BUDGET PROCESS DEFINITE STEP FORWARD

If I may, Mr. Chairman, I would like to conclude with a comment or two on the still new Congressional budget process. For my part I believe the budget process has been a definite step forward, and a remarkably successful step thus far. It has provided a mechanism whereby Congress can, an does, determine fiscal policy, focusing on the budget as a whole instead of making a series of isolated, unrelated decisions. It has enabled Congressional Committees, and the Congress as a whole, to address directly the difficult questions involved in setting appropriate levels of government spending, revenues and deficits and to make decisions on budget priorities in an overall framework. As I have watched the process I have been impressed by the way Congress has adhered to the concurrent resolutions, including the targets set forth in the first concurrent resolution each year. I feel strongly that the entire process has served as a useful self discipline and restraint on spending without becoming unrealistically rigid. Some have suggested, and I am sympathetic to their suggestion, that there should be greater attention paid to the longer run aspects of the budget process. Since so many of the programs impact more than one year it seems sensible to me for Congress to do what it can with respect to advance multi-year targets and to a review of the future implications of budget choices and decisions.

OFF-BUDGET ACTIVITIES

Finally, one aspect of the budget that I feel is too often neglected is the so-called off budget activities, loans, guarantees and quasi-governmental operations. When you add the new credits involved in these off-budget activities to the proposed within budget direct spending the total budget picture changes and becomes even more expansive, and the related public borrowing necessities loom even larger. The result of that is to impact on private sector borrowing and to reinforce the upward pressures on interest rates. Thus I would close my remarks here this morning with a plea to you to give more careful scrutiny to the off budget programs and activities. A BUDGET SUPPORTIVE OF NON-INFLATIONARY EXPANSION

Obviously, Mr. Chairman, my comments as to national policy reflect in no small part my experience and contacts in this fine community and region. As I sense the things that are disturbing people here it is an uncertainty and unease regarding the extent and character of Government regulations, the future rate of inflation, the weakness of the dollar particularly as it impacts on the stock market, and the energy outlook as it affects costs and the quality of life. If our people here are worrying about these things I suppose it must be true more generally in the country as a whole. As we get an energy program in place and if we formulate a budget that is supportive of a noninflationary expansion, rather than overly expansionary, I believe we will have a resurgence in confidence that will assure continued sustainable economic growth and expansion in 1978 and well beyond.

PERSPECTIVE ON THE INTEREST RATE OUTLOOK

REMARKS OF J. DEWEY DAANE, FRANK K. HOUSTON PROFESSOR OF BANKING AND FINANCE, OWEN GRADUATE SCHOOL OF MANAGEMENT, VANDERBILT UNIVERSITY, AND CHAIRMAN, INTERNATIONAL POLICY COMMITTEE, TENNESSEE VALLEY BANCORP, INC., AT THE Sixth AnnuaL BANK INVESTMENTS CONFERENCE, AMERICAN BANKERS ASSOCIATION, FAIRMONT HOTEL, Dallas, Tex., FEBRUARY 8-10, 1978

When George McKinney first contacted me last July about being on this program I was on vacation at our summer home in northern Michigan and, of course, readily acquiesced to a talk in February. At that time he asked me to give a "nonmonetarist, academic" view of the interest rate outlook. I immediately thought that some might view this as a contradiction in terms, although I believe that there are many academicians besides myself (perhaps even the silent majority) who do not subscribe to the gospel according to Milton, or at least not to anything like the same extent, in looking at the appropriate role of monetary policy and the best means of implementing it. My own credo which I have stated many times before is simply

this:

that money matters-certainly

that money alone matters-certainly not

that monetary policy matters-certainly

that monetary policy alone matters-certainly not

"PRACTICAL MONETARISM"

Two of my distinguished friends in the financial arena, Paul Volcker and Henry Kaufman, defend "practical monetarism" as a way of credibly communicating policy. But this credible communication process has had not so credible (or desirable) results in terms of unsettling markets and increasing interest rate volatility nor has it had seemingly much success in reducing inflation. And to the extent a monetarist approach has been adopted in other countries there seems to be little progress in stimulating a noninflationary expansion. Here at home sensitivity of policy makers to short run changes in the monetary aggregates has only served to make the market paranoiac-as some of us thought it would—and made it difficult, if not impossible, for monetary policy to move gradually and imperceptibly toward its goal. Instead the market has been constantly whipsawed, and the consequent interest rate gyrations have been of benefit only to the sophisticated investors in the Government securities market and related capital markets. Preoccupation with the growth rates in the monetary aggregates is not confined to our own domestic observers; foreigners as well follow closely the weekly published figures on the U.S. money supply.

