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Monetary Policy: A Letter... Chairman Burns examines the

record of monetary policy, ina letter to Senator Proxmire.

Weakening Boom?... The Western boom showed signs

of weakness even before theonset of the energy crisis.

Fueling Bank-Loan Growth... Third-quarter Joan upsurge

helped by sell-off of securitiesand by expansion of CD funds.

Business Review is edited by William Burke, with the assistance ofKaren Rusk (editorial) and Janis Wilson (graphics).Copies of this and other Federal Reserve publications are available fromthe Administrative Services Department, Federal Reserve Bank of SanFrancisco, P.O. Box 7702, San Francisco, California 94120.

The role of the money supplyin the conduct of monetarypolicy was discussed in detailin a recent letter from Arthur F.Burns, Chairman of the Boardof Governors of the FederalReserve System, to SenatorWilliam Proxmire of Wisconsin.The text of the letter follows.

November 6,1973

The Honorable William ProxmireUnited States SenateWashington, D. C.

Dear Senator Proxmire:

I am writing in further responseto your letter of September 17,1973, which requested commentson certain criticisms of monetarypolicy over the past year.

As stated in your letter, thecriticisms are: (1) "that there wastoo much variation from time totime in the rate of inctease in themoney supply, that monetarypolicy was too erratic, too muchcharacterized by stops andstarts"; and (2) "that the moneysupply had increased much toomuch last year, in fact that theincrease would have been toomuch even if we had been in thedepths of a recession instead ofenjoying a fairly vigorous eco­nomic expansion."

These criticisms involve basicissues with regard to the role ofmoney in the economy, and therole that the money supplyshould play in the formulationand execution of monetarypolicy. These issues, along withthe specific points you raise,require careful examination.

Criticism of Our Public PoliciesDuring the past two years theAmerican economy has experi­enced a substantial measureofprosperity. Real output hasincreased sharply, jobs havebeen created for millions ofadditional workers, and totalpersonal income-both in dollarsand in terms of real purchasingpower-has risen to the highestlevels ever reached.

Yet the prosperity has been atroubled one. Price increaseshave been large and widespread.For a time, the unemploymentrate remained unduly high.Interest rates have risen sharplysince the spring of 1972. Mort­gage money has recently becomedifficult to obtain in manycommunities. And confidence inthe dollar at home and abroadhas at times wavered.

Many observers have blamedthese difficulties on the manage­ment of public economicpolicies. Certainly, the Federalbudget-despite vigorous efforts

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to hold expenditures down­continued in substantial deficit.There has also been an enormousgrowth in the activities of Feder­ally-sponsored agencies which,although technically outside thebudget, must still be financed.The results of efforts to controlwages and prices during the pastyear have been disappointing.Partial decontrol in early 1973and the subsequent freeze failedto bring the results that werehoped for.

Monetary policy has beencriticized on somewhat contra­dictory counts-for beinginflationary, or for permitting toohigh a level of interest rates, orfor failing to bring the economyback to full employment, or forpermitting excessive short-termvariations in the growth of themoney supply, and so on.

One indication of dissatisfactionwith our public policies wasprovided by a report, to whichyou refer in your letter, on aquestionnaire survey conductedby the National Association ofBusiness Economists. Of theresponents, 38 percent ratedfiscal policy "over the past year"as "poor"; 41 percent ratedmonetary policy "over the pastyear" as "poor"; and only 14 per­cent felt that the wage-pricecontrols under Phase IV were"about right." If this sampling is

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at all indicative, the publicpolicies on which we have reliedare being widely questioned.Many members of the abovegroup, in fact, went on record fora significant change in fiscalpolicy. In response to a questionwhether they favored a variableinvestment tax credit, 46.5 per­cent said "yes", 40 percent said"no" and 13.5 percentexpressed "no opinion."

Let me now turn to the questionsraised in your letter and in someother recent discussions aboutmonetary policy. I shall discuss,in particular, the role of moneysupply in the conduct ofmonetary policy; the extent andsignificance of variability in thegrowth of the money supply;and the actual behavior of themoney supply during 1972-73.

Role of Money SupplyFor many years economists havedebated the role of the moneysupply in the performance ofeconomic systems. One schoolof thought, often termed "mone­tarist," claims that changes in themoney supply influence veryimportantly, perhaps evendecisively, the pace of economicactivity and the level of prices.

Monetarists contend that themonetary authorities should payprincipal attention to the moneysupply, rather than to otherfinancial variables such asinterest rates, in the conduct ofmonetary policy. They alsocontend that fiscal policy hasonly a small independent impacton the economy.

Another school of thought placesless emphasis on the moneysupply and assigns more im­portance to the expenditure andtax policies of the FederalGovernment as factors influenc­ing real economic activity andthe level of prices. This schoolemphasizes the need formonetary policy to be concernedwith interest rates and withconditions in the money andcapital markets. Some economicactivities, particularly residentialbuilding and State and localgovernment construction,depend heavily on borrowedfunds, and are therefore influ­enced greatly by changes in thecost and availability of credit. Inother categories of spending­such as business investment infixed capital and inventories, andconsumer purchases of durablegoods-credit conditions playaless decisive role, but they arenonetheless important.

Monetarists recognize thatmonetary policy affects privatespending in part through itsimpact on interest rates and othercredit terms. But they believethat primary attention to thegrowth of the money supply willresult in a more appropriatemonetary policy than wouldattention to conditions in thecredit markets.

Needless to say, monetary policyis-and has long been-a con­troversial subject. Even themonetarists do not speak withone voice on monetary policy.Some influential monetaristsbelieve that monetary policyshould aim strictly at maintaininga constant rate of growth of themoney supply. However, whatthat constant should be, or howbroadly the money supply shouldbe defined, are matters on whichmonetarists still differ. And thereare also monetarists who wouldallow some-but infrequent­changes in the rate of growth ofthe money supply, in accordancewith changing economicconditions.

It seems self-evident thatadherence to a rigid growth raterule, or even one that is changedinfrequently, would practicallyprevent monetary policy fromplaying an active role in eco­nomic stabilization. Monetaristsrecognize this. They believe that

most economic disturbancestend to be self-correcting, andthey therefore argue that aconstant or nearly constant rateof growth of the money supplywould result in reasonablysatisfactory economic perform­ance.

