real terms exceeds the normal growth rate by at least 2 percentage points.

Whether monetary and fiscal policy will or will not in fact turn out to have "accommodated" a 12.5-percent increase in money GNP for this current year is not firmly predictable because the quantitative relations on which such a prediction would have to be based are not sufficiently dependable.

But I hope, and I am inclined to believe, that our monetary and fiscal policies will turn out not to have accommodated such a rapid rise in the third year of the present recovery process.

In the first place, in my appraisal it would be a big mistake to make room in our demand-management policies for a 62 percent inflation rate in a year that so far has brought to a 6- to 7-percent annualized increase in adjusted hourly earnings and has brought rising labor productivity. And I think my conclusion would be the same if I started from compensation per man-hour rather than from adjusted hourly earnings. I think it would be a big mistake to make room in one's conception of a desirable course for a 612 rate of inflation from the last quarter of 1976 to the last quarter of 1977.

Indeed, the fact that the administration is taking the posture implicit in its midyear projection may in itself have adverse consequences for wage and price developments during the remainder of the year.

Second, our past failures-the lack of sustainability of the high levels of activity we occasionally achieved-have much to do with the fact that in the expansion phases of the cycle we became overambitious, and 5.5- to 6-percent real growth in the third year of the present recovery is very rapid growth.

It follows from this appraisal that during the first half of 1977 it would have been preferable to obtain a somewhat lower real growth rate than that which we had, which was 7 percent, annualized, because the slowing of real expansion will in any event have to be somewhat less gradual than would be most desirable.

The risks of a cyclical downturn developing from an initial slowing of real expansion are always greater when the initial impact expresses itself in an abrupt slowing than when the initial impact leads merely to a very gradual diminution of the rate of expansion.

This problem of the abruptness of the required slowing is much more likely to become serious if in the remainder of the year we try to move at a rate very far in excess of what is sustainable in the long run than if we set a more moderate pace.

As for interest rates, I would expect the short rates to rise above their present levels even if policymakers should succeed in getting the inflation rate down to the 5- to 512-percent range rather than have it come out at well over 6 percent from the last quarter of 1976 to the last quarter of 1977. Yet if the markets could be convinced that our policymakers will make a genuine effort to gradually reduce the rate of inflation to insignificance over the next few years, then the long rates would gradually decline, and not even temporarily would they increase along with the short rates. On the other hand, fear of renewed acceleration of inflation would bring about a rise in the long rates.

Now I will end with a very brief comment on the question of what I would call the weight of the Fed in the decisionmaking process.

During the past 4 years, the views represented by the Fed have been more consistent with those expressed in this testimony than have been the views of many policymakers who are more directly under political pressures reflecting short-run considerations.

Our troubles, and the even greater ones experienced by some other countries, have been caused very largely by an orientation of the political decisionmaking process to short run objectives.

I would like to end this testimony by placing emphasis on the importance of keeping the weight of the Fed in the joint decisionmaking process intact a goal that can be achieved only if the present degree of independence of the Fed is not curtailed.

Thank you very much, Mr. Chairman.

The Chairman. Thank you, Dr. Fellner.

I would just say that the advice given by someone like yourself M2 for this year, at least, should be located at the upper end of the range, around 10 percent; in addition to the advice that you have given for some time now, although not in this paper, on attacking structural unemployment in which you emphasize that it ought to be on some sort of rifleshot public service jobs program; if that is conservative advice. I am a conservative all the way, because I think that is excellent advice. Your papers have been simply splendid.

I want to ask the one question I will have on something that is very much in the public eye these last few days, namely, the alleged international condition of the dollar, which is supposed to be weak. I reject that view.

Let us see whether you would agree with my view, which is that the international value of the dollar ought to be determined by supply and demand. This is one place where Adam Smith was exactly right. Except for disorderly market conditions, where central bank intervention is needed, central bankers ought to resist the temptation to intervene.

My own view is that the dollar probably is close to all the depreciation it is going to suffer, vis-a-vis the major currencies. It is down 10 percent against the yen, which I believe is a good thing. The yen was misvalued. I would think that we need to do three things about the international dollar:

First, hew to maximum-production, maximum-employment, maximum price stability guidelines for our domestic policy, which has been in the laws since 1946.

