witnesses. Mr. McCollum. Mr. MoCoLLUM. Dr. Schultze, in your testimony you indicated that the unemployment rate might be reaching a point shortly at which we were faced with possible inflationary pressures. A few years ago the figure for full employment was 4 percent. Does your testimony indicate that we are now using a level higher than that, 6V2 percent? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 223 Dr. SCHUJ.TZE. Yes, sir. Let me start with the obvious point that nobody wants to stake their professional reputation or any kind of reputation on a precise number. Nevertheless, I think virtually all economists who have studied the matter would say that the level of unemployment at which you begin to have to worry about pres- sures in the labor market and excessive wage increases is higher than it used to be. It probably never was quite as low as 4 percent. It may have been 41/s percent, but I would suggest that in the late 1970's the number probably grew into a range a little above 6 per- cent- For demographic reasons it is probably declining slightly so if somebody put me on the spot and said you have got to give me a number, I would say it is a little under 6 percent now. But the un- certainty is such, and the costs of reversing an inflationary mistake are so great, I would play that fairly cautiously. Once you e~et down in the neighborhood of 6 percent I would start to worry. Mr. McCoi.ujM. So if the Fed were to target or to try to target unemployment at some level in close proximity to that, mistakes could gravely be made in your judgment that would touch off infla- tion? Dr. SCHULTZE. Well, I don't think the economy is so hair-trigger sensitive that small mistakes would do it. But conversely, having just gotten burned yes, I would play a little cautious. I wouldn't go through the roof if the Fed made a little mistake, I don't think it would kill you, but it would become more and more of a problem. Mr. MoCoLLUM. With the import-export deficits, trade deficits we talked about being what they are, why are our European allies cur- rently not having a better recovery than they are? Dr. Greenspan, Dr. Schultze, Dr. Poole, any of you? Dr. GREENSPAN. Remember that a good part of the recovery that they do have is in fact attributable to our trade deficit. It is diffi- cult, to make a judgment, but I think the point that Dr. Poole made earlier, namely that they have not managed to get their internal central government, finances in a shape, and that is clearly imping- ing upon their ability to be productive. I suspect that a goodly part of Europe's difficulties in the last 10 to 15 years is reflective of the fact that their version of entitlement programs have begun to create some fairly significant problems for their underlying vitali- ty. Mr. McCoLLUM. Dr. Poole, would you aerree with that? Dr. POOLE. Yes, sir. I think that there is an enormous range of policies in Europe that influence this result. Let me give a specific example. In the United Kinerdom there is a clearly improving pro- ductivity performance now, but it is comine primarily from reduc- ing labor input and not from substantial increases in manufactur- ing output, though their output is growing. So the unemployment rate has boon risine. They have some pretty good .ioh opportunities in the south of England but the midlands are in pretty bad shape. Why don't people move to the south? Well, one of the reasons is that they live in highly subsidized council housing—local govern- ment housing—in the midlands. The local government housing is not available in the south because there are just no units available. So, people won't move out of their highly subsidized houses when they are sunnorted with unemployment benefits of various kinds. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 224 There is no incentive, so you can't get labor to move where the jobs are. Mr. McCoLLUM. They do not have the growth that otherwise we would expect. Let me move over to one last questoin before my time runs out. Chairman Volcker last week in testifying before this subcommittee, indicated that he was not only concerned about public debt, but the growth of private indebtedness. As a matter of fact, in addition to the Ml charts he brought along, he brought along the private in- debtedness charts and he urged us to consider the tax structure changes that might favor equity financing rather than debt financ- ing in addition to simply getting control over the deficits. Do you gentlemen all agree with that in general principle? Should we be doing that and is there a great concern with the growth of private indebtedness in the country today? Dr. POOLE. If I had my way I would do away with the corporate income tax and tax corporations as if they were partnerships. That would eliminate the major incentive for corporations to finance using debt rather than equity. That is where the bias comes. It is built into the tax law. Dr. SCHULTZE. There is another alternative. I haven't thought it through very carefully, but I think that Treasury Secretary Donald Regan's tax plan—his outgoing gift to the Nation—is a great gift if somebody would take it. It does move in the direction of reducing the penalty subtantially of equity financing versus debt financing. In fact I think they were quite ingenious in getting at this problem. Mr. McCoLLUM. Dr. Greenspan, would you care to comment? Dr. GREENSPAN. There is a very important issue for this subcom- mittee in the sense the problem exists largely in the business area where ratios of short-term to long-term debt have been rising inex- orably, and our equity debt ratios, until recently have not been looking terribly healthy. What that means is that the major domestic lending of the com- mercial banking system reflects dealings with business institutions whose balance sheets are getting less and less viable. Since a signif- icant part of those with better balance sheets are borrowing with commercial paper; that is, outside the commercial banking system, the commercial banking system is being left with the sludge so to speak. A goodly part of our loan problems, not only reflect the local problem loans with respect to the oil patch and for agriculture, but the general quality of loans by necessity is lower because the bal- ance sheet ratios, and the debt burdens of the borrowers have gotten worse. That is clearly a major problem for this country. Mr. McCoLLUM. Thank you very much. My time has expired. Mr. COOPER. Mr. Hiler. Mr. HILER. Thank you. I just have a couple of quick questions here. Gentlemen, I have this nagging fear based on 4'/2 years now of watching the Fed, that the Fed believes that real growth will lead to inflation and that therefore whenever real economic growth begins to go over ;j percent, which is the long-term historical aver- age in the country, that inflationary fears of the Fed begin to be ignited and then the Ml growth is kind of clamped down. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 225 And at the same time, I have this fear that the Fed, in its deficit bashing that it does fairly often up here on the Hill and in the media, that when it kind of puts the clamp down on monetary growth so that the real GNP does not grow by more than that 3 to 3 Vz percent, it becomes a self-fulfilling prophecy that that deficit then begins to climb. Do you have any comments on my fears? Dr. POOLE. I think they are fully justified. As a general proposi- tion, I think it is unwise for the monetary authorities to target on the rate of real growth or the level of unemployment. In the 1970's we made mistakes over and over again anticipating the so-called natural rate of unemployment. Our estimate of the full employment level of unemployment at which we would have to worry about inflation was lower than it should have been. So we followed expansionary policies too long and then it turned out we could not get down to 4 percent unemployment but inflation start- ed to pick up in a major way at 5-percent unemployment, and then at SVa percent, and so forth. That process is perfectly symetrical. It can work in exactly the opposite direction. We do not know on a professional basis where that point is, or how fast the economy can grow. Given that we don't know, I believe that the way in which we should view policy is to have sound and stable policy conditions, and let the economy go for it, to have an automatic, built-in stabi- lizer rather than try to have the Fed decide exactly how far the economy can go. Mr. HILER. Dr. Greenspan. Dr. GREENSPAN. I don't think the Fed is working on that assump- tion. We don't know what the growth rate is, in the underlying sense. I think the Federal Reserve is endeavoring to avoid mone- tary growth rate which is far in excess of our physical capacity to increase. Irrespective of where you put it, such money growth will ultimately show up in inflation. But the presumption that they be- lieve that that number is 3 percent, I don't think is correct. The goals are supposed to create an environment for maximum econom- ic growth. I think they are endeavoring to avoid the extremes of major monetary expansion, which would create inflation and reduce growth. Acceleration in real growth alone is not going to create a tendency on their part to clamp down. If monetary growth has moved at a pace, which in conjunction with near term possible economic growth, implies an inflation rate that is unacceptable, then I think they move against it. But I would be very cautious in interpreting their actions as being ready to put a clamp on at the point when growth goes above 3 percent or even 4 percent. I don't think that is in fact what they are trying to do. Mr. HILER. Dr. Schultze, before I allow you to answer that, if I could just interject one question to Dr. Greenspan. I would very much like to leave this room today 100 percent confident in your answer, but I look at 1984. We had an Ml growth rate of 5.2 per- cent over the year. That 5.2 percent was made up of two very dis- tinctly different segments—a growth rate of probably somewhere in the neighborhood of 7Vi>, H, or 9 percent in the first half, and about 3 percent in the second half. Now, it is difficult for me to take the fact that the Fed may have clamped that Ml growth rate down to 3 percent, and at times, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 226 lower than mat, except in return for tne nign economic rate, real GNF growth race in the first ana second quartern. Inflation had not cnaiigea over trie course of tne yyar. It was ba- sically 3 :/2 to 4 percent, which was aoout a point to a point and a half less than what many of the forecasters and economists in the country were predicting. Ana so with inflation remaining ae the point where It had been for several years, we clamped down on Ml growth and it seems to me in looking at trie minutes of the Federal Reserve, which tney are kina enough to give us 45 days afterward, it JOOKHU or certainly appeared that tney were concerned aoout eco- nomic growth. Dr. ScH(JL?'ZE. In tne first place, if rney were tryi.ng to 10 it, they sure missed because they allowed 6Va percent growth in 1983 and about 5!/y percent growth in 1984. It seems to me that is pretty good. In fact, it is trie west recovery in terms of tne output growth that we have riau—not try a oig amount, out by enough to make it interesting. The Fed does not so rnucn target growtn but the Fed aoeo worry that aggregate speriuing in tne economy will proceed, one, too fast, and second, too far; leading to producers trying to increase output, the higner factors changing tneir expectations, everything in a way that couJd set off inflation. When that increased spending gets what the Fed considers to oe too fast, 1 think tiiey do cracK down. So far, I think it nas wortced quite well. I happen to agree that that is about trie way tney ougnt to do it. I remind you again thai tills economy is oeginnmg to gee i'airiy close to the point wnere we are reacnmg wnat appears to be the zone of capacity liimt-auon. We still have a ways to go, out we are getting close, and every indication is that the Nation's capacity to produce measured in terms of its capital stock, measured in terms of tne Fed's capacity measures, measured in terms of its productivi- ty and iaoor force growth—all or which are imperrect—out all of those seem to indicate that we are continuing to grow tnat capacity and 2H, to H peicynt a year-, and I think the Fed has to be fairly cautious. You can quiobie at tne margin aoout not letting spending get to tne point wnere it tries to drive us tnrough tnat capacity and does set on inflation bum in expectations and in actuality. Mr. HILKR. My time has elapsed but if I might take about 30 sec- onds to conclude. Mr. COOLER Certainly. Mr. HILKR. With unemployment at 7.4 percent and capacity utili- zation in tne Fed statistics at 82 percent, and prices at the farm level and metal prices depressed, and land prices with no apparent bottom in signt in some areas of the country, it is difficult for rne to see wneie we aie Dumping up against, or ciose to uumping up agtuiiic me extremes of our capacity utilization potential. .But f am not an economist, so I will deter. Mr. COOPER. Mr. Neal. Mr. NEAL. I would like to asK you all to help me with wnat 1 think are essentially a couple of technical questions. One, wnat is tiie reai savings rate in this country? 1 had thougnt it was aoout 6 percent oi'GNP. I heard Dr. Schuiue use some otner numbers. Let me go anead and ask tne second question so you could all re»ponu to ooth. That question is, wnat would bring down the vaiue Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 227 of the dollar relative to other currencies? in looking at that ques- tion, I don't see anything that would—except bring down the budget deficit ana even that would take a long time to produce re- suits—unless we were to do something very foolish internally. There is no sensible thing that I can see that we would do at this time to bring down the value of the dollar. I can see stupid things, reinflating the economy, or putting ourselves through a deep reces- sion or going to war, or doing other things to destroy confidence in this country, but I can't see anytning sensible. Dr. GREENSPAN. Speaking for the three of us, that we would probably agree witn you on your second point. Mr. NEAL. That there is nothing sensible that we can do? Dr. SCHULTZE. I wouldn't agree with that. Dr. GREENSPAN. You are talking about tne ouaget deficit. I think he is talking about monetary policy. Mr. NEAL. Even on that question, as I see it, if we were to oring the buaget deficit aown, as I hope we will, that would, only inspire more confidence in our economy and would not prooably bring the value of the dollar aown very soon. That wouid attract even more dollars. Dr. SCHULTZE. I would put much less weight than my colleagues here on confidence in savings and more weight on the fact that you can make a nice buck in the United States—you can earn a good return—if you can bring down the rate of interest responsibly. And, I thiriK you can bring down the rate of interest responsibly by a substantial amount. I don't know exactly what it will do to the dollar 1 don't know exactly what it will do to foreigner's willing- ness TO buy dollars. I don't know exactly wnat it will do to the trade deficit. I do know it will push it substantially in the right di- rection. It will make it less attractive to invest in the United States. It is one thing to invest in the safe haven at 8 percent real growth and another thing to invest in a safe haven at 4 percent. Mr. NEAL. But it is all a relative matter, isn't it? Where will the money go? Where else could you get this kind of return or even two points iess with the kind of safety that their investors could find here? Dr. SCHULTZE. I don't think tnat the rest of the world is in that bad shape—my point is, the world doesn't have sharp corners. Clearly, there is some interest rate at which we wouid be unattrac- tive and I don't think that we are very attractive at interest rates of 10, 9, 7, 6, 5, or 4 percent, and then not attractive at 3. It is a curve. It is continuous and as you pull those rates down, people who are at the margin on investing in the United States are going to begin to drop out. Now, I can't tell you how many are going to drop out and how much it is going to do. Mr. NEAL. What you are suggesting would be the seiisiole thing over a penoa of time. That is precisely wnat we want. We want to gee the deficit down and hope the other economies in the world ap- prove. Dr. POOLE. You asked a question about tne saving rate. The per- sonal saving rate is in the neighborhood of 6 percent, but we have, of course, corporate saving—business saving—and then we have Government, which is generally dissaving. The net of all of those is in 1974 aoout 15.7 percent. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 228 Mr. NEAL. Personal is six? Dr. SCHULTZE. Not of GNP. Dr. POOLE. What I did was this. Take GNP and subtract out con- sumption and Government expenditures. Subtracting out the ex- penditures that we would regard as being not saving and taking that residual as a ratio to GNP, you get about 15.7 percent. Mr. NEAL. As net? Dr. POOLE. Well, as gross. It is not net of depreciation allowances, that is. Mr. NEAL. Could you run over the numbers with me one more time? Personal savings is 6 percent of GNP? Dr. POOLE. No, it is about 6 percent of personal income. Mr. NEAL. What percent of GNP? Dr. POOLE. I don't know. I can make the calculations but I don't have them right here. Dr. GREENSPAN. It is about two-thirds of that, or 4 percent. Mr. NEAL. Four percent of GNP and 6 percent of disposable per- sonal income after taxes? Dr. GREENSPAN. Yes sir. Mr. NEAL. And corporate would be roughly what. Dr. POOLE. Well, we are talking about corporate cash flow here. I don't know. I can't tell you right off the tip of my fingers here. [The following supplemental information was submitted on the savings rate for inclusion in the record by Dr. Poole:] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 229 A Note on the jsav_ing__Rate William Poole, Brown University Before discussing the saving rate, the important distinction between gross amd net product must be explained. Gross National Product is the total production of final goods and services, including production of capital goods to replace capital that is wearing out. Subtracting the capital consumption allowance from Gross National Product yields Net National Product. For most purposes NNP is a more appropriate concept than GNP, However, economic analysis is often bassed on GNP because employment fluctuations, a matter of major concern, are related to GNP fluctuations and because measurement of the capital consumption allowance is subject to substantial error. (For example, I live in a 110-year old house that the national income accountants probably wrote off years ago.) Saving is the part of national output that is not consumed. By convention, the consumed part of national output includes all personal consumption expenditures and all government expenditures as measured in the National Income and Product Accounts. This convention neglects the fact that, tor example, cars and highways are not used up during the period they are built and appear, respectively, as personal consumption expenditures and government expenditures in the national accounts. In 1984 gross saving was 15.7 percent of GNP compared to 16.2 percent in 1980. Subtracting the capital consumption allowance yields net saving — 4.7 percent of GNP in 1984 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 230 compared to 5.1 percent in Ttie personal saving rate (gross) in 1984 was 6.1 percent of disposiDle personal income, or 4.3 percent of GNP. The corresponding figures for 1980 were 6.0 percent and 4.2 percent, respectively. Taking all levels of government together, in 1984 government dissaving was 3.4 percent of GNP, compared to dissaving of 1.2 percent of GNP in 1980. The rise in government dissaving of 2.2 percentage points netween 1980 and 1984 was mostly offset by an increase in tne gross corporate saving rate amounting to 1.0 percentage points. Gross saving, and especially net saving, fluctuates substantially from year to year. Net saving was 7.4 percent of GNP in 1979, but only 1.4 percent of GNP in tne recession year of 1982. Sorting out tne effects of the Dusiness cycle and the effects of government ouaget aeficits on tne saving rate is a complicated task. There is little agreement in tne economics profession aoout these matters, ana precise estimates, or even generally - accepted rough estimates, are not available. Tne comparisons between the 1980 ana 1984 saving rates discussed earlier oo not "prove" anything, but snould alert us to tne possible interactions among the components of sav ing, On the on« hand, tne increase of government dissaving from 1980 to 1984 may have been partially, or even largely, oftset by an increase in corporate saving. On tne other hand, tne increase in tne corporate saving rate might have occured in any event. Future fiscal policy actions that reduce government dissaving might Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 231 reduce both personal ar.d corporacs satiric,, or iiignt nut. These issues are unseeded. The one conclusion that does seem clear is tne Reayan Administration's success in increasing the national investment rate has not yet Deen matched r>y success in incr^^sing the national saving rate, whatever may Ds tne reason. no«evever, it should oe noteo that the amount or saving nas Dtsen growing rapicily during the Business cycie recovery; even if the saving rate were constant, rapid growth in GNP would yield rapid growth in the amount of saving. None ot this analysis iihould oe intetpreted co imply tnac the present Feaeral budget cieficit is nat 3 pccoiom. The extent. of the fcLteci; o£ the deficit en tne national saving rate is certainly important in assessing tne overall economic erfeet or the deficit- But even if the ettect of tne aericit on ere national saving rate vari zero it wo'.i'id still t:-e .Vgri|.y oesitaole to reduce j^d ever.tuaily to eliminate the ri'j Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 232 Mr. NEAL. Well, let me get at it one other way. The Government deficit is roughly 5 percent of GNP. I had thought, obviously incor- rectly, that savings was roughly G percent and therefore the deficit was eating up most of our savings. How would you make me under- stand that a little better? Dr. SCHULTZE. Let me try to bridge the difference in numbers. I don't have exactly the same numbers in mind, but let me start with 16 percent of GNP as the gross savings rate. It has two compo- nents: One, depreciation allowances, which at least in theory are roughly sufficient simply to keep our capital unchanged, to replace it as it wears out, and that is about 9 percent of GNP. That means our net savings is normally something like 8 percent of GNP. So your number is in the right ball park for net savings. Both are le- gitimate concepts. I think if you are looking at a long term economic growth and the amount of funds available to expand the Nation's capital stock, you want to ask how much do we save net and therefore, can invest in adding to our capital stock. This means you have to have the net numbers. So Dr. Poole's 16 percent and your 8 percent are both right, but they are different concepts. Mr. NEAL. But if you are thinking about them in terms of what is needed today to finance the deficit, is 8 percent probably the more reasonable figure to think about? Dr. GREENSPAN. Yes, sir. The depreciation is also an optional number, which basically reflects the average age of the types of equipment purchased. As a consequence the decline in the average age of what we have been investing in in turn reflects the high cost of capital and leads to depreciation charges accelerating. It is not a fundamental economic improvement in savings. It is merely a re- flection of investment processes. Since the claim of the Federal Government reflects the same net concept as that net savings figure, the lower figure is the more appropriate number to match against the Federal budget's claim on the gross national product. Mr. NEAL. So a deficit of 5 percent and a savings rate of 8 per- cent are a reasonable way to think about that. Dr. GREENSPAN. Yes sir. Mr. NEAL. Thank you. Mr. COOPER. Mr. Carper. Mr. CARPER. Thank you, Mr. Chairman. I apologize for arriving late. I have three subcommittees going at the same time and it is tough to cover all three. I would like to follow up on what you were beginning to say, Dr. Schultze, in response to one of the questions. I think you were talk- ing a little bit about the Treasury tax reform plan. I would like to ask you, and then I am going to ask Dr. Green- span and Dr. Poole to also comment on those aspects of the plan, particularly proposed changes in taxes on business or corporations, how they may effect, in your judgment, positively or negatively the prospect for economic expansion in this country. The President, in his State of the Union Message talked about the need for reforming the Tax Code in a way that was consistent with economic growth. Most of us took that as a signal that he was sort of getting behind the Regan Treasury plan, but as it turns out, he apparently didn't realize that the Treasury plan increases busi- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 233 ness taxes and lowers personal taxes. Are there any thoughts that you might share with us this afternoon? Dr. SCHULTZE. The Treasury plan, it seems to me, affects the prospects for long-term growth in a number of ways, but let me just concentrate on two of them. On the one hand, it does raise, as I understand it, the tax rate on business. Now, part of that is in some very special areas such as financial institutions where it significantly tightens up the tax- ation of banks. It also raises revenue by changing the construction loan period on various defense contracts and other things, and oil and gas depletion. If you take those out, there is still a net increase in business taxation, but it is a much smaller amount. You could say all right, on balance everything else being equal, that still tends to depress the incentive to invest, I think modestly. On the other hand at the same time, it substantially reduces the current distortions in the Tax Code which arbitrarily favor one form of investment relative to another form of investment. The schedule of depreciation allowances combined with the investment tax credits that is now in the Tax Code, arbitrarily pushes and pulls investment in directions that economic logic would not. When you consider the fact that they are they are making the tax system much more neutral, much more even, and with less distortions, I would say that probably in the short term the plan would have only a modest penalty on investment. In the long term, it is going to improve the efficient allocation of investment and have a favor- able impact on economic growth. Combine that with the substantially lower marginal tax rates on individuals and the effect of that is positive. Don't expect miracles at all, but it is a plus from the standpoint of economic efficiency, in growth and improvement in the Nation's ability to grow, a modest amount, but that is about all we can do. Mr. CARPER. All right, thank you, Dr. Greenspan. Dr. GREENSPAN. It is a very difficult question to answer easily. There is no question that the simplified tax is superior to the exist- ing Tax Code, There is also no question that you will, if you elimi- nate the investment tax credit and significantly increase the aver- age depreciation lives of equipment and plant, reduce the level of capital investment in the short run. It is unclear, however, how it all comes out in the long run. There is another issue which probably will surface in these hear- ings, and that is a bias that does exist in the whole taxation area relative to investment. It is something we don't think about very much because it was defined many years ago, not by the tax law- yers, or not by the Congress, but by the accountants. They stipulat- ed that research and development expenditures be written off im- mediately. R&D is a long-term capital asset which increases pro- duction in the long run but is expensed immediately. Training courses which improve productivity and are a long-term invest- ment are the same sort of thing. A large number of corporate ex- penditures are written off immediately, but effectively address the long term. While it is certainly true that every time you shift the depreciation schedule, you favor one investment versus another, and impose taxes on one area versus another, the ability to arrive at so-called tax neutrality I think is a will o' the wisp. We are not Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 234 going to be able to do that. Unless we eliminate the corporate tax— which I favor—we end up with some form of distortion in the in- vestment process. Mr. CARPER. Dr. Pooie? Dr. POOLE. The taxation of financial institutions is a major part of how the Treasury proposal would get extra tax revenues out of business. The main issue here is that banks are permitted to deduct interest on funds they borrow—let's say certificates of de- posit—even if those funds are invested in tax exempt securities. You and I are not permitted to deduct such interest expenses on our own returns. I don't think the current tax treatment of banks is a sensible provision of the tax law. As for corporate investment in general, that is the key issue, and how we approach it depends on what our basic objective is. If we would like to move our tax system toward an ideal of a well-de- signed income tax, then we ought to use depreciation allowances that are close eo economic depreciation—that is. depreciation for tax purposes that closely reflects the actual wearing out of capital. If we want a tax system that is more oriented toward a consump- tion tax—that is. that does not tax saving—then if we keep the cor- poration tax we ought to permit expensing of investment—immedi- ate write-off. One of the things that we certainly should not do is to leave in the negative tax rates that now exist in some circumstances. If you look at the Treasury tax propsoal you will see some tables that show negative tax rates on certain kinds of investments. There is a net tax subsidy. That is. present law provides for more rapid depre- ciation than expensing in some cases. The combination of the de- preciation provisions and the investment tax credit lead to a net tax subsidy. That certainly should be changed. Mr. CARPER. My time has expired again. Thank you, each one of you, for being with us this morning and sharing with us your thoughts. Mr. COOPER. I, too, would like to add my thanks to the distin- guished panel. We are indeed fortunate to have had the benefit of your testimony. As the last matter of business, I ask unanimous consent to include Dr. Tobin's remarks in the record. iThe statement of Dr. Tobin entitled "Monetary Policy in 1985" follows:! Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 235 MONETARY POLICY IN 1985 Jane* Tobio Statement for House Subcommittee on Dctefitic Monetary Policy March 5, 1965 The Federal Reserve MoneJm Policy jteporj of February 20, 1W5 and the accompanying Statement* of Chairman Voleker are important and reasonable documents. The Federal Reserve has managed our economic recover? veil eince 1962. Both that record and the current statements give promise that the Fed is willing and able to keep the recovery alive. Ope reason is thst the Fed is orienting its operations to mflcroecoDoraic objectives—GSP growth, unemployment, and prices—and subordinating its targets for intermediate monetary aggregates to those objectives. Although this has been the practice o£ the Fi>d since fall 1982, it ie now stated quite clearly and explicitly as policy. I find this a very encouraging development. Mechanical monetarism scans to be dead at the Fed. The monetary aggregates, Ml and its four compenions, never were economically important per .