But neither historical evidence,nor the thrust of explorations inbusiness-cycle theory over a longcentury, give support to the

notion that our economy isinherently stable. On thecontrary, experience has demon­strated repeatedly that blindreliance on the self-correctingproperties of our economicsystem can lead to serioustrouble. Discretionary economicpolicy, while it has at times ledto mistakes, has more oftenproved reasonably successful.The disappearance of businessdepressions, which in earlier

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times spelled mass unemploy­ment for workers and massbankruptcies for businessmen, islargely attributable to thestabilization policies of the lastthirty years.

The fact is that the internalworkings of a market economytend of themselves to generatebusiness fluctuations, and mostmodern economists recognizethis. For example, improvedprospects for profits often spurunsustainable bursts of invest­ment spending. The flow ofpersonal income in an age ofaffluence allows ample latitudefor changes in discretionaryexpenditures and in savings rates.During a business-cycleexpansion various imbalancestend to develop within theeconomy-between aggregateinventories and sales, or betweenaggregate business investment infixed capital and consumeroutlays, or between average unitcosts of production and prices.Such imbalances give rise tocyclical movements in theeconomy. Flexible fiscal andmonetary policies, therefore, areoften needed to cope withundesirable economic develop­ments, and this need is notdiminished by the fact that ouravailable tools of economicstabilization leave something tobe desired.

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There is general agreementamong economists that, as a rule,the effects of stabilizationpolicies occur gradually overtime, and that economicforecasts are an essential tool ofpolicy making. However, noeconomist-or school ofeconomics-has a monopoly onaccurate forecasting. At times,forecasts based largely on themoney supply have turned outto be satisfactory. At other times,such forecasts have been quitepoor, mainly because of un­anticipated changes in theintensity with which the existingmoney stock is used by businessfirms and consumers.

Changes in the rate of turnoverof money have historically playeda large role in economicfluctuations, and they continueto do so. For example, thenarrowly-defined money stock­that is, demand deposits pluscurrency in public circulation­grew by 5.7 percent betweenthe fourth quarter of 1969 andthe fourth quarter of 1970. Butthe turnover of money declinedduring that year, and the dollarvalue of GNP rose only 4.5 per­cent. In the following year, thegrowth rate of the money supplyincreased to 6.9 percent, butthe turnover of money pickedup briskly and the dollar valueof GNP accelerated to 9.3 per­cent. The movement out of

recession in 1970 into recoveryin 1971 was thus closely relatedto the greater intensity in the useof money. Occurrences such asthis are very common becausethe willingness to use the existingstock of money, expressed in itsrate of turnover, is a highlydynamic force in economic life.

For this as well as other reasons,the Federal Reserve uses a blendof forecasting techniques. Thebehavior of the money supplyand other financial variables isaccorded careful attention. Soare the results of the most recentsurveys on plant and equipmentspending, consumer attitudes,and inventory plans. Recent Ittrends in key producing andspending sectors are analyzed.The opinions of businessmenand outside economic analystsare canvassed, in part throughthe nationwide contacts of Feder­al Reserve Banks. And an assess­ment is made of the probablecourse of fiscal policy, also oflabor-market and agriculturalpolicies, and their effects on theeconomy.

Evidence from all these sources isweighed. Efforts are also made to ~ Iassess economic developmentsthrough the use of large-scale

econometric models. An eclecticapproach is thus taken by theFederal Reserve, in recognitionof the fact that the state ofeconomic knowledge does notjustify reliance on any singleforecasting technique. Aseconomic research has cumu­lated, it has become increasinglyclear that money does indeedmatter. But other financialvariables also matter.

In recent years, the FederalReserve has placed somewhatmore emphasis on achievingdesired growth rates of themonetary aggregates, includingthe narrowly-defined moneysupply, in its conduct ofmonetary policy. But we havecontinued to give carefulattention to other financialindicators, among them the levelof interest rates on mortgagesand other loans and the liquidityposition of financial institutionsand the general public. This isnecessary because the economicimplications of any givenmonetary growth rate depend onthe state of liquidity, the attitudesof businessmen, investors, andconsumers toward liquidity, thecost and availability of borro\Nedfunds, and other factors. Also,as the nation's central bank, theFederal Reserve can never losesight of its role as a lender of lastresort, so that financial crises andpanics will be averted.

I recognize that one advantageof maintaining a relatively stablegrowth rate of the money supplyis that a partial offset is therebyprovided to unexpected andundesired shifts in the aggregatedemand for goods and services.There is always some uncertaintyas to the emerging strength ofaggregate demand. If moneygrowth is maintained at a ratherstable rate, and aggregatedemand turns out to be weakerthan is consistent with thenation's economic objectives,interest rates will tend to declineand the easing of credit marketsshould help to moderate theundesired weakness in demand.Similarly, if the demand forgoods and services threatens tooutrun productive capacity, arather stable rate of monetarygrowth will provide a restraininginfluence on the supply of creditand thus tend to restrainexcessive spending.

However, it would be unwise formonetary policy to aim at alltimes at a constant or nearlyconstant rate of growth of moneybalances. The money growthrate that can contribute most tonational objectives will vary witheconomic conditions. Forexample, if the aggregatedemand for goods and servicesis unusually weak, or if thedemand for liquidity is unusuallystrong, a rate of increase in the

money supply well above thedesirable long-term trend maybe needed for a time. Again,when the economy is experienc­ing severe cost-push inflation, amonetary growth rate that isrelatively high by a historicalyardstick may have to betolerated for a time. If moneygrowth were severely constrainedin order to combat the elementof inflation resulting from such acause, it might well haveseriously adverse effects onproduction and employment. Inshort, what growth rate of themoney supply is appropriate atany given time cannot bedetermined simply by extrapolat­ing past trends or by somepreconceived arithmeticalstandard.

Moreover, for purposes ofconducting monetary policy, it isnever safe to rely on just oneconcept of money-even if thatconcept happens to be fashion­able. A variety of plausibleconcepts merit careful attention,because a number of financialassets serve as a convenient,safe, and liquid store ofpurchasing power.