Second, do our best to conserve energy, and thus cut down on our oil imports. They are a crucial part of what seems to be a temporarily overlarge trade deficit.

Third, let our central bank, and all other central banks keep their hands off, and not do any intervening, except for disorderly market conditions. Equally, let us not have our central bank, as Dr. Heller suggested, conceive that it has got some Heaven-sent mission to raise interest rates now, just for international purposes, to attract foreign capital here, because I think that would be counterproductive and end up causing a recession which would cause foreign capital to depart. Those at least would be my views, and I continue to put my money where my mouth is by taking my salary in dollars. I don't exchange it into marks, or yen. I have great confidence in the dollar, and I hope this symbolic act will go far to allay foreign fears.

You see, I think this controversy in the press between the Fed and the Treasury is of no bloody use whatsoever. People aren't saying what they mean. I have tried to say what I mean. I would like to get your comment, and corrections, and improvements.

Dr. FELLNER. I do believe that the market should set these exchange rates; and that intervention, aside from exceptional circumstances, is to be avoided.

What I do not know is whether the markets were not influenced in the past few months by statements repeatedly made by American policymakers, according to which the mark, the yen, and some other currencies should be driven up in the markets, because that did imply intervention either by the United States or by some other countries.

And I think that the suspicion may have arisen that if the other countries are not doing it, then we are going to do it. And if we are going to do it, then that does indeed mean that the dollar will decline.

So I don't know how much of the decline in the dollar was attributed to this. Basically I think the situation that has developed for the current year in the United States, is this: That somehow larger capital inflows will have to develop or lesser capital outflows for this year than for last year. That may be a difference of about $10 to $15 billion, the difference between 1976 and 1977, concerning capital flows. That much more capital will have to be attracted, somehow.

Now I think there have been enough changes abroad that would suggest to me that this might come about without any substantial changes in the relevant variables quite nicely, and more or less automatically. After all, some of the countries abroad have become increasingly less. promising areas for investment, as compared to ourselves.

And that would mean that there will be no substantial interest-rate effects. There don't have to be any substantial interest-rate effects in order to attract this amount of capital.

If that should not be so, for some part of the needed capital, then on the other hand I believe interest rates will rise regardless of who does what about it. Because once we take these current account conditions for granted during the year, then those capital movements will have to develop. And of course interest rate changes would be one variable that would attract this additional capital.

But I would be rather optimistic in this regard and believe that this is not really very much additional capital, as compared to last year, judging by the standards of the world economy, and that there have been a number of changes abroad which would, I think, increase preferences for buying American investments rather than other investments.

The CHAIRMAN. Dr. Heller, would you address yourself briefly to that?

Dr. HELLER. Well, I will ally myself with the chairman and with Dr. Fellner, in bowing before flexible exchange rates. I think that is a consummation devoutly to be wished.

We shouldn't, however, assume that central banks are ever going to keep their I thought you were going to say "their cotton-picking hands off" of the exchange relationships. There is always going to be some intervention by some banks. There is no way you can prevent

that. And you just have to hope it will be benign, rather than malignant.

Now a second thought here is that the general motto is "talk is cheap." Well talk, this time, has been rather dear, in the sense that the talk by Secretary Blumenthal and by our administration, that Japan and Germany, the other two economic powerhouses of the world, ought to bear their fair share of the OPEC oil deficit, with which I agree; that that talk has had something to do with the deterioration and the depreciation and the weakening of the dollar.

Now all those are bad words. I would just observe that the other side of that international coin, weakening of the dollar, is strengthening of our trade position. We use all the wrong semantics, as it were, to condemn a little weakening of the dollar-which in present circumstances is a good thing.

Now what about policy? Well, we should keep our cool, without being complacent. We should gradually check, and then cut, oil imports. I think we all agree on that. We ought to keep the pressure on Germany and Japan to do their share of financing that deficit. And we ought to keep the U.S. economy competitive and expanding.