£€_• They stood between the central bank's actual operating instruments and the ultimate objectives of wonetnry policy, and toioetiwes they got in the vay. The targets were a vehicle for establishing the anti-inflation credibility of the central bank, but adherence to them became a criterion of its credibility. On occasion it WBB unfortunate that the Fed's inflation-fighting credentials were tied to those numerical targets. In the first eight nontha of 1982, the Fed stuck to the wooey growth tareets it had announced in February, with disastrous results ff*r th* performance of the economy. Tigure 2 shove how drastically current-dollar GNP fell abort of the Open Market Committee's erpecta- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 236 (ions at the start of the year, and it also shows the main reason. The velocity of HI—the number of times a year the average dollar nates the circuit from one GK? purchase to another—fell far short of the assumptions implicit in the Committee's Ml growth target relative to its $GNP projections. In August-October 1982 Chairman Volcker and company reversed priorities, deliberately exceeded their monetary targets, made up for the velocity slowdown, and turned the economy around. (Figure 3 shows hov the HI target range vas first exceeded and then lifted.) Ever since then, at least by my interpretation, the Fed has geared its operations to macroeconomic performance first and foremost, specific- ally to managing the recovery. The FOHC has touched the brakes vben, as last spring and summer, real growth appeared too exuberant, and has eased when, as last quarter, the recovery gave signs of petering out. Fow that the recovery seems to be on track again, Chairman Volcker indicates "steady as you go" and says he is content with interest rates at current levels. Under this flexible policy interest rates have been much less volatile than in 1980-82, though they have by no means been pegged. (Figure 5). Moreover, Chairman Volcker and his colleagues have not lost their reputations as inflation-fighters, dearly earned over the three years from October 1979. Their credibility rested on firmer foundations than monetary targeting. The current Report and Statement support my interpretation. They pay as much attention to the velocities of monetary aggregates as to their amounts. They explicitly indicate that the Fed will continue to alter growth rates of money supplies to offset velocity surprises as soon as they can be detected. Although HI velocity has an upward Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 237 trend, its growth from quarter to quarter is quite volatile. (See Figure 4.) Indeed, as Chairman Volcker hat often pointed out, the pace of technological, institutional, and regulatory change in the financial industries has made velocity nore uncertain than ever. Bow the fed has clearly accepted the fact that it is Honey tines Velocity that matters, MV not M by itself. Of course HV is by definition current dollar GOT ($GHP). In effect, the FOMC is targeting $GNF. That means that the paths of HI and other aggregates will be moved within their target ranges inversely to velocity. Indeed we may infer, also from 1982-83 experience (Figure 3 again), that they will be moved outside them if necessary. The "central tendency" of the FOHC'a projections of $GN? may be the true target of policy, ahead of any of the aggregates. For the year beginning in the fourth quarter 1984, that central projection is 7.5-8Z, The midpoint of the Ml target range, 5.51, augmented by a normal trend growth in velocity of about 31, would more than suffice. But if velocity growth fell below 0.5Z, HI growth would have to exceed its 7X upper limit. The macroeconomic objective of the Federal Reserve, the goal that has guided its management of the recovery, is, I feel sure, a "aoft landing" on a track of sustainable growth at as low an unemployment rate as will not cause prices to accelerate. When the economy finally climbs back oo. to that track, the temporary cyclical components of recent growth will disappear and the economy will be limited to the growth in production attributable to increase in its resources and in their productivity. The Fed does not know, nor does your panel today, exactly what that sustainable growth rate is; most economists put it at 31 per year or a bit lower. The Fed does not know, nor does your Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 238 panel today, precisely what the inflution-safe unemployment rat* i« these days. It is quite clear that it is significantly lower than current unemployment. A consensus estimate is around 6X. The recovery ban some distance to go. The Gap between actual real GNP and Potential real CNF (estimated «t 6Z unemployment) appears to be about 3X as of I9fi& fourth quarter. (See Fijture la for the history of the Gcp, estimated two vays, the last four years. Figure ib shows its change quarter to quarter in recession and recovery.) To complete the recovery over two years would require real growth Averaging A.SX per year—1,5 to take op half the remaining slack plus 3 for the trond of potential GNF itself. The FOHC consensus contemplates real growth of 3.5-4Z from fourth quarter 19R4 to fourth quarter 1985; the other half of its SGJITP projection is for continuation of the moderate 3.5-^1 inflation. It is understandable that the Fed wants to approach its goal more slowly the closer it gets; that is the meaning of "soft landing". Still, the Fed's 1985 scenario seems over-cautious, leaving the unemployment rate at 6.75-7J and the Gap above 21 at year end. I believe 4.5Z re»i growth would be warranted in present circumstances. I hope that the Fed will not oppose a rise in both dollar and real GN? somewhat faster than their Secort projects for this year. The Fed's adout'.cin of velocity-sdjunfed mon«y growth targeting, in effect $GNF f.argeting, is welcome progress. However, rigid adherence to any dollar-denojninntpd target can cause excessive real damage to tbe economy in case of supply price shocks like the two big oil price increase in the 1970s. Under SGNP targeting, if price* rise II wore thsn expected real growth must be 12 leas. The one-to-one eacrifice ratio if nevere, unnecessarily no if the price shock i* non- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 239 recurrent ao that the extra inflation is temporary. The FOMC has not told UB vhat it would do in such contingencies. At this date price shocks like those of unhappy memory Beem unlikely. Oil prices are moving in our favor. The main possible source of bad price news ie depreciation of the dollar against other currencies, raising the dollar prices of some internationally traded goods and services. That development vould reverse tone of the disinflationary gains due to the amazing appreciation of the dollar these past five years. But those are gains we have to relinquish sooner or later, as we should always have known. We could not expect to hold the dollar at exchange values so far out of line with costs of production here relative to those abroad. The chances are good that dollar depreciation would not trigger a secondary wave or Spiral of domestic cost and price inflation. In current labor markets wage increases and new settlements are nodest. The hunger of workers and employers for jobs and market abates eroded by foreign competition should keep them moderate if and when the dollar declines. A decline in the dollar would be s welcome development. Our present huge trade and current eccwmt deficits are untenable. Agriculture and other export and import-competing sectors are hurting badly. The longer the exchange rate adjustment is postponed the lese able will these sectors be to exploit the competitive opportunities the adjustment will bring. The dollar might fall through no action on our part, simply because investors throughout the world become saturated with dollar assets, find better opportunities in other currencies, or lose confidence in the long-run prospects of a currency tied to a large Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 240 trade deficit. It IB commonly said that our interest rates would then necessarily rise. It is true that as long as the dollar was in the proceaa of falling and was expected to fall further, investors in American assets would went interest compensation for the expected decline. That ie why, contrary to common impression, a sharp and rapid decline might be preferable to a protracted gradual correction. In any case U.S. short-term interest rates will not rise unless the Fed wants them Co. I do not think Chat the Fed should automatically try to "defend" the dollar by raising interest rates. Instead, the Fed should consider whether a rise in interest rates is appropriate to its domestic macroeconomic objectives, discussed above. A depreciation of the dollar would eventually, after lags of several quarters, promote exports and retard imports. That welcome improvement in our trade balance would also be extra demand stimulus in the U.S. economy. If the economy were at the upper limit of a "soft landing" track, the extra demand stimulus would be unwelcome. The Fed would have to make room for higher net exports (lower net imports) by raising interest rates enough to "crowd out" an equivalent amount of domestic spending. This might be the case. However, as I noted above, the Fed's projected paths of real GUP and unemployment are cautious. We could well afford to close the Gaps faster, especially when the extra demands come to depressed sectors with unemployed labor and underutilized capacity well above the national averages, I have referred just now to a dollar decline brought about by a shift of world portfolio preferences away from dollar assets. Another way the dollar could fall would be by deliberate changes in U.S. fiscal and monetary policies. A significant reduction in the budget deficit, by expenditure cuts or tax increases or both, would withdraw Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 241 demand stimulus from the economy. To atoy on the desired GNP track, the Fed vould, if I am right about its present policy stance, ease monetary policy and lower interest rates to replace the lost fiscal stimulus. The reduction in U.S. interest rates might deter capital inflows and lower the dollar against other currencies. But it might not. Our trading partners overseas might seize the opportunity to lower their interest rates too, preventing or limiting the dollar's fall. The European and Japanese economies need the stimulus of lower interest rates, and improvement in their economies would help our trade balance whether the exchange rate falls or not. In conclusion, I welcome the Federal Reserve's adoption of a philosophy of monetary policy that places important macroeconomic objectives first. That shift has served the Fed and the nation well the last two and a half years. It is good to have it stated so clearly and explicitly as the Board and Chairman Tolcker have done in their Report and statements. The recognition of the need to offset velocity shocks by compensating changes in growth of money supplies gives the present policy specific content. For 1985, the Fed is right to continue to manage the recovery toward a "soft landing" at the lowest inflation-safe unemployment rate. Hovever, I find the Fed's 1985 scenario somewhat over-cautious. Finally, I warn against assuming, without careful consideration of the domestic macroeconomic scene, that interest rates must be allowed to rise when and if the dollar falls. Anyway, a preferable approach is to seek a decline in the dollar by a shift in our mix of fiscal and monetary policy. This depends on action by the Congress to reduce the budget deficit, and it would result in lower interest rates all over the world. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 242 Figure 1* The Cap in each quarter it the difference between Potential Real GHP and actual Real GNF, both in constant 1972 dollar*, at percent of Potential. Potential correspond* to 62 unemployment. tJnemployment- based Potential is calculated from the excesa of 6Z over the average of actual unemployment rates, leasonally adjusted, for the three months of the quarter. An "Okuu's Law coefficient" of 2.25 ii assumed; that is, Potential exceeds Actual by a percentage 2.25 times the ezce»> unemployment. Trend-based Potential assumes that Potential and Actual were on average equal in calendar year 1978 and that Potential haa grown at 0.721 per quarter since then, i.e. 2.92 year over year- The "avg" line graph in the Figure ia midway between these two Gap estimates. The unemploymentAbased Cap estimate was much the higher of the tvo at the depths of the business cycle in late 1962 and early 1983. Evidently unemployment was extraordinarily high relative to output. At the end of 1984, however, the trend-based estimate was slightly higher. If the rise in unemployment reported for January 1985 ia indicative, the unemployment--based Gap will move toward the higher trend-based Gap. The plots for 85:1-85:4 are those implied by the midpoint of the central tendency of projections of real GKP growth to 85:4 by Federal Reserve Governors and Bank Presidents, an stated in the Monetary gepp.rt ,t£ Congress of February 20, 1985. It ia assumed that their projected growth rate applies evenly throughout 1985. Fig. 1a GNP GAPS (% of Potential) (actual 81:1 thru 84:4 ; estimate 85:1 thru 85:4). 2 3 4 62:1 2 3 4 O3 1 2 3 464:1 2 3 4 8S 1 2. 3 A average + unemployment-based ^ trend-based Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 243 Figure lb . Gap" of Figure 1« i» the difference i After the Fed"« policy change took effect in 82:4 cbe Gap declined rapidly. The general decline in the rate of decline since then is consistent with a "soft landing" policy, as are the ct>n*sction» tne Fed engineered to »lov oovn rates of Gap fiecliue that seemed too high in the first halves of 1983 and 1984 and coo low later in boch yvata. Fig. lb Change In GNP GAP •(actual 81:2 tnru 84:4 ; estimates 85.1 tnru 85:4) 81:2 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 244 Figure 2 SCKP surprises are excesses, negative if shortfalls, of actual $GNP for the quarter over the $GNP projections stated in the Monetary Policy Report to Congress. They are plotted as percentages of actual $GNP. The midpoint of the central tendency of the Governors and Bank Presidents, or of the range vhen central tendency was not reported, is used. The projections are for rates of grovth over years ending in the fourth quarter; these have been spread evenly over the intervening quarters. The projections are those in the February Report except for 1983:3 and 1983:4. For those two quarters the $GNP projections implicit in the midyear Report of July 1983 vere used. This was the only occasion during the period when HI targets for the year in progress vere altered. At that time both the GUP projections for the year and the monetary grovth targets for the year were raised. A velocity projection for Ml is calculated on the assumption that velocity will grow at a "normal trend" rate of 0.75X per quarter from the base period of the Fed's $GKP projections and HI targets for the year. The base period is always the fourth quarter of the previous year, except for the latter two quarters of 1983, for which it is the second quarter of 1983. Telocity Surprise is the difference between the "projection" so calculated and the actual velocity of the quarter, expressed in percentage of actual. The general correlation of the two Surprises is clear, especially dramatic in the 1981-82 recession. The success of the Fed in compensating for velocity shortfalls in 1983 with higher monetary growth also is exhibited in the figure. pig. 2 $GNP and Velocity Surprises (FOMC projections & Ml targets, 1981 - 84) SGNP surprise (%) •f velocity surprise (%) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 245 Figure 3 The quarterly history of HI, seasonally adjusted, is shown by the line graph. The upper and lover limits of the target ranges as shown •re derived from the annual February Monetary Policy Reporta. except that the July 1983 midyear Report is used for 83:3 and 83:4 because the monetary growth targets for the year and the base period for HI vere then revised. The HI growth targets and ba§e periods, as thus announced, define HI target ranges in absolute billions of dollars only for the coming fourth calendar quarter. The intervening target ranges must be inferred. However, the mid-range target Ml ia defined for every quarter by the base HI and tb,e, mid-rang* growth rate. Her* it i* assumed that the upper (lower) limit of tbe target range for Ml is above (below) the mid-range target for every quarter in the same ratio aa in the fourth target quarter. This seems preferable both to the conventional "cone" and to the assumption that a limit differs from the mid-range by a constant amount of billion* of dollars in each quarter of the year. The figure shows the planned slowdown of Ml grovtb for 1982, as the Fed was pursuing the gradual disinflationary policy of October 1979. It also showa the decision to ignore the Ml targets, in favor of nacroeconomic performance, from 82:4 and the similarly motivated upward rchasings of Ml target*, twice in 1983 and at the start of 1984. The lower 1985 targets are also shovn, together with a mid- February figure for actual Ml for 85:1 close to the top of the target range. Fig. 3 M1 targets 81 -85 and history (February targets yearly & July 1983 revisions) § .82:4 i Quarters actual Ml Ml target highs O Ml target lows Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 246 The figure Btiows toe percentage cnaflge in velocity relative to the previous quarter, multiplied ££ Jour. Tins it is the cnange chat vould have occurred ill B >e«t had it COntinueO at tiie dame race. It is * number (JompoiaOle co Che 3X a year often caken as toe nonaal trend. The figure illustrates the volatility of velocity, vbich explaioa the led'a turitiic eopnasie QU coirettiog monetary taigetu aiifl gruwcb rate for peiteived velocity tluctuutionB. Fig. 4- % cnange M1 velocity 1981 —1984 -12 H Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 247 The nvtiage daily eitective Federal Fuoda rate tor cue quarter it ploiieu. The dramatic effect of the Fed'« policy cnun^e ovec iiuurccc* 7-9, &2:3, 82:4, 83:1, is clear. Lifc.eHi.ne, toe bwJtig* eiiic« then lefieci tot Fed's maii«K«uient of tbe epeeti of recovery. The point plotteo for quarter 17, 85:1, i» au entimate based on history through fig.5 Feaeral Funds rate Quarterly average or aaily races Quarterly, 0-80:4, 17 = 85:1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 248 Mr. COOPER. If there be no objections, the hearing is adjourned. [Whereupon, at 12:15 p.m., the subcommittee was adjourned, sub- ject to the call of the Chair.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis A P P E N D IX ADDITIONAL MATERIAL SUBMITTED FOR INCLUSION IN THE RECORD FEDERAL RESERVE press release For Use at 4;30 p.m. March 29, 1985 The Federal Reserve Board and the Federal Open Market Committee today released the attached record of policy actions taken by the Federal Open Market Committee at its meeting on February 12-13, 1985. Such records for each meeting of the Committee are made available a few days after the next regularly scheduled meeting and are published in the Federal Reserve Bulletin and the Board's Annual Report. The summary descriptions of economic and financial conditions they contain are baaed solely on the information that was available to Che Committee at the time of the meeting. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 250 RECORD OF POLICY ACTIONS OF THE FEDERAL OPEN JjARKET COMHITTEE_ Meeting Held on Fehruary 12-13, .1985 1. Domestic policy directive Thf. InforvnaMoti reviewed at this meeting suEgesrsd that the rate of economic exnansfo:] strengthened In latu ]98i. For the fourth nuarter as a whole, grourh in real, gross national product picked up to an annual rate of about 4 percent, according to the preliminary estimate of the Commerce Departnier't, from about 1-1/2 percfint in the third quarter, and there was evidence of continued moderate expansion in early 1985. The pick-up in growf-h fron the third to the fourth quarter was attributable In large ngrt to stronger donipnMc. final demand and a reduction in the current account deficit with forfJpn countries afrpr a sharo further wldpilng of fhat deficit 1" ttip third qnsrtpr. Broad mea.tiirea of nrlc.fts and wapps generally continued to rise In 1984 at rates close to those recorded In 1983. Industrial production Increased 1.0 percent In the Hoveraber- Decemner period, offsetting the declines In the preceding two months, and preliminary Indications sugepsted a further gain in January. The Hecetnbetr ripe was hro»(Uy ba.^ed, In contract to the Increase In November, which was concentrated lii thp automotive category. The Index of Industrial capacity utilization Troved up to 81.9 percent in December, but remained almost 1 percentage point be] ow ItH recent high In mld-1''8i. Nonfarm pavrol.l emi)) ovment. adjusted for strike activity, rose more than 300.010 further In January. The largest gain occurred af retail trari>> eBtahllsVments, but employment growth was also strong In services Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 251 snd in conorructton, ubere unseasonably olid weather boosted Hiring In both December and early January. In manufacturing, employment rose moderately after a large gain In December, and the length of the workweek edged down but remained above the average level In the fourth auarcer. Despite the continued rise In employment, the civilian unemployment fate increased slightly to 7-4 percent, as the civilian labor force R'-eu inb- Stentially. Sptall salpR rose 0.7 percent In January, continuing at about tbo samp pace as the average for Wovenber and December. Mur.h of the January rise was attributable to sales at automotive outlets. Rales of new domestic automobiles were at an annual rste of 8-1/2 million units, ghr.ut 1 fliil.11on units higher th?n the average in the fourth auarfer of 19RA. stores Bellini; primarily discretionary Items such an ?er)f>ral wrrhandl ne. apparel, furniture, and aoplianr.^s regi^fereii a mqrVo^ decline in sales in January, after substantial increases In the final months of 1984. The decline in housing activity that had characterized t.Vie Sfrond half of Jlfli appeared to be ending as the year drew to a rln^e. Tnt^l pri«at*- housing starts, though down about 6 percent In the fourth quarter as a whole to an annual rate below 1.6 million units, edged up in the Ho ""in her-Dec em her period, and sales of existing homes rose somewhat o"er rhp final two months of the "ear. Hi'F'npso ffved in"pitn>ent spending continued to pr'iw in The fourth Quarter, althnuph at a less rauid nace than in the first rhree Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 252 quarters of 1984. Shipments of nondefense capital goods Increased moderately In the fourth quarter, and spending on nonresldentlal construction advanced substantially. In contrast, new orders for plant and equipment fell in December and over the fourth quarter as a whole. Some Imbalances in business Inventories had developed during 1984, but businesses appeared to have made substantial progress toward attaining desired inventory levels, and in some sectors inventories relative to sales were quite lean. Investment in business inventories slowed markedly In late fall, largely in response to the earlier weakness in orders and sales. In November, stocks at all manufacturing and trade establishments were little changed in real terms, after average monthly increases in the range of S20 to $25 billion at an annual rate during prior months In 1984. In December, the producer price index for finished goods and the consumer price index edged up 0.1 percent and 0.2 percent respectively. During 1984 the rise in producer prices was 1.8 percent, compared with 0.6 percent in 1983, while the Increase of 4 percent in consumer prices was about the same as Chat In the previous year, The advance in the average hourly earnings index was 3.0 percent last year, compared with 3.9 percent In 1983. The foreign exchange value of the dollar rose about 5-1/2 percent to a new high over the Intermeeting period. After the announcement on January 17 by the G-5 Ministers of Finance and Central Bank Governors regarding coordinated Intervention In exchange markets, and subsequent ex- change market operations, the dollar tended to stabilize. The rise resumed in early February, apparently in association with a perception Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 253 that the outlook for economic activity in the United States was improving without algna of a strengthening In Inflationary pressures. The U.S. merchandise trade deficit declined sharply in December and for the fourth quarter as a whole, primarily because imports dropped substantially from the high rate in the third quarter. Nevertheless, the trade deficit for 1984 totaled nearly S108 billion, compared with $61 billion in 1983. At Its meeting on December 17-18, 1984, the Committee had adopted a directive that called for some further reduction in the degree of restraint on reserve positions. The members expectei that such an approach to policy Implementation would be consistent with growth of Ml, M2, and M3 at annual rates of around 7, 9, and 9 percent respectively during the four-month period from November to March. Given the estimated shortfall in growth of Ml for the fourth quarter relative to the Committee's expectations at the beginning of the period, the members agreed that somewhat more rapid growth would be acceptable, particularly if the faster growth occurred in the context of sluggish expansion In economic activity and continued strength of the dollar in foreign exchange markets. The Committee also Indicated that greater restraint on reserve positions might be acceptable if growth In the monetary aggregates were substantially more rapid than expected and if there were indications that economic activity and inflationary pressures were strengthening significantly. The intermeetlng range for the federal funds rate was set at 6 to 10 percent. After growing little on balance since early summer, Ml expanded at estimated annual rates of about 10-1/2 and 9 percent respectively in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 254 December and January«±/ M2 and M3 also expanded rapidly over the two months, rising on average at annual rates estimated to be around 14 and 13-1/2 percent respectively, considerably above the short-run objectives for the Novemher-to-March period established at the December meeting. Relative to the Committee's longer-run objectives for the period from the fourth quarter of 1983 to the fourth quarter of 1984, Ml grew at a rate of about 5-1/4 percent, somewhat below the midpoint of its 4 to 8 percent range, and M2 increased at a rate of about 7-3/4 percent, a bit above the midpoint of its 6 to 9 percent range. M3 and domestic nonfinanclal sector debt expanded at rates of about 10-1/2 and 13-1/2 percent respectively, above the Committee's ranges of 6 to 9 percent and 8 to 11 percent for the year. The rapid growth in total debt reflected very large government borrowing and strong private credit growth that was boosted in part by the unusual size of merger-related credit activity. Over the December-January period, the average level of borrowing by depository Institutions at the discount window declined on balance, despite a bulge around the year-end statement date, and both nonborrowed and total reserves expanded at very rapid rates. In the first part of the recent intermeeting interval, open market operations were directed toward achieving some further reduction In pressures on reserve positions. Adjustment plus seasonal borrowing at the discount window, after bulging around year-end, declined to the $250 to $300'million range over much of \j These growth rates and all subsequent data on the monetary aggregates reflect annual benchmark and seasonal factor revisions as published on February 14, 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 255 January. By the latter part of January, against the background of continued rapid growth In the monetary and credit aggregates and the relatively good performance of the economy, the easing process came to an end; reserves were provided more cautiously through open market operations, and borrowing rose somewhat, partly because of unexpectedly large demands for excess reserves. Reflecting variations In actual pressures on bank reserve positions, but in part In anticipation of an easing in pressures, the federal funds rate declined in the early part of the period from around 3-3/4 percent to the 8 to 8-1/4 percent area; subsequently It rose to around 8-1/2 percent or somewhat higher. Other short-tern market interest rates generally rose somewhat on balance over the intermeetlng interval, while most long-term rates were roughly unchanged or a little lower. The staff projections presented at this meeting suggested that real GNP would grow at a moderate pace in 1985. Business fixed investment was likely to expand further during the year, and anticipated gains in real disposable income were expected to support continued sizable advances in consumption expenditures. The unemployment rate was expected to edge down over the period, and the rate of increase in prices was projected to remain close to, or slightly below, that experienced in 1984, In the Committee's discussion of the economic situation and outlook, the members agreed that continuing expansion in business activity was a likely prospect for 1985, though at a nore moderate rate than In the first two years of the current cyclical upswing. As they had at previous meetings, however, members referred to persisting problems and financial strains in various sectors of the economy that constituted Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 256 threats Co the attainability of the overall expansion, especially if sub- stantial progress was not made toward reducing the massive deficit In the federal budget. Moreover, the high level of the dollar and large trade deficit were Increasingly being reflected la pressurea on some sectors of the economy. Most of the members expected about the sane rate of Inflation In 1985 as that experienced In 1954, assuming that the dollar exchange rate remained In the ratige of recent months, but some saw the odds as tilted In the direction of some modest further progress toward price stability. At this meeting the members of the Committee and the Federal Reserve Bank, presidents not currently serving as members presented specific forecasts of economic activity, the rate of unemployment, and average prices. For the period from the fourth quarter of 1984 to the fourth quarter of 1985, the forecasts for growth of real GUP centered on a range of 3-1/2 to 4 percent, with an overall range of 3-1/4 to 4-1/4 percent. Forecasts of the rate of Inflation, as Indexed by the GNP deflator, also centered on a range of 3-1/2 to 4 percent, and the central tendency of the forecasts for growth In nominal GNP was a range of 7-1/2 to 8 percent. Forecasts of the rate of unemployment In the fourth quarter of 1985 varied from 6-1/2 to 7-1/4 percent, but most of the members anticipated unemployment rates ranging from 6-3/4 to 7 percent. These forecasts were based on the Committee's objectives for growth in money and credit established at this meeting. The members also assumed that signi- ficant progress would be made toward reducing future deficits in the federal budget, thereby helping over the nearer term to moderate inflationary expectations and pressures on interest tatee, and they assumed that the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 257 foreign exchange value of the dollar would fluctuate within the range experienced in recent months. While a number of members commented during the discussion that actual growth in line with the forecasts would represent a favorable development for the third year of an economic expansion, several observed that growth might well be faster, especially In the short run. This possibility was raised by current indications of appreciable strength in both consumer and business spending and an expansive fiscal policy. It was also pointed out that a large decline in the foreign exchange value of the dollar, should It occur, would tend to stimulate domestic business activity while also adding to Inflationary pressures. Several members noted their concern that strong growth in spending by the private sectors in the context of a stimulative fiscal policy could lead to some Inflation- ary pressures, particularly as the margin of unutilized productive resources diminished, with adverse consequences for Interest rates and interest- sensitive sectors of the economy and ultlmstely for the sustainabllity of the expansion itself. While the overall expansion in economic activity was currently displaying some momentum, the members also referred to the decidedly uneven participation In the expansion of different sectors of the economy or parts of the country, including adverse conditions in agriculture and In certain sectors of industry. Circumstances and problems varied from one industry or region to another, but particular concern was expressed about the damaging impact that a rising dollar internationally was having on a number of manufacturing and extractive industries and on agriculture, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 258 with attendant financial difficulties for those sectors of the economy and related strains on the financial institutions that serviced them. Reference was also made to the overbuilding of multi-family housing and office structures in some parts of the country and to the problem loans associated with such overbuilding. Some concern WPS expressed about the rapid accumulation of debt by many households and businesses that rendered these borrowers more vulnerable to adverse economic developments. It was generally expected that sued problems would not significantly retard over- all economic expansion in the near term, but several members indicated that they were more troubled by the economic prospects for the longer run. The members agreed that the odds of prolonging the expansion would be greatly enhanced by a substantial reduction in federal budgetary deficits and the emergence of a more sustainable pattern of International trans- actions. With regard to the outlook for inflation, most of the members anticipated that continuing economic expansion in line with their forecasts would probably be associated with little change in the rate of Inflation during 1985, Some members were more optimistic and viewed the prospects for some decline in inflation as relatively favorable. Although the members had assumed in presenting their forecasts that the dollar would remain within its recent range of fluctuation in foreign exchange markets, they recognized that the future performance of the dollar was in fact highly uncertain. Members who were relatively sanguine about the outlook for infla- tion cited the favorable trend in wages, the strong competition from abroad in many industries, the growth of productive capacity, and the widespread Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 259 efforts of businesses to Improve productivity. The possibility of further declines In oil prices was also cited. The removal of quotas on Imports of automobiles from Japan would also help to restrain the rise in average prices, although tne extent of tnat effect was uncertain. Members who were less optimistic about the outlooK for inflation noted that unit laoor coats could be expected to be under upward pressure oecauae productivity gains would tend to diminish as the nation continued to move toward fuller utilization of its productive resources during tne tnird year of the current expansion. One member also raised tne prospect of at least some pressures from rising commodity prices in 1985. At this meeting the Committee reviewed the 1985 growth ranges for the nonetary and credit aggregates that it had tentatively set la July 1934 within the framework of the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkina Act). Those tentative ranges included growth — measured from the fourth quarter of 1984 to the fourth quarter of 1985 — of 4 to 7 percent for HI, 6 to 8-1/2 percent for M2, ana 6 to 9 percent for H3. The associated range foe total domestic nonfitianclal debt had been provisionally set at 8 to 11 percent for 1985. The Committee's discussion focused on whether the tentative ranges for 1985 remained appropriate in light of developments since mid- 1984 and foreseeable economic and financial circumstances. There were a number of proposals for small changes in the ranges. Vlith respect to Ml, a majority of tile members wanted to retain the tentative tange of 4 to 7 percent, but the remaining members expressed a preference for raising the upper limit to 7-1/2 or 8 percent. In the majority view, the tentative Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 260 range provided adequate room to accommodate a desirable and sustainable rate of economic expansion and retention of that range would also serve to underscore the Committee's commitment to an anti-Inflationary policy. The members who preferred a higher limit for the Ml range gave considerable emphaaie to the uncertainties that surrounded both the economic outlook and the relationship between money growth and GNP. They did not necessarily disagree that the tentative range might In fact prove to be consistent with a satisfactory economic performance, but they believed that some additional leeway was desirable far use if needed. In the course of their discussion, the members referred to evidence that the income velocity of Ml — nominal GNP divided by the Ml stock — seemed to be returning to a more normal or predictable pattern. Some analysis suggested that the trend growth of Ml velocity might be somewhat lower than that experienced over much of the postwar period, reflecting in part the deregulation of deposits and other financial changes in recent years and the related prospect of a slower rate of financial Innovation in the future. A number of members emphasized that such a development would imply the need for Ml growth In the upper part of the Committee's tentative range. It was also noted that the lagged effects of the Interest rate declines during the latter part of 1984 were likely to depress velocity growth in the first part of 1985. Other members raised the prospect that