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The Federal Reserve publishesdata corresponding to threedefinitions of money, and takesall of them into account indetermining policy. The threemeasures are: (a) the narrowly­defined money stock (M1 ), whichencompasses currency anddemand deposits held by thenonbank public; (b) a morebroadly-defined money stock(M 2 ), which also includes timeand savings deposits at com­mercial banks (other than largenegotiable time certificates ofdeposit); (c) a still broaderdefinition (M 3 ), which includessavings deposits at mutualsavings banks and savings andloan associations. A definitionembracing other liquid assetscould also be justified-forexample, one that wouldinclude large-denominationnegotiable time certificates ofdeposit, U.s. savings bonds andTreasury bills, commercial

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paper, and other short-termmoney market instruments.

There are many assets closelyrelated to cash, and the publiccan switch readily among theseassets. However money may bedefined, the task of determiningthe amount of money needed tomaintain high employment andreasonable stability of the generalprice level is complicated byshifting preferences of thepublic for cash and otherfinancial assets.

Variability ofMoney Supply GrowthIn the short run, the rate ofchange in the observed moneysupply is quite erratic, andcannot be trusted as an indicatorof the course of monetarypolicy. This would be so evenif there were no errors ofmeasurement.

The record of hearings held bythe Joint Economic Committeeon June 27,1973 includes amemorandum which I sub­mitted on problems encounteredin controlling the money supply.As indicated there, week-to­week, month-to-month, andeven quarter-to-quarterfluctuations in the rate of changeof money balances are frequentlyinfluenced by internationalflows of funds, changes in thelevel of U.S. Governmentdeposits, and sudden changesin the public's attitude towardsliquidity. Some of these varia­tions appear to be essentiallyrandom-a product of theenormous ebb and flow of fundsin our modern economy.

Because the demands of thepublic for money are subject torather wide short-term variations,efforts by the Federal Reserve tomaintain a constant growth rateof the money supply could leadto sharp short-run swings ininterest rates and risk damage tofinancial markets and the econ­omy. Uncertainties aboutfinancing costs could reducethe fluidity of markets and in­crease the costs of financing toborrowers. In addition, wide anderratic movements of interestrates and financial conditionscould have undesirable effectson business and consumer

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a monthly rise or fall in themoney stock of even $2112 billionwould amount to only a 1 per­cent change. But when such atemporary change is expressedas an annual rate, as is nowcommonly done, it comes out asabout 12 percent and attractsattention far beyond its realsignificance.

The Federal Reserve researchstaff has investigated carefullythe economic implications ofvariability in M I growth. The ex­perience of the past two decadessuggests that even an abnor­mally large or abnormallysmall rate of growth of themoney stock over a period up tosix months or so has a negligibleinfluence on the course of theeconomy-provided it is subse­quently offset. Such short-runvariations in the rate of change inmoney supply may not at allreflect Federal Reserve policy,and they do not justify the atten­tion they often receive fromfinancial analysts.

The thrust of monetary policy andits probable effects on economicactivity can only be determinedby observing the course of themoney supply and of other mone­tary aggregates over periodslasting six months or so. Eventhen, care must be taken tomeasure the growth of moneybalances in ways that temper the

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Table 1DEVIATIONS IN M I FROM ITSAVERAGE RATE OF GROWTH

1970 THRU MID-1973Annual Rates of Change

in percentAverage Maximum

Deviation Deviation3.8 8.82.4 5.51.8 4.1

Some indication of the extent ofshort-term variations in the re­corded money supply is providedbelow. Table 1 shows the averageand maximum deviations (with­out regard to sign) of M I fromits average annual growth rateover a three and a half yearperiod. As would be expected, thedegree of variation diminishes asthe time unit lengthens; it ismuch larger for monthly than forquarterly data, and is also largerfor quarterly than for semi-annual data.

Form of DataMonthlyQuarterlySemi-annual

In our judgment, there need belittle reason for concern aboutthe short-run variations thatoccur in the rate of change in themoney stock. Such variationshave minimal effects on the realeconomy. For one thing, theoutstanding supply of money isvery large. It is also quite stable,even when the short-run rate ofchange is unstable. This Octoberthe average outstanding supplyof MIl seasonally adjusted, wasabout $264 billion. On this base,

In any event, for a variety ofreasons explained in thememorandum for the JointEconomic Committee, to which Ihave previously referred, theFederal Reserve does not haveprecise control over the moneysupply. To give one example, asignificant part of the moneysupply consists of depositslodged in nonmember banks thatare not subject to the reserverequirements set by the FederalReserve. As a result there is someslippage in monetary control.Furthermore, since deposits atnonmember banks have beenreported for only two to fourdays in a year, in contrast todaily statistics for member banks,the data on the money supply­which we regularly present on aweekly, monthly, and quarterlybasis-are estimates rather thanprecise measurements. When theinfrequent reports from non­member banks become available,they often necessitate consider­able revisions of the moneysupply figures. In the past twoyears, the revisions were upward,and this may happen againthis year.

spending. These adverse effectsmay not be of major dimensions,but it is better to avoid them.•

influence of short-term varia­tions. For example, the growth ofmoney balances over a quartercan be measured from theamount outstanding in the lastmonth of the preceding quarterto the last month of the currentquarter, or from the averageamount outstanding during thepreceding quarter to the averagein the current quarter. The firstmeasure captures the latesttendencies in the money supply,but may be distorted by randomchanges that have no lastingsignificance. The second measuretends to average out temporaryfluctuations and is comparable tothe data provided on a widerange of non-monetary economicvariables, such as the grossnational product and relatedmeasures.

A comparison of these two waysof measuring the rate of growthin M 1 is shown in Table 2 forsuccessive quarters in 1972 and1973. The first column, labeledM, shows annual rates calculatedfrom end-months of quarters;the second column, labeled Q,shows annual rates calculatedfrom quarterly averages.

Table 2GROWTH RATES OF MONEY

SUPPLY ON TWO BASESAnnual Rate of Change,

in percentM Q

1972 I 9.2 5.3II 6.1 8.4

III 8.2 8.0N 8.6 7.1

1973 I 1.7 4.7II 10.3 6.9

III 0.3 5.1

As may be seen, the quarterlyaverages disclose much moreclearly the developing trend ofmonetary restraint-which, infact, began in the second quarterof 1972. Also, the growth of M l1

which on a month-end basisappears very erratic in the firstthree quarters of 1973, is muchmore stable on a quarterlyaverage basis. For example,wh i1e the level of M 1 did notexpand significantly betweenjune and September, thequarterly average figures indicatefurther sizable growth in thethird quarter. For purposes ofeconomic analysis, it is anadvantage to recognize that themoney available for use wasappreciably larger in the thirdquarter than in the secondquarter.