MONETARY POLICY FLEXIBILITY

The result has been to increase de-stabilizing movements in the market and to take away the ability of monetary policy makers to engage in probing operations to test their own wisdom against the market as to market conditions and policy implications. Now the market all the time is trying to congeal around what they think the Federal Reserve is going to do. Consequently the Federal Reserve policymakers can no longer learn from the market, and the capabilities of public policymaking have been correspondingly reduced. This has been reinforced by Congressional insistence forcing the Federal Reserve into earlier public release of its targets and actions. But the present unduly short time interval has affected the market so much that it is constantly poised around actual or expected Federal Reserve decisions which has, in turn, made the Federal Reserve unduly self-conscious and deprived it of needed flexibility in action. And I might add that the Federal Reserve has not helped itself on this score by its overly close monitoring of the Federal funds rate.

In any case, if our monetary policy is to be kept flexibly attuned to the business outlook there might well be less effort to correct for temporary aberrations in the aggregates which, if past is prologue, are inexplicable and unexplainable even to, and by, those most knowledgeable and experienced in dealing with projections of, and movements in, the aggregates.

DISSATISFACTION WITH MONETARIST APPROACH

My dissatisfaction with the purely monetarist approach, even when presented under the guise of "practical monetarism," has generally revolved around a number of facets.

(1) The first is the admittedly imperfect relationship between money and other economic variables. The monetarists have never provided a satisfactory explanation of the linkage between money supply and GNP, and their own empirical evidence shows an extremely high proportion of cases of at least equally nonexplainable nonlinkage. Studies like George Perry's at Brookings, for example, certainly do not support the simple view that deviations in trend growth of the money supply are responsible for real economic developments.

(2) Second, the monetarists have generally had to shift ground in picking particular monetary aggregates in differing circumstances, in determining relative weights to be assigned, and the particular aggregates themselves have changed drastically in character and meaning in the technological age of banking in which we are living. Unexplainable large shifts in the growth of the aggregates, and wide deviations from estates, lead to uncertainty as to their policy implications, as does the unpre dictability of velocity.

(3) Third, rigid adherence to a fixed rate of money growth is distinctly unappealing to one who thinks we ought to make use of judgment to do what we can countercyclically, rather than tie our hands, in terms of appropriate monetary policies, and in so doing give consideration to the sectoral effects and market impacts, both domestic and international, of changes in the supply and cost of money. A commit

ment to fixed monetary targets limits the abiity of the monetary authorities to respond quickly to specific changes and circumstances.

(4) Fourth, the sole emphasis, or over-emphasis, on the aggregates' movements reflects a sublime disregard for the significance of interest rate movements and particularly those rate changes reflecting expectations. While focusing attention on aggregates may help divert Congressional concern over interest rates, the economy still remains responsive to rates.

(5) Fifth, the position of many monetarists that fiscal policy does not matter, or only matters in so far as it affects the aggregates, has never seemed to me to be realistic or helpful to monetary management. To view a $60 billion budget deficit as irrelevant, or to ignore the consequences of not accommodating a given deficit, is unreal to me. Eliminating the linkage between fiscal stimulus and monetary management-proclaimed by adherents of practical monetarism-is to me not a step forward in rational policy-making.

(6) Sixth, and finally, the whole monetarist assumption of causality troubles me in the inflationary age in which we live. The assumption that a constant money growth can somehow prevent or roll back an inflation caused by other forces, such as energy costs, wage increases outstripping productivity gains, etc., is to me another heroic abstraction from the real world.

All of these comments on monetarism, however, are really a prologue to my broader focus here today, since a few weeks ago George McKinney "freshened the but" to use golfer terminology and broadened my assignment to that of looking at the impact of international developments on the economy and, correspondingly, on monetary policy and money markets. But the analogous need for discretionary judgment in the international area is just as clear to me, and flexible monetary policy also means more room to reflect international considerations.

WEAKNESS OF THE DOLLAR

In looking outward at the international factors affecting us the focus these days inevitably, and understandably, shifts to the continued weakness of the dollar and to the continued inadequate economic recoveries in the industrial countries-twin concerns that are not unrelated. To begin with my conclusions, they are as follows:

ATTRIBUTABLE TO TRADE DEFICIT

Conclusion No. 1. The weakness of the dollar is primarily attributable to our massive trade deficit, which in turn is not just due to the imported oil component, important though that may be and is. But there is also considerable skepticism abroad, as well as at home, as to whether we have the political will and leadership to combat inflation and design an effective energy program. While the President's energy proposal may be an essential first step-and a first step is essential-it will in itself not bring an early reduction of our oil import bill, and it will adversely affect the inflation rate.