the growth in Ml velocity might not decline as much as expected from the rate experienced in 1984 and in that event growth of Ml near the upper limit of the tentative range, or above It, would have Inflationary Implications. The members agreed that the trend rate of increase in Ml velocity, as well as the velocity of the other monetary aggregates, remained subject to a considerable range of uncertainty, given Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 261 the still limited experience with a relatively deregulated financial environment. Under these conditions, the Committee members Indicated the need to continue to judge the behavior of the monetary aggregates In light of the flow of information on business activity, inflationary pressures, and conditions in domestic credit and foreign exchange markets. With regard to M2, moat of the members indicated that they could accept an Increase of 1/2 percentage point In the upper limit of the tentative range, although some expressed an Initial preference for no change in the range. The small upward adjustment reflected the technical judgment, baaed upon an assessment of recent developments, that growth In M2 for the year could revert to Its earlier pattern that was more In line with the growth in nominal GNP. Most of the members also supported an increase of 1/2 percentage point in the upper limit of the tentative range for M3 and an Increase of 1 percentage point In the provisional monitoring range for total domestic nonfinanclal debt. Growth within both ranges In 1985 would represent a considerable slowing from the actual pace in 1984. Some members questioned the need for any increase in those ranges, both because of the anticipated moderation in the expansion of GNP and because the higher ranges could convey a wrong impression of the Committee's anti-inflationary policy. Nonetheless, total debt was expected to continue to grow at a faster rate than nominal GNP, reflecting further rapid expansion In the federal debt, larger than normal growth in meiger and other corporate restructuring activities, and the continuing need to finance increases in spending by domestic sectors that exceeded the rise in nominal GNP, as reflected In Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 262 the expected further widening of the nation's large deficit in Its external trade balance. In the course of the Committee's discussion, consideration was given to a proposal for using the midpoint of cue i/ieviuvs ynve's it/jrrb- quarter target range, ratner tnan tne actual fuurtn-quarter outcome, aa the base for tne following year's target range. This isH'ie tiad tvjen discussed in some aetail at the previous meeting of the Committee. No support was expreaaeu in favor of such an approach, altnough t!i« members iceuftiilzed tnat In some circumstances such an alternative migfit oe appropriate. In setting Its objectives for a current year, tne Committee already COOK into account the prior year's monetary developments and tneir Implications lor tne evolving relationship between money and GNP. It was generally felc tnat employing the midpoint of the previous year's target range as the base for the current year's target would have the disadvantage of introducing a degree of rigidity in the decision-making process; it would impose a base that was decided upon many months Det^re ,mder possibly quite different circumstances. In cne current situation, sucn problems were particularly evident for M3 and total credit whose levels at the end of 1984 were well above their long-run ranges; use of a previously targeted fourth-quarter base would therefore imply either a wrenching slowdown in actual growth for 1985 or adoption of very high target ranges for growth in 1985. The nembers also noted that the levels of tne monetary aggregates at the sturt of the year were ail above the eatyet lauges under considera- tion, as those ranges were conventionally iliubliatea, uecauoe niuuctdry growth had been relatively rapid In Luce 1984 and early 1985. No member Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 263 expressed concern about this development, since It was contemplated that monetary growth would slow as the year progressed and expansion for the year as a whole would be consistent with the target ranges. With reference to the Humphrey-Hawkins testimony, the pictorial representation of the targets as "cones" would be supplemented by ether lines to indicate that the Committee was not concerned about variations In money growth outside the relatively narrow portion of the cones early In the year. At the conclusion of the Committee's discussion, a majority of the members indicated that they favored or found acceptable a policy that included retention of the tentative range for Ml, Increases of 1/2 percentage point In the upper limits of the tentative ranges for M2 and M3, and an increase of 1 percentage point In the provisional monitoring range for total domestic nonfinancial debt. The members indicated that It might be appropriate for growth in the aggregates to be in the upper part of their ranges for the year, depending on developments with respect to velocity and provided that inflationary pressures remained subdued. In keeping with the Committee's usual procedures under the Humphrey-Hawkins Act, the ranges would be reviewed at mid-year against the background of economic and financial developments. The following paragraph relating to the longer-run ranges was approved: The Federal Open Market Committee seeks to foster monetary and financial conditions that will help to reduce Inflation further, promote growth in output on a sustainable basis, and contribute to an improved pattern of international transactions. In furtherance of theae objectives the Committee Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 264 agreed at this meeting to establish ranges for monetary growth of 4 to 7 percent for Ml, 6 to 9 percent for M2, and 6 to 9-1/2 percent for M3 for the period from the fourth quarter of 1984 to the fourth quarter of 1985. The associated range for total domestic nonfinancial debt was set at 9 to 12 percent for the year 1985. The Committee agreed that growth in the monetary aggregates in the upper part of their ranges for 1985 may be appropriate, depending on developments with respect to velocity and provided that Inflationary pressures remain subdued. Votea for this action: Messrs. Volcker, Corrlgan, Boykin, Gramley, Mrs. Horn, Messrs. Partee, Rice, Ms. Seger, and Mr, Balles. Votea against this action: Messrs. Boehne, Martin, and Wallich. (Mr. Ballea voted as an alternate). Messrs. Boehne and Martin dissented because they preferred a somewhat higher upper boundary for the Ml range in order to provide enough leeway, If needed, to accommodate a satisfactory rate of economic expansion. In their view, the additional leeway was desirable because of the uncertainties surrounding the outlook for velocity, and it took account of the favorable outlook foe inflation and the continuing financial strains In some sectors of the economy. Mr. Boehne also noted that Ml growth in 1984 was In the lower part of the Committee's range, Mr. Wallich dissented because he wanted to retain the ranges for the broad monetary aggregates that were tentatively adopted in July 1984. In his view those ranges provided adequate room for fostering a sustainable rate of economic expansion. They were more consistent with the Committee's long-run objective of bringing down inflation, and raising them might be misinterpreted by the rsarket as a weakening of policy in that regard. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 265 In the Committee's discussion, of policy implementation foi the weeks immediately ahead, all of the members Indicated their support of an approach directed toward maintaining the reserve conditions characteristic of recent weeks. Such an approach was thought likely to be associated with reduced growth In the monetary aggregates over the balance of the first quarter, although growth for the quarter as a whole would probably exceed the Committee's longer-run ranges for the year. That approach was reinforced by the current strength of the dollar in the exchange markets and the sense that the outlook for the economy and prices did not appear to signal a need for a change. With regard to MI, the members referred to an analysis which suggested that expansion in this aggregate should moderate as the lagged effects of earlier declines in market interest rates on the demand for money balances dissipated. With respect to the outlook for the broader aggregates, the members viewed appreciably slower growth as a reasonable expectation, partly because of the prospect that Inflows of funds to money market deposit accounts and to money market mutual funds would moderate as the interest paid on such accounts was brought into better alignment with short-term market rates. Indeed, evidence of such a development was already apparent with respect to money market mutual funds. Additionally, the expansion in M3 might be held down by continued moderation in the issuance of large-denonination certificates of deposit by commercial banks. Despite the prospects for more moderate growth in the monetary aggregates, some members were concerned that such growth might not alow Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 266 sufficiently over the period ahead and that some firming of reserve conditions might be needed to foster a desirable rate of monetary expansion. They found the current approach to policy Implementation appropriate for the present, but they did not want to rule out the possible need for some modest firming over the weeks ahead. Several members Indicated that the degree of any firming should remain fairly limited even if money growth was above expectations for a time because they were concerned about the adverse impact that a substantial rise in market Interest rates over the near term could have on the exchange market situation and on tnterest- or trade-sensitive sectors of the economy and ultimately on the economic expansion itself. Members concluded that evaluation of the desirability for firming should take account of the strength of the dollar in exchange markets as well as the business outlook and inflationary pressures and that any firming of reserve conditions over the weeks ahead should be undertaken In a limited and gradual manner. Accordingly, relatively rapid monetary growth would not automatically call for more reserve restraint If it occurred in the context of emerging weakness in business conditions and a strong dollar In the foreign exchange markets. The members also agreed on the possibility of some easing in reserve conditions, but in the view of at least some of the members, any potential need for easing seemed less likely, given the recent strength of the monetary aggregates and the performance of the economy. At the conclusion of the Committee's discussion, all of the members indicated their acceptance of a directive that called for main- taining the degree of reserve pressure that had prevailed in recent weeks. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 267 The members agreed that modest increases In reserve restraint won1*1 be sought If growth in Ml appeared to be exceeding an annual rate of about 8 percent and M2 and M3 a rate of around 10 to 11 percent during the period from December to March, particularly if such monetary exnanslon was associated with aatiafaetor> growth in business activity and diminishing pressures in exchange markets. The members also agreed that lesser restraint on reserve positions would be acceptable in the event of substantially slower growth in tlie monetary aggregates, especially against the background of sluggish growth in economic activity and continued strength of the dollar In foreign exchange markets. It was agreed that the interraeeting range for the federal funds rate, which provides a mechanism for initiating consultation of Che Committee when its boundaries are persistently exceeded, should be left unchanged at 6 to 10 percent. The following directive, embodying the Committee's longer-run ranges and its short-run operating instructions, was issued to the Federal Reserve Bank of Hew YoTki The information reviewed at this meeting suggests that real GNP expanded at a moderate pace in the fourth quarter, reflecting some strengthening in late 1984 after several months of considerably reduced growth, and there was evidence of continued moderate expansion in early 1985. Total retail sales rose in January at about the same pace as the average for November and December, while the decline in housing starts appears to have ended. Industrial production and noofarm payroll employment increased appreciably in the November-December period and nonfarm payroll employment rose substantially further in January. The civilian unemployment rate rofie slightly in January to 7.4 percent. Information on business spending suggests less rapid expansion In outlays for fixed invest- ment, following exceptional growth earlier; businesses also appear to have made substantial progress In adjusting Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 268 their Inventories. During 1984 broad measures of prices generally increased at rates close to those recorded in 1983, and the Index of average hourly earnings rose somewhat more slowly. The foreign exchange value of the dollar against a trade-weighted average of major foreign currencies has continued to appreciate strongly since mid-December. After the announcement on January 17 by the G-5 Ministers of Finance and Central flank Governors regarding coordinated Intervention in exchange markets, and subsequent operations, the dollar's rise moderated somewhat. The merchandise trade deficit declined sharply in December and for the fourth quarter as a whole, primarily because of a large drop in Imports from the high rate in the third quarter. Nevertheless, the deficit for the full year 1984 was sub- stantially higher than in 1983. After growing little on balance since early summer, HI expanded at a rapid pace in late 1984 and early 1985. The broader aggregates also expanded rapidly in recent months. For the period from the fourth quarter of 1983 to the fourth quarter of 1984, Ml grew at a rate of about 5-1/4 percent, somewhat below the midpoint of the Committee's range for the year, and M2 increased at a rate of about 7-3/4 percent, a bit above the midpoint of its longer-run range. Both M3 and total domestic nonfinancial debt expanded at rates above the Committee's ranges for the year, reflecting very large government borrowing and strong private credit growth, boosted in part by the unusual size of merger-related credit activity. Short-terra interest rates have risen somewhat on balance since the December meeting of the Committee, but long-term rates are about unchanged to a little lower. On December 21, the Federal Reserve approved a reduction in the discount rate from 8-1/2 to 8 percent. The Federal Open Market Committee seeks to foster monetary and financial conditions that will help to reduce Inflation further, promote growth in output on a sustainable basis, and contribute to an improved pattern of international transactions. In furtherance of these objectives the Committee agreed at this meeting to establish ranges for monetary growth of 4 to 7 percent for Ml, 6 to 9 percent for M2, and 6 to 9-1/2 percent for M3 for the period from the fourth quarter of 1984 to the fourth quarter of 1985. The associated range for total domestic nonfinancial debt was set at 9 to 12 percent Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 269 for the year 1985. The Committee agreed that growth In the monetary aggregates In the upper part of their ranges far 1985 may be appropriate, depending on developments with respect to velocity and provided that Inflationary pressures remain subdued. The Committee understood that policy Implementation would require continuing appraisal of the relationships not only among the various measures of money and credit but also between those aggregates and nominal GSP, In- cluding evaluation of conditions In domestic credit and foreign exchange markets. In the implementation of policy for Che immediate future, taking account of the progress against inflation, remaining uncertainties in the business outlook, and the strength of the dollar in the exchange markets, the Conuolttee seeks to maintain reserve conditions character- istic of recent weeks. Should growth in Ml appear to be exceeding art annual rate of around 8 percent and M2 and M3 a rate of around 10 to 11 percent during the period from December to March, modest Increases In reserve pressures would be sought, particularly if business activity is rising at a satisfactory rate and exchange market pressures diminish. Lesser restraint on reserve positions would be acceptable in the event of substantially slower growth In the monetary aggre- gates, particularly in the context of sluggish growth in economic activity and continued strength of the dollar in foreign exchange markets. The Chairman mmaay call for Committee consultation If it appears to the Manager for Domestic Operations that pursuit of the monetary objectives and related reserve paths during the period before the next meeting is likely to be associated with a federal funds rate persistently outside a rang* of fe to 10 percent. Votes for short-run operational paragraph: Messrs. Volcker, Corrigan, Boehne, Boykin, Gramley, Mrs. Horn, Messrs. Martin, Partee, Rice, Ms. Seger, Messrs. Wallich and Balles. Votes against this action: None. (Mr. Balles voted as an alternate). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 270 2. Authorization for Domestic Open Market Operations At this meeting the Committee voted to Increase from Si billion to S6 billion che limit on changes between Committee meetings In System account holdings of U.S. government and federal agency securities specified in paragraph l(a) of the authorization for domestic ooeu marker operations, effective for the intermeetlng period ending with the close of business on Hatch 26, 1965. Votes for this action: Messrs. Volcker, Corrtgan, Boehne, Boykln, Gramley, Mrs, Horn, Messrs- Martin, Partee, Rice, Ms. Seger, Messrs. Wall3ch and Ballea. Votes against this action: None, (Mr. Belles voted 33 an alternate). This action was taken on the recommendation af the Manager for Domestic Operations. The Manager had advleed that substantial net purchases of securities were likely to be necessary over the upcoming Intermeeting Interval in order to offset the estimated absorption of reserves stemming from technical factors Including changes in currency in circulation, vault cash, and required reserves. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 271 Some Problems and Prospects for Monetary Policy in 1985 I am delighted to have this opportunity to talk about the But the classic preconditions for recession just do not unfolding economic situation and how it might affect seem to be present. The inventory problems have been monetary policy- I want to give some indication of where no more than minor and scattered. Consumer confi- I think ** can be going new year, but I also want to dence and linancial positions have remained basically point out some Of the possible pitfalls for monetary strong. There are no signs ol major or pervasive policy. I then plan to offer some thoughts on the broader capacity constraints—in good part reflecting our heavy issua of how monetary policy should be structured. As reliance on imports in this economic expansion. On me you probably know, my official role in monetary policy financial side, credit has continued to expand rapidly will come to an end on January 1. But I can assure you and has remained readily available. There has been that my interest in these issues will remain intense. nothing remotely resembling a credit crunch. Tne effects The economy has given convincing signs of slowing ol the moderate run-up in interest rates earlier in 1984 substantially after an unexpectedly strong first half. This seem to have been conlined to some softening in slowing was badly needed. Continued expansion at the housing. Now, rates have come down substantially, more earlier pace would have begun to re-ignite inflationary than reversing the earlier advances. tensions within a matter of months. More recently, ttte Looking just at the business cycle picture m trie con- question has become whether the slowing has gone too ventional way. the prospects look good lor a resumption far. Indeed, some have been questioning whether a new of the expansion. To be sure, we may still see some recession might be brewing. effects Irom the inventory blip created by the uneven My Own sense ol it is that the signs of outright pattern of consumer spending. But in the absence of weakness are likely to prove temporary. As we all know, major capacity strains, and in view of the fact that the exact timing of consumer spending is very hard to overall demand appears to have slowed to a sustainable predict. In 1984, for reasons thai are hard to pinpoint, rate, 1985 could turn out to be a very satisfactory year. consumer spending tended to bunch heavily in the first Real expansion could average close to or somewhat half ol the year. This was then offset by a lull in sub- above our long-run capacity to grow. We could see sequent months. The result of this uneven performance some gentle further declines in Ihe unemployment rate. was apparently some overbuilding of inventories. The The inflation story could also be very good with, at more recs.it signs of softness in production represent most, only a very modest acceleration from this year's efforts to correct this slluation. low rale. Assuming no further distortions in the money measures from deregulation, such an evolution ought to Remarks ol Amnonv M Solomon *no retired as Presides of ihs be readily accommodated by something like the tenta- F M e o d n e a ra y l M R a e ' s k e e r i v e e fl i B s a o n f k h tive 1985 growth ranges announced iast July. November 20. 198' But as we all know, there are a lot of things in the FRBNY Quarterly Review/Winter 1984-85 1 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 272 situation that have to raise questions about the appli- tionary experience ol the American peopie has been cability of conventional business cycle analysis to the very uneven. First we had very high rales of inflation prospects (Of 1985. Lei me lick off a tew of them. One for several years in the late 1970s and early 1980s. is our still-nigh level ol real interest rates. After the fact, Recently, inflation has been much lower and I am it is easy to think of reasons why we have been able pleased to see that inflationary expectations also seem to have a strong expansion even with these levels ol to have come down. But given this major transition, rates—the fiscal deficit, changes in business deprecia- many people probably have a very hard time figuring out tion rules, and financial deregulation are perhaps the what should be regarded as "normal" as far as inflation most obvious But even after allowing for these (actors, is concerned. I would therefore guess that views about there remains an unexplained element in this situation. the prospects for inflation are likely to continue for some For this reason, the continued existence of relatively lime to be unusually volatile. high rates is bound to make us less confident of any economic forecast. We simply cannot be sure that high If my comments on these various matters aeam to real rates wiil not become more of a barrier to expan- add up to a plea for the exercise of a large sion than they nave been so far. measure of judgment, let me aay at once that I A second difference compared with earlier postwar plead "guilty"—guilty with an explanation, but not expansions is the persistence of some degree of with an apology! financial fragility both domestically and internationally. This fragility is the residue of the late inflation, the recession and the related perform a nee of interest rates. A final unusual factor is of course our fiscal situation. As the expansion har- proceeded, and as vigorous It is unusual in terms of the large cyclical stimulus it efforts have been made to deal with the international continues to provide us well into a business expansion. debt problem, financial health has been returning. But It is also unusual in terms of its structural implications problems do remain. They underscore tne importance for interest rates, inflationary expectations, our balance of sustaining the U.S. economic expansion as a con- of payments, and the dollar. dition for restoring financial health. By the same token, Now I do not mean to imply that all these unusual they could also inhibit us in using as much monetary features of our situation are necessarily going to be restraint in the event that inflationary pressures sources ol trouble or that alt the risks are on the relumed. downside. For example, the international debt situation A third obvious difference from the past is our record has clearly been improving rather than deteriorating trade deficit and the extraordinary strength of the recently. And a general consciousness of financial dollar—of which more in a moment. fragility does have some virtues! It encourages a desire to improve balance sheets, to shun extreme risks and, m general, to avoid the kind of unrestrained and ulti- Given the various special features of our mately self-destructive optimism that has always been situation, It looks even more dangerous than a feature of mllalionary booms. Moreover, on the fiscal usual to be dogmatic about the appropriate problem, with the election over, we can hope that course (or policy in 1985. serious negotiations to deal with our fiscal imbalance will bear fruit. And of course while the strong dollar is hurting our export industries it is holding down prices. A fourth unusual lactor is the relative sluggishness of For monetary policy, the real point about these special the economic recovery in much ol the res: ot the features at our situation is thai they raise doubts that industrialized world. A related feature ol this situation the course ol policy can be as smooth next year as it is the prolonged and very high levels of unemployment looks at first blush Given the various special features m many of these countries. The social implications of ol our situation, it looks even more dangerous than this situation—especially as applied 1o the young usual to oe dogmatic about the appropriate course lor people—are already serious. They become progressively policy m 1985 Even absent these special factors, we more serious as the problem continues. Frankly, al this would have tha normal problems in anticipating the point. I do not see too much basis lor near-term opti- strength of the economy and therefore the appropriate mism on this front. The importance of a continued, stance of policy. But that is at least a problem made sustainable expansion in the L'.S economy is obvious familiar by long experience in dealing with ihe postwar in fnis context. business cycle. It is Itie special features of our situation A fifth unusual factor is what might be called the that create the potential for unfamiliar problems. "fragility of inflationary expectations" The recent mfla- Suppose, for example, the economy expands aignil- 2 FRBNY Quarterly Review/Winter 1984-85 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 273 icantly more rapidly f.an capacity and price pressures cj.i also be made that in the short run at least, the re-emerge No-'ially. in the conte<t c-f slsady money economic restraint exerted by actions to reduce ihe growth rate:, L-jtr. a development would put some Deficit should be aclively offset by speeding up money upward pressure on interest rales This would be an growth Again, this is one of Ihese decisions that would appropriate and constructive result in such a contest have lo be made in light of all the developments in the 6jt jnoer present conditions. Ihe response of Ihe economy at the time economy could be very hard to judge For example, it Overall. I tnmk it's clear there are many issues mon- Ihe resulting rise in rates led to another lump in the elary poncy may have to !ace in 1985 that could go dollar, depressing our irade balance further. !he restra'nt beyond the routine So it would be even more foolish on the economy could be unusually large In that case, lhan usual to try to tie policy rigidly to specific money even a mild rise m rates could prove a powerful offset growth targeis sel m advance And this would be the to inflationary pressures. On the olher hand, if, as some case even if no new problems turn up with the money believe, only guile large jumps in interest rates have any measures themselves. In fact, such problems have been significant effects on our deregulated economy, we pervasive throughout my tenure on tne Open Market would have to consider how much restraint could be Committee. We of course have multiple money targets- tolerated m j world with significant remaining financial three to be precise— and an associated total credit fragihty. So ailhei way. np-« Isciors have ciealed new measure. Moreover these multiple targets are defined uncertainties about how poiicy should respond to any m terms ol ranges rather than points The existence ol resurgence in inflationary pressures. multiple targets and 'he use of ranges, plus our ability Another policy issue that could arise from the special to reset the ranges if appropriate, provides JS wrih conditions of our present situation is how to factor m considerable flexibility within the targeting approach I movements m the dollar 1 myself have long tieheved think this flexibility may be needed again in 1985 as 't that our domestic monetary policy should take greater has m ihe past account of the performance of the dollar Certainly there have been instances— Move mOei 1976 arrQ OcioDei 1979 are examples— when the dollar has been an Fundamentally, the basic need is lor the central important factor in domestic monetary policy. But the bank to show thai it can and will take the action* performance of the dollar has generally been only a needed to control inflation. background consideration in routine month-to-month _ decision-making. Now, however, given the extent of the dollar's rise and given its apparent over-valuation m If my comments on these various matters seem to add purchasing power and trade terms, further advances m up to a plea for the exercise of a large measure of the dollar next year might provide a valid reason for judgment, lei me say at once thai I cleat) ' gartty' — gwlly some shading towards an easier position with an explanation, but not with an apology! Conversely, while a gradual and moderate decline in I think I understand and appreciate the arguments of the dollar would be welcome, a sharp drop could raise those who favor some form of explicit rules lo govern other problems for domestic monetary policy. Such a central bank performance. Basically, their argument is sharp rtrop would, even without any change m monetary that rules are needed to protect central banks from policy, tend to put upward pressure on our interest rates. pressures lo focus on short-run problems at the expense And I could imagine circumstances where international of a loijg-run commitment to price stabihiy Monetary considerations could contribute to a tightening of mon- rules provide, tl is aigued, protection against an intla- etary policy tionary bias inherent m the political process Moreover Now just now we should respond lo any of these con- they can, on this view, provide a form of accountability tmgencies tor the dollar would of course depend on the for the central bank. context of domestic developments. But I suspect that the These arguments lor some form of rule have appealed foreign exchange markets will, and should, come to play to some observers as long as central banking has been a more prominent role in our thinking about domestic a subject for public discussion. The reason for the monetary policy than has been true in the past. enduring appeal of this position is that the arguments A third policy issue created by our special circum- clearly have some elements of validity. The case lor stances could arise from significant action to reduce the some form of monetary rules — and against discretion deficit. Action on this front, substantial enough to con- and judgment — is one ot those perennial philosophies vince the markets, would of course put downward that tends to re-emerge, though m changing form, from pressure on interest rates. This would be true even m generation to generation As a student of Henry Simon the context of unchanged money growth But the case in my early days at the University of Chicago I can FRBNV Quarterly Review.'Wmter 1984-85 3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 274 personally attest to the durability ol this position. well-earned confidence that the central bank will act Nevertheless, a position tnat would rule out major overall as needed to do the job, even if il does not elements ol judgment in making monetary policy is not pursue monetary targets closely in each and every year. one that I find congenial. First, there is the problem of The success of these countries in limiting inflation has finding a rule that works. The most popular proposal in generally been reinforced by fiscal policies compatible recent years has been to fix on some growth rale for with anti-inflationary objectives. some definition of money. Bui as almost everybody is Now one objection to actual performance as the lest now willing to concede, all of the various money ol a successful anti-inflationary monetary policy might measures have given us ma|or problems in recent be that the price effects of policy show up only with a years. Tne reasons are too well known to naad repe- lag. If so. a satisfactory current price performance may tition here. Basically they involve the effects of financial not warn you of troubles lying ahead from a too innovation and deregulation. These forces have at times expansionary policy. So. especially if the lags are long, produced major and unpredictable aberrations in the ill effects of such a monetary policy might become velocity. Perhaps the worst of these aberrations are apparent only when it was too late. behind us and we are returning to more "normal I agree this could be a problem. But my feeling is that behavior. But no one can be sure about this. In any the lags have shortened a lot in recent years. The truth case, the new version ol "normal" is not likely to be the seems to be that the inflationary experience of the 70s same as Ih* "normal" of earlier postwar years. At this and early '80s has greatly sensitized the financial mar- point, we just can't be sure what "normal" really is. kets and the public at large to any signs that monetary Leaving aside the problem of finding a rule that would policy may be loosening its grip on inflation. Indeed, one "work", my own feeling is that monetary rules are really school of academic economists apparently now lakes it not the requirement for success in achieving reasonable as a working assumption that all markets can more or price stability. The reason is that in the end, it is results less immediately foresee the price implications ol that realty count. Monetary targets