Experience of 1972-73During 1972, it was the respon­sibility of the Federal Reserveto encourage a rate of economicexpansion adequate to reduceunemployment to acceptablelevels. At the same time, despitethe dampening effects of thewage-price control program,inflationary pressures weregathering. Monetary policy,therefore, had to balance thetwin objectives of containinginflationary pressures andencouraging economic growth.These objectives were to someextent conflicting, and monetarypolicy alone could not beexpected to cope with bothproblems. Continuation of aneffective wage-price programand a firmer policy offiscalrestraint were urgently needed.

The narrowly-defined moneystock increased 7.4 percentduring 1972 (measured from thefourth quarter of 1971 to thefourth quarter of 1972.) Betweenthe third quarter of 1972 and thethird quarter of 1973, the growthrate was 6.1 percent. By thefirst half of 1973, the annualgrowth rate had declined to 5.8percent, and a further slowingoccurred in the third quarter.

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If

J

United StatesUnited KingdomGermanyFranceJapan

Evaluation of the appropriatenessof these growth rates would

I require full analysis of the$ economic and financial ob­

jectives, conditions, and policiesduring the past two years, if notlonger. Such an analysis cannotbe undertaken here. Someperspective on monetary devel­opments during 1972-73 may begained, however, from compari­sons with the experience ofother industrial countries, andby recalling briefly how domesticeconomic conditions evolvedduring this period.

Table 3 compares the growth ofM , in the United States with thatof other industrial countries in1972 and the first half of 1973.The definitions of M, differsomewhat from country tocountry, but are as nearlycomparable as statistical sourcespermit. It goes without sayingthat each country faced its ownset of economic conditions andproblems. Yet it is useful to notethat monetary growth in theUnited States was much lowerthan in other major industrialcountries, and that it also wassteadier than in the other

\ countries.

Table 3ANNUAL PERCENT RATES OFGROWTH IN MONEY SUPPLY

1971.4 1972.4to 1972.4 to 1973.2

7.4 5.814.1 10.014.3 4.215.4 8.723.1 28.2

The next table shows, in sum­mary fashion, the rates ofchange in the money supplyof the United States, in its totalproduction, and in the consumerprice level during 1972 and 1973.The table is based on the latestdata. It may be noted, in passing,that, according to data availableas late as January 1973, the rateof growth of M , during 1972 was7.2%, not 7.4%; and that therate of increase in real GNP was7.7%, not 7.0%. In other words,on the basis of the data availableduring 1972, the rate of growthof M, was below the rate ofgrowth of the physical volume ofover-all production.

The table indicates that growthin M , during 1972 and 1973approximately matched thegrowth of real output, but was farbelow the expansion in the dollarvalue of the nation's output.Although monetary policylimited the availability of moneyrelative to the growth oftransactions demands, it stillencouraged a substantialexpansion in economic activity;real output rose by about 7 per­cent in 1972. Even so, unemploy­ment remained unsatisfactorilyhigh throughout the greater partof the year. It was not untilNovember that the unemploy­ment rate dropped below 5.5percent. For the year as a whole,the unemployment rate averaged5.6 percent. It may be of interestto recall that unemploymentaveraged5.5 pe rcent in 1954 and1960, which are commonlyregarded as recession years.

Since the expansion of M 1 in1972 was low relative to thedemands for money and credit, itwas accompanied by rising short­term interest rates. Long-terminterest rates showed little netchange last year, as creditdemands were satisfied mainly inthe short-term markets.

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Table 4MONEY SUPPLY, GNP, AND PRICES IN THE U.S.

(Percent change at annual rates)

The severe rate of inflation thatwe have experienced in 1973cannot responsibly be attributedto monetary management or topublic policies more generally.In retrospect, it may well be thatmonetary policy should havebeen a little less expansive in1972. But a markedly morerestrictive policy would have ledto a still sharper rise in interestrates and risked a prematureending of the businessexpansion, without limiting toany significant degree this year'supsurge of the price level.

In view of these powerful specialfactors, and the cyclicalexpansion of our economy, asharp advance in our price levelwould have been practicallyinevitable in 1973. The upsurgeof the price level this year hardlyrepresents either the basic trendof prices or the response ofprices to previous monetary orfiscal policies-whatever theirshortcomings may have been. Inparticular, as the above tablesshow, the explosion of foodprices that occurred this year isin large part responsible for theaccelerated rise in the over-allconsumer price level.

12.1 11.75.4 4.8

7.1 7.84.0 4.1

1972.4 to1973.2 1973.3

5.8 5.6

materials. The expansion inindustrial capacity needed toproduce these materials had notbeen put in place earlier becauseof the abnormally low level ofprofits between 1966 and 1971and also because of numerousimpediments to new investmenton ecological grounds. Third,farm product prices escalatedsharply as a result of crop failuresin many countries last year.Fourth, fuel prices spurtedupward, reflecting the develop­ing shortages in the energy field.And fifth, the depreciation of thedollar in foreign exchangemarkets has served to boostprices of imported goods and toadd to the demands pressing onour productive resources.

3.43.0

10.67.0

1971.4 to 1972.47.4Money supply (M1)

Gross National ProductCurrent dollarsConstant dollars

PricesConsumer price index (CPI)CPI excluding food

The extraordinary upsurge of theprice level this year reflects avariety of special influences. First,there has been a world-wideeconomic boom superimposedon the boom in the United States.Second, we have encounteredcritical shortages of basic

In 1973, the growth of M 1

moderated while the transactionsdemands for cash and theturnover of money accelerated.GNP in current dollars rose at a12 percent annual rate as pricesrose more rapidly. In creditmarkets short-term interest ratesrose sharply further, while long­term interest rates also movedup, though by substantially lessthan short-term rates.

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Concluding ObservationsThe present inflation is the mostserious economic problem facingour country, and it poses great

difficulties for economic stabili­zation policies. We mustrecognize, I believe, that it willtake some time for the forces ofinflation, which now engulf oureconomy and others around theworld, to burn themselves out. Intoday's environment, controlson wages and prices cannot beexpected to yield the benefitsthey did in 1971 and 1972, wheneconomic conditions were muchdifferent. Primary reliance indealing with inflation-both inthe near future and over thelonger term-will have to beplaced on fiscal and monetarypolicies.