Now that leads to several "dos" and "don'ts." Starting with the don't, don't go protectionist. That would be the worst way to deal with this problem. Don't raise interest rates.

Do stimulate cost-cutting and capacity-expanding investment. And finally, do fight cost-push inflation more aggressively. I think that is one of the weakest parts of our present policies in this country. Because, apart from the kind of careful and well modulated fiscalmonetary policy to which Dr. Fellner has referred-I don't really subscribe to his formula-that is a prerequisite to cutting inflation. But, in addition to that, you have to have deregulation, bottleneck spotting, rebuilding buffer stocks, careful policing of the Government's own inflationary crimes and misdemeanors. Most important, we have to get on with this job of challenging and discouraging excessive price and wage increases in the private sector.

That job will be all the harder if we cave in on price supports, minimum wages, maritime subsidies, and import limitations, and boost energy prices without some cost cutting offset.

So I think a tougher attack on inflation from the cost and supply side is vital to both the domestic objectives and the international economic objectives with which this committee is concerned. And I think that is the kind of response-general response-we should have to the trade deficit and the weakness of the dollar.

The CHAIRMAN. Mr. Annunzio?

Mr. ANNUNZIO. Thank you, Mr. Chairman.

I am again delighted to welcome both Dr. Heller and Dr. Fellner to the committee. I have two questions:

Dr. Heller, although some increases in the Federal Reserve rate is necessary to slow down money growth, in April many people felt that the 16-percent increase from mid-April to mid-May was overly severe. And I would like to get your opinion on that.

Dr. HELLER. I agree entirely. It seems to me that that jump in the money supply, in part, was the result of rather capricious and shortrun factors. There was no indication that the economy was overheat

ing, or overexpanding; it was neither getting beyond its speed limits, nor getting close to its potential.

And I don't see why the Fed would have repeated the mistake that it made the previous year when it overreacted to an April jump in money supply, and then backed off, as it did in 1975 when it overreacted to the tax cut, and then had to back off.

But I do feel that whatever you or I might think about it, the Fed in this case is determined not to back down from those enhanced interest rates; that indeed, if anything, Dr. Burns might be implying tomorrow that they might snug up a bit. I think that is entirely uncalled for in the current economic situation.

Dr. FELLNER. May I say a word to that?
Mr. ANNUNZIO. Certainly.

Dr. FELLNER. I really don't think the Fed has that under control. I think that pursuing interest rate targets is a self-defeating policy. I think that if you create an environment in which inflation is increasing and is expected to increase, those short-term rates will indeed increase.

And I don't quite see the consistency between accepting something like a 6-percent inflation rate for the year, and saying that the present short-term rates are right, or are too high.

I think that if you really create an environment in which the people expect the 6-percent inflation rate for the year, then the present shortterm rates will sooner or later rise.

And an attempt to pull them down will just create more inflation and subsequently a greater increase in the short-term rates.

So I am strongly opposed to trying for interest-rate targets by monetary policy. I think one should indeed have an idea of what the probable implications are of one's forecasts for interests rates.

My own view is that the administration forecasts, which I think are overly generous on what inflation they are willing to accommodate implied higher short-term rates than those which we now have. And I think that those are overgenerous for the willingness to accommodate inflation.

Dr. HELLER. Mr. Chairman, if it won't steal Mr. Annunzio's time, I just want to come back on that, if I may? How do we know that the negative impact of a more miserly Federal Reserve policy, and the consequent higher interest rates, is going to be on prices rather than on output? That is certainly one of the mysteries that neither the monetarists nor the Keynesians have solved.

And if inflation today really is of this hard-core, as I say, Burnsresistant, intractable variety from the cost-push side, my fear is-and this is certainly where my fear is-my fear is that squeezing the money supply and boosting interest rates is going to express itself in lower production, and lower jobs, and lower growth than we otherwise would have, and not in lower prices.

If you are right, and it would just translate into lower prices, it might be a price worth paying. But I don't see it that way.

Dr. FELLNER. Well, I would assume that it would translate into relatively slow further expansionism, as compared with what one would consider "ideal." But, nevertheless, to a continued and more durable. expansion and to lower inflation rates.