provide necessary excessive monetary growth. If this were true, an infla- long-run discipline when applied with a measure of tionary monetary policy would have immediately visible flexibility to deal with changes in velocity But funda- effects on actual inflation. And in this case, in turn, the mentally, the basic need is for the central bank to show inflation results of policy could be continuously monitored. that it can and will take the actions needed to control To be sure, such an extreme claim seems unjustified. inflation. If it does this, whatever the precise approach, But I do think it is clearly true that financial markets, it will acquire the credibility it needs to do the job of notably including the exchange market, are far more controlling inflation at reasonable cost. sensitive to the inflation implications ol policy than they were in the past. And perhaps commodity and even labor markets respond more rapidly to policy. SO I sus- I do think it 1* clearly true that financial market*, pect the problem that lags could represent for judging notably including the exchange market, are far policy by its results is much reduced in today's world. more ten*illv« to the Inflation implications of Hence I come back to the working proposition that policy than th*y *»•« in the put. monetary policy can be and will be most meaningfully judged by its results rather than by adherence lo some particular formula. In my view, the Federal Reserve has in fact acquired I think I should add that the "rules versus judgment" credibility in recent years. This is not because of the debate has a somewhat academic ring looked at from performance of trie money measures it targets. It is the point ol view of working central bankers. Within the because inflation has in fact fallen sharply and because Federal Reserve, Ihe practical issue that has really the public has become convinced of the Federal gotten attention is the degree ol reliance on mechanistic Reserve's determination to conduct an anti inflationary as against judgmental responses to changing devel- policy. The key has been results, not monetary targets, opments. In particular, the post-October 1979 approach let alone monetary rules. allowed for a relatively mechanical response of interest And that is true not just in the United States Other rates to short-term movements in money growth— countries with relatively good inflation records, such as although even in this period there were clearly rnaior Germany, Switzerland, and Japan, pay attention 10 elements of discretion in the process. More recently. money growth and. in the case of Germany and Swit- purely mechanistic responses ttave been essentially zerland, set targets. But my evaluation would be that it eliminated. is not monetary targets that have produced a successful In practical terms, what kind of monetary policy record on inflation in these countries. Instead, it is the approach is going to bring about a sustained period of 4 FRBNY Quarterly Review/winter 1984-85 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 275 rougn price siaotmy? We nave TO recognise mat as Obviously laoor marKet issues are not part ol mon- mucn as we nave accomplished in recent years, the etary policy. But to me. tne other side ot a successful problem is no! yet soiveo. inflation is still at levels mat long-run anti- in nation strategy woi>lo nave to do with the would nave Pean unacceptable in earner years. And our functioning ot our labor marnets. The level of unem- progress to date is partly nostage to a ioreign excnange ployment rates consistent with nonacceierating inflation rate thai will probably sooner or later move down. Fur- has been too nign in recent years given me social casts. ther, the progress we nave made continues to co-exist If I were to name trie smgie most important issue in witn levels UT unemployment, ootn nere ana abroaa. tnai oomestic mauio-ocoriomic poncy. I wuuia say it is the are just 100 nigh 10 oe accepiame over ine lonyer run. neea to lower me average uneinpiuymuiit rate con- sistent witn price staonity. THIS is too large a suoject to go into nere. Some reasons lor muoeraie optimism may Out gual snouia oe a peak cyclical rate ol De cnangirtg Demographies ana a pru&uectivtt improve- lMl»injti m »acn nutinMB cycta expansion tnai is ment in out prouuciivny periorrnanue relative to tne low«r tnun me on* wa nad in Ine previous dismai recoro ot me 'a70s. Aamineoly. nowever. such •a pan * ion. an improvement nas net yet snown tnrough m tne liguies. Wnat auout tne totitnis 01 nioneiary puiioyV Personally It WH follow me usuril uyciiuai script. mumovit, price I ani reasonably satistiea wnn me approach me Federal inflation will not imuruve luraiei in uus economic Reserve nas wsen SIIKB aouul laie 1S82. M thai pojm expansion. Ir.staaa, n couio wuisen somewhat—aim on gn we ne\ asiae ihe appioacn aaupted m Uciooer 1979. Inn aciuai uutcurne obviously depends importantly ooth That approach, as I riotea earlier, aiiowea interest rates on tne aoiiar ana on some crucial commodity markets to respond semi-automaticaily to deviations ot money notably tne Oil market, "inis suggests to me mat a growth—especially Ml—trom target paths. Tne prooiem strategy tor reany oereating intiatiun win nave to look witn mat approacn was mat MI was yiving out unrea- bey of 10 tne current Business cycie expansion. A! tne sonable signals R>r a oriel penoa we tried to aaapt (he same urns, I also Deiieve there is a goon chance tnai same general approacn 10 an emphasis on M2. But carried through one more tull cycle, such a strategy can since about tne beginning of 19B3 we nave nad what I come close to tne desired objective. Our goal should be would call a "tripartite" approach. This approacn allows a peak cyclical rale ot inflation in each business cycle us to continue to take account, in a judgmental way. of expansion that is lower man the one we had in the the performance of money growth as before, but also previous expansion. Under normal circumstances—that of the economy itself and. indirectly, o' the behavior of is, assuming no major lunnef shocks trom financial short-term interest rates. innovation ana deregulation—sucn a strategy snouid impiy a similar aownwdro ratchet in the peaK rates ot money growin tt is mis oownwara ratchet in money I should add that you can often i««rn inings irom growth trom one cyclical expansion to the next that looking at ihe economy, mcmoy, and m(*ie*1 rat«* should be our principal objective so far as money is logetner that you could not learn trom looking at concerned. •acti Of them MpaiBt«ly. Gradual year-by-year slowing in money growth rates certainly remains a generally desirable objective. Indeed, Ihe ideal of gradual, year-by-year reduction in Each of these three elements has a legitimate role to monetary growth has continued to be a factor m the play m decision-making. The relevance ot looking minds of most FOMC members in setlmg the annual directly at the performance ot me economy is obvious. targets. But the actual results, for an the Ms. have in The uroad, longer-term irend in money growth is a fact differed substantially trom this pattern. The need to component ot our anti-inflation strategy along the lines take account 01 tho various effects ot deregulation on I nave already described Ana interest iates memselves the Ms is one reason tor (ho difference. The sharp and clearly warrant explicit consideration lor me manifold essentially unpredictable drop in all velocity measures effects they nave on tne lunctiuiung 01 mantels ana The in 198* anu me continuing weanness ot M1 vfciocity economy, inaeea, tne intrinsic importance ut interest ove< rnueli ui 1983 is another This experience—plus my raies becomes yisaier m circumstances wiiwe snarp b*jlt«i i»a\ -m nave lo IOOK al ending inflation over a excnange rale movements ano financial fragility in credit mulii-cycie rioiuon—is what eaos rne to a cycie-by- maikeis are a tactor. cycle leouuiun m moneiary gtowtn rales as tne more I should aoo tnai yuu can otmn leaiii [ih,iys nuin critical lest looking at the economy, money, ano imeiesl iates FHBNY UuBii.eriy heviewurtinter iyo«-tt5 5 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 276 fogetner that you could not learn from looking at each decision to change reserve availability would be made of them separately. For example, If money growth ia in lha context of unfolding developments in the economy stowing down, does that mean policy is tightening? Does and the financial markets—with the precise emphasis It mean that the economy Is weakening? Or just that varying from Directive to Directive. money demand has shifted? Looking at what interest Now what does all this mean for Interest rates? rates are doing can help solve this puzzle and help Clearly It means we have moved a substantial distance indicate the proper course of action. For example, the from the post-October 1979 procedures where an sharp slowdown in Ml growth that worried some automatic mechanism could set In motion large and monetarists in the last half of 19B3 looked considerably often volatile rate movements. On the other hand, we less significant when Ihe continuing strength of the have definitely pot returned to the pre-October 1&79 economy along with reasonably stable interest rates was situation where the Federal Reserve sought, usually taken into account. successfully, to control the funds rate week to week with On a day-to-day operational basis, our focus since a rather high degree ot precision. early 1963 has been on bank reserve "availability". Within limits, the present approach gives significant measured in terms of member bank borrowing and/or room for market forces alone to generate movements net free or nel borrowed reserves (excess reserves less in trie funds rate. I realize that mis fact at times creates borrowings). Now there is a loose and shifting, but uncertainty about Federal Reserve intentions for those nonetheless real relationship between borrowings and who try to read those intentions trom the funds rate the level of the Federal funds rate and other short rates itself. But I think there is a lot to be said for a procedure for any given discount rate. So when a particular level that gives scope lo market forces. Market pressures can of borrowings is sought, we have some rough range for themselves be a source of valuable information to the Ihe Federal funds rale in mind as the expected result. policymakers. Moreover, rigid Interest rate targeting Of course it is possible that changes In banks' willing- seems to have a built-in weakness in making policy- ness to borrow at the window—due to changing levels makers too slow to act when action is needed. This was of financial market anxiety, for example—could push the the lesson that brought about the changes of October funds rate out Of line with Ihe rough range we had 1979. expected, in such a case, we could, of course, always Now I Know none of this tells you what is going to adjust the level of borrowings we seek accordingly. happen to interest rates next week or, for that matter, Whether we would actually make such an adjustment next year. But I am sure none of you really expect that wouW depend1 on the surrounding economic ana market from me. What I have been trying to say is thai my circumstances. It would be a judgment call. years on the FOMC nave convinced me that there is no Moreover, all recent Directives 10 the Open Market simple formula for making monetary policy even in the Desk here in New York have made the desired level of easiest of times. And these last four and a half years reserve availability conditional on unfolding events In have certainly not been the easiest of times) Nineteen general, these Directives allow for the possibility ot eighty-five may be a relatively smooth year to negotiate, increasing or decreasing the levels of borrowings or net But tot the reasons I have spelled out, mere are plenty free reserves during the inter-meeting period. Such of grounds of suspecting it may not be. Never. I think, possible adjustments may, but need not, necessarily has the kind ol generally pragmatic approach to poll- result from substantial deviations Of money behavior cymaking I (avor been more clearly called for than at from the expected performance as stated in the Direc- present. Certainly I will miss not being with my col- tive. What I want to emphasize again is that such leagues in the Federal Reserve as they work on these adjustments are discretionary, not automatic. The problems next year. But I wish them Ihe best ol luck in Directive language has always made it clear that any an endeavor that is so important to all of us. 6 FHBNY Quarterly Review/Winter 1984-85 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 277 WALL STREET JOURNAL Wednesday, February 22, 1985 Stock Prices Rise in Active Trading OnHelpFromStrongBondMarket ABREAST Robert Barbera, cnief economist at OF THE E.F. Hutton in New York, said Mr. MARKET Volcker's testimony before a congressional committee sounded a strong note of con- By BEATRICE E. GABCIA cern about the recent strength of the U.S. dollar. Mr. Barbera 'believes the volatile Stock prices rose in active trading, foreign currency markets "could play a helped along by a strong bond-market ad- role in a more accommodative monetary vance. policy" over the neat-term. The Dow Jones Industrial Average fin- "The stock market is looking over its ished 8.61 higher at 1286.11. The broader shoulder at the bond market" once again, market averages also registered hefty said Gerald Simmons, a vice president in gains: Standard & Poor's 500-stock index the listed trading department at Smith rose 1.94 to 181.17 and the New York Stock Barney Harris Upham. He and other Exchange composite index moved up one traders believe the.stock market now is point to 104.82. The number of Big Board movtaf m tockstep with the fixefrttGMM advancing issues outpaced declining stocks market. They said further gain* tit equity 1,018 to 563. prices will depend on declines in interest Volume on the Big Board expanded to rates. '_ _____ _--,~- -_ 114.1 million shares from 89.7 million wr White ttededliMs to interest rittioYtr traded Monday. The number of block the latt two sessions were certafatbr wel- trades of 10,000 shares or more rose to 2,- comed, many traders said fte Vh to-a 157 from 1,787 Monday. crease in short stoc* positions on the Nenr^ Yesterday's session started off rather York Stock Exchange in tie month ended quietly but on a positive note, following Feb. 15 were a potential source of future news of a 0.2% rise last month in the Con- buying power. Keith Herteli, vice president sumer Price Index. Trading activity accel- in the institutional trading department at erated and the gains widened as the Drexel Burnham lambert, said investora closely watched federal funds rate dipped buying stocks to coyer these short M^JOTs _. below 8% for the first time in recent could be'"a tremendous factor UCtt tails weeks. The industrial index showed a gain this market." -— of more than 13 points at mid-afternoon be- fore easing into the close. A correction yesterday in the dollar's Several buy programs on the Big Board fftenl sharp rise provided aftoost for mul- added some spice to yesterday's activity ' trnational stocks such as Eastman Kodak, and lured some investors into the market International Barinesa Machines and some from the sidelines. of the drug issues. The stock market also was cheered by IBM moved up % to 134%. The com- indications from Federal Reserve Chair- pany has expressed concern that the man Paul Volcker yesterday that the cen- strong dollar will cat into its foreign reve- tral bank isn't about to tighten monetary nue during the current quarter. Since it's a policy. Last week he had told Congress the bellwether stock, IBM's advance did much Fed's more accommodative credit policy to encourage the rest of the market for- of late 1984 had ended. ward yesterday. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 278 Bond Prices Register Their First Gains t M o o d o a d y y . ' s T I * n < v e h sto » r * s S m wv lc '" * " * In * c . — a — nd — d o ~ vbM r' r In Over a Week as fed Funds Rate FaU* A plus by Standard & Poor's Corp. / sue A o l f s o g e se n l e li r n a g l o b b r l i i s g k a l t y io w n a h s i g a h w IT a B y m D il » l n io d n s b is y - Ohio Underwriters headed by Prudential- CREDIT a n a fe v w m ou e ld d t i t a ft , a d U r n lr c la re i d u it p e b o i r le tt r t e to K M m w e t t t , t t h a i B le a r c l a i u e c S ti e o c n u r t i o ti e y s i e I l n d c . f r p o r m ic e 6 d . 7 t % ne in b o 1 n 9 d 8 s 8 a t f o - MARKETS an eHnrl to stem the rapid growth ol Ihe 7 8% in 1992. Bonds due 1986-1987 weren t money supply. Higher rates, however, reoffered. As of late yesterday, the unsoU And B K y D W T A U K H O H C tH . M fru A L J4 DiaSY c ti o v u e l d lo m a fo k r e e i t g h n e d m o v ll p a s r t o e r t s e n " T m h o e r e d a o t l t l r a a r c 's - b ab a o la u n t c H e 4 a m m i o ll n i g o n u . n T ^ he ™ oo n n te d n s , a r t e o ta ra le te d d o d n o l u y - NEW YORK-Bond pnces rallied yes- s e t n r i e n n g g 1'1 t h t h w a i t l l t m he i ti F g e a d te c I a h n e a u m nd ou er n t i a k of e , t i s g a h i t d - ble- H A e w o y M M ex o i u c d o y i ' s s s u a e n d d 1 t 6 n 4 p le m -A ill io o n y o i f & s P ta . te g te a r i d n a s y in a f m te u rn re o o t n h , a n r e a g i w st e e e r k in . g their first D Pa o r n t a n l e d r s K - . Maude, chief i-conomist of Refco e d M d e u a rw r c k a r e t i i t t o s e n r u a s n l l c g e e e d d n e o t r h y a e l M b o o b e n r li d r g i s l a l t a i L o lt n y e n r b c a n o u n c C d t s i a o . p n U i t n a to l - sury bonds dimbeo h point, or aruund [5 Higher Rates Expected yield imm &.2S% in 1986 to 8.5% in 1994. for each Jl.OOO face amouni. Still, prices of But Mr. Maude and others still expect The unsold balance among underwriters many issues are more than 3% points • higher interest rales ui coming months. "I lale yesterday was 138 million. The issue Is lower lhan they were less than Iwo weeks think you'll see the federal funds rate up to rated double-A by Mth Moudys and ago. 9% by the end ol Math." Mr. Maude pre- SiP Traders were cheered yesterday by a dicted. By midyear, the funds rate will A 1270.1 million offering of New decline in Ihe interest rate on federal spurt to the 10»% lo 11% area, he con- State Pc-wer Authority revenue refunding funds, wh>ch strongly influences other tended. bonds drew a warm response from inves- rates. The rate on Fed funds, which are re- "The mi major more IB ma will te tors Underwriters led by Salomon serves that banks lend one another over- up," tfrvft Mr. TtwnbfTf of RM Ttan- Brothers Inc. yesterday repnced most of n w Ir i e o g e A m h k t l s s , a . o n f e b l a u l v o t e y o r i a n a g g b e t o h o u e l t m a 7 b 1 a 4 o r % u k t e t 8 l a w 4 te % a s y I s e n t s r t o r e e n r c g d e e a n r y t - t b I n N e e e n U s a . s M e u B s R x I M a a n " E t d « a f c i w n r r o d e il w d i l v i t t i t i a d U f u d n a e e b l c m s w o a n a n t o n n m a d U s y t " i a m w l f i e e l r l o w w m j t h m n e e n o b r u u a I s h n t i e e - t t p f h r e e o r m c U i e s n n s ( d t u 2 a e 6 e g r 8 , e , t 8 h lo e p m w o n i e l n e l r u w t i . o n n s g T c . h y a e i l e e l s , d i z I s h e e a w s is a s m s u u e i c n i h n c r c e a l a u s s d e e • d * s I T h r a e n a - s e u x r p y e 's c te a d u ct i i n o v n e s o t l o r $ 7.0 d 1 em bi a l n li d on o a f t n t e h w e h fe e d a e v r i a ly l a g s o v w e e r l n l m . M en o t reo w v il e l r , b M e r. b T o h rr u o n w b i e n r g g s 1 e 98 r T ia l t o h o 8 o % ds I p n r i 1 c 9 e 9 d 4 , to in yi a e d l d d i t f io ro n m lo 6 % te r i m n y fi i v e e ld -y e w a a r s , 1 Iw 1. o 43 -m % o . nth notes. The average e ti x g p h e te c n ts cr t e h d a l t l c th o e n di F ti e o d n s t e o v e s n lo tu w a ll m y on w ey il - l b th o e n d o s l d p r s i c c a e l d e , t o s e y n ie a l l d b 9 o .7 n 5 d % s w In e r 2 e 0 0 p 9 r . i c U e n d d e to r Some analysts were encouraged by tes- supply growth. y ad ie d ld it io fr n o m to e t f e t r m in b 1 o 9 n 8 d 7 s t o d u 8 e .2 2 5 0 % 09 I n p r I ic S e M d . t t o o timony yeslirday by Paul Volcker. chair- Lawrence N. Leuza, a vice president yield »JT*%. "The i«« »at uerjr warmly man of Ihe Federal Heserve Board, at s and economist al E.F. Mutton & Co.. dis r*cel«d." ttii Jobn J. O'ftltn.^ rnmr House Banking subcomnuttee hearing. Mr. agrees. He expects interest rales will be M« dtnctor of burnt BMktn. V fo o re lc c k a e s r t . s as a u b s o u u a t l, I d h i e d n' F t e m d a 's k e c a r n e y d i s t- p p e o c l i i f c i y c m "r o el n a t t h iv s. e ' ly H e s t a a r b g l u e e s o v th er a t th th e e n F e e x d t 's s e re v c e e r n al t ' Citicorp'* Paper Rates Rite p hi l s a n r s e . m B a u rk t s s e I v n e d r i a c l a t t e r d a d t e h r e s c c e o n n t t r e a n l d b e a d n t k h a Is t d st e a c g is e i on fo r t o a st m op od e e a ra si t n io g n cr in ed l m l o h n a e s y - s s e u t p p th ly e ' At Its Auction Thit Weds Increasingly concerned about the dollar's growth. By a WALL STHKBT JUUHNAL Slajf Rtpaner i s c b a t k I I t D n h h n h u g r e i t e t c e e u o r t a e t r s M g d i e s i l r U e r . n l i r e n m a a a t l . s S a c s y S n r t a c e t o o i y . i n y o s o m m o P t e n t h n U c h b e r p d i a f a o n o e e . e o i e t l S n t r t m e c r i t i o . o e o v f h t m t m i i i n i h p n e e v g n n a s e o n t i n a e d j c d s m n o - t u m d o e h c p e r s i C x o l a s i x o o t l a t c c r n l a p r s o s l i l h u e i e r a a m t a r ' I s i n r ! s s r r n o t e ' e e s t s p g n r w h a i v l n a o l u e a a r c a a s i n c v l h i n i h s u t e t n i e m h a s a a e s p t . n a n r w s a c r p h t c t d e r o o o a t c k v m o r i u i s o e i l n n l o d n p t t d t c e s i u e l t g r r a i n s m n o s e i h l s n l a d u a y o t i a n e e e e s f . w r d d n y e d d - g q t a d t n I T m a h h r a a u r l o a e o p t y e a I F i w t m r . o o n a r c i u t s n c i t u u e e n h T r u e a t n r t t r e g p h h r r l h t ' s y e o u u e a e a p e n f ' i m t 4 r t s c r t m , 9 c o o o 9 . c a I r 6 d q n l % u H n o e H o u u t 1 d r g m . c a a e e c 8 i o % t n r l t . l / i , o h t i n 3 c e e d p e ' 2 u m s b a r M s . t , a e , d o i G a y x l m j n a r u d u r i p . N d n r o p e k s a a a s d l w t P e t d n e t f L e t d e n r d s s s I d o e i u s e l o o u m f o e f r y r t f n i t o v h o z h e 2 3 r m i e l 1 9 a s i 0 c % 1 6 s t t I 1 e n e . n n 6 t c 5 4 s t a r t h f ' 6 o l o h . d t / l c e % i a 3 n e a l o 3 g t o 2 t y i n f a W e s o g o , I i e n M n n r s u r c d d o o , i t r t n e h o t s m o I i a h d g e n s n s - l - 8 a c 8 s 8 p n w d . . o u ' . 8 a e 6 a l 7 a r b c 1 n 0 * 9 y N s A p A l 4 1 m y 9 t i o E % % o % s l c r s i t e W n T t a s o o o t t l w t u t . e m t a a o e o a e a d a t t Q l l m e s Y l 8 . s d 9 d l . D 8 l o i e O a A a 1 s O t 3 f r s c y e s - R c c a 0 d t o U t . 1 i c 1 % n a r K a 9 5 w s a e y p o l 8 . p t 0 . - t e 5 A T t c h s C e e p m T o a h e n k d m a l i m r e h i l ' d p s l k a i l m b , b e i l a H o i o l s i r a v a i O d e r a n . o n e p r s D w l n k r c e r ' a T a s a i a . r u a h m h t g i a s 1 e c n l o a n e 1 i t l i l i g 0 p d u o l o b 0 e i i a r p f n o w i n d a d p m 9 n g a t s o e . e i 1 s f c f r f l r 5 s r , o l w 1 o i o a 0 o u m o o 8 m m a l % f p 2 n e r s - - Mr. Volcker told the House Banking 11.72%. The government's i:V& nolesdue from 8.76?% at lasi week s sale. subcommittee yesterday that "1 don'l like 1995 rose to K7 11/32 from 97 5/32. par- A total ol Mi5 million in bids was whats been going on in the markets-m ing the yield in 11.71% from 11.74%. submitled. AM the accepted Bids were at' the volatility, or necessarily the direction." Bill Rates Slip >.iso%. Ottcorp M anotner W nUJUon H tio e n d s idn b ' u t t off I e n r d a ic n a y t e s d p ec tn if a ic t re th c e o mm do e l n la d r a 's - Treasury bill rales edged lower. The snJe Beit Tutiday strength is playing a more Important role latest 13-week bill closed at 8.35% bid. in the Fed's policy-making than pre- down from the average rale ol 8.36% set at viously. auction Monday. The bid on the latest 26- "Volcker seemed lo display more con- week issue eased lo 8.52% from the auc- cern about (be dollar than he did when he -jon average ot 8.5371. testified last week" at a Senate Banking In the municipal market, a 1240 million cnmndtMc hearing, said Sminti Humbert issue of various-purpose general obligation u eeanonfcl it Rted, TfadMft *<X a bonds by California sold brisk!;'. A group N M e r w c k C f a lr u m u . , Co*B.-taM< toiMOneM M- M Af k W f E « tm k t i f t A * r • an * ca M • " • 'hr" m l"° O H t t m be y m wi t n t - - fejr mi nOrnt the ton* priced M #t». *— UM feUM tt> UM, ttiMW** Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 279 Dollar Eases From Highs After Remarks By Volcker on Intervention Trigger Whit MI. VoJcMr aid doesn t ipfftr By STEPHEN UKUVEH to IIIHLMK a chanfp -n administration thinking aUut Intervention in the forelgn- The U.S. dollar fell back against major eichange market. said Mr. Hurley. "As I , foreign currencies in panic selling after read his remarks," Mr, Hurley said, "he's * Federal Reserve Board Chairman l"aU saying that more intervention should be Volcker suggested that recent toreign-ex- used, but not necessarily by tne Fed." change market imerveniion by I'njor cen- which has been reiuclam under president tral banks and other JfCOInpanying poli- Reagan to intervene except to cairn disor- cies haOn't been force!iil enough. derly markets. Lesi than Ih minutes after be spoXe be- . "He's suggesting thai oilier central fore a panel of Hie Hcuse Banking Coitunii- banki haven't Been as active a.s they uuuid tee, the dollar plunged from an interday have been in the foreign-exchange market, high oi more ttan 'i.tl "fttsl German and he's interring insd it they nafl movBl. marks to about 3.39 marks. Later in the we also would nave moved." day, as traders began to focus on favorable Nonetheless, some traders criticized the economic indicators released in the morn- apparent disparity between President Rea- ing, thp dollar recovered some of its losr gan's remarks last week and Mr. VolcKer's strength, settling at 3.+060 marks in late testimony yesterday. Last Thursday, Mr, New York trading Reagan told a news conference that the The favorable indicators were the 0.2% U.S. shouldn't attempt to Oring the dollar rise last month in US, consumer prices, down. indicating that inflation still was under "The market may even nave been set L™"*>«mr««i, control, and the 3.8% rise in January L'.S. up for a fa!!," a trader said yesterday. The durable goods orders following a revised fact is that the dollar advanced an as- 1.9% decline In December. The December tounding 4% against major foreign curren figure originally was given as a decline of cies on Monday, largely as a result of Mr. 2.9%, so that the upward revision also Reagan's remarks, only to fall back nearly helped the dollar. "Under normal circum- 3% yesterday, before^the dojlaLgradually stances," said Barry M. Wainsteln, a vice began to recover some o( Hs lost president of BankAmenca International, strength. New York, "the market would nave bought "WKh that kind ol vobHttlty." Mr. dollais like crazy on news like this.1' McGroarty aid, "the fontgn-exchaiife The dollar also was helped late in the markets an breaking dam. Hew can you afternoon by Alan Greenspan, who was «P«i UK dollar in iuMllze when the chairman of the Council of Economic Ad- president says there's nothing you can do risers under President Gerald Ford, In tes- to slop the dollar from rising, and Volcker timony before Me Joinl Economic Commit- apj*ais to say stmtthing much differ- tee of Congress, be said It was possible the ent?" He added: "The authorities bave a U.S. gross national product, the nation's responsibility to the foreign-exchange mar- output ol goods and services, could rise at ket," a 6% rate in the current quarter. Mr. Hurley said that, despite yester- Even so, the dollar sclLed lower across day's correction of dollar strength, "every- the board following its record-setting per- thing's coming up roses lor the U.S. cur formance Monday. The British pound, for rency, and we're going to see the dollar example, after having declined to less than mucb higher than Its recent levels. The (1.04 in early New York trading, regained reason Is tbat we've had an economic revo- some strength, settling late in the day at lution in this country, and It's been accom- (1.0615. uj. from its recoid low of S1.054S panied by a revolution in pxchange Monday. rates." Traders said the foreign-exchange mar- In early trading in Tokyo Wednesday, ket yesterday was totally disorderly, with [he dollar fell against the Japanese cur- spreads between the dollar and the mark rency to 259.93 yea from 260,33 in New fit one time reaching 150points, or l.&p'en- York yesterday aftenmun. nigs. "You can't enecuie a commercial or- On the Commodity Exchange in New der in a market like this. ' said James T. York, gold for delivery this month rose J6 McGroarty, a vice president of Discount an ounce to (288 an ounce, in reaction to Corp. ol New York. Douglas E. Han 11, an the dollar's declines. Contracts lor all de- assistant vice president and manager of liveries amounted M a moderate 3.8 mil- the corporate advisory desk of Credit lion ouncCT. Sui'iS" m New York, said that "people Cold was quoted at 1288.45 an ounce wouldn't even aniwer their telephones. We during eirty trains m Hong Kong couldn't gel a price out of anyone." Wednesday. The result, said Timothy F. Hurley, a first vice president of Bank ol Boston, was that "it was extraordinarily difficult even to eichange J2 million for marks, whereas normally a 110 million transaction is exe- cuted without any difficulty." Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis THE WASHINCTON J ff EDMiDAY. FEBBUBY27. I9BJ G3 Dollar Falls After Volcker Testimony By John M. Berry tral bank policy-makers are "not "I don't like what's been going on Utahvcrai Pmr Sljff WEIHT alarmed by the level of the 'M's"— in the markets, either the volatility the various measures of money— or the direction," he declared. Federal Reserve Chairman Paul bul they are worried about the Volcker said that the current sit- A. Volcker said yesterday that re- money supply's "trajectory." uation, in which more than Si 00 bil- cent actions undertaken to stem the He reiterated that the Fed lion worth of foreign capital is flow- rapid rise ol the U.S. dollar on for- slipped easing its monetary policy ing into the United States annually eign exchange markets, including stance last month, but that it has in excess of that being sent abroad intervention by central banks, have not begun to tighten that policy. by Americans, is an unstable and not been forceful enough. "The value of the dollar in foreign risky one. "The incentive to put "If the proof of the pudding is in exchange markets ... has been a money in the United Slates could the eating," Volcker told a House moderating influence on going in prove quite fragile" to a shift in ex- Banking subcommittee, then the ef- the other direction, which we have pectations about future inflation and forts have failed, since the dollar not done," Volcfcer told the subcom- interest rates, he warned. has continued to rise. mittee. "We are hostage to. we are However, as soon as foreign ex- A move toward tightening—mak- hooked on, foreign capital for a change markets became aware of ing reserves less readily available to while* because of the large budget h T i h s e r d em oll a a r r k s d , ro t p h p e e d d o f l r l o a m r p 3 lu .4 n 7 g e t d o . f t i o n a r n a c is ia e l s in h s o t r it t u -t t e io r n m s — in w te o re u s ld t r t a e t n e d s a d n ep d e t n ra de d n e c d y e i f s ic t i h ts a . t T "i h f e w p e r c ic a e n n o o f t t h g a e t l OoO 3.39 German marks in the space of and. all other things being equal, • so easily the foreign capital we about 5 minutes, the value of the dollar as well, in the need, then interest rates will rise" "Now the feeling is split." said opinion of most analysts. and domestic credit users, such as one market analyst in New York. we S a h k o e u n l , d f t o h r e c w u h rr a e t n e c v y e r be r g e i a n s on to , h w o il u l s g in e g t c a ro n w d de in d v e o s u ti t n o g f t b h u e s m ine a s t s k e e s t. , "Some people think this is the first Volcker said, "some decline in the "That's the risk," he said. sign of a dollar decline and others dollar would not be adverse," since Volcker said chat he cannot pre- think we will have the dollar at 3.50 it has risen so strongly since the dict when foreigners might become marks by the weekend. first of the year. Bui he warned that less willing to invesl in the United Volcker, who essentially repeat- a larger reversal of that trend could States, but he added, "It's an in- ed the testimony on the economy mean higher interest rates and creasingly uncomfortable situation. and the Fed's monetary policy plans higher inflation. We are putting ourselves at risk." that he gave last week to the Sen- The Fed chairman said that in- After Volcker spoke to the Sen- ate flanking Committee, also indi- tervention in exchange markets "is ate committee last week, bath cated that the strength of the dollar not likely to be an answer standing short- and long-term interest rates has become "a moderating influ- alone." More fundamental policy rose in the money markets. As of ence" in the central bank's discus- changes, such as major progress on yesterday, they had not regained sions about any possible lightening reducing federal budget deficits, the ground lost, analysts said. The of its monetary policy position. are needed in the United States, three-month Treasury bill was The Fed chairman noted that while other countries take actions yielding about 8,45 percent before money supply growth has been to stimulate their domestic econ- his testimony last week and yester- "well in excess of our targets." Cen- omies. day it was at about 8.66 percent. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 281 THE WALL STREET JOURNAL DAIt: rebruary Z/, tstib Volcker Implies The cb*ln«B dife't ntptt* ftfere Moves to Check *» tt* problem of UK M(hdeeii-, but he , did expres continued concern over market conditions. Dollar AreWeak "1 don't like what's been going on in the TUs dbctaun wwn't nrpiMc: e*r- markets-in the volatility, or necessarily B*T this year, the Fid ttrjeB CWgrwi to the direction." he said. eliminate govenumot-flimbM maniD While bemoaning the Ineffectiveness ol requirements, saytaj securities exdttntea . Congressional -Testimony recent Intervention efforts, Mr. Volcker re- should be allowed to set thetr own credit iterated his longstanding view that inter- requirements, subject to review by gov- P O r n o duc F e o s r eig S n h arp M a D rk r e o t p s v o tr v e e n e n r t d i c o s o n . m , e b y b a I s t i s c e lf c , u c rr a e n n 't c y b e an e d x p e e c c o te n d o m t i o c | e st r o n n T m a h e i e n c t F o e m r d eg . m u I i l n t a t t e o a e r s , l . e H tt i e d r t s h e e n r t e to "n c o o n lo g n re g s e - r Strong growth &nd political stability remains JoftificatMn" for limiting bomnr- make the U.S. an ittracUve place to In- Ing to 50% of the stack's vtlue. By LAUME MCGINLEV vest, he said, uMlng thai some European ; SU/T Heporrero/THE w*". STREET JOUHNU, countries should consider cutting taxes to i Vol W ck A e S r H of IN th G e T F O e N d era - l Re C se h r a v ir e m B a o n a rd P s a u u g l - stimulate their economies. ; gested that efforts by the U.S. and other No Change for FSnners ; countries to check the dollar's recent rise Mr. Volcker also stressed that the dol- 1 should hsive been more forceful. lar has been an Important consideration in Mr. Volcker's statement produced a setting domestic monetary policy. The sharp drop in the dollar on foreign-cur- strong dollar, he said, "has been a moder- rency markets yesterday, as traders ap- ating influence on any tendency" by the parently concluded thai more forceful ln- central bank to tighten monetary policy, "which we haven't done." ISr. Volcker's testimony initially Mr. Volcker also put [arm-state law- sfirred nervous currency speculators makers on notice that he doesn't Intend to into a sharp, though short-lined, doilar- loosen monetary policy to aid the ailing ag- selhng spree on foreign exchange cash ricultural economy. "We can't deal with and futures markets. It also helped Mi- all the sectoral problems in the economy ster bond prices, which, in turn, mere except by producing a prosperous whole," credited with aiding a stock market he said. ratty yesterday (see stories on pages S3, The Fed chairmaji said Congress could 50, tS, 631. help debt-ridden farmers by reducing the federal budget deficit which, over time, terventlon might soon drive the dollar would lead to a decline in the dollar. In the down. The British pound, which had been short run, he acknowledged, a reduction in below Jl.W during the day's trading ses- the deficit could actually push up the dol- sion, bounced back to 11.06. for example. lar, as foreign investors gain increased The Fed chief, asked at a House Bank- _ confidence in the U.S. economy. t i r o n e g n r c e O y c J e m m nt a m r e k it f e t f e t o s e r , t s h r e e t p a o l r i i e i n n d g t , e " a r 1 b v o e c u n a t e n h ' i t i n s s a t r h y e e a t c h c t e i u o r r n e - war A n s e d h e U K to c t o m In m i t t h te e e p th u a t t . t M he r . c o W w M wy c ' r i tas been any dramatic success from re- entreat heavy relance on ton&a oipttil cent actions. I think there is a question of to finance IU tr»d» sad bodfet deficit* car whether actions were taken forcefully Ties the "seeds of la awn dtttractkn." enough, Including In the intervention Eventually, he said, foreign Investors are area." likely to stop investing so heavily In the Criticism of Treasury Seen U.S. and Interest rates will go up. "It isn't Some viewed Mr. Volcker's comments a pretty picture." he said. as a criticism of the Treasury. Throughout Asked by committee members whether he Reagan administration's first term, the the Fed would tighten monetary policy this Treasury adhered to a hardline, no-Inter- year if the economy grew faster than ex- vention policy. pected, Mr. Volcker said no. as long as But late last month, concerned about other economic variables, such as infla- he soaring dollar, the Treasury agreed to tion, continued to perform well, ran other major Industrialized nations in As part of a wide-ranging discussion be- acting more aggressively to help stabilize fore the panel. Mr. Volcker renewed his he foreign-exchange markets. Since then, call for legislation to deregulate the bank- he U.S. has intervened more regularly, Ing Industry, warning It may be Congress's but still modestly. last chance to influence the evolution of Fed officials contended that Mr. the rapidly changing banking industry. Volcker wasn't singling out the Treasury And he said the Fed Is considering reduc- for criticism but merely stating the obvi- ing 1ta cradlt, or margin, requirements on ous: that recent attempts by the U.S. and purcbue*ofiecuritin;cunwl]y>Mm>«- ., other countries to curb the dollar's rise tof tor nod prices to Hmltfd to 50* of md bolster foreign currencies haven't Ibe vtlue of (be nock. been large enough, coordinated enough or sustained enough to do much good. In tfle U.S., the Treasury, after dtaflMi Mtk to Fed, mlkMtte deduce mwMfe* to Wenw U hn4c*e«*ttft motets. Md the FW cinfca oat tke decision. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 282 THE HEU YORK TIMES WEDNESDAY, February 27, 1985 Dollar Plunges in Late U.S. Trading "I think it's H correction — no more •y MCHOLAI D. KM»TPF than that — but It still may have a way to go," said Larry Ryan, senior ,.. iW dollar plummeted TWterday, vice president and foreign-exchange tt iMvtaf traden divided ovvr whether manager at the European American '' Itt long mtrcii upwud had stalled. Bank in New York. Mr. Ryan cool- i.; "J »U«ve the trend ha* been pared yesterday's dollar plunge tc rev*rwd," MM Albert Sort*, foralgn- last Sept. 21. when market Interven- axdunge manager «the Swin Back tion by the Wes! German central bank Foreign Exchange - • Corporation. "THi li the tint leg of • precipitated a sharp drop for the big move. It could snowball." American currency. The dollar then TUESDAY, FEBRUARY 26. 1985 Other trade™ were not M bold. gradually recovered, and a month Some expect the dollar to recover ago it surpassed its previous peak. soon, though perhaps after dropping a "We're playing by a whole new set bit wore Bret, And even those, such of rules that no one really under- at Mr. Sort*, who expect a looser stands." Mr. Ryan added. He and downturn Mid the dollar probably other traders cautioned thai predic- : would touch bottom at level* that are tions were extremely risky. : Mill high by recent aperient*. "People are just following the lead, in Europe, before trading began In whatever it happens to be," he said. New York, the dollar rose sharply, Yesterday's plunge in the dollar's , retching '3.47 Weit German marks exchange rate from the morning high p an ou d n a d . $ B 1:0 u 3 t * la l t e e v r e t l h a e g d a o l l n la tt r f th el e l I B n r N it e is w h w pr a e s v io ev u e s n c la m y o 's r e ri s d e r . amatic than the York, and the decline accelerated as Among other currencies Ihat rose bank* scrambled to dump dollars yesterday in relation to the dollar, the they had accumulated. Japanese yen ended at 260.3 tc tlie to a lew hours, the dollar lost more dollar, compared with Monday's than 2 percent of Its value. In light, 262.5. The French franc moved lo nervous trading in the afternoon, the 10.42 to the dollar from 10.54, and the dollar recovered slightly. By the time Swiss franc moved tc 2.88 to the dollar moH trading bad ended in New York, from 2.92. the dollar WM quoted at 3.40 marks And the price of gold, which often and the pound at 11.081. The dollar tumbled after traden moves in the opposite direction as tbe received report* of yesterday'* testi- dollar and bad plunged more than 112 mony before Congress by Paul A. an ounce on Monday, climbed about Volcker, the Federal Reserve chair- 16 yesterday, to 1288.75. roan- Intervention by central bonks in the currency markets, he said, may not have been forceful enough. »K» 17 JWg T Fe ra d d e e ra rs l R to e o s k e r t v h e i s a n to d m ot e h a e n r W tha e t s te th rn e Dollar's Action Abroad 5t» JSC5 central banks might intervene more LONDON. Feb. 26 (AP) - Despite forcefully in the future, selling dol its late drop in New York trading, the lacs to push down the exchange rate. dollar closed in Europe today at Last week, however, President r li e r c a o a rd n s d a t g h a e i n F s r t e t n h c e h p f o r u a n n d c , , t a h t e 1 I 3 ta -y li e a a n r Re*gan indicated reluctance to inter- highs againsl the Dutch guilder aiid fere with the dollar's course West German mark and at a 10-year Trading already was Jittery yester- high against the Swiss franc. jwt .ira into u>a _ d l t f w s t h h a r a a a a i e h r s y T i e p s y d t e , d p r n e , a a e w n w n d C t n m o h i d e o o t n u e a h r u a e g s n s l d p m x h d e y o p h t l a i , l l r a b f o l n e t a v t e h t f h y h r h e e e t e e a b y h b n l m r b e i a o s e s t l n g i s t a e v w l k a i e i e e m d n s t e h o , i m r f a t d o b e l o b u e u l u e a d o a f s n d t a i u h d l i e n l o a w t e l v g w , a t c w e h e d t l i n d a l i r h t n y i a h o e c t e . d h l t n w d . l h e e o a o S e i r m s r l l o s r - s e l 2 p i o I m n t 6 u p 3 G o T s e c t . h r l n h 0 h o o e e 5 l e e a s d d , e n d t F d b d h b t o a h u a u l I c r l e n l n t l a l o i r E d T o s E 2 o n e o a w u l k s , e l a r t y y w a a o s , e r o r p h w n h l a e u i i i c e t a h p t h f r n 2 e b r t 6 r t o h o y h e 0 m t a a . r p 3 M t d a n h r 5 d o e l l i M i y . o f n n 5 i e s m t g 5 o t E n n a , t S u y a d r d I r l e k k S a a o o n i e y t p w n . a e t ' e g s s n r n . w s in a h g i o d b t e e h l x e o p w d e o c t l t h l a e r a l s e h c v o o e u n l l t i d o n f u s 3 t i o n .2 p g o b r d e o f 3 o w . r 3 e n W t t u a e r i n s l- l o q f Z r u u u o n o r m t c i a c e h d M h a M o i t n L a d C o U a n B y d t . ' e W o i U n C , d M tb u p p e . r I d i f t c r a e W o y m o M f b O e 8 f q 1 8 o u 3 7 r o J . e 9 t O , e 0 W d . . u H ~ i p n S German marks. And some expert* said the dollar could again climb until it 1* nudging parity with the pound. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 283 THE NEH VORK TIMES, WEDNESIWW, February Z7, 1985 Fed Held But Mr. VoJcfcer WM not aikod, during a bearing that lasted nearly Trade and other imbalance*, be three hours, whether the Fed would In added, cannot be "papered over." In Inhibited by f b a e c e t n h f a o v r e th ti e g h d t o en ll e a d r' s c r s e tr d e i n t g h t a h d . it not f w a h c a t, t be p e s r a v id er » se t an e o ff t e h c e t r p o o l i n a t c , h a i e so v m in e g - It Is widely assumed that a tighter such a desirable goal as reducing, the monetary policy would raise Amer- Federal budget defich "might be to Dollar Rise ican Interest rates, thereby making i send the dollar higher." Investments In this country still mare tttntttve to foreigners and further strengthening the dollar. Impact on Various Seem* The rising dollar, about which Fed- Volcker Tells era! Reserve officials have long ex- pressed concern, lias had adverse ef- fects on sectors of the American econ- Of Impact on omy that face competition bom Im- ports or, like agriculture, rely heavily on exports. Money Policy Mr, Volcker's prepared, statement today was virtually Identical to the one he gave the Senate committee last week — a major point was the dangerously high American reliance By ROBERT 0. HERSHEY Jr. on foreign capital and the need to cut the Federal budget deficit — but the Special to TO* N«* Yort TlmH q ad u d e i s t t i i o o n n a in l g o r In re c l l a u t d e e d d su a b j n e u ct m s. ber of WASHINGTON. Feb. 26 — Paul A. When asked, for example, why the Volcker, the Federal Reserve chair-. American economy was not proving man, said today that the dollar's to be a better "locomotive" in pulling spectacular rtse in world currency markets was inhibiting the central other countries from recession. Mr. bank's conduct of monetary policy. Volcker laid It was partly a matter of The implication seems to pe that the United States attracting "so the Fed may be supplying more much of their capital." money to the economy than it would Some nations such as West Ger- prefer, thereby eventually contribut- many and Japan, he suggested, ing to upward pressure on prices. should consider tax cuts or other Mr. Volcker's comment, thought w "stimulative action" without which be the first public acknowledgment of their growth would probably not be a predicament that analysts have dis- sufficient to reduce unemployment. crased tor cnanj «wka, came during Mr. Voider also Mid be haft had extensive questioning by a House sub- "some concern" about the wave of committee on a host of subjects that corporate mergers that, although included the lam crisis, corporate now somewhat abated, has burdened takeovers and securities margin re- both the surviving companies and the quirements. Institutional lenders that have fl- Last week, appearing before a Sen- nanced such deals. ate panel, Mr. Volcker disclosed that On yet another subject, the central the Federal Reserve had ended the bank's chief indicated that the Fed- progressively easier credit policy It era] Reserve would cut securities pursued during the final four month* margin requirements, which have 0(1984, stood at 50 percent sine* W*.11 such Aggregate*' Growth Noted a st c r t u io ed n w a e s r e h n a o v t i n l g ik e s ly ig n to if i b c e a n M ce is co fo n r - when Representative Jotm P. monetary policy, The Fed recently Hiler, an Indiana Republican, today Issued a report declaring the require- asked the reason for this. Mr. Volcker ments, which date from the lS30'a, to cited rapid growli to the monetary be outmoded. aggregates since November and As for the fann situation, about "some evidence ol renewed which Mr. Volckec has been toked re- alrength" to the economy. peatedly of late, be Mid It was Dot a Mr. Volcker men suggested that the problem that could be solved by central bank might have taken monetary policy. Faster money ex- s so tr a o r n in g g e r d a o c l t l i a o r n . h T a h d e i d t o n l o la t r b , e b e e n a fo w r a th it e - p p a ro n b si l o em n, b to e s so a m id e , w o o th u e ld r o se n c ly to s r h o u f t t t h h e e ed, "bw bean * moderating Influence economy, «uch at home bunding. A on any tendency to go In the other di- lower dollar, he laid, would not lead rection, which we havent done." to lower interest rates. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis D2 THE NEW YORK TIMES WEDNESDAY; FEBRUARY 3t. UK Economic Scene Leonard Silk The Flight the United States is a highly attractive place 10 lodge funds." Among the reasons for this: higher Interest rates here than elsewhere, the mor« dy- To the Dollar namic American economy and '•the safe-haven ap- peal of a country that offers political liability." "Neither the unusual fundt-gaUierini role of American banks nor the foreign Investment In the ATER soaring 10 record heights this week, the M Un o i r t g e a d n S e ta c t o e n s o c m a i n s ts b e s c a o y u . nt " e B d u 1 t o n th ( e n r d e e f I t s a f a te ls l o y, " l it t t h l e e dollar fell back yesterday. But the swing reason to expect either an imminent decline in dollar still promises to reach new altitudes large capital flows to this country or a major weak- t l a a p p c b h a n a g o e u i u d n r a c s N h n i k y n r a a d e e e f s n p w o m t a f a s r e r t l e l i h y . Y a l l m e s B l p o a t b o W e s r t s k h f u e o t e e n l r h o r s y d e w i w t w e n s G t s a h k a e a t y e e i e e s I l n r u r m t i J d m n p t c l s a h g . o a t W y e I o u n a n , l 4 n p c m d b I o a o m t e a c n u f l l r a c r o n a i k o e r r m t d k e e s , iv w e b r s a a r . n r a i b t A a s e d o s l i b c e n n s 3 o w r d o g t o . v o 6 o m t a e l h t r d o r m h e t e i h I o n l a t B t s . g r o r n O a e r k e d a i w S s t 3 a e i b ; . r h s 4 r o l i h a s o 7 y t r e t o p b m t h o n n a a e r M o c n i t n s n t k h c e a g e s i o o n s y n I y f d t ? c n c o E a " o e t y f u a r h p I o n i s n n e o , r s t d t e l , r d i i e E y " g t b e o i W ' u n c s e d l r e a l s o h a r M s l a s p r e a f . I e r y e r " n e a . - s a s h n M , n t a e a d h v d l b c s a e e i N e v l b A n i e a t t y m r m w o p r a e o l r a a e o n r u r n i g b l c f p d d o e l a u e r d n t m t y s c u s o f a r s h r m u p a o e o i r m a o n t e p a v i u G l l y t . t h a e I I s s e n n r t k y m r v i e o i t n e m a h s u s g n s e r - - » t R h . . e H T o . T w M re l c a o N s n u g a r m y c , a a n s r u , g U th g K e e s h t f s i o g r h t m h -f e a l r y t , i D n th g e a p d n u o k t l s y l a t S r o e s c t t h r a e e y t a s r a t y r lo o f o n t f ? g g d v a e o n n ll e a e r I m n 's b c r u r i a s rr c e e e n d a c n t y h d e m I e n a c d r o i k c n e a o t t m s e d I i n c a a g n r r o y e w l e u t f c h fo t a t r h n t e c t o o e r d y t r o i f v o I e r n t t t e h h r e e , M ica i " d , W d w l h e h i l i E e ch a I s n I t n s a o n r m e d c e e t h n c e a t s d w e e s e b e t t h k s e s i t f h u e a a a s ti n o f l n o a f r I e n I d n L v u e a s p ti t n o a r g A s a m m in e a . r y - 00 Inflow of foreign capital to the United States, the dollar down. Paul A. Volcker, chairman of the Fed. have been exaggerated," he said, "the perception dollar will stay permanently strong. In a leant eral Reserve Board, Indicated hi> own reluctant* that the United States ii a safe and secure place for s N p e e w ec Y h o t r o k . t i M e r N . M ati c o N n a a m l F ar o r s e u i g g g n e s T te ra d d e th a C t o t u h n e c d il o l I - n t to o r I s n t t o e o rv k e t n h e i s I n a s th a e c e u x e c h to a n b g id e t m he a r d k o e l t l s a , r a h n i d g h s e p r e . c Y ul e a s , . f o u th nd e s r c I o s u n n o tr t. y " In H t e h e c o w n o te r n ld d , e " d t h t e h a U t, n r it e e la d t i S v K e I M to c a o n n y - l t a ra r d '! e d st e r f e i n ci g t t , h w , a d s e d s u p e it t e o t t h h e e p r r e e c fe o r r e d n c U e n o i f te i d n ve S s ta to te rs s t h e a r d d a n y o , t M be r e . n V f o o l r c c k e e fu r l s a e i n d o t u h g a h i , i a n n te d r v tr e a n d t e io r n s t p o e o r k h C ap M t * tinues to have an advantage," all over the world to put their money here more to mean that action might be more forceful in the than In any other country. future. Without United States cooperation, It Is un. But Is all this new-era talk? The flight to the dol- likely that foreign governments can Intervene on a lar, driving up Its price. Is certainly not an un- large enough scale to force the dollar down. mixed blessing. It Is Intensifying the problems of Mr. McNaraar contends that the steep decline in American farmers and other exporters. It Is exac- TMs preference, the result of a search for maxi- the rate of United States Inflation, relative to other erbating protectionist pressures, as producers try mum, safe, after-tan returns, he asserts, stems countries, has also helped to strengthen the dollar. to offset the damages resulting from an otvrvaliud basically from the resurgence of United States eco- The strong dollar is Itself a source of disinflation- dollar. And Mr. Volcker said yesterday that the nomic growth. The American economy grew by S.8 ary pressure. Within the United Slates, It curbs ex. dollar's rise was Inhibiting the conduct of mone- percent lut year, compared with the average ports and spurs imports, giving Americans mor* tary policy, seemingly implying that the Fed might growth rate of 1.3 percent for the [our largest Euro- goods to consume than they produce. Internation- be supplying more money to the economy than It pean economies and the 5.J percent growth rate of ally, the dollar's strength is depressing commodity would prefer, thereby eventually contributing to Japan. The United States growth rate has sextu- futures, which this week fell to a 23-month low. upward pressure on prices. pted from Its rate of slightly above 1 percent In Gold dropped $12.30. to 1281 an ounce on Monday, s By forcing other countries to raise interest rites 197WXI, wMle the other countries have been essen- five-and-a-half-year low. before rising yesterday. as a means of preventing further declines of their tially flat. The persistently low European growth Many economists who, a year ago, were warning currency, the soaring dollar Is threatening to make rate) and the higher Japanese rates, according to of an imminent collapse of the dollar have now a sick world economy even sicker. Yet a precipi- Mr. McNamar's theory, explain why the European begun to say it may stay up for yean to come. The tate tali in the dollar would also destablllie the currencies hive fallen so far against the dollar, new Morgan Economic Letter, released this week United State! and other countries, W* shall con- and why the Japanese yen hu declined much leu. by the Morgan Guaranty Trust Company, leea "» sider the** problem*, and what to do afcam them, At nil newi confertnce last week, Pieeldent Re»- growing perception on the part of foreigner* th*t in another column. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 285 NEW YORK TIMES Sunday, March 3, 1985 Econoftiic Scene Leonard Silk Fed, Reagan dr M cu r U . f M to a a r . t* M w n U n M i - t l u . p t a n t H U s , d M M n a I t M aR * M c C ha f d M * .. And the Dollar "HdWlouW the marten Interpret BBS at tight- ening?" he asked rhetorically. In raising iulm«q| rates ut response to its expectarloni of fatal* TH by E s th oa e r in n g a m do in ll g a r w o! a s ti J e o lte F d e a d g e a r i a n l th R is e w se e rv ek e m "se o F U n o e - r f t u t a h U r e y t n p w i o n h u g o c l y p e p r o o h f [ e * 1 s 9 i o e 8 l c 5 d y , , . H " th e e s n a u id r , k t e h t fe w F a e s d m w a o K ul n d f b i * Board's chairman, Paul A. Volclter, thai at or above its targets for M-l. depending on what there could be a "very sharp decline" In.Ilie dol- happoMd to v*iodty. If vetocitMgf** again, u tt lar's value because market psychology coold '' cnange rapidly. * Psychology oh™ Jsly has a lot to do with the day- to-day course of the dollar, whose drops send inter- Aad wi«« M OH Fed nMan to'oo tbout the Oat est rale up and the securities markets down. Yes- (ar? he ••• aitot " We cwtt h»v* a* oven policy terday, the dollar jumped on news that the money with respect to the dollar," Mr. Martin laid, sup- supply had grown Faster than expected. porting the Administration's position. But the big question is whether the markets are Mr. Volcker, however, seems leas bound by the starting to see a peaking out ol the dollar resulting . Administration's position. In recent weeks, he has from fundamental changes in the economic .and given encouragement to foreign centra] bank inter- political climate and from the actions of the Fed, vention, which be suggested had not been on a the Reagan Administration and Congress, aa well large enough scale to move the dollar down. The as those of [oreign central bonks and governments. . Fed itself has intervened only lightly. Under Mr. Volcker's leadership, the Fed does ap- pear to Be set oa a monetary courve aimed at grad- Mr. Volcker, wttether he intended to or not, ually reducing the exchange rate of the dollar, knocked tie bond inarket down and interest rates which Is Inflictmt heavy damage on American ex- u H p u t w t i h th e h » is e j C o ii n ad gr e e s n s d io e n d a l i t t s e s p ti r m og o r n e y ss i a v e w ly ee e k a a s g ie o r p c o u r lt t u s re ai , x i r n im cr p e O as T in t^ g o m p p re e s ti s n u g re I s n d fo u r s tr p ie n s t e a c n ti d o n a i g s r n i ) - monetary policy of the last tour months but had not and threatening world trade. . y k t t t t w a h h u e e k a e T e r t t e n e s y h F d d n t h i h e e s t a c a d o t " d i w h d a d p c e b e e m h r m o e o d a m k u i v i i s s . t r i r a i r m d n o M e r o e k t a a e n t r e d i e n r e . g t p n s h V j H r n o ' a e t a u o i e l t m r n d g e l n e c o d h . . a k o s c I e m n e n h t r c i W i o o o s h s n u n i n e s s e g d d t y g p a b n " e t r t y e e h e t s s o m t p i d s e s a a a r d e y r y y e n e i a e t n t d t h a c h . g a r t a s B . t t t t t I a # o t h " m h t w e e c s e p y m u a e l m r s y i e h t w c i a n a a n a i i r t d l n g - - , l • "r I c I t U T h n n e q h n S p i f t n s e l e i i a a t d n r e y w t e n c i d d m o s e o t a t t n S u n e a o r l g n t a a d f f a e t ) a t m t e r p l e p U t s u ) o r h , I o n t n e e s t b e h e u c d l t o p d e t e a o h n o m w r l l a o l y l e l a a s t m a d r p r r o d s i o d r c o f c l a p e i o a g t c c r c h r u r y e e i l l o i n i s : s r d n w g s d t a e i u o n t s w r r h t c . r e o , I a o r I u t e i o t t r . n e g a l t n t d t s i h s o e g e I n p c g h n w s o r I u t t o i n e u e o f a b f n r y u n r l e l s l a d t e s d r i t m i h t m i a e o g e r c s n o a I a h d n n a t a i e e e e n n n c I b y s t s d k d s t . , t o sa rd y e w rl h y a g t r t o h w eF th e i d n w de o m ol a d n d ij o a n n e d x t o , u M tp r u . t V ." o P lc r k e e ss r e s d ai d to , . duinp the world economy into recession. "1 don't know what the next move Is1." In confusion, the dollar again fell in response Io The best way to offset this effect would be for the Mr. Volcker's latent testimony, and 90, a nanosec- Federal budget deficit to be reduced, and Mr. ond behiai, did the swtk and bond maikett. Corfu-, Volcker has been campaigning hard for a cut of at sloe, which the markets abhor, was Intensified by a least »0 billion, President Reagan and Congress ' speech given at the BrooUngs Institution the same. share that objective, but disagree on how it Is to be day by Preston Martin, the vie* chairman of the acnlevtri. That disagreement was dramatized this Fed and * Reuaa appoint**. i|r. UutinwtU that week, on one side, by the President's veto of emer- ill h^^" «,i»lfc -:*-*":^—-^"i r I gency term credit legislation, wtdch he called "a massive new bailout that would add billions to the velocity, the rate at which the money supply turns deficit," and, on the other side, by a vote of the Sen- oyer. ate Budget canmlnat to slash ITS billion over the Was Ml-. Volcker actually trying to slow UK- next three, years from Mr. Reagan's military growth of the money supply and Mr. Martin trying spending plain.- to I s n p a e n ed i n i t t e r u v p ie ? w yesterday. Mr ' . Martin sought to an A x ie s t t i a e t s e n o u l it b e u s o i n n e t s h s e , t b h u e d g se e c t u w ri i t l i l e s a g m g a ra r v k a e t t e s a t n h d e d a w s i h s k p i e l e e d l M t h h i r e m . c V o t o o n l f c u I k D s e i C o r * n w a b a h y s e a l s o d a o y k i t n i h n g r g o t u b h g a a h c t k B 1 w 9 r 8 o a 5 r o d k a l n t n h d g r s o 1 u h 9 g a 8 h 6 d , t t S h h u e e c f h d o o r a e l n i l g a si r n e , ] t K e tQ x s c t e h f r a e e n s r g t e e r m a m le o a s u rk n a e ti n t n d g o v e W e c r o a n t t h o w e m e o i e c u k t , l g o a r o o s k w t f t h o h e r . the latter part of 19M. "While we eased back In Au- White House, Congress.and the Federal Reserve > g F u e s d t ' s a n v d ic S e e c p h te a m irm be a r n , w sa e i o d r . e T n h o e l o p n re g s e e r n e t a s s t i a l t y u . s " , t h h e e s m tr a u r g k g e l t e s d s e t e o m g e e d t to th b e e ir b e D t e ti l n at g e d th a a c t t t s h e to y g c e o t u h l e d r n . o T t t o » r s e a n i i d n , g w ." a s E t s h s a en t t " i w al e ly a , c h e e n i e n it s h is e t r e d ti , g h m te o n n i e n t g ar n y o p r o lo li o c s y - t KM *M In tuBt«*nie|t * ware--. bad not dunged. "We were pernlttfe* On Mi- —rr fiiniinii MI innii)-ij|npi» in linn iimn tftrir COM «• tbalr tar***) r^*." nd tfM to Mil tte co*. h> kddwt Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 286 THE NEW YORK TIMES Monday, March «, 1985 Fed Debates a Chart's Shape By ROBERT t>. HERSHEY Jr. Proposed Changes tn Portraying Monetary TarR«ts '- r~ ';" ,* sim W r A ri S er H in IN g G a T nd O N h , i g M h a ly r c t h e 3 c h — ni A ca l l o n d g e - - InblinOrWoftialarS ,' t '. -,"' bate over the way the Federal Re. s h c e a a n r s v e b e u p p r r r s o e ! f s e a e s l n s m i t o s o n s S a t i l s o v j m o e u o rn r n n i e g a t h a ls t r y f I r n t o a t m o r g t e a h t r e s - H Th o e w " G th o i n F e a ": d t w P o r e lin ie es n t o i r M ln o in n B a lln v o n I r r o om w t • ri b T a a t r * get Flrtur** Ho h n i o g m h- ic s ta p k o e li s c y a m re a n ki a n jg o . f practical eco- e I w n q i l d h u e e a n F l i t n o o g l u h I r h e lh r a o o v u u e o s r h i a l o e D u r e o l l H t e h h v e f t l i c o lo u r f r P l r h x iv a n l m o l y u n e s n a y * r e y . a T « r g i . n M Dp id ly Although It is too early 10 tell for Ihe rsoid peih o! M-1 yiQurti. central bank may be on its way to em- bracing a new method of denning and portraying its all-impoittnt targets for money growth, a change that proponents say will greatly enhance Ac lull 141 the nation's economic performance. Others, however, suspect the Fed has little intention a; changing It* Th»-Band": [ method and wlD use the Issue this „--- 1aro,el_eurrerillyar«lehalfwa>(b<it»een4 and 7% growth. Thin bund, originating (rom 1h« It will conduct an overly expansion- aama base Defied, maintains a constant KvMlh through- ary policy motivated by political and out Ihu year, end Ev Ihoupht more likely to contain {he actual economic exoedlency. growth line despite occasionally wlo« Ehort-njn nijctuationi- The issue, in the Fed'B vernacular, is whether (he traditional "wedga" or "cones" used by the central bank to portray it* monetary targets should be supplanted by "parallel bands." This seemingly small dis- n d t f r e w e o w d t i o o f h a a r v n r r e e o T i r e a r A e c f d d d l r m w h t r t t y o l e a g g - h i , e t o " t n w c h e e e i e C n m s a . o ' s r s T m o . d u " m r o t I — h w g e o h b s n t i i h m h r e n o s t e e a e h , i u d o t i c r n s h c i n r g e t F n g i e u d l l e m o e a i p a a e " t d t i f t l p e a d r s e r l i p t s o r r o e y d l e h e a a r m o a r s e o n l t t q o l u a v m c h e u n n w y a r e i a l d i e a e t e r , t s h e n e e a l t c f a s i I e r s a o a n s t i u p e l s r m v e a l w u v p p x e s e a e e q p o d e t h r * r r i u a y o d e — e n r e I e r " n m t e n h t l s b c a i d o t a e t t a t i t n a w h t h d o h l s l r i t y e e e n e n e e , e - t s a n p B F r m t A h i a h t o r e n r t o A o n e e " t o d a ' c Q p T g r a w c c e p o h e e s h c u k o r n n u r a o r e a e f l e s f r r b U l y v o r e t d t i a f p u h a i t r s n i o y i s n t r r e i , i i e e u s e n M e v g f C s e s c d o e o d e - i t d o r o r 1 a t y f n r s a u n i . 1 t e i t W m f i n o t t 9 4 t a t m r y h 8 c . s b o o r p i , e i v 5 l ' p l e n l H e s l t ' ' s i h o s r e — i n l a e P c n t e y r e m a a r e g t l m m b e c r r a a n g r g a h u p n T n t a r o i e t o o t - c i p e w l o n t r w o o f r t t . o t t o o e o d a t l 7 g s f e i h w i H o f e t p . n s i s a h e e a e — s i o s l n s r o t * o f c I t r h s h e i a t t t t t h h h n h u a t a a o e e - t e t e s t l o t d F F t t V C f b E L i o h a e o e e r o o W e r a r m i n k T d d i m l n n d r c c e a e h . i g a g e I h k t e l r e s h n r n I a p e c r e n r d H b l a r e t s u a a i s h u l s n d f e r r b t r , e a r o e e r i t u i e u g s e e n c a n s a r d d r n , t e i p s d e , g o n n d t c m , a T y s h e l g n y o o t r l e t a h w u w t a u m t n i h r a r m d h c c n n a . n l a e a e a u d m s . l e , v f i p e r o l e n c r i p e k a a i s c a r o h t a n r e i r a u i f h t ^ t s i e n l h l r s t n e s p o f e m m a g m r t m a S e t w v e n a h a c v i s y e n k d o r o r o C s i m i k e i s e p n s w i w n o w e e n i d o b r m n g t e i e t m e s i e g e s h h , r p o f k r s i s M u r s a n f t u t s f o t h o h n g u a r m H l r r f e e y a e - e o . - t , . or more, V was not until last month mistakes into the next year's tar- ••absolutely no constituency (or that the proposal lo change existing gen." Mr. Pnole said in a telephone, monetary restraint." With the Res- practice attracted significant public interview. He likens his proposal to gan Administration "going for attention. The challenge was con- the "quality control" that is prac- growth." the Fed will find it almost tained in the annual report of the ticed by any company. impossible to resist the political and President's Council of Economic Ad- Under current practice, the Fed economic forces pushing for an ex- visers, which offered an alternative takes the actual fourtttquarter level pansionary monetary policy. The. "parallel lines" approach and a ol Ihe money stock as the starting adoption of parallel bands could, in strong argument for enlisting this de- point lor the following year's target such a climate, \K * cover under vice In the battle against "drift." usu- ranges. Mr. Poole. however, would which higher-than-targeted money ally upward. In the base. employ, say. the midpoint of the ISM growth might be pursued for some target range In setting Ilie range for time before arousing market fear* monetarist school who support such i 1385. about the potential for inflation. l c c m s F e u h u e a o b a r d d n r d n i e e w u g n n y e e g a t . c s t t p r h o T e r r e a a e h a c t q n d e i t u o o y i o c i n u r u e a e b t d r d l b r e g u e u - u r t s d r o i e u s n i g t l t g t a i t e o t h k t d f h a i e n i t e I n f n t f l h l I a l a t h a e o t t e t i e o i o d o n m 1 F r n a 9 , e . u 7 s t d D t T c i i n ' h c o ' i i ' o p [ p m in M n o o j o D l u i ; y n l r n t r . e t h a d , u p e w l e s n r e d u f e i d e i n , p v r w e g s p e r t b a n s o y u h p f t r e t t o a i e w o n o r r v w a t s m w s e l o l r m — h o e s u i h n l l a c d f o t i h h r l n o i o s t n t t g o m a s o e i i v f s o n — b e r p , h e f e w r i r o r t n o o h y a r g m u , e t e e l a c d a o d r s F t n . h m u e o i i r d n - s t - a a J n C th d u b e o W e o l x l y y n p t t h , g e t w s e s r n w e e t i t h m s t l a h h l s e t e i . e r n i - n v a o A t e h m n t l M e n m o b t u r n F e h o a . e e a n l k t d V t e a n a , t r o t o p a i i l i s w m p r c n t y e k n e ( a e t c a a u r r h h c a r n t a g e n m , t n i e c w l g a f t e o s k e a i l r e b t — l m s p e l g f e r a a o o h i a l n v b r l s i y d e e i - t c a a a t ls t T u e o s h n e e o t d i l o c t n t o h h u e e n n s o c c e t i e v l o n ' e s n t r r l e r a y e l 1 p o 9 b o R l a r M W t n k S a a 8 l t I l 2 t t r s t S a e e c t l m r f t e . e s e d W s t i h t b o h e n i e n t . . t s w m h o o e o T r c r h k " e o e w n c s f F e a i i d g n n e g n d in b i e f g e s i i s c " s a t a » h k n w 1 a e t t w t a h t r h e t i e h s d a , e n t b o i m y e l a n e c a t o s i o n n r u l e o e r y s w v e e f e s a r , n t a r o t t m h r a n m e a r o e - t t c h a e lc b u a la s t e e d u p — on f o w r h I i M ch S - Ihey are to be Paul A. Volcfcer. chairman ot the Federal Reserve, went before the checks from being cleared promptly. Senate Banking Committee on Feb. Mr. Volrker tin's told Congress that 20 in announce Ihe 1993 targets lor he was not at a!l disturbed that some money growth, his prepared slatfr of the aggregates are now far above meat contained lour charts showing the target range, and he said that no the 1SSS trajectories based on both remedial action need oe taken. wedges and parallel lines. The juonetarists. however, argue Mr. Volckerwasnmcnmiltal about that i-vcn if the Fr-A Is not a slave to whether he thinks the monetarist pro- the tare els there would be less uncer- posal is a good idea. "We have some- tainty if the markets did not have to time" considered," he said, "and guess at the rea.