The prospects for regaining pricestability would be enhanced byimprovements in our monetaryand fiscal instruments. Theconduct of monetary policycould be improved if steps weretaken to increase the precisionwith which the money supply canbe controlled by the FederalReserve. Part of the presentcontrol problem stems fromstatistical inadequacies-chieflythe paucity of data on depositsat nonmember banks. Also,however, control overthe moneysupply and other monetaryaggregates is less precise than itcan or should be because non­member banks are not subject tothe same reserve requirements asare Federal Reserve members.

I hope that the Congress willsupport efforts to rectify thesedeficiencies. For its part, theFederal Reserve Board is evennow carrying on discussions withthe Federal Deposit InsuranceCorporation about the need forbetter statistics on the nation'smoney supply. The Board alsoexpects shortly to recommend tothe Congress legislation that willput demand deposits at commer­cial banks on a uniform basisfrom the standpoint of reserverequirements.

Improvements in our fiscalpolicies are also needed. It isimportant for the Congress to putan end to fragmented considera­tion of expenditures, to place afirm ceiling on total Federalexpenditures, and to relate theseexpenditures to prospectiverevenues and the nation'seconomic needs. Fortunately,there is now Widespreadrecognition by members of theCongress of the need to reformbudgetary procedures alongthese broad lines.

It also is high time for fiscalpolicy to become a moreversatile tool of economicstabilization. Particularlyap­propriate would be fiscalinstruments that could beadapted quickly, under speciallegislative rules, to changingeconomic conditions-such as avariable tax credit for businessinvestment in fixed capital. Onceagain I would urge the Congressto give serious consideration tothis urgently needed reform.

We must strive also for betterunderstanding of the effects ofeconomic stabilization policieson economic activity and prices.Our knowledge in this area isgreater now than it was five or tenyears ago, thanks to extensiveresearch undertaken by econo­mists in academic institutions,at the Federal Reserve, andelsewhere. The keen interest ofthe Joint Economic Committee inimproving economic stabilizationpolicies has, I believe, been aninfluence of great importance instimulating this widespreadresearch effort.

I look forward to continuedcooperation with the Committeein an effort to achieve the kindof economic performance ourcitizens expect and deserve.

Sincerely yours,Arthur F. Burns

The Western boom continuedduring the summer and earlyfall months, helped along by theupsurge in the farm sector andin the export trade. At the sametime, production became seri­ously strained by shortages offuels and other basic materials. Aslowdown in employment growthreflected some of these supplydifficulties, but it probably signi­fied also a weakening of demandin certain sectors of the regionaleconomy. Then, as the fuelshortage worsened in late fall,many observers began to revisedownward their forecasts forregional business in 1974.

Civilian employment increased atless than a 2-percent annual rateduring the third quarter, extend­ing a deceleration which first ap­peared during the spring period.Jobs continued to expand in mostindustries, but sluggishness wasapparent in several fields, suchas non-aerospace manufactur­ing. Not surprisingly, the un­employment rate remained ratherhigh, averaging 5.5 percent dur­ing the third quarter, just as ithad for most of the earlier partof the year. In view of a slower­than-national rise in employment,the regional jobless rate remainedabove the national rate duringthe quarter, and this situationcontinued in October as thenational rate fell from 4.8 to

Consumer buying generally heldat a high level, despite the firstsigns of weakness in durable­goods sales and a deceleration ininstalment-credit growth. Yetwith prices soaring, real gainsmoderated in most sectors,especially food.

Business firms continued to spendsubstantial sums for new plantand equipment, in an attempt tokeep up with heavy boom-leveldemands. Public utilities, tradingfirms and durable-goods manu­facturers relied heavily on bankterm loans for their capital-goodsfinancing. In short-term financing,bank-credit demand slackenedtowards the end of summer asfirms rechanneled much of theirbusiness to the commercial-papermarket, following a decline inpaper rates below the banks'prime-loan rate. But retailers andsome manufacturing firms, espe­cially in machinery and transpor­tation equipment, maintained aheavy demand for bank credit.

State and local governmentsremained in a relatively easy fiscalposition, helped by boom­generated tax revenues andfurther infusions of Federalrevenue-sharing funds. At thesame time, municipal-bondfinancing continued stronger thanin 1972; for the year to date, newissues have totalled about $2.2

Western farmers and ranchers benefit from soaring prices,with wheat being only the most conspicuous example

year-ago pace. During the thirdquarter, local governments inCalifornia and Arizona, and stateagencies in Alaska and Oregon,went to market with sizableissues.

Farming: banner yearWestern farmers this fall beganclosing their books on a banneryear. Total cash receipts mayapproach $11.0 billion in 1973,about 24 percent above lastyear's record, and net farm in­come cou Id rise even faster to arecord $3.3 billion, despite fallinggovernment payments and rap­idly rising production expenses.Sharply higher field-crop pricesand expanded fruit and vegetableproduction are contributing to arecord gain in crop receipts, off­set only partly by a drought­induced 17-percent cutback inthe Pacific Northwest's wheatcrop. Similarly, record price in­creases are boosting returns to

last summer's price freeze. Live­stock production has been run­ning below year-earlier levels,with cattle and calf slaughterduring the January-Septemberperiod falling about 6 percentbelow the comparable 1972figure. Prospects for livestockproduction now look more prom­ising, however, in view of thelifting of beef price ceilings andthe availability of bumper feedcrops. The number of cattle andcalves on feed this fall was about2 percent higher in California,and 4 percent higher in Arizona,than a year ago.

Aerospace: strongerThe Western aerospace industryremained a positive force on theregional employment scene,adding 13,200 workers to its pay­rolls between June and October.Total employment in the industrynow stands at S80,SOO-about1S percent above the mid-1971low but still about 2S percentbelow the late-1967 peak. BothCalifornia and Washingtonshared in the gain, which wascentered in electronic equipmentand aircraft and reflected thestrength of the commercialmarket for those products. Ahighlight of the Washington aero­space market was the strong paceof orders for the Boeing 747. Asof September, the Company hadreceived a total of 29 orders forthe wide-bodied plane, compared

160120

livestock producers substantially,more than offsetting a moderatedecline in the volume ofmarketings.