ADVERSE IMPACT ON ECONOMY

Conclusion No. 2. The dollar weakness has adversely impacted on our domestic economy and our financial markets. It has unquestionably added to the inflationary strains here at home, and is continuing to do so, and it has been an additional element of uncertainty disturbing financial markets and reinforcing the trend to higher interest rates.

AFFECTED INVESTMENT SPENDING

Conclusion No. 3. This additional uncertainty has adversely affected investment spending at home and abroad. Consequently it has been a not insignificant factor in the slower than expected rate of capital spending all around and in the relatively weak performance of the economies in other industrial countries.

REAL AND POTENTIAL TRADE EFFECTS

Conclusion No. 4. The exchange rate movements and uncertainties, and the real and potential trade effects, have led to an incipient wave of protectionism and to a weakening in the commitment of some countries to a system of international trade free from restrictions and discrimination.

FACTOR LEADING TO HIGHER INTEREST RATES

Conclusion No. 5. There is another dimension to the dollar weakness that applies directly and specifically to the possible developments in our money markets. For the dollar is not simply a national currency, and possible shifts in demand for dollars may be amplified by the international role of the dollar and the large reservoir of

mobile dollars outside the United States. Thus a decreased appetite for our securities on the part of foreigners could be an additional factor leading to higher interest rates. And there are already some indications not of a shifting out of existing assets but of a channeling of new funds into non dollar assets. What we need to do is to create a climate in which voluntary demand for dollar assets replaces involuntary acquisitions reflecting intervention.

DEFENSE OF THE DOLLAR

Conclusion No. 6. The decisions reached jointly by the Treasury and Federal Reserve to intervene in defense of the dollar and the subsequent decision by the Federal Reserve to raise the discount rate for international considerations make good sense, and in terms of the domestic economy as well.

CAUSE OF TRADE DEFICIT

Looking at these conclusions in a little more orderly way, I think one would begin with our trade deficit and its causes and implications. The U.S. trade deficit widened last year from roughly $6 billion in 1976 (Census basis) to close to $27 billion in 1977. Many observers focus entirely on the oil imports, noting that the some $45 or $46 billion of oil imports far exceeds the trade deficit. But I think it is important to note that oil imports still account for only about one-third of total imports, and while about one-half of the $21 billion deterioration in our trade balance between 1976 and 1977 was accounted for by an increase in oil imports, another half was accounted for by a decline in our non-oil trade balance. Much of this may be cyclical but there are disquieting signs of a deterioration in our underlying competitive position.

PRICE ELASTICITY IN IMPORTS

Why has the dollar weakness and the corollary improvement in our terms of trade not led to an improvement in our exports, decline in imports, and a diminution of our trade deficit? Why has it been disequilibrating rather than equilibrating up until now? The answer I think lies in part in a stretched out J. curve-one with a longer than expected time lag-and in part is due to lower than expected price elasticities. As our dollar depreciated this past year-by 4 percent on a trade weighted basis overall, by 13 percent on a trade weighted basis excluding Canada, and against the major currencies by 26 percent against the Swiss franc, 23 percent against the yen, 15 percent against sterling and 13 percent against the D-mark-as the dollar fell, the immediate effect was to cause a rise in the cost of imports rather than any marked acceleration of exports. All too often I think what is overlooked is the lack of price elasticity in the demand for imports (most notably in Germany and Japan but also in the United States and the structural impediments to imports. In time perhaps some offsetting adjustment may take place-perhaps more because of the domestic expansion measures taken by the Germans and Japanese than because of the changes in exchange rates, although the latter should ultimately lead to some improvement. Meantime the United States will continue to face a substantial deficit on trade account, and also on current account, this year and beyond. In my judgment then we can expect a continuing large outflow of unwanted dollars.

This outflow which threatens the viability of any international monetary system, floating or otherwise, definitely carries the seeds of protectionism, and there is disquieting evidence of pressures for protectionism in the major trading countries, including our own. The dangers and disadvantages of protectionism need little elaboration with this audience. The lesson of the 1930's was that it can only lead to a shrinkage of world trade without removing the fundamental difficulties of individual countries in terms of unemployment, inflation, etc. But too often governments forget the clear lessons of history, particularly when political pressures point the other way. One problem is that the cost of imports in terms of lost jobs is very clear and politically has higher visibility, while the cost of import restrictions in terms of higher prices to the consumer is diffuse and politically has low visibility.