-4ins why money others have suggested, a better 'pic- growth Is not being contained within torial'approach would be lo illustrate the presr_ribed range. The Fed'i cred- the targets by i different, but also ibility would be enhanced, «i Profel- n B e u c t e M ss r a . r V ily o lc a k r e b r i 's tr m ar e y r , e c m o e n n v t e io n n ti o of n . I " t 1 in 0 g ! P to o n p l i e p e p - u n t a s t i I o t. n b s. y " "acting accord breakthrough. Many analy^s ^ay the current eco- nomic climate spcms likely 10 put the Fed to > severe lest, one that could make the case for change particu- larly compelling thii year. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 287 THE HEW YORK TIMES MbnBay7~Ha>-cb '4, 1585 Fed's Interpreters Economic Calendar Uiled b*b>* BFB 1*4 target irletM dalei View Rise in Rates fa m»fry economic dxlicjiTr-i Khedutod By MICHAEL QUINT _ F«J watching — > fa vorlte pssllmi (a many of economists who Inok In the central of • Ugttr baiUfa actions and etflrtmenti for can hemm They s« Jttnllarltle , hi* yielded mlied results laiety, Vhna rapTd economic growth and leivlnf analysts imsun of the Fed'a jirong crrdll Jsmnnis wert MSOd. willingness to enmu m B* Wgtier I mar. on I i*l . Ihe Fed did nnt rtslrt. Hit shaip rise In during the They remember that the overnight past month has surprised many ana- Tttt lor tank loans n*e from »H per- iyta who did not rxpeef the uptu cent Jest January to 11^4 percent ta until later In the year. But tradr- August and September. wllH Oie Fat ' and investors, who profit from antf •'•'" .ys ratifying the higher ratal. pallnE tbanges fc> Fed pbttcy enfl l TEVW I •ar. Henry Kaufman, chief economist at Salomon Brothers Inc., described the Fed'i recent policy as a "gentle fu*. flat at tbe credit relmr that wUI ralM tot overttigbl Federal tonoa rtte to 9 percent by the tod of the nonlh. That mild restrnlnt, he noted, has changed market psychology 10 Ihat "opectationa of eaie havebeea i of alseralcibe- upplygrowts penmt. while an «4 plrcml rau w thf u e e t w he e e f k t s a j o n f l l J rd an u d a u z r T G . uj the Bm Current Interest Rates Hgbfeninf ]• Doubled . "Then U not much evident* Ihut t n h u e n F " e d r e h t a tr s i c c d h v an e g e o d n a JQ .' I d p > a a n p u lt r e v t t o h e a Long-Term Rates Short-Term Rates ihirp KDaff tl»t hu ocxuTTed," tatd Alan C. Lemer, aeruor vice pnuldBnt iltbeBinlienTnnlCDnipaiiT. Inlhe lateait IBUB of Profpecu for the Credtt Markcu. Mr. Lnner uld •otnfl of the rl>« In ntei "can be u- trltuted to bloatod Inventoried and Ite n«ny rtreJUTj tA nev Dlfertfigt comlnf Inln tile marlierpuicv.*' gfllon Pl«rr an economist u tlM Doiatdaan, Lufltin ft Jenratte Securl- Orf Corporation. laid In Ihe litsst Imw of Money Notea that -'the ab- tc0e* ot m Fed poltcy-flmSm la ntt adtfquaie to preclude a rlu" In short- term rata. fle noted thM private thort-ierjn credit demanrij are grow- ing itpiffly at the nine time Ihat On Treasury continues to hcrrow large nota and bond market, where »e»k lovHior demand baa led securities deafen to cm prlcei and raise yleldi.Aa a result, (he 11U percent nrasury bondl due Id 10t5 wera of. fcred Friday at «U, u yield 11.71 perc«u. dowo from their lev»l m Long-Term Rates FeV 14. which was 1001»/31, to yield ahoul ll.JO percert. ID late January. Ihe M" 90-year bond traded briefly OB a when-liaue4 basis with * yield of 1D.O perrem. f hdu of MM* in fc Fean Called Overdoaa MKcbel I. Held, an econofntst u Smith Barney. Hlrrtl Upham 4 Com- pany, «M the lean ol a tighter Fed paUcy "are vaUd" bid have been ""overdone and probably have al- ready been discounted by the nuu- aaL Pradlnlni thai Interest nice, MpediDj bead ylaldi. mljW toca CerVttcaltiolDepoaft pobn. Mr. Held n«ed that "eeonomle Short-Term Ratet growtfa la not yet llronf enoug)! to hu- tify i change" to a lighter Fed policy. FedtrelFundt* evea Ihoufh mrmey supply arowlh Eurodollar Tlma Depealta baibeeo raptd. Who*, many ecommlKa ba.va beea revWInf upward tt.elr astlroatei far economic (rowtli In thi flrsi quarter to t parcenl or more, Mr. Held uld rrowth la likely to remain at about« percent, after adjmUnf for Inflation. Mr HeUandHi.naUDaUdtliUttia IncrelM la Ihe UnllMl StalH Irtde Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 288 Treasury Yields Expected At this week's regular auction of total about $1.4 billion, Including a new Treasury bills, interest rates are • J3QO million Issue by NewYork City. Mtrrlll Lynch. - N lik o e v l e y m t b o e r b o e f l t a h s e t y h e ig a h r, e b st a s s e i d n c o e n r m at i e d s - cu T ri h ti e e f s o l a l r o e w i s n c g h e n d ew ul e fi d x e th d i - s in w co e m ek e : se- lut F x t x o d y T -t n n il M In du O i t lr t l x n n , t v 1 r 5 n 0 , m d il u lio t n M of M c . t tf W vw tr l r l l b N k prevailing last week. TAXABLE Lvnch. Late Friday, the outstanding three- month issue was bid at about 8.69 per- ONE DAY CHJRINQ THE WEEK cent, while the six-month issue was Ti S nt o a v n th d e r r e n fu C n il d lf in o g rn r l n iE o i r f l l a H tg jn e .u b p o t n o d m i, O d m ut m 2 t 0 o f5 n . e A f / 8.98 percent. Rates tor both Issues A« l/AA. Competmv* have climbed sharply -in recent weeks. As recently as Jan. 28, three- month bills were sold at 7.76 percent, TAX-EXEMPT while the six-month issue averaged 7.97 percent Merlgigt Einktn Flninclil Corp.. Ibout lilt wh O e u re ts i a d u e c o ti f o t n h s e a T r r e e a h s e u ld ry w b e il e l k m ly a , r k th e e t m r b i o t i e a ll t d I o t A n A c o e A f . t c o c r l S lm lto lir d i a ll r iK d l & m p j o rt w os i. M K i d n e d l e ic r, t i P lo e r t * - , n sc e h x e t du th le re o e f n w e e w e k is s s u p e r s o . m E is x e c e f p t t l f i o g r h f t t nit T e h d ou s n a o n t d it . T d ri m lli , 1 1 T 7 O J , m M illi R on /D o -V f B tv . n lo P r r u tu o b e o n r l d lil l - - one-year bill auction expected March BiLhe SKiirllln Inc. 14 and & two-year note auction ex- Duk* Power, I1U mil lion or flnt «nd ritundlng pected March M, there are no longer- t o m e f r o m M nt a h Is r , c su d h e e 2 s a 5 l c e . o r I m s n in e th x g e p o e l u c a t t s u t a n w ti t l e h e t r h k e e e o w - f p e a t e h r k t e T C E o N nn T e A c T tic IV u E t R O t F to F u E n H * IN R D K I e D n U rv M A 1N u O ttw W It E v I . K OH package of four-year notes, seven- no I t n n l. . r n d . m tkx i i m il L , U H M R yS rin n i J n /B c B *. B t . » C * m tn i llio w n lt t o tr f year notes and 20-year bonds totaling Reynold! Inc. CMKilb CDuntv, O»BT1. Ut.1 about $17 billion. Nu-NUd Inc.. HO mlllleii ol dtbenluru, OM MM. Prudent III-Bidv. In the tax-exempt bond market, a e n st a i l m ys a t t s e i th t at S a t l h o i m s o w n ee B k r ' o s t h o e f r f s e I r n in c gs . l M u C t c tf n o r r d W r l v n I t . A g i t _ l C d F o . m O R C o o b o F t w h tt i i r c t , u n r U i t l t d o , , A m U M i m ll io 3 ir D n D Q t 5 o r , p f r . c l t T o a a f w w B M e - r l n tl W . tl* Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 289 THE WALL STREET JOURNAL Decline In Rates Predicted Surge in the Money Supply Will Cause Mr. Johnson looks for decline in inter- est rales in the months ahead. For exam- Fed to Tighten Policy, Analysts Believe p m le o nt h h e T p re re as d u ic r t y e d b il t l h s a , n i o th w e a b ra o l u e t B o > n * % th . r w ee ill - drop to alwut &,*%, over tne next couple ol months. CREDIT Ml Money Targets enc T e h e U f . a S t . e i o n f t e th re e s d t o l r la al r e w s, i ll s s o t m ro e n g a l n y a in ly fl s u t - s c t F c b m w c v c l h y r l h i o e e g e i e o s i m a n s l d f o i u U d i e j n t s d e n B r s l b i v d g n o i t r f . t W , e a l i s i u t n o l k i l a h d i l A s e a g o n y o n e c s n r R t . Y l e h t d p c . d p ' h e s O c o a B o a s I B e r E h s t l m R u e d i y n o i n c e t M r t i h o K o w t n v y t l T m n h F n y e e g A - A e I , T , e I K e m o F M R y t s h d D n S a o u e o e e U s K n y f c m d H P u r y s . b d S h E o c E p t e c . a e g m . a R p o T I l n m F r o n o l n M n o y k u S n t d l t f w e ' A i e i L l g g n o w r t t r N t D a e e h h o u h s ll f e t r i a s e t l a f e , s o l d t a r h l s n i ' e r p g a t n s v h d r i s r n h s d a e o a u t g l t s s b e m o e n r e e t g e n a r s c c p e e e d o l r y a t e n n e n w s n I i I l o g d t h a s t n a s s i - t o l l e y l h l T ( " « • , m ™ B 3 . h 0 i . l e , l m i o C n o . 1 n !> T I ( e 1 I d N T v o 1 j S e ll , a T r 1 r s s u T , 1 s « J 1 5 T V t I \ « ^ I < o L J l ^ n f c T , k T r ] t e l J T ! , M r U r I ' i s ) d - J r T ^ J M I i t u - I t f T n w T ^ n ^ l] el s a m c i m f a d U a r l d n u m a h r u b o d e n v m e e y a i a n a l a d l I d v e e a . n j l M n " o t a r e l a e s s s t T k v ' r r d " ( l e j t t i s o e o e n o h h o o . f l l p c r t M s g r o r e h r r e n s o e u s m i t u c s n . m r r m i , s d r g o b f e e " . e r i o H u e e o o l e s n B e u M o e n s n t l , e n t b l h r v a s a a t r d c e c i u s " e e s s i n n r e l d i t d l r a ' e h k o m s s b g m i d i f s ' e o n n d e M i s y e n a o m f a a " t r a l r a F w l l s g k M o y . o c a d n r e t e r v a o I r h r e e r e l c M s e d e a l n r . e f a i n i m i n k c b g " e c w g o t e e p e e R e n g i l e o t t f d r i g o o r f s e f l o n i n o t n i I l . i . n h t c n r h b t r e T g s t s b e T i e e f s h e a o n h o i e r h a i g e h t t l r r l e s o f U s i g i t n a s a o r o . a h p - v p S e I w l b l e D n o s e l i i o r a n g y s . e x o n o i S s l s c h l c u p g i l f g u a s d a t . h t i e r l - t i o a g i n c m e n t n a s b r o e v y e r r g n , i t e o r e e a e l h I I i g m h o n e t n l r h n d e t i y n e f e o - - d e i d r - - . eig M n o ex re c o h v a e n r g , e t h tr e a d d in ol g la l r a 's s t s w et e b e a k c k g iv In e s f o th r- e „"„ ^-rnf 1 l1' M M c to re r d th it e p d o o lic lla y r . ' s " A be f h a a ll v in io g r c d l o os lla el r y w In i l s l e e t n ti a n b g le Fed a little more leeway In carrying out N D J F'M A MJJASOND the Fed lo tighten policy, while a strong or domeslic policy, many economists say. •W *5 rising dollar Implies the Fed will be reluc- Vilia lever the case, last Wednesday's The Federal Resene wants 4% to tant to adopt a more restriclive stance." plunge in Ihe U.S. dollar senl bond pnces 7% growth in Ml this year. The cone he said. tumbling, underscoring the Importance ol on top is the traditional way the In Ihe credit markets Friday, the Trea- foreign exchange developments for the tarmt has been depicted But Fed sury's 11V% bonds due 2015 closed at a U.S. credit markels. Chairman Paul Volcker suggests the price of 95 15/32 to yield 11.8%. That com- A Weather Vane far Bonds p m a a r y a l b le e l p lin re e f s e , r a o b r le tu . nnel, shown above p w a h r e e r d e w th i e th y T ie h ld u rs w d a a s y ' 1 s 1 . c 8 l 8 o % se . o Th l e 9 t g o 2 v 7 e /3 rn 2 - . t c o o s n s B e te o s n n d d la t t h e p a ri l i c a e i s n s v t e w s r e t e o e c r o k s u . i p n B e c u d r t e a m p s a a in r n t g y ly o a f w n a i t l h l l y e b s i t e r s • S F e tb m r e o n u I j n r a c t . imate,b y Monty Mark« m 9 1 6 1 e . 8 2 n 2 2 t % ' / s 3 2 f 1 r f o r 1 o m « m % 1 H 1 .9 n 7 1 o /3 % te 2 s . , lo d w tie e rin 19 g 9 t 5 h e r o yi w el d t 1 o 0 w d n r w i p m i e t o r e a i e s e p l a t l " s d a c s l T t i h i h c r O c h , ' a e i s t n e f t s r t h f i g v o o t R v e a r r n a e e y l o u s n I n i g h g e e s d f e e n o a c f r i y r o n o i n N . r F u d v in l o e . b e d t l o d K e s l a w n t r u p o r e d e ' b r o s s s l s a l l t . i c r a t I r y y o n b a f c f , e l e h e h a c h c o s . h d a t l a c d d w v t n h h i i t o U i i g i e o l e r l e . n S f w b s . e e t i a i l o n c s l s in u o e I I n c p h g h u o , a e - e " - - t b w e t a 5 h o . n y a 5 h a d t r % e M t h l t y w n e t d r h m i . r o p t n e a a r l V d w e p r t t g o a r s h a n a e e l r e c r n g n a t k a g y e w t l e e l t e e e t o r d a m a l u n o r n a l l o l i f d a g n s t e t n l ed i - l a x • d t e s u , b t a t c F w h h r e c l e e a r n i o d d s b t t e n e ' i e s I , s s h g m t t t I t t a . e r e s a b i H n c r t r l v i a r c t g n e e e e a r e g p r g d s y t f r e r . u a h e o g B n e t s t g m a e r u u r e e a n r n t s r n n n t t o t M e g h c e e w d e e d e ! w S w 8 c m . . e e 8 i 5 a o e e 2 2 T F l n % % k k l r y t e e h . b a b T i r s s f i h u f o l s o u l u a r u r r r r y e s c y d l t b o h b a o s o I y n w i e n l s . d l c d a e r r T s e a m a h w a l t e e s a a h e s r g o n b k d . i r e M d o b l e s % o t o e x o i u n n t . r g v e b T h [ e 8 h m id t h . s e 9 , e t e 5 o l l l % o a y i l u s a n t p , t e g e t s - e o f s t r f t s e r u o t o p 2 r g m 1 m e 6 m 3 h - - - Short-Term Interest Rates l t a h - e rt tu m n o n n e t l t , i a a c lr c e o a i d d y liig n t « o I e ti s E tim u a p t p e e s r o p f a so rt m o e T su re ry a ' s s u r 3 y 0 - b ye o a n r d s b . o T n h d e tu p m ric b e le d o f 6. t 7 h 4 e % T r la e s a t - (Weekly average, in percent) analysts, month, the biggest one-month decline since "Whether you use the Cone or the paral- an 8.49% drop In February 1980, according /^s »•* lei lines, recenl moey growth has been ex to Sharmin Mossavar-Rahmanl. senior an- fj \ Federal Fundi c v e ic s e s i p v r e e , s " i d s e a n i t d a N nd orm h a le n f R ec o o b n e o r m tso is n t , o s l e M n e io l r a d l i y vi s s t io a n l R of y a R n e f F co in a P n a c rt ia ne l S rs t . rategy Group, a \ / U° Ion Bank, Plltsburg '\ 10.0 c w F r e e e d e d k i w t o i s l r l t a t h w n a c o v e e o . " f t o s i a n co n p g t m i o n m ey o r g e r o re w s th tr , i c t t h iv e e ouw IFPTI William Melton.vice president and se- /'. \ 9-° Inc., Minneapolis, grees that the money supply graphics aen't important at thr 3 B -M ill o . nth Treasury U •-. -..• • " B , O 6 d m th ic e o a m t m o e o r n s n t . e a " t r a W e r y a h l a a l t g t e m g l r l g ti a e t r e s s r a ig n h d t b n u o s w in e Is s s t h In ai Ij IA sn iImDi iiI iNii| NIDi| iiiji i|IiiFi pace of economic ctivtty has picked up D«n*Ad W»ITi - S"MH * P.JD substantially." hesaid. He expects "an -FlJ Jtnmv Ban* ^Klu r*-i oit.er very minor tentering move" by the m re i s s e t a o rc f h t h g e r o C u o p n . fe "T re h n e c e e B co o n a o rd m , y a i s b u s s t i r n o e n s g s Fed M r w . li M hi e n l to a n m p o re n ti h ic . led that the 1 literal InctodH t*re< limt OtMlli ~ and money supply is growing much loo rate on federal hinds, or reserves th f t k a o n s o p S t w . r i o n T n c m h e a o e s O t e F M c e t l h , o d i b g h h e w a e r s , i r l l t g h t r I e a o n l t w i b e e a n re s e s a ic v t t e m a r r a n y o l e n a o s e n p . y n p " u o s a u r l t p u r p n a l i y t t e y , t b f S u o a ' n * n a d '" k b s ' s . o u H r le a t e n t 9 e d a 1 l e s re a o b c c h c y p n n c th • t d y h ie i e e n t h r e d a d o O s v f t e h h th r a o n i v t s i g e I h h r m e t e , d o j w T n t a e h il r l l . o d u n T o n h e d n e of more than 11^, according lo some «Q- the Treasury's newesl 30-year bond w11 malrs. The Ml measure consists ol check- rise to about 12W% by the end ol tle ing deposits plus cash held by the public. month from )usioverlive currently Because it represents funds readily avail- The Fed alrt ayhas tightened llscreltit able for spending. 11 is considered an im- hold slightly, acerdlngtoMlckeyD.Levy. pnrtanl determinant of Ihe economy and senior vice presient and chief economISt inflation. at Fidelity Bank.Philadelphia. As a resiJi If rapid money-supply growth con- of a more reslrictive credit policy. Vlr. tinues, the economy might race ahead at Levy said he epects money growthto an unsuslalnably rapid pace, relgniting in- slow down soon. flationary pressures, some Investment Others say th Fed hasn't changedIs managers fear. policy course sine early this year, whenII Paul Volcker. chairman of Ihe Federal ended 3 series ocredit-easing moves«• Reserve Board, said late last month that gun last fall. Son-e, such as Dana B. JoJi- the Fed "Isn't disturbed by the present son, an economl1 at northern Trust O0,. level" of Ml. The Fed Is seeking <% to 7% Clrttago. piftollhal UK Fefl -*on'1 neefllo growth this year In Ml, which now stands tighten credit lecause they anticI DSle well above the upper limit of the cone-like slower money sujply and economic grim1n figure that analysts traditionally have used soon. to Illustrate Ihe target range. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 290 NEW YORK TIMES Friday, March 8.- iGrpwth and Inflation Debated White House, Fed at Odds ty MOUEL QUINT On* Of (he (faarnMt lama facing FWtfcer MpBi • e I t O G w n c f o t B o e n h e n m o n e a m m l F o y e m M t d s « o n e a a n r U d a e — y l a i n m ( t f t M o l O o a t * t p D e i p o m T B l n y s p l — M B a s b o k m I a C t n r y a • d t M i h n n m a y . d a f c t b t t e h t e e n i - r e n o m ip e A M o e n d B e O a t t a l d o r w • y n r a a d p * c j o l a a b b a n m c t y o a M t m n t t a m e a e o n M t i F i e - a a m r d t . f t V l l a w o l w t k O a a k » B i B m t a r h i f 1 y * - ! t p m a t r a W u g y m e h c t i t a l a e e M c M t o h n G M e o O m t P M eD e i l c a t U o ( o e m t e D o d a w t t y o h t b s a t a h , i y m e th r A I e « t D t F d « y e d o e d e o f o t d D • o n j e » o o * a t ' X b U w b c M C t b m a • h o n o n O o M h e l • S a f t a d n d e D T a u i h t k f c a y h o t g . a s a n e " c i o t g a e u n x g a p h t t e n r » t o o v t i n f o o e N e m h , U l w U l r n m A b o t t M b I M t g f e h r I r o a e h c a I h t t e a d i j h M M B n m w d m d c a y e e a . . M I M h n a l o r c n n J w l p d i r n t o U y - O t a f n a o T e t n l t V m t a t M l t g n T y a U o o n t t t B O e M i m i r w J u a B e o t a u a j c t a n f n q D . y r a s , g l - i r F n , a u t n o n i r , h b a t e t V t e t « , M r C m d u t i i e s e n o m o a t d t o w r i t a w n s • F o m t o , . w ™ C n t t h n - a g J | p B h c a b o d w T r a d a o a e D a a t o t i n n d w n t w O m a n w h e y h f s m F a D * o t d u l t c o n » h y e u o o h M s l - w « t e d n r o t t a , i C g t t m M p g n " F p • w h o K a M r w e p e o h A l a O r o e r M l d n t i i . o t c H c t c M d l n - f o h e t v u v h i I n f h y n " n n o * n o e t n c u t t O f f o l t a r e i l u « o r t n a r t ( k B e i f p r t v » h a a a c t M n s a e n p o r c o l F r M a m d e a n t t l o n e O y e o o l o n o l n d l t n m M o t r a t p n p a g o o t o n ( n t a r a n r o e t t w r n a i d m c i o U r c r , g o l w t e t e m n d e M k t i 1 I o g t c f a e b " p o h e u W o r t M n v s a n r o o n r a a d a a y w o r o l F c a r n o o m t e f t i m e e c p o r i b M t t D n d i m t h l m e c a c t e J M x e u e b o t d " i c ( a c p v a r r r o a b . e t c e t m t " l u " a n e c n M w , T t a r t a b r T c n B g . t a U o I e J v h b n a o r e W l w % d r i e e - o l e r u , . • n t s o c • * a o S g a t a o l a u r o e « o r o o b e l e n y i e o m w « g d w t a n d t t w e e n B - i a I i » , i , v W r c t t t " l » n M s n h n , e P e g h a b a I « r o » D h r g w b d a p i c T . t B n r l a a l t w a m T e a v T i « s t t S w o o o h t e i F • A h p n o c n d i o C c t n e e e t . d m i o i d s r B « n H w d M M n u c e w h r ^ c . e h r g o k e i H n n a o a g a n e f a i t m l a f B n t l t n e r M a t M U m R c m o a J M t N j t n n d a r a m i m e a t s a l , o a o y p y a t a n a " o w i o F o b r a m d 1 n t ( s n m y e a h e a u a m a d , a e p n w M l g G t t K p r n t r B s o m o e l o c o k t y r a < n n b a w a T e n n t H c a t e i > o t h h o a k r n h y J f r - a o - e , - , • b m H e b t e a o a d b t b * u u » w a h d * a a v n P h g u k e b n l « i c o h f u ud d ta a fl r p u o k t U n im . a e e n T u r h e B e - • Vo " l T dW he I U M a U ix i d a h . a tn n o K t f U tn e ntB " n iw U t c t d ab re a a u l r p a e t M r e c r e i - n s K t c u o d n t t o td w e r w a a b n lf e d le a t s h , a " t o il r A nb d o m u n t v 3 • Fed diMiintti, Pnl A. Votefera, I* Istatlon ntflirtsls poi pAssun on OM •dfl fftatnt by lavBCon and Fed atto L lanpmoilalng M tiUmrtla- Uon pobcy , the nault would be bUber •r, bat, in Ut Coiia>Miu»i u*n- dent of Unrtence Kadlqw AancUtM, rsta in tbe future- "A doae at ro- laoay UM rnoKh, be fadlcmMd that he Hid. Toe Whtta Uouee aocuted ttralm by ite Fed m UM HTM t»U at tabttdni a Dole to accommodate Votcker ot andetndnla» dMr last IMs vMr-«lil keep tafUttODaiy e^BC- the Beaftti AttmttMiatton'i doaln growUi pottctM by o*a»ott« m UH. tsnbns tow and open the door to lower te tat ecaa«B)c (mwtb. Now, Votator* trrhti to affiar their bneien rate* to the secont! haH," M TUMM* 9«M Omnk feus by MVau 1M tf> IWd do« DOC laid. "Bat a don ot ease In the first . d y a e k o r e a j g n a g a l i d L o a r I , , i U X K w t i U f b t n l n b M e U M a M r a c y v B a e B v a w D t , " b b M » b a a , o i l n o y w e t b t i ( a m t d t n n o t k r w m o , U m n d M a i u a y d r d y o . u c u V t i a o l - o l l s l e a t t y c r a t t t a r t o e e t e r i e - - b nM aa o * t e I t g s r o p w ot t t h e ? r ' on latjeu ** •"•• K h f e a u a a a u * a t u i r L l i t d c f d l e e n y t r i p o w i d e i d w | M i U n H l n l i a < e s r t 4 U » y n e a H e d a J M i M d k . g C f w B T m U t r O a M i g m t r S l b r i i B b t i r e g l r m n i s a n u i e n e t i c c m l l g r h o e n a f n n h l n B r a d d i t g t O i l l h y h D t t n o a e t n m v t H r h i e a r l l r , B a g r " n a U O b r d t M - e o e r r a r o s t r. money Mppty growth In the upper move to ttatfiu paUcy- pan of tin 4 p«K«u to 7 percent ^•owtb WVM. W bom S3 pereent Mr. Veteher Mid bwt*r growth could M wmnaoMd by a itowdnn in velocity, or tta rat* « wbk* moony 1* tuned over. Bvt aom> *aOyt» worry tbat nn» money unity KTuipUi tt not coDBteteot wttb tte Fed-« objective at gradually redtadng bdUtknaod monqr euppl^growtb, The flee In 3*-yeu TrMMr* bond ylehta to ll.W percent, bom about 11 percent lithe end of January, oomnr be attrOnted to tear taatf tnvenoni tbat (MM mooey m^fty growth ttata yew will brlof mom taMOaa. Bui tbe rlae to boDoTyleldi ao tar above 11 percent, even tbwgb, ooDMUner prlcet Aav*^cnaMd-M a.iwe at f. percent or tat* (or the MM three yeui, 1* a Bfltt that man inveaun are (till worried tbat inflation will Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 291 FOREION EXCHANGE! ian lira anQ the Belgian franc. Traders typically position tnernseives within the EMS that way if tney are expecting a EUROPE POUNCES dollar con-ecuon, since the mam is the biggest beneticiary of a tu moling buck. ON THE MIGHTY DOLLAR Indeed, Uie main's resurgence within the EMS is putting sucn pressure on tne W weaner cunnncies that Citibank's Men- hen currency waders finally bankers nad caused the dollar to dive 5% zel tfirnxs the shifts could trigger >n bid up the dollar so high that, against the mark. EKS realignment in the second quarter they themselves got nervous, The turnaround was a dramatic end lo of this year. Europe's central banKS saw their oppor- the dollar's swff February climb. The By Sana BarUeK in Neu York, lailii tunity and pounced. Selling an estimated currency nan sunk below the previous Jonn Tempifiaaa in Lausanne $1.5 billion in a mailer of flours on Feb. day's close only a coupie or' umes during 27, Europe E monetary guardians pushed the enure month, "The runup over the the dollar down a seaming IT pfennigs last two WCCKS was much too much," against ttie West German mark. The says Herat Duseoerg, executive viee- central banns," says Uavid C. Redoing, presinKnt of European American Bank. vice-president at HanKtra Trust Co., "are "This reaction was overdue." on a eredjbility-ouilaing exercise." But while many traders were antici- The impressive display of intervention- paung some sort of correction td the ist muatiB aratteieO namei prayers lo i^eoruary irenzy, it is narfl to find any- the sidelines. Trading was so sparse that one willing to net that this is the begin- ning of tne long-awaited decline of the THE STRONG DOLLAR dollar. In fact, tne dollar is expected to IS FINALLY TAKING renuund—and mayoe rise snli further. ABREAYHtR Higher U.S. mu-rest raws are the most frequently citea nsuun, and, as Duse- berg points out, "tne underlying funda- mentals Bull favor a suung dollar." UHUIUM. SHIFT*. Early warning signals that uie aouir'F, Gteliai Btauia was com- ing to an ena were evident in two areas of the currency marKetE. The Japanese yen, wnicfl has fallen Dy mure than 40% against the dollar since 1980, has been holding up surprisingly welt aver the past few weens. While the Brrosh pound is down 5% since Feb. 4, and the mark 6.5%, Ute yen nas declined less than 1% (chart). The impressive pencirmance of the Japanese economy explains the yen's strength in part, out traders also note increased intervention by the bank of Japan. 'There is a ciear indication that i > n 11 i] 11 is it a n a » : the dollar is not going to rise against the »UUIMIttl*n-l«t yen from now on/ says tne Paris-based ML MU WNKB MC ' foreign excnange manager of one Urge U. S. ban*. "In toe past oays, hundreds the spreads between the Did ana ask of millions of dollars nave been thrown prices on currencies widened from the at tne dollar/yen rate." normal 10 oasis points no a full \'<Xt. , Currency tracers thinK tne Japanese Traders at France's nanonaiized WUIKS autnonties nave uecoine exuemely con- were to disnearieneu thai many neaued cerneu arxnit tne possibility of urutec- home m none. tjonist legislation coming oui of the U. S. The concerted central Dank anaeit on Gonjpess (page a*}. To nead that off, the dollar followed some laud want-ratr they are nymg » inane sure the yen tling by Federal Reserve Cnairman Paul does not weaken further. "The Bank of A. Volcker before Congress one day ear- Japan is trying to control the situation," tier. Testifying before tne house sub- says Frieuench W, Meniei, managing di- committee on domestic monetary policy, rector of Ciunanfc in Frankfurt- Volcker criticized tne dollar's level and UnuEual acilts wtthin tne European suggested tnat tnere was a need for Monetary System (IMS! also foreshad- more foreeiul central Dank intervention. owed tne, Ikeniiuoa of a ooimr setback. The Federal Reserve email-man's re- Altnongri tne mark nas Deen nitting 13- marks triggered a sharp dollar decline, year lows against the dollar, it nas actu- setting me stage nkely for the Europe- ally been,strengthening within tne EMS ans' selling action. In just 24 hours, the at the expense of tne traditionally weak- combined efforts of the world's central er European currencies, sucn BE the Ital- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 292 TUESDAY, MARCH 5, 1985 THE CHRISTIAN SCIENCE MONITOR DAVID R.FRANCIS Should the Fed One ol the Fed's problems is (hat is has been as- signed by Congress what might be called a "mission be more open in impossible." The Federal Reserve Act, as amended by the Humphrey-Hawkins Act of 1978, steles that Federal Reserve policy should promote maximum its money policy? employment, stable prices, and moderate interest rates. These goals should be pursued with due atten- tion la production, investment, real income, produc- WisNnglon tivity, international trade, and balance-of-payments Lawrence K. Roos called himself a "disillusioned equilibrium, as well as employment and prices. ild codger"; but Mr. Roos, retired president of the Mr. Black notes, however, that Congress gives the Federal Reserve Bank of St. Louis, doesn't sound Fed no priorities for these various objectives. Nor !U<e it. He speaks more like an enthusiastic reformer. does it specify any time horizon over which the Fed's "Because we live in an open and free society — in success is to be evaluated. the political sense, monetary policy goals must be Roos termed these goals a "wish list," saying that agreed upon by. and known to, the public," he told i "asking monetary policymakers to do all this is sheer recent conlerence htfld by the Cato Institute, »tree- nonsense ... a total lack o! undeistBTidinE as to what market public-policy research institute. the Federal Reserve is capable of doing." "And the method chosen by policymakers to Probably Congress itself could not agree on priorities, achieve those goals must be clearly understood by since such matters as unemployment and interest-rate Ihe public. Policy actions must be easily observable, levels are highly sensitive politically. So it dumped this well explained, and, of Course, consistent with the hot potato on t£e ftd, ssymg; in effect," Make 1lie econo- goals sought. And finally, it is essential that my run perfectly" policymakers be held accountable for the achieve- Black doesn't tike bouncing this hot potato around. ment of their announced goals." "It should be obvious to anyone that a mandate which in- That may seem reasonable. But the fact is that the structs the Fed, in essence, to pursue all desirable eco- Federal Reserve System, the nation's central bank, is nomic objectives is no basis for an effective strategy for one ol the most secretive of federal institutions, its money policy. Such a broad mandate merely transfers all goals are not clear to out- of the hard strategic choices regarding priorities, time FQMC members do siders - °T- for.th[lt mat- frames, and what is and what is not feasible to the Fed, "- _. -L..JT.,. M^r. M ter' to mejV insiders, which is not in a position to make them, precisely be- cause it has no clear mandate." Most economists He corithided: "Clearly it puts the Fed in a Calch-22 says. 'There were, . would agree nowadays position." -;;— _ -~~~ that the Fed's monetary Mr. Black would like to see Congress instruct the Fed USUaMyjISmany . policy is an extremely to put its top priority on price stability. He regards this goals as there were important-it not Uie as a feasible objective for Fed policy Chairs arOUtld the most important - influ- "The dose longer-run correlation between the povrth ence on economic trends of monetary a^^regate* and the price level is one of the table.' —— in the United Sfeies. most firmly established empirical relationships in eco- t Tight nwiney can prompt nomics," he noted. a recession. Loose money can encourage a boom. The There is much less agreement, he added, on the Fed's level of iniiation generally reflects the amount of ability to influence such variables a5 employment and money the Fed pumps irAi) the economy, though, only production "in a systematic and socially beneficial way." after a lag of two years or so. Frank Morris, president of the Federal Reserve In fact it is often said that the chairman of the Fed branch in Boston, counters that Black's proposition for IPaul A. Vslcker at the moment] is the nation's sec- an inflation-only goal is not practical. Because fiscal ond most powerful individual, after the president policy (federal laiation and spending levels) has proved himself. Since the US has the most powerful econo- to be inflexible, monetary policy must also consider em- my in the world, accounting for about 20peicentof ployment objectives. "Government can't take the posi- global output, some economists regard Mr. \bleker tion it doesn't have any unemployment objective," he as No. 1 in world economic power. contended in an interview in Boston, What bothers Mr. Roos about all this is that not Nonetheless, having been given a many-sided policy only does the Fed ' 'love to be secretive and mysteri- problem, the Fed has hsd difficulty itself setting ous," but- it does not set any "clear, achievable, long- priorities and goals. range goals." Mr. Roos recalled: "Never once in my participation in Roos was joined to a degree in his Complaint by an meetings of the FOMC {Federal Open Majket Commit- actual Fed policymaker, Robert P Black, president tee, the 12-pereon policymaking body of .the Fed] do I re- of the Federal Reserve Bank of Richmond. Va. call any discussion of long-range goals of economic "It would seem to make sense," he said, "to nar- growth TO desired price levels. It was, like trying to ttm- row the Fed's mandate in order to reduce its need to struct a house without agreeing upon an architectural rely heavily on discretion in conducting policy. Such design." a narrowing would enable the Fed to develop a cohe- One difficulty is that FOMC members do not always sive strategy with clear and feasible objectives and, agree on priorities when the goals are not compatible in my opinion, would very likely improve the quality with one another. "There were usually as many goals as of monetary polity over the long run." there were chairs around the table," Roos said. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 293 Treasury and Federal Reserve Foreign Exchange Operations During the six months ended in January, the dollar rose up Private economic forecasters landed 1o scale back to Us highest levels ol Ww (loahivg-iate period agamsl their projections o( U.S Output gains 'or I ale 1984: th« German mark and to record levels against me some even speculated that lha United Stiles might British pound and mosl ottwr European currencies. The experience a growtn recession in toe coming quartets dollar's advance largely occurred in two steps—lirsl At ihe same lime, long-term U.S. interest fates were around mid-September and again from early November progressively Declining By early autumn, evidence to mid-January. In all, the dollar rose some a percent accumulated \f\a\ ihe narrowly defined monetary againil tne currencies ol Continental Europe and 15 aggregate was no longer expanding and short-term percent against Ihe pound sterling. It advanced by a interest rates began to tall back. By late January, substantially imaltet S'<i peieeM agawsl the Japanese interest rates on long-term U.S. government bonds had yen and by about 1 percent in terms ol Ihe Canadian eased ono and a halt percentage points. Short-term dollar. In trade-weighted terms the doiiar rose some 8 interest rates had dropped even mor», iiie decline percent over the six-month period. accompanied by two half-perceniage-poml cuts in the The dollar continued to rise despite i shift in trie Federal Reserve s discount rate to 8 percent. For tha prospects for the U S. economy ana (or U S. inteiaM period as a whole, the rale ror three-month Eurodollar rates, which began to occur in ihe summer For the past deposits had declined by more tnan three percentage couple ol years, the dollar's strong performance had points, and interest differentials vis-t-vis th« German been •ssoctateO wrth exceptionally vigorous U S. eco- ms'K. for example. Ifiough still favorable to tha dollar, nomic growtrt, contrasting wiin slower recoveries else- had been cut jusl about m hail. where. Relatively high U.S, i merest rates had also been Under these circumstances, e*pec\aWns developed viewed as Supporting tne dollar. But indications emerged that me dollar would weaken during the latter part ol in August tha' Ihe U S. e'pension was Slowing ir the 1984. but these expectations failed to materialize. Eacn third quarter, while economic activity abroad >*a& picking lime ihe Oollai slarleO to move lower, it quickly recovered. The dollar was buoyed by an easing a< inflationary fears in the United States thai implied U.S. real interest 'ales were still attractive, even at lower nominal leveli. Forecast; thai price pressures would reappear, made when ihe U S expanaicio was jlrongei early in 1984, had not been borne out. Inftaiidn con- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 294 tmued moderate, ana continence grew mat me U.S consumer anO invaBtniBni goods. For other countries, economy nagn experience reasonaoie price stability lor marKet participants noted ine competitive ooost being some urns, This continence guinea support iiom con- given 10 tneir eipons. me leading source ot stimulus to tinued declines m worio commodity price*, most partie- utany crude petroleum The strengin of me aoiiar rerinctad as well a contin- uing preference on ine part ot BOin resiOent) ana non- resiaents to invest in dollar-denominated assets Since Currency Arrangement« ine last recession economic giowtn was consiaeraoly greater in inn United Slate* tnan m most oilier indus- trialized con nines many ol wnicn were still tacmg near- reeoro levels ol unemployment, fie unned Stales and its currency commueu to ce weH-riujstaefl on grojnas ol relative political siaoiiiiy. 