The sharp price rises underlyingthe Western farm prosperity re­flect to some extent the boom infarm exports. In fiscal 1973, West­ern farm exports jumped to anall-time high of $1.5 billion. Thesharpest gains were registeredby Pacific Northwest farmers,with the area's wheat exportsalone far more than doubling ina single year's time. Moreover,export demand for farm productsremains strong, especially forwheat, cotton and rice.

For livestock producers, 1973remains a difficult year despitesoaring prices and incomes. Theyhave had to contend with soaringfeed costs, along with the marketuncertainties arising from lastspring's consumer boycott and

Percentage Change (1972.3-1973.3)

o 40 80

EGGS

TURKEY

WHEAT

COTTON

BEEF CATTLE

with only 7 for the comparableperiod a year ago.

While the civilian sector hasbeen responsible for most of therecent strength in aerospaceemployment, the ability of theindustry to sustain employmentgrowth next year may well de­pend upon the emerging strengthof the defense market. The Arab­Israeli war may provide addi­tional thrust to an already evidentuptrend in military spending. ThePentagon has submitted a $2.2­billion supplemental budgetrequest, mostly to replace warmaterial furnished to Israel, andit may ask for more funds to buytransport planes and expand itsinventory of sophisticatedmissiles.

A slowdown in commercial­aircraft orders seems all butinevitable, on the other hand, inlight of the poor traffic and earn­ings reports emanating from thenation's major airlines, plus thecutbacks in scheduled flightsnecessitated by the current fuelshortage. lockheed has an­nounced plans to layoff 1,500workers by January, because ofthe decision of one of its majorairline customers to postponedelivery of nine l-1011 jetliners,and the profits outlook for thisand other aerospace manufac­turers has become somewhatclouded.

16

Construction: mixedThe pace of construction activityincreased during the third quar­ter, with construction awardsrising about 9 percent to a $15.4billion annual rate. The increasecentered largely in the non­residential sector: as a result, thisDistrict contributed more than itsshare to the nation's fixed-invest­ment boom. Non-residentialconstruction surged to new highsin virtually every state of the re­gion, with awards rising substan­tially for commercial, educationaland (especially) manufacturingfacilities. Heavy constructionactivity also advanced during thequarter, largely in response toincreased demand for water­supply and waste-disposalsystems.

In the residential sector, activitycontinued to recede from theearly-1973 peak, with a sharper­than-national decline. The num­ber of Western housing startsdeclined to a 422,000-unit annualrate, some 21 percent below the1972 pace. (The decline in dollarterms was less, reflecting thecontinued upsurge in construc­tion costs.) Mobile-home salesmeanwhile trailed last year's pacein most District states.

The early-1973 downturn re­flected a general weakening ofhousing demand, and thus pre­ceded the late-spring run-up ininterest rates. The more recentdecline, in contrast, reflected agrowing stringency on suppliesof available funds and an atten­dant rise in borrowing costs.

Western S&l's experienced a netoutflow of savings, because of thestrong competition from inceas­ingly attractive money-marketinstruments. (The bellwetherTreasury-bill rate rose from 7 per­cent in June to over 9 percent inmid-September-a full percent­age point above the early-1970tight-money peak). New savingsactually exceeded the year-agoinflow by almost 30 percent, buta doubling of withdrawals re­sulted in an overall net outflow of$165 million. California S&l'saccounted for all of the loss, how­ever; most other District statesrecorded continued (albeit re­duced) savings inflows. For theirpart, large District banks posteda net inflow of $313 million­several times the previous quar­ter's inflow-as a substantialincrease in consumer-type certifi­cate accounts more than offseta large loss in passbook savings.

The mortgage-lending pace re­mained at a fairly high level evenin the face of this overall slow­down in savings flows. District

100

Thousands

'73'70'65O~-'-"""L...I""""""'..L-IL-L."""...L-L­

'60

Housing Permits

Nonferrous-metals producerswere prevented by price controlsfrom raising their prices duringthis period, despite the world­wide boom in demand whichsent foreign prices soaring wellabove u.s. producer quotations.The outflow of metal to overseasmarkets combined with produc­tion problems to create seriousshortages, which in one case(zinc) forced a major steel pro­ducer to discontinue galvanizing

Regional housing activity showsdecline, measured on any basis

By October, wholesale prices forsoftwood lumber were almost4 percent below their May peak,while softwood plywood priceswere almost 37 percent lower.The turnaround was triggered bygovernmental actions to increasesupply, and the price declinecontinued as housing activityslowed. However, the closure ofsix Oregon plywood mills in mid­October, due to a shortage ofglues and fuels, touched off awave of scare buying, and initi­ated a 30-percent surge in pricesfor key items within a month'stime.

Materials: shortStrong demand and upward pricepressures characterized the mar­kets for most Western-producedbasic materials this summer andfall. The one major exceptionwas forest products, and eventhere a shift is now in the wind.Lumber prices had advancedalmost without interruption for2% years until last spring, butwere already dropping from rec­ord levels when the 60-day freezewas imposed in mid-June, sothat the Cost of Living Councilfelt safe in exempting the industryfrom Phase IV wage-and-pricecontrols.

S&L's increased their mortgageportfolios by $1.1 billion duringthe third quarter, partly by reduc­ing their cash and liquid invest­ments, and partly by drawing onadvances from the Federal HomeLoan Banks and other borrowings.District banks increased theirmortgage loans by $1.2 billion,with roughly three-quarters of thetotal in residential mortgages.Some individual banks becameless willing to make mortgagecommitments, especially formulti-family units, but banks gen­erally did not curtail their lending.

Mortgage borrowing costs rosesubstantially during the summerquarter, reflecting both the con­traction in savings inflows andthe rising cost of funds associatedwith the mid-year increase inrate ceilings payable on savings.The average rate on conventionalloans rose from about 8 percentin early June to almost 9% per­cent in late September, evenexceeding the rate increase re­ported nationwide. In October,however, a number of lendersbegan paring their lending rates-in some cases to 8% percenton prime-quality homes-inresponse to a decline in money­market rates and an improvementin bank and S&L savings inflows.