DEFENSE OF THE DOLLAR

The main thread of my remarks here today obviously leads me to conclude that the Treasury and Federal Reserve are on the right track in giving renewed emphasis to international considerations. After long hesitation-too long in my judgment-the U.S. finally began again to intervene to defend the dollar in the foreign exchange markets-and this time in a much more substantial way-and to use our domestic policy instruments also to support the dollar. I would applaud both efforts. On the intervention side there still must be enough short positioning of the dollar that aggressive operations could further strengthen the dollar in the near term, just

as they did in early January. In fact, I have been wondering also about the possibility and desirability of another so-called "operation twist" whereby the Treasury in its debt management operations undergirds short rates while the Federal Reserve in supplying reserves emphasizes the buying of long issues, serving as a drag on an undesirable rise in long rates. I recognize the argument that our problem is more of a goods flow than a capital flow problem, but I continue to believe that interest differentials, and the responsive flows and their effects, are important.

DISCRETION IN EXCHANGE RATE MANAGEMENT

This brings me full circle in my remarks here today. I begin with a plea for discretion in domestic monetary management rather than the imposition of a fixed rule for monetary growth. And I end up with a defense, not of pegging but of exchange rate management. This is not to say that I have any preconceived notion of what our exchange rate ought to be, although I cannot help but believe that the dollar is undervalued, particularly if we manage somehow to move ahead, and not lose ground, on the energy and inflation fronts. But there was a clear need to intervene to stop the sort of self-reinforcing market panic and flight from the dollar that had carried rates beyond the parameters associated with real economic factors, and to permit the market itself to make a more orderly appraisal of the basic forces within more realistic and supportable parameters. Clearly intervention has dispelled expectations of an endlessly falling dollar and regenerated uncertainty, but perhaps adroit management could lead to expectations of a rising dollar more consistent with the basics.

INTEREST RATE FORECAST

Finally, George has asked each of us on the panel this morning to "close out with a broad interest rate forecast, both short and long." As far as the rate outlook is concerned, one's view of necessity relates to how one sees the course of the economy over the year ahead. Here as I look at the components of aggregate demand I am relatively optimistic and look forward to a possible further rise in GNP again this year in the neighborhood of 5 percent in real terms. The key factors in this view are continuing strength of consumer spending as income and employment rise, some acceleration in business spending, notably capital spending, and rising government spending with sharp acceleration of state and local government outlays. While business investment spending is not rising as much as had been expected or hoped at this stage of an expansion, the crucial point is that it is still rising, and significantly so in dollar terms. And so is our federal budget deficit. I would therefore, not expect credit demands to be less in the period ahead and, more likely, to increase. More importantly, I am not so optimistic as to the course of inflation. If in fact we prove to be on an inflationary course, as many are predicting, one that leads to a higher rate, and a rising trend, of inflation in this country by the end of 1978, inevitably this will impact on interest rates. And I have already indicated that there is another possible dimension to the dollar weakness that could apply to the developments in our money markets. Here my concern is that with an increased supply of Government securities coming into the market, reflecting growing rather than decreasing federal budget deficits, any decreased appetite on the part of foreigners could add an additional amount of upward pressure on interest rates. For if my arithmetic is anywhere near right, foreigners, on a net basis, absorbed the equivalent of over half the new issues of U.S. Government securities last year, and a diminution of voluntary foreign demand, reflecting widening distrust of the dollar, would inevitably impact rates adversely.

MONETARY POLICY

As far as monetary policy is concerned I think the Federal Reserve has done an excellent job of maintaining a moderately expansive, noninflationary stance. I would hope they could continue this posture even if it reinforces the possibility of some further increase in interest rates. Since the announcement regarding Chairman Burns' replacement, many people have immediately and, in my opinion, mistakenly jumped to the conclusion that there will be a major change in the course of Federal Reserve policy once the new Chairman comes on board. I think that this is a mistake both expectationally and substantively. While the Chairman's role is, indeed, more than that of one among equals in the formulation of Federal Reserve System policy, the System is a larger and slower moving organism than generally assumed. There are a large number of policy-makers involved, and the System does not change direction (or often even degree) of policy that rapidly without clear justification, and there is nothing at the moment in the domestic economic outlook

27-922 O 78 - 5