'ine iienoiiity or us labor and prtMucf makers ciiinpataa invmacly wnn [nose <" pinei countries, ecine ot wnicn nao Deen etperi»nr;ing unu- sualiy pruiraciso laoor aiapoies. Tne meanness of pre- cious menus ana oiner commoaity prices lenaed to underline me attractiveness ot nnancial assets in gen- eral ana ol aoiiar sssais in particular investors, still reacting 10 ine creatt prooiemg ol recenl years, altempteO 10 be more selective. They tended to place a greater premium on security in mas ing investment decisions, ana Ine aoiiat ptovioed an outlet lo> mucfi ol these invest men it Porttono managers as well remained amactea to aoiiar marKeis Tnese nwKets seemed to proviae tne fianiDuny neeoso to aoiuai investment slraiegiea quicury in me tace ol smmng iniorest rale •upBciBiions, ana me liquidity 10 cover tne currency exposure it me aoitar snoulo orop. Thus, capnat mtiows conlinuea ID r>e atlracted to ihe United Staiea ai a pace greater tnan needed to imarce a large current account Oeiicit at prevailing encnange Unltea Sl«ies Ttaaiury and wtoral Reserve rates. During tn» inira quarter, Jieavy imlDvys cams Curttni Foreign Excnenge Opacationi tftrougn tna Canning sector, as Genus in tne united Stales pulled UBCK tunas previously placed in the Guroaoliar mamei AB intiBiiorary eipectations m ine Unitsa States cQnlinueo to moaerale, as long-ierm interest rales ten, gno as expectations gt a decline in the Collar laoea. a larger portion QT tno intlows su&s«- quenuy toon me tortn 01 pon'oua investments in aonar- dBngmirimed SBOUIIIIBS In Novemoer ana L)«i;«inber. ine U.S bona marKet in pamcuiar ettrdctea anention at least parity D*t»m» PI relatively attractive yields and pros- peels tot capital appreciation As these asvijigprnonia unioiaeo curing tne six fnonlns, m«fX«r participant Totu»»o on tne economic consequences ana tne poiiSioiu policy implications ol the dollar's continued aovance For tne Unnea States, wnile a strong cuirency helped ID moat)rate price pressures at a ttnw 01 vigorous economic g'owin, it imp^jaeo 'h*|or Strain* on me U.S. competitive oostnun, Tne curient account rjeiicii was building up ciose 10 S'OO million, laigeiy as tne result ol sharp increase* m imports ot Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 295 oltiaiwtse relatively mtxiesi economic lecoveTies. Bui structural rigiojiies in irieir economies. They also reaf- they believed me authorities WOuld pie'tr a broader, firmed the May '983 Williamsourg agreiment to based recovery ana, therefore, would seek lo keep undattane cooi*naied iMetvendDn as necessary. interast rales as low as possible particularly since After me G-5 meenng. visibi* foreign excnange market inflationary Pipecia'ions were subdued operations were in fact urKl»ria)<en t>y several countries Thus, market pamcioarws cwxJuQea Wwrt trie author Most central Oanks m Europe ana the Bank of Japan ilies would 09 reiuciam to use monetary policv 'o resist opsraleo on occasion to sail dollars during ine rest ol me dollar 5 rise. For a time eauy in ine penoa, dealers January, ina U S. authorities. >n cooiO'tiBiton witti Ihe were she plica I that even iniarvention would oe used But otders, also iniervened on two occasions late in January rnatket sensitivity to imervention increased, arier trie ta sell donars against marks. Bundesbank sola aoilaij. aggiessweiy in ;ne exchange Tnese operations reinto'ceo1 marnet percoptions that market late in September in ine just ol several, higlily ine carnal canns were more willing to intervene than visible operations The U.S. authorities, having rntai- Before At me e,ixo at in« monvh, fiowevet, marX*t par- ven«0 on one occasion earlier that rnontrt, again entereo ticipants were stiH uncertain of the extent to which the the market on lour days following me BundesOiink's lale authorities were prepared to intervene and ol the cm Seplsmfjer ope ration Genual oaons ot sortie other cumstanees in which ine central banks would juoge eeufiines also intervened to sell dona's "wring late intervention to pe aopropnals or helpful. Dealers September ancl early Octooer Later in the period, when remained impressed oy ilw s»»0y Mream ot commercial Die dona' resumed us advance, market professionals and in ve stm en'-related ofOers tor dollars coming into the again expected the authorities would try to moderate ine market. UntJei tnese circumstances Ihe dollar steadied move wiiti intervention. EipeciaUons ol central can" out OID not lall tack appreciably from miO-january resistance, aiodg witr Itie interveni'on operations tnat levels actually loos place, ioi a lime Kept the dollars rise in in summary, Ounng Ih* sin triomns under renew, Ihe check. US. authorities intervened m the exchange markets on By lie turn of tne /eat, me outloon tor me U 5. seven <xtaaions. sailing donars and Buying, marks in esOfXiTty wa.1; y:s5ies^i"eiy 'rnpicv-ng PuDtishea fla'a eacn irisiance. Tney cougnt $50 mnsicn equivalent at reuealeo ou";te: gi-o^li in t^e lourtn cufirter lor the nar«s nn ona Day early in September, $229 mi'liijn on United Slates than nafl been anticipated. 4iso in foui occasion* oeween S«p\«rnbor 'i* ano October T7. acceleraiing enpansion ol monetary aggraqatss i^le in ana $94 million on two days late m January Tne total, the year was seen as narrowing me scope lor any lur- S373 million-equivalent ol mafKs. was shared equally Iner aasing ot U S, monawr policy. £connmit per- Between the U.S. Treasury and the Federal Reserve. tormance in several tuiopean countries, Ifiougn also in other operations, tne Treasury Department improving, was still viewed Dy marKei professionals as announcao on Qcwoei 12 lhal rt haO |omed wltn the not so vigorous as '.o require greater monetary restraint. Ban« 01 Japan and me 6ann ot Korea >n arrangemenls As sentiment io»aro me dollar became even more oul- to pioviQe sii&ri-teim nr.ancmg lo in* Central Bao« of lisn eauy ir. 4ar.ua<v. ^» dCHtars ^as agamsl all cur Ihe PMnippifies, lotaling S80 mdiion in support jt the reneies g3ine<1 increasing momentum. Ths mgrkat noisO Philippine economic adjuslment p-ogram which nad Ihe Collar's aoproacn to levels againsi the German mark Qesn agi^ed upon w\*i th» rnonagement of tie inter- where the Bundesbank "ad peen seen intervening national Monetary Fund (ll^F). Ths Treasury, tn'ough the severs! months oetore. as well as intense selling pres- Exchange SiaDilnation Funo (6SF), agreea la piovide sure against the Smisn pounQ, in s tew European S45 million, tn» Bark of japan $30 million, ana me BanK countries, domestic interest rates were tending to firm of Korea $5 million. The tuil amouni of the facility waa in response to concerns thai the dollar's continued rise drawn on frio^emOei ^ The drawing occurred after the would eventually be reflected in increased domestic Managing Director ot tne IMF confirmed that Ine IMF inflation. had received assurances of the availability of adequate With '.ne apofoacft o1 a scfisdutec nesting o! G-E financing in support of tns Philippine economic adjust- (inan;e ministers aid cent's' bank governors, market ment progiam ana 'hat he nac formally supmiltnf the professional anticipated that this might be an occasion Philippine (flq^**i (t" a siandOy arrangement to the Tor monetary authorities 10 plan a large ana concerted Fund's Eiecu'iv* Boaid. Tha drawings *>era rftpaiH on exchange market operation. The official* diJcussed 3 December 2B, after tn< Pniiippmes drew on its staiuWy range o( inttmationai aconomic atnj financial issues, m arrangement wilri the FunO thsil innoudcemsnt ot January 17, they reaffirmed their On DecemDer 3, Ihe U.S. Treasury agreio lo provide condiments to promote a convergence of economic a (5QQ muuon &*ap Hreiiily \t> ine Centra) Ban* ol tne parformanc* and stressed th> impotianc* 01 removing Argentine Republic a* Bridging credit m support of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 296 Argentine economic adjustment program, which had driving force to economic recovery—was seen in the been agreed upon with ihe IMF The lull $500 million mark el as a welcome boost lo the economy and a spur was drawn on December 26 On lhat day ihe IMF to employment Meanwhile, depreciation was not gen- Managing Director indicated trial the IMF dad assur- eratmg any evident pickup in inflationary pressures, ances of adequate financing trom commercial banKs in partly because of trie weakness of world commodity support ol the Argentine Government's economic pro- prices. Moreover, market participants were unsure what gram Argentina's requests to draw on a standby policy tool Ihe authorities might use if they chose to act arrangement and on the Compensatory Financing against the mark's decline. The Bundesbank had Facility (CFF) we<e then approved by the Fund's Exec- emphasized oefore, when the mark was also declining utive Boarci The drawing was repaid m the amounts of against Ihe dollar, thai it did nol intend to tighten mon- $270 million on January 3, 1985. and S230 million on etary policy. As lor official intervention, remarks of January 15, 1985. after the Argentine Government's Bundesbank officials pointed to its limited effectiveness drawings from the IMF unaer the CFF and its standby in resisting fundamental market trends. arrangement, respectively. In fact, the Bundesbank had been intervening regu- The Federal Reserve and the ESF invest foreign larly at Ihe Frankfurt fining* and on occasion at other currency balances acquired in the market as a 'esult cl times m the open market. These operations, at least their foreign exchange operations m a variety of during August, just about offse! interest earnings and instruments that yield market''elated rales ol return and other inllows into Germany's reserves, so that the for- thet have a high degree of quality and liquidity Under eign exchange reserves Showed little net change from the authority provided by the Monetary Conirol Act of end'July's $38 billion level. When the dollar's rise 1980. lie Federal Reserve had invested $870 1 million accelerated, pulling the mark rate Gown to DM3.1785 on of He foreign currency holdings in securities issued by September 21. the Bundesbank intervened more foreign governments as ol January 31. tn addition, the aggressively Us actions, followed by Other European Treasury held the equivalent of S'.573.8 million in such central banks, helped the mark to bounce back up securities as of the end of January. immediately FQI several days thereafter, market partic- ipants were eitremely wary of possible further doll*' German merit sales by the Bundesbank, and rumois ol other large During the period under review, the mark lell 8.5 percent operations circulated widely. For the month o! Sep- against ttie strongly rising dollar and eased relative to tember, Germany's foreign eiehange reserves fell S2.7 all other major currencies except sterling, ending the billion period near the bottom of the EMS. The mark's decline The U.S authorities fiad purchased $50 million- against the dollar was inlerrijpted only temporarily— equivalent of marks on one occasion early in September, between late SeptemOer »nd early November, After the Bimaestiank's action of September 21, they At the start of the period, international investors purchased a total Of S13S million equivalent of marks attention was deflected to do liar-de nominated securities. during three days trom laie September to early October A rally in the U S. DonO market had |jat gotten lo counter disorderly markets. These purchases were underway. A much lalKeC-abOut elimination ol U S snared equally Between the Federal Reserve and the withholding tax on interest payments to nonresidents Treasury was finally approaching And talk spread that the U.S. immediately after the central bank intervention! the Treasury would soon issue securities targeted especially mark traded generally between DM3.00 and DM3.10 In lor foreign investors. Meanwhile, Ihe mark continued to early October the mark received a further lift when ihe suffer from comparison between the recoveries in Gar- cabinet announced repeal of Germany s 25 percent many and in the United Stales. Under these circum- withholding ta< on German securities held by non-ree- stances, the mark was trading at DM29170. near 11 idents, retroactively 10 August 1. sparking renewed for- and a half-year lows against the dollar early in August. eign interest in German bonds. But soon thereafter, the Its margin over other currencies within the EMS had mark began to drift lower against the dollar and to a also been significantly reduced. lesser extent most other currencies. In mid-October, After trading steadily in seasonally thin markets for when the mark was approaching the low* of September several weeks, the mark again began to decline as Ihe and trading at DM3,1575. the Bundesbank again inter- dollar rose early <n September As the mark's fall pro- vened. The U.S. authorities also bought S9S million- gressed, market participants questioned whether Ihe equivalent o! marks on one occasion to counter a German authorities would act to stop the decline. The renewed outbreak of disorderly market conditions. economic justification lor doing so was unclear. Addi- The mark then rallied. Market panic!pants had become tional stimulus 10 Germany's export sector—already (He impressed that the Bundesbank and others were Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 297 Dr*wlngi ind R»p*ym«iti l>y Fortign C»n1r»l Banks under Special Swap Arrangement* with the U.S. Treasury resisting tha generated rise c< lh« dollar. Furthermore, mark had been pulled d'iwn to a rpcord low fui th« the economic environment flppeved to have shifted in floating rate period o* OM3 2020 Germany s favor since mid-summef Statistics were The Bundesbank had coniinueJ to operate in the released inciicsling Ifis* (he economy had i«vw»d e»chariQB m»rn»ls lo sell Qollars These operations strongly during the summer. Exports continued lo be the contributed to a $950 million decline in Germany's for- principal boost to output sno earnings. Su! for the first eign exchange reserves Ounng the three months lime iftt export boom appeared to be spilling over to October 10 December But German authorities were alsc.. other sectors, as reflected in increased domestic new attempting to modify th«ir money market management orders for cflOi'ai goods U S imeresi rates of ail to ensuri that German banks not daws permanent maturities were deciminp.. so that the market no longer recourse to large amounts of Lgmbstd loans a* We perceived Ihe Bundesbank ss haying to resist E gradual csntrai bank and they were concerned that larger dollar decline- in German utes lo obtain s narrowing ol sales night complicate this endeavor. Accordingly, by adverse interest difleienlifiis to strengthen the mark JanuTy, central bank rnonf was increasingly b(*ing 'jnder these circumstances, mflrket professionals began provided ihrrjugh secuiity^Oased repurchase agree- to Build up long positions in marks in tr.e oxpeetalion menls sometimes a' interest rato sllghlly below the infli a major adjustment in the <1oliar-mark relaticnslup Bundesbank's Lombard rate Foreign exchange market was about to occur The bidding tor marks pushed th« operators at times misread the central bank's actions as spot rate up 9 percent to DM2 90 in the first week in signaling a desire tor 6h<;rt-term int£ esl rale? to ease, November in fad. the Bundesbank haO announced That its mon- But ade- November 7. ihe mark changed flireclion and etary gowih targets tor 1965 would be lower than lor declined as trie dollar strengthened 'or Ihe balance ot thfe prtvious year, at 3 to S percent, Bi.ndesbank offi- tha period under review At first the selling ot marks cials pointed to the impact of tha rna'k's continued Qac'iTie on import prices, thereby suggesting there was that her) postponei! dolla' purcfiasea reguitsd b»loie Ihe little scop"* lor easing monetary policy Yet the market's year-end in riopas ot taking advantage of the expected misinterpretation of Ihi Bundesbank's intentions tor rise in l*ie mark Belore long trie selling of marks money market rates was not lully dispelled until tha broadened as expectations of a generalized decline in Bu'lssbank announced it would raise the Lombard rate dollar rates diminished Speculators in the futures half a psrcentage point, to 6 percent, elfecliva markets and dealers m commercial bsnks liauidated February 1. much ot their leng mark positions by year-end. Mt>i6- In any case, by the lin^e Ihe m&rk hit its mid-January over. intsmt-iipnal TiveElori. no longer as concerned iha' low. market atlentipn was focuted more on thp rise of a decline in the dollar would erode their total return on Ihe ^Jllar than the decline of the mark Other gurran- dollar-d9nommatsd securities, came Pack to U.S cies. too, were weakening sharply, most especially the lecunties markets in siz« With investors attracted By pound As a result, when market pa'ticipants became the remaimnfl interest diflererttials (avormg tha dollar aware that a G-5 meeting of finance ministers »nd and Ihe prospect Oi piotils as U.S interest rales con- central bank governors was to take place in Washington tinued lo decline. Ihe dollar Quickly came ro overshadow on January 17, they began to expect a concerted !he mark in tne exchange markets. By January 11, the intervention operation. Between the middle ol January Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 298 and tnn C'DSB i-f Hie oe(ii)G, r.erc *e-e ;omt mteri,eition 3:0 wth of Bn'ish nionetarv aggregates permitted staged Operations IP which tho U S. monetary authorities our- reduftmns m short-term sterling interest rales during onaseO S94 rnillion-eouivslont of marks. These opera- August totaling 1 '-i percentage points. With these cuts lions, like those earlier m the ne<;oc were stia'ad (ha interest dillerential* favonng sterling were more then eguailv between lha Federal Heseive ana the Tieasury e'lminated. ana weie conducted lo resisl ci rsnewsd rise >n trie Notwithstanding me ocund's steaoi^r tone in the dollar. eicnange markets, a rmmtef of lactots undermined At the eno of January tne 'flfl'K was above its lows. market conl'denc* mat the British autnonlies would halo :rad;.".q at OMJ.167Q agamsi ir.e dollar. But it *as J to thei. anti-inf'ation nolitiea. Britain & economy, in ila percBrii beiow its high reached m early Mcvernbur afd third yea; ;. exOiinsi-N-., was showing signs of low.g B''z peicenl below end-JulV iB'-elS. oarrr.anv'S OEer^fiS -nomc-it,',- grille unsmoLivmenl *-as sli" rn'ng. No declmee a (L,rth«r S821 miti'ei 'i Jar^orv lo ;'ose !hc ifxiras* wt!S Being rnarlo in bringing ir f.ni.on down period at S34 Ijiihon, hsiciw 5 oercenl ur !h slowing the r^se of unit labor Wlihir-i {he CMS. the mains atnafMion as an invest- cos's, bv then i.iereasiig rnore rapidly than m other •nent «»'i.rie *'-r piiv&ic-soctoi invo^-'cis weaK<>-,ad ,r miL'Sttia! rouniner Uav.rfni'e S'ltamS currant account reiatioo to ot'ifr ~W5 currBfiLes, as well as to ifie r-osmon was dete- orating, Opspite a pickup in demand do!.!1'' fccoiijui"-: cfl-ion-'Sfii-B and rr,acicatonomic pil- in maior e»port maikels. because ot a sharp jump in .citi an:ont) EMS countries ntr? crowing growing imports ft lefg'hr sf'r**r by coal Timers was hs'iif? art coriMirgsnce Otl.a: European cou'ilriei weie adorjting adverse 6(tee! on pioduci'on, as well as tfie Unlancs ol mere riarKM-oneonid r.oi.t.aa Agains: this ba^pi'C'T.o, p^vments sines i.n,iu'ia<j oil ,,as. nemg auDi.:V.iiid tor Itia f-*fstst«nce 01 wi,!a. jifauoiabie ir.is'est diferisniiaia aome&'.icMy-prf<iijf.fi t-oal. Mnreo^B' the fl sector, al a [inw v.hfm inli?]ion dlferenliais weie raironin-j J.id whitl' iic.J Peer aci-ji^iing tor more '.hen h»;i ol tna prosp«c!$ 'or a n<Jw cunsncy res'ig^msni wer^ economy i iecel-t <,.v»rl' end had kcct BritaM>'s nrrenl a s- r i j e p n e g a t 'i h n o g n r r o e m la o t t i e ve le S d o t v r i i r e l u m ai a 'y r k s ll T I h t' e s e E u M ^o S n c tm ur s ie o n t d o ^s th u 1 - 0 s , o it u c r n c L e m c i ^ m s ir s e t 1 / ' J i^ IN us . W w .l e h s p n r o e d lo ^ i f g jn a s r I s d n s e ', n N a o s r tr a i r x .e ^ a u D n l i e l EMS countries rook advj'itny'e Of ll*.;s dsve'oomeni to production we-ulrl pea'' m ;he r,9«t ccuple cf y«ars, the buy substantial amoi:-ts of "-a^s .n ifie marte! tc add st-n-ulativB effect of the oil sector 01 thij economy WBS to reserves ennectec. to w^ne. m the meantime me contribution ot net oil enporis lo Britain's baisnr.s ot payments was Sts-iling oxpsc-ed to be L:nciercj! if an apparent v/aakness in Oil A! the beginning of Ihg oefioo1 uhftrr rs/iew. a live- raarkfs ltd to any sgnifieaiii droo in petroleum prices. month decline of sterling agamst the Oollai was ending Britain's domestic ecjnotiy and B»loinal position were witti the currenLy trading around $1.30 and between 78 thus perceived lo ce in precarious balance Market and 79 according to tne Hank of England 3 trade- participants DaiJ close attrition lo any developrneril weighted Hide* Alter mid-October, howevei. the pouna ihL-ught cap?hlo of torcmg the gove-nrnent to liava 10 bsfariie irc'6Fi5ing;y vuinerabie to selling pressure and choose Dfllween ijjpoortirig lu'thnr growth and fiy Uacamber it was falling across the (warn Tfre g-nQtav/nattt :>• Ofslmg unit' pressures <?-r 0-ices. oosrs, downward pressure continued m January t-cr ine Denod and '.'19 eic'.ange rate Thus, c-rosoocts of a possible as a wholo Ihe pour.d f»!l 15 oBrveW against the doii*i spieau.^g <i\ tim coai r eis sinks ann ol a reduction and 9 cerium ;n '.arms 0" in* Bank ol trigland'i trade- in oil si"-95 set the r.sos <tv an aorupt Out limited drop weighted muex n i'ie eiciiangt •«(« aroi;,ij rmd-Ortoosr. Wlihih a in A^usi a"C Seoitmbar aier'ing iiadeii 5!3ud ly w.es, t^e p^urd ^ id afilow ji £C aoains! ihe da;Ui and rtqs^nst cither Eurcnes • ciirrai--ie6. even ihoi.j.. ali were lo 74 (I n>iiir!,i !hs "ade-^9tg(.ied indB> declining agiiinsr 'lie dollar Trie Eniisr ai.morit.es1 For abci^t Iv^c months, the cound then steadied Tho resolve lo aaiiero ',c their nieifiuin-igrm fmarc'a p'sn coal nin^rs sf *"=. !aiiea Ic widen a;id tlovir.wa'd prcs- c jg a i l G lin w g t r lo h r a o J ut . s a ' i ; n ^ i. m tl> o r n e ti i s a f ry ." a f n e d a t p fi u t b ii d ie c- a s . ew T» or u b B or d T i O m w m 01 c 1 s i s ,r e o s o s n io o n ' s e tm lit e w s & < w ts a s to b e ( i l n e g s l I ,o w r> ilh l8 .n w e e < a l n a s o i i l ' in p g ri c a e * s O c P cn E - C tnylancl ratitiod s substantial increase ir short-term liiiucn The pound 'i^Oed w.thin a lan^e of ~l to '1 tint'sh irierest r^les. ths' 'f?s[ore^ ao "MS'est rate flcocrT^.m; rp (np "dni's-weigrued ir.rex Aciainst 'r.i: 0^'Ur aQvoi'age for lh*. po-nC reialii/e to i!-c coi!ar Although i! moved in lire wiih other Europeon cuirftncir^, risinr; the pivunc decliriti 8"1'? oai-air apa.nst 'he flcilar to dur-r-g la'i <Jf-loher and earlv Novemtsr Oeforp tailing Si .22 as trc- Co: la i advanceo r.anfiraily. it niu not move been GP t-w Ji 21 sd'ly -n Dpcembci vVith Ihe oouna 5elow 7fi 6 on the traae--ve>gMBd mces ThB ^.'eraii agaip vading rro^e ^'eadilv BnCsh sriort-'erm inlereft ateaomosa of sterling and an appaieni modBratifJri in inu rates coilnued lo ease iarqeiy 'i i^ie with the decline Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 299 m Eurpdollar ratas. By mid-December, lhe Bnhsh The pound closed slightly above its low ai S1.1275 and clearing banks had cut their base lending rales from Iha 71 5 m terms of the Sank of England's trade-weighted mid-summer highs by a total of 2''j percentage points index to B'/tor 9';. oercen.1. British loreign exchange reserves were little changed Frpm December on, sterling Began to fall sharply or t>alance between end-July and the end of December, against all currencies, setting successive new lows m Then tor January, they dropped £233 million to £6.73 term* ol both the dollar and the trade-weighted Index billion an ot the end of Ihn oahod Selling of sterling was stimulated by tha etoaetatioo that On Dee«tnbei ^8. the Chancellor ol lhe ExcheQuer, OPEC would have d'Mtculty reaching an effective in reply to Questions in Parliament, staled that the Bank agreement on price differentials. In addition, the mar- of England would no longer reouest foreign monetary k»t's underlying concern intensified that fhe authorities authorities to restrict sterling balances to working levels, were shilling their priorities lor economic policy toward theteby er«li<Mf (oimartv ai> apieeTnenl the government Spurring output. Growth of public-sector borrowing was felt was no longer appropriate to the currenl mierna- turning out well in excess of the governments laryet, ;ional monetary sotting The announcement did not only partly because of slnkn-related expenditures. Credit cause any visible impact on exchange rates at me limb, extended to the prlva'e sector also showed signs of accelerating, The monetary aggregates remained near J»o*n««e yen the top of their official target, ranges. Adrnitteoly, Ihe Over the sin-month period under review, the Japanese monetary aggregates ware distorted n> December by a yen eased against Ihe dollar but appreciated against the sloe* issue. But marXel participants, interpreting Ihe European currencies. A reciwd-tvieelsinQ paca tl long- evidence at hano, conc:udGO that the Bank of England term capital outflows continued to be a source of would be reluctant to see a reversal ot the interest-rate downward pressure on th« currency against the dollar, declines of the past several months even In slam a fall Outflows of Japanese resident capital wer» attracted in in the eichmnge rate Markot participants also came to part by relatively hign interest rat«s ftbro&d. They also douot the authorities were breoaied to use intervention refiecied the continuing diversification ol financial assets to resist a renewed decline in sterling, Official decia- by Japanese investors and increased yen lending to ralions and actions suggested the authorities were foreign bornwers. Meanwhile. BPme non-residents thai willing to let ths pound fsll 'f dictated by market fprcas. had been among the largest investors m Jsomnew Under these circumstances the ppund dropped seeurilies several years ago continued tp liouidata their Steadily, falling mpst precipitously in mid-January when holdings at maturity, largely to meat payment needs, the OPEC negotiations appeared to be under particular The net long-term capita! outflows swamped Japan's strain. The pound louched a low againsl the dollar Of large and growing current account surrjlus, which was $1.1015 in Far Eastern trading en January 14 and of reaching S3* billion tor the year. At times, however, 70.6 against the trade-weigh fed index at the opening in favorable shi'ts in commercial leads and lags gave a London that same day. As the exchange rate fell, the boost to th* yen against all currencies. Vis-i-ws the authorities did not resist a rise in money market interest European currencies, Japan's large cut rent account rales. The Bank ol England at pne point sailed the mi- surplus and rpbusl domestic econpmy was an important native tp pusii interest rates up further, to the levels of source of strength. mid-summer. In lhe end, sterling Interbank rales rose At first, ths yen got some respite from the full brunt even more—fcr a to'el increase of 4v, ceicentag6 ol lhe capita' outflows lhat had helped to push tfie spot paints IP 14 percent. At that point mtereal rsle differ- rate down to ¥246 45 by the sled ot the six-month enlials were again sirongly in favor of the pound. period. The outflows subsided in August as foreign reaching a level ol 3v* percentage points for three- investment in Japanese eouiiies resumed during a late- moFith deposits relative to the dollar. summer rebound m the Tokyo stock market, Also. Jap- Lale in January, Tne nign Itve) ol sterling interest rates anese investors slowed their net purchases o1 foreign made sellina the pound short expensive. In addilion, securnies ahead of the end ol the financial halt-year in OPEC had demonstreted an ability to work out a limited September. Thus, the yen advanced to V242 early in agreement on pricing differentia's, and spot oil puces August and traded steadily against Ihe dollar at thai (Itrriert. Thus, the immediate pressures against the cur- level lor several weeks. rency abated. In addiiion, sterling benefited from market During SeP'ember and October, the yen also received talk ot stepped-uo central bank intervention following the a lift from a favorable swing m commercial transactions. mid-January G-5 meeting in Washington Although lhe The yen started to ease against the dollar which had DouwJ ternairiea sufciBCt to spoiadio otessme Itirougti become well-bid across lhe board, But market partici- th* end ot tha month, it traded without clear direction. pants e"pec'ed this weakness to Oe short-lived, antic- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 300 ipalmg that ihe dollar would soon decline in response for short.term rales But market operators began to to declining U.S. interest rates. Thus, as ins yen (ell waver in their expectations that Ihe yen would Ihrough the lows ol lale July-early August and toward Strengthen further in response lo this narrowing of Ihe ¥250 level, Japanese exporters stepped up their interest differentials. Because the dollar generally had selling ol dollars to take advantage o' ihe current dollar eased relatively little from its highs of October. rale Meanwhile importers postponed their currency Thus, the allure ol the remaining interest differentials purchases- At the same time. Japans imports ol oil lavormg the United States and ot prospects ol significant slowed so (hat trie net export Balance was unusually further capital appreciation on dollar-denominated bonds favorable, began once again to weigh on the Japanese yen. With these trade transactions favoring the yen anO Coward Ihe end of the year Japanese investment In capital outflows temporarily subdued, Ihe yen's decline foreign securities mounted. The December U S gov- •gainst the dollar was more gradual msn the decline of ernment issue targeted al foreign investors, as well as the European currencies during September and early lha offering ol British Telecom shares, were well October. The yen flifl touch a two-year low oi ¥250.45 rsceived in the Tokyo market. Thus, net capital outflows on October 17, but it gained 7 percent against the jumped up in November and December to SS Billion and German mark to trade near a record high vis-it-vis that a record S8 billion, respectively In the year as a whole currency. Moreover, me yen recouped ils losses against rel long-term capital outflows from Japan rose lo $50 the dollar during lale October when Ihe dollar eased billion At trie same time, market participants noted that back By early November the yen was again trading foreign private borrowers rushed to take advantage of near the ¥240 level againsl the dollat and reached a the opening of the Euroyen market lo them, effective high for the su-month period al ¥239.ao on December 1, to place yen issues To the extent Ihese November 7 issues were purchased by Japanese residents the Meanwhile, the changing economic environment transactions contributed to Japan's capital outflows. abroad had several implications lor Japan The slow- Commercial leads and lags also began lo shift against down ol me U.S. economic expansion in Ihe third ihe Japanese yen. When expectations of o decline m quarter ot 1984 seemed lo show up alms si immediately the donar faded, importers who had postponed their in a sharp deceleration of Japan's export growth As a currency purchases came to fear thai exchange rates result. Japan's external position actually had a negative would become even more unfavorable if they walled any impact on GNP the same Quarter in add-on, the longer. Meanwhile, exporters had already converted decline in U.S interest rales, widely expecied to be some of iheir loreign currency proceeds ahead of further encouraged by cuts m ihe Federal Reserve's schedule discount rate, contributed to a substantial easing ol As a result, the yen progressively weakened againsf long-term interest rates in Japan. Japanese enterprises the dollar, failing over 6'.'