The West thus will be con-fronted with severe problemsbecause of the petroleum crisis,but it could also playa major rolein the long-term solution of thecrisis. On the consumption side,heating-oil problems could beless severe than elsewhere, atleast partly because of the mildertemperatures on the Pacific rim,where most of the region's peoplelive. Gasoline maybe a differentmatter, not only because West­erners rely almost completely onthe private auto as a means oftransportation, but also because •Western driving involves muchlonger distances than drivingelsewhere. On the productionside, the crisis has already has-tened Congressional acceptanceof the Alaska pipeline, and it mayalso hasten the exploitation ofRocky Mountain coal and shale-oil resources, which up to nowhave lain idle because of botheconomic and environmentalconsiderations.

Verle Johnston, Yvonne Levyand Dean Chen

supplies from Canada-anotherlarge exporter-also will beaffected by the Arab moves.

Western refinery activity isbound to decline as a result of theArab embargo on oil shipmentsto this country and related cut­backs in their shipments to othernations. Prior to the embargo,Arab states were supplying overone-third of the crude oil im­ported into the Pacific region, but

Western oil refineries boostedtheir operations to near-capacitylevels during the summer andearly fall, and thereby recorded a7-percent year-to-year increasein output. Foreign crude flowedin at an increased rate after mid­April, when the Administrationsuspended oil-import quotas andremoved existing tariffs on crudeand products. These imports morethan made up for the continueddecline in domestically-producedcrude.

which induced Japanese pro­ducers to turn to other markets.Despite its improved balancesheet, the domestic steel indus­try was one of the first to receivepermission to boost its pricesafter the freeze was lifted thissummer. The Cost of LivingCouncil supported industry argu­ments that a 4.8-percent increasein prices for sheet and strip itemswas justified on the basis ofhigher costs, as well as necessaryto finance the new capacity re­quired to prevent a future "steelcrunch."

operations. Fearful that supple­mentary supplies from the gov­ernment stockpile would soonrun out, producers asked Con­gress to authorize the release ofadditional stockpile metal, butpassage of such legislationseemed remote because ofnational-security considerations.

Pacific Northwest aluminum pro­ducers were hard-pressed tomeet customers' heavy demandsbecause of a shortage of hydro­electric power. This drought­caused shortage forced a cutbackin operations to 75 percent ofcapacity by mid-July. During thesummer months, the domesticindustry relied on governmentstockpile metal to meet 20 per­cent of customers' total require­ments, but by November all ofthe aluminum authorized for salehad been withdrawn, pointing toeven more serious supply prob­lems in future months.

The Western steel industry ex­perienced the highest third­quarter production levels in itshistory, as output surpassed theyear-ago mark by 10 percent.The industry benefited not onlyfrom the strong demand for steelfor non-residential construction,but also from a slowdown in theflow of foreign imports. Steelimports tapered off in responseto the devaluation of the dollarand strong overseas demand,

18 .it_ __l1lil1lil1li111·[1I-1II•••••••·•••1lI•••••· ·· ...•[.111111 •·•

Commercial banks, regionally aswell as nationally, continued tomeet heavy boom-level loandemands during the third quarterof the year. Money-market ratesincreased steadily, pushing bankcosts for funds to record highsand posing problems of disinter­mediation. Banks also had tomeet higher reserve requirementsagainst demand deposits, as wellas newly imposed marginalreserve requirements on certainoftheir deposit and non-depositsources of funds. To counter thesedevelopments, banks madenumerous increases in their primebusiness-loan rate, to a record 10percent, and bid aggressively forlarge-denomination time certifi­cates (CD's), and also for four­year certificates during therelatively brief period in whichrate ceilings were removed onthese deposit instruments.

In late September and October,however, there was evidence ofsome slackening in bank-creditdemand. Money-market ratesmoved down from their recordhighs; also, banks bid less aggres­sively for funds and (in October)lowered their prime rate gener­ally to 9% percent.

Loans at Western banks rose by$2.5 billion in the July-Septemberperiod. This increase representeda 15-percent annual growth rate,slightly higher than in the pre­vious three-month period butonly half as large as the spectac­ular first-quarter gain. Theregional loan expansion laggedsomewhat behind the nationalpace during the summer period,reflecting a slowdown in busi­ness-loan growth which actuallybegan as early as last May. On theother hand, mortgage lending inthe West accelerated from analready rapid pace and contrib­uted nearly half of the total third­quarter loan increase.

To accommodate these heavyloan demands, District banks re­duced their holdings ofTreasurysecurities by $800 million, butpartially offset this reduction byadding $350 million in tax­exempt and Federal-agencysecurities. Banks also increasedtheir borrowings from the Fed­eral Reserve Bank and throughrepurchase agreements with cor­porations and public agencies.But the major source of funds forthe third-quarter credit expansioncame from a $2.1 billion increasein time deposits, mainly in large­denomination CD's.

19

Business loans finally level off at Western banks ...security holdings increase, and CD upsurge tapers off

Billions of Dollars

A decrease in the demand­deposit component was due to alarge decline in U.S. Governmentdeposits, as the Treasury randown its balances to unseasonallylow levels. As monetary pressuresmounted, private demand de­posits slowed to a 3-percentexpansion rate, down from thehigh 12-percent rate of theJanuary-june period. Even thetime-deposit rise, at an 18­percent rate, represented somereduction from the first-half paceas banks began to feel the effectsof disintermediation.

Deposits mixedTotal deposits at District memberbanks increased by $1.9 billionin the third quarter. This 11­percent annual growth rate waslow only in relation to the excep­tionally high rates recorded dur­ing the first two quarters of theyear. Incidentally, it was some­what greater than the third­quarter gain reported by bankselsewhere in the nation.

Individual deposit componentsmoved in divergent directions, asis evident from an examination ofunadjusted data for large Districtbanks. By July and August, dis­intermediation at these bankswas seen in a sharply higher out­flow of passbook savings. Theirthird-quarter decrease amountedto $573 million, or several timeslarger than the normal seasonal

1973

Not seasonallyadiusted

1972

Security Holdings

Business loons

1971

Ratio Scale

4

8

16

20

20

decline reported during the pre­ceding quarter. However, attri­tion at banks was relatively smallcompared with the withdrawalrate of savings-and-Ioan associa­tions.

The more favorable bank experi­ence was surprising, since manymajor banks retained a 41/2­percent rate on savings instead ofmoving to the 5-percent ceilingpermitted under Federal ReserveRegulation Q as of mid-year.However, most District banks in­creased rates on other consumer­type deposits to their higherceilings, so that these time de­posits rose $886 million in thequarter. Of this amount, over$200 million was in certificateswith 4-year maturities-the "wildcards" which were freed fromrate ceilings onJuly 1.

The volume of "wild card" de­posits doubled, but this percent­age gain was only one-fourth aslarge as the increase reported bybanks elsewhere, perhaps reflect­ing the less-active bidding forsuch deposits on the part ofWestern banks. But these longer­term deposit instruments are nowlikely to become a less-importantsource of bank funds, in view ofthe 7% -percent rate ceiling thatwas reimposed on November 1.During October, however, theygrew rapidly in response to offer­ing rates as high as 71/2 percent.

The most significant change,however, was the $2.6-billionincrease in large-denominationnegotiable CD's. Last spring'sremoval of rate ceilings on suchdeposits permitted banks to bidcompetitively for corporate andother funds, in contrast to thesituation in 1969 and early 1970,when severe attrition occurredbecause ceilings did not permitCD rates to rise as high as therates offered on other money­market instruments.

Western banks were particularlyaggressive in bidding for CDmoney during the July-Septemberperiod; outstandings rose 28 per­cent in this period alone, sub­stantially above the increasereported by large banks nation­ally. (But at the end of the quarter,CD's accounted for only one­fourth of time-and-savings de­posits at District banks, comparedwith a one-third share nationally.)Some of the funds acquiredthrough issuance of CD's servedto offset the large $855-milliondecrease in deposits of states andpolitical subdivisions-a some­what greater-than-seasonaldecline.

Record ratesRising interest rates this summerpresented banks with serious costproblems in the face of continuedstrong loan demand and a restric­tive monetary policy. The Federal

Reserve discount rate went to arecord 71/2 percent in mid­August, and the Fed-funds rateand CD offering rates reached101/2 percent or more at theirSeptember highs. Banks there­upon took a number of actions inthe third quarter to increase theirreturn on earning assets.

They made nine increases, of 1/4percentage points each, in theprime rate for large businessborrowers, bringing this rate to arecord 10 percent in mid-Septem­ber. However, in line with therate guidelines ofthe Committeeon Interest and Dividends, banksmade smaller adjustments in ratescharged to smaller business cus­tomers. Fewer and smaller ad­justments also were made inmortgage-loan rates and rates onconsumer loans.

For many banks, their most im­portant cost decision was a neg­ative one-not to increase therate paid on passbook savings tothe 5-percent ceiling permittedunder the revised Regulation Q.The cost reduction obtainablefrom maintaining a 41/2 -percentrate was quite substantial, sincesavings deposits at District banksexceed $21 billion.

21

The higher loan rates that wereapplied to the expanded loanvolume produced increases inincome for most Western banks,both before and after adjustmentfor securities transactions. But thewide variation in individual bankperformance, already noticeableearly in the year, was very markedduring the third-quarter. Duringthat period, some major banksrecorded lower earnings, eitherbecause of special circumstancesor because of large borrowingsand heavy reliance on high-costCD's.

Higher required reservesRequired reserves of Districtmember banks rose by $219 mil­lion in the third quarter, to $5.7billion, at least partly because ofan increase of about $2.0 billionin deposits subject to reserves. Inaddition, reserve requirementsagainst net demand depositswere raised by 1;'2 percentagepoint in mid-july. Also, marginalreserve requirements (over a mid­May base) were imposed in juneand early july on large-denomi­nation CD's, as well as on fundsobtained from sales of financebills and funds obtained throughissuance of holding-companycommercial paper. A further in­crease in marginal reserve re­quirements became effective inearly October.

22

As monetary policy became morerestrictive, banks borrowed moreheavily at the discount window tomeet their reserve requirements.Borrowings from the San Fran­cisco Federal Reserve Bank rosefrom $174 million in the secondto $195 million in the third quar­ter. On the other hand, majorDistrict banks reduced their netpurchases of Federal funds byabout one-fourth to $275 million.(But these aggregate figures donot reveal the continued heavyreliance by some banks on theFed-funds market as a source ofborrowed funds.) Repurchaseagreements with corporationsand public agencies providedbanks with their largest source ofborrowed funds-over $2.3 bil­lion, for a one-third increase overthe prior quarter. (Data on re­serves and borrowings are on adaily average basis.)

More favorable setting?As the economy showed signsthis fall of gearing down to a moresustainable rate of growth, loanpressure on banks abated some­what, although pressure onreserves continued restrictive. Itshould be noted, however, thatsome of the recent slackness inbusiness-loan expansion was dueto the diversion of lendingto thecommercial-paper market whichfollowed the drop in the paperrate below the banks' prime rate.In addition, some easing in termlending began to occur in thewake of heavier corporate bor­rowing in the capital markets.With business-loan volume de­clining and money-market ratesfalling, banks lowered their primerate from 10 to 9% percent in lateOctober, and some even went aslow as 91;'2 percent.

Mortgage rates at some Westernbanks dropped from 9112 to 91/4percent this fall. Although real­estate loans have continued toexpand at a relatively rapid rate,a slowdown is expected as res­idential construction stays on itsdowntrend. Meanwhile, the highratio of consumer debt to income

Federal Funds

Percentapparently is being reflected in areduced expansion rate in instal­ment credit. As overall loan de­mand eases, banks should be ableto replenish their holdings ofsecurities and improve the col­lateral-shortage problems thathave been plaguing some of themin recent months.

District banks borrowed less fromthe San Francisco Reserve Bank inOctober, but they continuedunder reserve pressure with theFed-funds rate holding around9% to 10 percent. The threat ofdisintermediation lessened, andbanks showed a small gain inpassbook savings as well as con­tinued expansion in consu­mer-type time deposits. Inthis situation, banks bid lessaggressively for negotiable CD's,running off over $800 million inthese deposit instruments. Banks'earnings prospects improved inOctober as the cost of CD moneyfell, but the picture clouded againduring November's energy/financial crisis, which saw money­market rates stiffening again.

Ruth Wilson

11

10

9

8

7

6

5

4

1971

Prevailing Prime Rate'\

1972 1973

Bank borrowing costs decline (at least temporarily)in early fall, permitting drop in prime business-loan rate

23