* percent from its early shifted iheir expectations about immediate financing November high to ¥255.40 by the end of January. At requirements and the future costs of funds Credit this level it was down 3"'; percenl on balance during demand softened and corporate borrowing increasingly Ihe si« monlhs. although against Ihe maior European tooli place at shorter maturities. currencies, il rose nearly 5 percent Against this background, there was discussion in the Throughout the six-monlh period Ihe Bank of Japan (all that a reduction ol the Bann of Japan's official miarvenad in the foreign exchange market in compar- inierest rales coulo entail large potential benefits and atively small amounts Following the meeting of the G- low risks for the Japanese economy, given Japan's 5 m mid-January, the prospect ol an increase in coor- restrictive fiscal policy, low inflation, and the more dinated intervention made market participants wary of restrained economic growth outlook Bank of Japan speculating too heavily against the yen However, the oflicials were concerned, however, thai any lurther drop concern was hot sufficient to stem the yen's slide. In in Japan's relatively low short-term rates would put total, intervention sales of dollars offset only a fraction further pressure on the yen exchange rate al a time ol Japan a interest earnings on its loreign exchange when the sue Of Japan's current account surplus was reserves, which rose II 6 billion over Ihe six-month Ihrealening to provoke protectionist reactions in maior period 10 close at $22''= billion export markets It therefore Kept its discount rale at the 5 percent level established a year earlier with me result Europ«*n Monetary System I hat short-term interest rates remained steady During Ihe period under review, there was a growing As a result ol Ihese interest rale developments, the convergence ol economic performance among EMS interest differentials adverse to the yen narrowed counlnes. Recovery had spread lo all. The countries somewhat for long-term rates and declined even more showing the greatest improvement in 1984 were those Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 301 that hud still been in recession during 1883, inflation amounts of marks along will) some other currencies. was continuing to decelefale, with the couniries showing Another option, chosen in a small way by th» French the greater declines being those wilh the higher inflation and Italian authorities, was lo ease some of the rates * year before. In general, current account posi- exchange controls imposed during earlier periods ot tions were either stable or continuing to improve pressure against theit currencies. On December 1, me In all cases, the economic expansion proved Insuffi- French authorities announced a partial lining of controls cient lo reduce historically high levels of unemployment. on ihe transfer ol funds abroad by individuals and cor- Yet fiacal and monetary policies were generally porations and permitted Economic Community institu- restrained. Fiscal policies ware aimed at (Mutino the tions lo Iloal ECU-denomlnated bonds in ihe French size of the government deficit relative lo GNP, with market On December 1, the Italian authorities actual results varying depending on th» burden ol announced reductions in the non-interest-Dear I rig unemployment compensation and Interest payments deposit required against residents' irw«»tcn«nt abroad on government debt. Monetary policy was generally and eased restrictions on foreign exchange accounts as unaccommodating. Interest rales were allowed to ease well as on the means of payment to be used by Italians only in response lo declines In other countries or lo traveling abroad. Imptovements in inflation and fiscal delicti control K * tlwd option was lo taXe advantage ot the relative home. strength o' the currency to lower interest rates. In Under these circumstances, the exchange rate rela- France and Belgium the authorities cautiously permitted tionship within the EMS remained free Irom strain during an easing of interest rates once the foreign currency ihe entire period under IB view. Early on, most ol the reserve position was restored and after Inflation had EMS currencies were clustered within 1 percent ol tneir shown clear signs ol moderation. The French authorities bilateral parity rales. The only exception was the Italian also took advantage of moderating domestic credit lira, which started near Ihe upper limn of the wider, demands to replace the sulet guidelines on banks' 6 percent limit established for that currency. T"a credit, known as the encasement du credit, wilh a German mark and the Dutch guilder alternated a« the more flexible credit control system. topmost currency within Ihe narrow band agalnsi the But in general the authorities perceived the scope for Belgian franc at the bottom. Quiing ihe period, the lowering interest rates to be limited. Faster or more German mark and Dutch guilder leu progressively, albeit substantial cuts in interest rates were judged to tie unevenly, to the lower part ol Ihe bend- The two cur- inappropriate In view of the remaining inflation differ- rencies lell below the Danish krone end the Irish pound entials rtW'WJ Germany, the continuing neat) to lmane» by e*rly September, dropped below the French franc a large budget deficit, or the financing requirements of late in November, «nd approached the bottom ol the a current account deficit, lo both Italy and Ireland, narrow band to trade below ihe Belgian tr»nc by early interest rates were actually increased. The Bank of Italy January. temporarily raised its discount rale one percentage point The Strength of other currencies vis-a-vis the mark to 16.5 percent in September to curb growth in bank presented many EMS countries wilh opportunities and credit that was exceeding its target range. When credit policy choices. One option, chosen by the Belgian, growth moderated, however, Ihe Bank ot Italy cut its French, and Italian authorities, was to lake advantage discount rale back to 15.5 percent In recognition Of (he of the lack of pressure to build tneir foreign currency continuing progress in reducing mllalion 10 below reserves. Prior 10 Ihe period, the Belgian National Bank double-digit rates. had been able lo begin reducing Us liabilities, to «w Thus, inteiee) oiHeitnlla'iS among EMS countries European Monetary Cooperation Fund (EMCF), using remained relatively wide and did not narrow as rapidly the proceeds of the government's external borrowings. as, lor example, the inflation differentials. Residents In During the six months under review, the Belgian central countries with still relatively high interest rales increased bank was able lo continue this program, no! only with their borrowings in International markets, partly to proceeds ot further borrowings, but also with foreign finance domestic op era I ions, while short-term capital currencies acquired In the market By the end of tne movements through the banking sector also flowed to period, Belgium had fully restored Its European Currency the ce.nWrs with Wfllw laies, Judging these in1IOw» to Unit (ECU) position in th« EMCF ana increased foreign be potentially reversible, me central banks chose lo currency reserves more jhan J500 million ovei the six resist a substantial appreciation of their currencies monlha. Before the period, trie French and Italian within (he EMS through intervention. authorities had already i«»tO»d thaii fotaign cuueney Against the dollar, the EMS currencies fluctuated '•serves to the levels prevailing before ihe lest EMS generally in line with Ihe German mark, weakening most realignment However, they continued to buy substantial of the period under review with the only major reversal Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 302 during October and November. By the end of January agamst the dollar to reach its higli of the sifc-month many of these currencies were trading at record lows period ol SF2.36SO on August 16 The franc recovered against the dollar, and all ware some 8 percent below against trie German mark lor somewhat longer, moving end-July levels. la a level below DM0.82 after mid-September. Although several of the EMS central banks at limes Dunnci lale September and October, when European intervened in dollars lo limit the decline of their cur- currencies were generally fluctuating widely ris-4-w'j the rencies against ihe dollar, total dollar s*i« by ceiiral dollar, the Swiss franc moved wild the German mark, banks other man the Bundesbank ware modernte lor tne but not as widely. The Swiss (ranc was not the focus period as a whole. In any case, by end-January, the ol selling pressures prior tc September 21. Thereafter, EMS central banks h»d purchased considerably more it did not beneiit as much from intervention. The Swiss EMS and other currencies in the exchano* mark*! than authorities marie it clear that they did not intend to they had sold dollars. intervenn Bcqressively m the exchange markets out ol concern mat they might then have to deviate substan- 3win franc tially from their domestic monetary policy objectives. As I fit period under review began. Swiss interest rates When the dollar fell back In late October, tha Swiss ware under some unward pressure. Throughout 19B4. franc was aoain trading close lo its highs for the period Ihe monetary authorities in Switzerland aimed at con' against both the dollar and the mark. trolling inflation by monetary, restraint adhering lo a Thereallar, however, the franc Began lo lose ground targeted rate of growth of about 3 percent for the central relative to both currencies. This weakness in the franc ban* money stock. They held to inn goal even though followed statistical releases confirming that inflation economic recovery slowed during the second hall ol the continued to be higher and growth lower than m Ger- year. The economic recovery, though moderate by his- many. Also, the franc did not benefit, as the mark did. torical standards, was sufficient to generate a modest from continuing expectations ol central bank mterven- pickuo in credit demands and some increase in interest lion Trte National Bank, having kept its restrictive 3 rates. In addition, domestic financial markets ware percent Israel for growth of central bank money for somewhat unsettled by the decline of the SWIRE franc 19*15 was oerceived as reluctant to arid further unward ffom its peak in March that amounted to nearly 19 per- pressure on domestic interest rales by intervening in the cent ws-ii-vis Ihe dollar and about 2 percent ITIS-&-YIS eachange markets. The franc declined more raoidly than the German mark by ine end of July These declines tne mark as the dollar strengthened across lh» board had brought the soot rate down to SF2.4745 and during lale December and January. The franc closed the DM.3493 by inn opening of the period. period at SF2683Q, down B'l: percent relative lo trie During August the Swiss fianc steadied Although dollar lor trie s>« months. short- and long-term interest, rates in Switzerland As the franc began again to decline m late '984, remained the lowest of any of Ihe industrialized coun- market commentators started lo attribute the move at tries, the tightening of money market conditions in least in part to a long-term loss ol the franc's Interna- Switzerland combined with other (actors lo begin to tional appeal. They suggested Ihe franc might be suf- reverse the decline in the Swiss franc. Interest rates in lermg from an erosion of its "safe haven" Elatus in the Switzerland were rising at a time when r a tits elsewhere lace of worldwide reductions in inflation and the per- were either steady or declining. Interest differentials, ceotion ol an increasingly fragile political environment while still adverse ws-a-n'S botn the dollar and the in Eurooe. Some also suggested thai the transactions German mark, narrowed. In addition, non-rajidents had demand lor the currency had diminished to the extent significantly reduced tneir issuance of Swiss Iranc- that the franc has lost attractiveness as a trading denominalad bonds. Also, there had been a particularly vehicle As for foreign exchange dealing, the dollar/mark tharp drop In bond placements—and therefore in trie relationship was volatile enough to provide sufficient ensuing conversion of bond proceeds into dollars—by profit ooportumlies in markets larger in size and per- Japanese firms wtsose ability to offer attractive terms on mitting bigger transactions. As a medium lor investment, bonds with stock warrants became comorom<sed by a the franc wes being overshadowed by oiher currencies, poor performance of Jtcan's stock market during the mosl esDHcially tna dollar second quarter Nor did Swiss ' •me Bonds otter as The Swiss National Bank did not intervene in the much prospect lor capital aggregation to attract inves- enchGr-.gea Curing Ihe August-January period. Swiss tors as did bonds denominated in currencies where reserves Nucleated as the central bank used currency interest rates were declining. swaps to adjust domestic liquidity, closing virtually The Swiss franc therefore recovered irregularly unchanged from end-July levels, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 303 Canadian dollar Just betore the period opened, the Canadian dollar had economy and nigher rates to tight inflation. By mid- Shaken ofl the severe selling presajres of ttw earlier winter there was also some doubt that the new gov- part ol the year. In mid-summer. Canadian interest rates ernment would be able to implement its program ol had moved up. restoring a positive diflerential m law fiscal restraint. Moreover, large corporate transactions ot (he Canadian collar Wilh money martlet rates well occasionally weighed on ihe market for Canadian dollars above corresponding U.S. fates at the start of August, at times, tt)B coat ol short Canadian dollar positions had become Under th«se circumstances. Ihe Canadian authorities expensive. Thus professional selling ot the currency moved cautiously to take advantage ot tne decline of subsided and commercial leads and lags came into U S. interest rale* to avoid an outbreak of revived better balance, Also a public debale laded over whether pressure against trie currency. Canadian interest rates economic policy should give priority IP reducing unem- at lirst dn* not deelmp as quickly aa U.S. rates, and by ployment or dealing with inflation. The Canadian dollar mid-OcteOer the interest differentials vis-4-vis the U.S. rose from the historic low ot Can.$1,3368 (SO 748) dollar were even wider than in early August. Thereafter, against the U.S. dollar reached in mid-July to Canadian interest rates did ease more in line with U S C«n.$1.3094 ($0-764) by early August- interest rates, maintain ing ine wider differentiate for the Duilng the period under review, a number 01 factors Balance of the six-month period. supported the Canadian currency which along with ih» Against this background, the Canadian dollar fluc- U.S. dollar, rose eel alive to the other maior currencies. tuated without clear direction against the U.S. dollar, Canada's current account was in Surplus, buoyeo Oy a declining less inan other cuxeficies. On Balance >' strong export performance. Canada's economy revived dec'ined 1 '•'« Percent to Can S1.3250 ($0 754) by end- in the third quarter, catching up for slower growth earlier January, The Canadian dollar thereby continued to in the year. Meanwhile, inflation scnlinoed to macerate, appreciate against other currencies during the period falling to below 4 percent at an annual rate. In addition, under review, beneliting at leui in pan from high yields a change in government at Wi* Sepwmtw neiional on Canadian assets and the currency's relative firmness elections encouraged market participants Because ot ihe against the U.S. Oolla' 10 attract sizable capital inllowa new governing party's advocacy of policies to encourage from abroad. toreign investment m Canada, to reduce governmental Foreign exchange intervention by the Canadian intervention in the economy, and to cut government authorities was aimed at smoothing out sharp move- expendibles. These ideas vitro lettflirmeO In November men's in the currency Total foreign currency reserves when the government gave a statement so Parliament fell by S1.2 billion, mostly in Augoit and November, to of its intended legislative program stand at S' £ billion at the end of the period. The let market confidence m the Canadian dollar was not declines primarily reflected repayments of outstanding tully restored. The public debate preceding the election foreign exchange drawings made earlier in the year on bad left uncertain the priority any govern mem would the government's credit lines with Canadian and foreign pf*ce between lower Interest rates to stimulate the banks. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 304 THE ECONOMY FORTUNE FORECAST There are few guidelines lor estimating the rate policymakers consider unaccept- able, but Fed Chairman Paul Volcker has of- DON'T COUNT ten said the U.S. should not have suffered through the 1981-82 recession Only lo squan- INFLATION OUT der the progress it has made against infla- tion. The rale Iroughed in the 3% to 4% range in 1983, and the Fed would prabsbly The rapid money growth that began 2Vfe years ago hasn't yet like to keep cyclical pressures from in- creasing it by more than two percentage shown up in inflation. But that will change in 1985, says a lead- points. As a result. 5% to 63> would appear to be the upper end of an acceptable range ing monetarist, as the forces that suppressed inflation wane. lor 1985. If inflation pierces the 6% level, the Fed would be likely once again lo make fighting inflation a lop priority, even at the risk of significantly slowing economic ONE OF THE major accomplishments mn iifrr ROBERT SiNCKE, a mmtiana growth or causing a recession. President Reagan proudly claimed in itho a chief ao*e«ii3t at Ihf bmkenjgr huvuff Btar Judging by the recent course of inflation. his reelection campaign was low inflation, S w t i t l a l m ap s p . e a F r O R in T U th N e E ' n * e o x \ l f n i au 18 t. -nantk etonointc fyrttost there may not seem to be much danger of While the Administration blamed the reces- exceeding the critical level in 1985. Over the sionary rigors o( 1981 and 1982 on previous growth would be shortsighted. Each reces- last year consumer prices and the GNP economic policies and on a tightfisted Feder- sion in the last 20 years resulted from mone- fixed-weighted price deflator, a broader mea- al Reserve. it cheerfully took credit (or the tary policies designed to tight an unaccepl- sure of inflation, have increased an average dramatically lower inflation rale that fol- ablyhigii level of inflation. That level has ris- of 4.2$i. But slwik fll rercnl business cycles lowed the Fed's actions. Now some in the en steadily over the past decade: a 5% rate in shows this performance cannot be relied Administration suggest that inflation has 1971 led to the imposition of wage and price upon as a harbinger of future trends. been cured and thai monetary policy should controls, while lodsy 5% is considered tame. During each of the economic recoveries of be aimed at pushing the economy more rap- The economic outlook (or 1985 depends the 1970s, the rale of inflation continued lo idly toward full use of its resources. both on today's definition o( an unacceptable decline well into the expansion. Although the B«( inflation has been defer red. not cured, inflation rale and on the likelihood of inflation economy began to pick up in December and stoking the economy with faster money breaching that level. 1970—responding to accelerating money growth—the inflation rate did not revive un- A Rfte Ic In Hie Cards til July 1972. 20 months into the recovery. Other fanes may postpone the mulls, but inflation eventually follows Ml growth (show Similarly the economic expansion of the late year rait lo smooth fluctuations). And the trend of Ml suggests ruing infatun ahead. 1970s began in April 1975, but the rale of inflation continued to decline into 1976, rcariiinfr it (rough of 'J.3% in Ihe spring In both instances, however, inilalion acceler- ated markedly in later stage; o( the recov- ery, following ilie cnnrie 01 earlier rapid growth in the money supply. The message seems dear: pjoort inflation performance' guarantee continued low inflation into Uic third year of expansion. Evidence across tjm'? and across countries indicates (hat inflation is 3 monetary phe- nomenon—too much money chabmn loo few goods and services. Monetarists argue over the appropriate definition 'ji money, bat most have come to agree that the hest mea- sure is Ml. which incudes currency and checking account balances. Most also agree that Ml growth le;ids the inflation Mte by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 305 According I" strict monetarist models. inflation should alr.-.idy I"' raging in ilu- N<(, llh, 10 10% range—wluih is what some mone- iil.i|ji- ints tarists forecast a year aEft Nut white MI IB months. Recent signs »i stability sugges- growth provides valuable information about that the dollar won't help ai mu. h in 1 Wi— a '.he Irtnil uf infla'ion, the actual rate of prospect that has worried Federal Keirrve inflation often deviates from the rate of officials all year Ml growth for long periods. Nunmonetary The dollar's impact can be seen most forces—particularly isolated shocks—can clearly in the differences bet wren me infla- often push inflation well above or well tion rates for goods and for services (see below the trend induced by monetary chart at left). Though inflationary pressures growth, hfgan to mount early in I9KI, the sharp During the mid-1960s, for example, infla- rise in the value of the nollar pusherl nru'e tion remained consistently below the rate of inflation for goods back rown Dining the monetary growth. The Kennedy wage and last two quartern. inlUion in ihe non-con- price guidelines helped keep wage demands sumer-services sector of tin.' economv down through the early part D( the decade; slowed to a 3% annualized pai e., Hyt infla- along with strong capital spending and pro- tion in the consumer-services sector, which ductivity growth, thai restrained unit labor Services Tell the Tale now makes up about 305 of GM', was un- costs. In addition, inflation expectations affected by the dollar. And it h.ia been gath- moved upward slowly. Strong dollars and weak commodity pncis kavi ering steam steadily since ear!> iiln4, just From 1974 through 1981, by contrast, the ktpt the coils of goods doom, but consumer as underlying monetaiy growl h conditions inflation rate remained consistently above the urvtcfs refttct the growth of money. would suggest. During l!ic la1-! two quar- trend of monetary expansion. Wages spurted to make up for the ground lost to prior infla- ter claimed a postwar record share of real ated to a 6.6% rate, up !rom -1 It- in the tion; because productivity growth was poor, GNP. This strong increase in capital forma- unit labor costs soared. Worldwide crop tion against the backdrop of a slower- shortages boosted agricultural prices in 1973 growing labor force suggests that the capi- prices is that inflation is on an upward (rend. and 1974, and energy prices soared after the tal-labor ratio, one of the prime determi- It reached its low point Isle in ISS'i and is two oil shocks, finally, the flight from U.S. nants of the trend of productivity, should now following the acceleration of mnnclar; dollar-denominated assets in the late 1970s keep on increasing at an above-average growth thdl began in mid-15)82. The nonmon- drove the dollar down and inr-reaseri the cost pace. In I°fl5 productivity ihould grow eiaiy factors that have held it down—factors of imports, allowing domestic manufacturers at about the IVi% rots ol ih« aarly that did not suppress the underlying rate ot to raise their prices freely. In hoth petiods poitwar era, moderating unit labor cost inMation revealed in the service sector— the trend of Ml growth accurately forecast pressures. should dimmish n, importance. In 19H5 infla- the trend of inflation, but actual changes > ABUNDANT CROPS. Following poor tion should rise at a rale closer to its mone- in inflation rates departed from the trend harvests in 1983, the past year produced tary-induced rate of about 8% because of a combination of nonmonetary surpluses in major agricultural commod- How close the actual rale is dvpends larjje forces. ities, pushing prices lower. While policy- ly on the dollar. Assuming th.ii (iic iraclc- In the first linlf of the IBBOs a different set makers don't need to anticipate disruptive weightec value of the ciolkir sl.ibili/cs ne.ir current levels during ihe nest six month',, inflation is once again running consistently (a 11 mg agricultural prices to moderate fu- tha inflation rota could plater, the critical below a moiMri.-ry-mducsi! rate. While some ture inflation. 6% love I by midyear and reoth a cyclical ol these force? are likrlv :o rrm.im nt work » MODEST WAGE INCREASES. The pro- paak of up to 7% by yooi-eni* for the longei run. nthcts are ii'mporary. longed 1B81-82 recession and slmng impoil The major on,-' competition during Ihe recovery convinced > DECLINING COMMODITY PRICES, lies ple.ttiliil tfiinti-s ("i iHiticyn neralely short of c.ish, many less developed countries iLIK's) h.nebem pushing exports nation ot slioug ie<il giowili .m([ bw inlKi- uflMsit- inaicri.ik ,md depressing p.ices—in otls. of tin .As : levels e-iiniloynicnl declines and corporate profits Growth. it now appi-.irs, could roine in ;, remain strong, hourly campliation It Itko- halt m the first quarter ann resume jij.-Jaal- ly to ri» ot a rat* of 6% to 7°& during !y during (tie secunu1. Over thn ysor, rani 1985. That would be a significant increase ONP 8rewth will ovsfOBB J'i%. And from the 4.4% average of the last year. prices ovei the List couple of years. The » THE STRONG DOLLAR. Nothing has done the second-half pickup, ihe !-M'.-al fir LDCf' llnoerlnff dnbt problami could k»p more to hold down inflation in recent years serve will crank up it> mlldtion-h^t ling el- commodity pric#l W*c>k at laaBt through than the soarinK dollar. Since the autumn of forts. The coriibvi.ition of hiKtu-: 'iitlalion 1*95. 19HO its trade-weighted value has risen 74%, and monetary restraint will liMv i'<i"=c > BETTER PRODUCTIVITY, Capital spend- with a dramatic 16% gam since March I9B4 interest rates—particuhirly ^hi'i i ti i in alone. By depressing import costs and gener- ating strong competition for domestic pro- PXII.IIIMOII hv t..iilv innii Q Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 306 FEDERAL RESERVE press release Fcr inrrediatp release Match 8, 1985 The Federal Reserve Board today announced a two-part modification in its seasonal credit program. The changes are designed to provide further assurance that small- arri medium-sized agricultural banks can meet temporary liquidity requireme-its that night arise in acccmnDdating the needs of their farm borrowers over the forthrxrning planting and pi eduction cycle. While the great bulk ot farm banks appear to have adequate liquidity, the modifications are designed to ensure that liquidity strains do not hanper the necessary flow of credit in various local areas. T?ie modified program to meet seasonal liquidity needs complements loan guarantee actions taKen by the administration to help assure a necessary flow of credit to agriculture. The seasonal credit program, which has been in place for many years, provides access to discount window botrowing for institutions that demonstrate recurring financing needs related to seasonal fluctua- tions in their deposit Elows and loan demands. The program has been modified by (a) certain changes that ltt*?ralize amounts available under the regular program and (b) addition of a temporary, simplified prcyram which may Se used as an alternative. Modification of_Regular_Prg£rarn The regular seasonal program requires an institution to fund a portion of the seasonal swing in its net need for funds (computed (con past and projected patterns of deposit and loan variations) from its own resources before it can borrow from the Federal Reserve, The Board has reduced the amount that a bank must fund fron its own liquidity. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 307 Trie rormulti for cnnputing this cioductiDle has been cnarvjed Iron 4 CO 2 pur tent OL the.- first SKIO million in deposits, from 7 to 6 percent of tile secoro S100 million in deposits, wnile remaining at 10 percent of deposits over $200 million. This cnange will allow a borrowing institu- tion, especially a smaller one, to obtain a greater portion of its sea- sonal needs tor tunas from the t'eaeral Reserve. In adaiLion, discount officers will be taking a more flexible approacn to trie administration of the seasonal credit program, particularly irv juoyiny whether there are spscaal factors uiioer current ciresistances in tfie farm economy tnat would nodity evaluation of seasonal swings cased on historical oata. Reserve DanKS will oe making special efforts to acquaint depusitory institutions with both tne regular and teuiporary seasorial creait facilities. Temporary Simplified Program The temporary simplified program will be availaDle through SeptcmDer as an altemative to smaller banKs actively engaged in agricul- tural lending and with no or limited access to tne national rioney market. Such ban^s generally wojld have less than SZOO million in deposits aiid would have a ratio of leans to farmers or for farm real estate to total leans greater than 17 percent (tne average for the banKing system ot cr« ratio at eacn bank of farm Joans to total loans). Banks with loan-to- deposit ratios of GO percent or nore would ue eligiDle, For CMIIKS tnat qualify foi tne prugu'din, credit at u* rtistount winotw wcuJd Ce availaole to fund half of tneir total loan growth in ox- cess of 2 percent tron a base level, either tne average for t'eDruary or for the two weeks just prior to sudnission of an application. Credit under tnis program may not exceed 5 percent of a bank's Deposits. It is Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 308 expected that credit will be used primarily to fund leans for agricultural or agricultural-related purposes. Exceptions under the program may be made at the discretion of a Reserve Bank for banks particularly affected by agricultural credit conditions and that lack ready access to national money markets. As a matter of policy, borrowing under this program would be repaid as the seasonal credit needs abate. In no case should such borrow- ing, including renewals, be outstanding beyond February 1986. Interest on credit advanced under the special seasonal borrow- ing program will be set at a rate that will remain fixed during the time that the credit is outstanding. The rate was initially set at 8-1/2 [jet- cent, a rate between the basic discount rate and the rate on extended credit that is outstanding for more than 60 days. The rate for new loans nay be changed as the basic discount rate and extended credit rates are changed. Banks may borrow under either the regular or the temporary seasonal program. They may shift between programs, but may not borrow under both at the same time. The Board also stressed that the discount window would be available on a regular adjustment or extended credit basis where unusual demands developed in local areas as a result of the agricultural credit situation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 309 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 305! 1 Division ftesea'ch ind 5 March 8, 1985 Attached Is the press release of March 8, 1985, announcing modifications In the Federal Reserve's seasonal credit program and also announcing a temporary simplified credit program for smaller agricultural banks. In general, farm credit problems since 1980 have arisen from reduced credltworthiness of borrowers rather than from a lack of loanable funds at lenders. Nevertheless, some agricultural banks appear to be fairly "loaned up," and the temporary program may provide such banks with a useful source of additional loanable funds, should these banks get additional loan demands that they desire to accommodate. Tables 1 and 2 provide data for agricultural banks that may be useful in analyses and public explanations of the new program. Table 1 Indicates that most agricultural banks have ample liquidity; however, 9.9 percent (492 banks) have a loan-deposit ratio of 75 percent or higher, and 20.2 percent (1,004 banks) have a loan-deposit ratio of 70 percent or higher. These data include banks with deposits over $200 million that generally will not be eligible for the temporary simplified program; however, these larger agricultural banXe are relatively few in number, and some of them would be eligible for the regular seasonal program. Relative net sales of federal funds, shown In Table 2, indicate that it is the banks with these relatively high loan-deposit ratios that may be experiencing liquidity strains. Because of the relatively small size of most of these banks (see average deposits In Table 2), most of them lack ready access to national money markets; therefore, their liquidity strains may be restricting their lending activity. In these circumstances, either the regular seasonal credit program or the new temporary simplified program may be a useful source of additional loanable funds. Table 2 also shows an interesting correlation between loan-deposit ratio and the relative level of delinquent loans. On the surface, It appears that the more aggressively managed banks from the standpoint of liquidity also tended Co make relatively riskier loans. However, other possible partial explanations occurred to me while writing that sentence. Pleaee send me any insights or analyses regarding this correlation, along with any future analyses you may do regarding the new temporary program and its use. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Table 1 Percentage distribution of agricultural banks bj loan-deposit ratio at bank December 31 Total loans as a percentage of 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 tots] deposits at bank in 7 •i 5 9 3.4 4.7 6.2 7.4 7 ft 7.6 i 3.9 9 6 6.2 7.2 7.4 8 ft 7 fi •i 5.9 a. 9 10. t 9.9 in 9.9 '1 It 13. 8 12.7 n 14.9 14.8 n 13 6 6 7 9.7 1 8.8 8.0 7 10.3 1 Addendum: Average loan- deposit ratio 56 59 n 60.7 58.7 58.4 Agricultural banks are domestically-chartered Insured commercial banks with an above-average farm loan ratio on Che date specified. The farm loan ratio at each bank Is die ratio of total farm loans ("loans secured by farmland" plus "loans to finance agricultural production and other loans to farmers") to total loans (excluding lease financing receivables). On December 31, 1984 agricultural banks had farm loan ratios above 16.99 percent. In calculating loan-deposit ratios, total loans Include lease financing receivables. Date for December 31, 1984, are preliminary estimates baaed on specially edited reports from over 99 percent of all banks, available as of March 8, 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Agricultural banks and selected data for such banke, D> loan~depcslt ratio at bank December 31, 1984 Average Net sales of Total fain Total lie! 1 ntjuent loans as percentage Total loans as deposits federal funds loar.s of tctal loar.s a percentage °' (millions and RFs (bilMcnp total deposits of as percentage of Total Faet cue and Nonaccrual at bank dollars) of assets dollars) still accruing and 1 n t e r ee t renegot lated Total, 27 4.3 6.2 Und 35..., 379 19 8,0 1.2 3.3 35 39 236 23 6.6 4.3 3.2 40 44 3hO 24 5.6 1.4 5.0 3.6 1.4 45 49 492 24 5.8 2.2 5.6 3.9 50 54 604 28 5.4 3.3 5.6 3.8 55 c 59 661 28 4.6 3.9 5.8 3.6 60 64.... 673 27 4.2 4.4 6.2 4.0 65 69 569 28 3.E 3.9 6.6 4.0 70 74 512 35 2.3 4,6 6.5 4.1 75 79 273 28 1.9 2,0 7.6 5.2 2.4 84.... 136 27 1.4 1.2 8.0 5.4 85 and over. 83 42 -1.2 1.2 7.0 i.3 7.7 Agricultural banke ate dotnestIcally-chartered insured commercial banVa «Jth an above-average farm loaa ratio on the date specliied. The lane loan ratio at each bank la the raMc of tola] farm loans ("loans secured by farmland" plus "loane to finance agricultuta] production and other leans tc farmers") tc total loans (excluding lease financing receivables). On Dec. 31, 1984, agricultural banks had farm loan ratios above 16.99 percent. In calculating loan-deposit ratios, total loane Include lease financing receivables, Data for December 3:, 1984, are prelJmlnarj estimates based on specially edited reports (ton ovet 99 percent of all banka, available as of March 8, 1985. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Paul A. Volcker (1985, March 4). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19850305_chair_conduct_of_monetary_policy_pursuant_to

@misc{wtfs_testimony_19850305_chair_conduct_of_monetary_policy_pursuant_to,
  author = {Paul A. Volcker},
  title = {Congressional Testimony},
  year = {1985},
  month = {Mar},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19850305_chair_conduct_of_monetary_policy_pursuant_to},
  note = {Retrieved via When the Fed Speaks corpus}
}