CONDUCT OF MONETARY POLICY

THURSDAY, JULY 28, 1977'

HOUSE OF REPRESENTATIVES,

COMMITTEE ON BANKING. FINANCE, AND URBAN AFFAIRS,

Washington, D.C. The committee met at 10:25 a.m. in room 2128 of the Rayburn House Office Building; Hon. Henry S. Reuss (chairman of the committee) presiding.

Present: Representatives Reuss, Annunzio, Hanley, Blanchard, LaFalce, Spellman, Lundine, Pattison, Vento, Barnard, Stanton, Brown, Hansen, Kelly, Leach, Caputo, and Hollenbeck.

The CHAIRMAN. Good morning. The House Committee on Banking, Finance and Urban Affairs will be in order for its series of hearings on monetary policy.

Following this committee's last dialog with the Federal Reserve on monetary policy, 31 members of the committee on February 9, 1977, wrote the Federal Reserve Board and the Federal Open Market Committee conveying "our judgment that monetary policy during 1977 should aim at reducing unemployment and fostering recovery, without rekindling demand inflation, consistent with President Carter's proposed stimulus." In our letter, we made three recommendations to the Fed:

First, money supply: "For M1, in the months ahead, growth should be off the bottom of the range, and at least in the middle of the range. At that time, the Fed's growth rate for M, had been running at the bottom of the 412-62 percent range. We are pleased that for the year ending July 1, 1977, M, grew at about 6 percent, closely following our February 9 recommendation.

Second, interest rates: "Such monetary policy should give the Nation stable interest rates in the months ahead." In fact, intermediate and long-term rates have been remarkably stable since early February. The yield on 3 to 5 year Treasuries drifted down from 6.8 percent to 6.5 percent between February and June of this year. This represented a decline from 7.4 percent from June 1976. Longer term Treasury rates also were well below year-ago levels.

Third, the Federal Reserve's portfolio: "We commend the Federal Reserve for modest lengthening of the maturity of its security portfolio in 1976, and urge that such lengthening be continued." It is gratifying to see that lengthening of the portfolio has continued. From July 1976, to July 1977, the percentage of U.S. Government and agency securities of less than 1 year in the Fed portfolio has declined from 51.3 percent to 48.8 percent; and the percentage of 1-5 year securities has declined from 32.9 percent to 32 percent. The percentage

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of 5- to 10-year securities has increased from 10.1 percent to 12.2 percent and of securities of more than 10 years from 5.7 percent to 7 percent.

While the Fed has performed well in the longrun management of the money supply, short run management, and the performance of short-term interest rates, has been another story.

Month-to-month growth rates have fluctuated wildly, ranging as high as 19.4 percent in April of this year, down to a rate of less than 1 percent in May. Such fluctuations cause turmoil in financial markets, periodically drive interest rates up unnecessarily, and play havoc with investor confidence. The way the Fed manages the money supply-basing reserve requirements on bank deposits that existed 2 weeks earlier rather than on those of the current week-undoubtedly contributes to these undesirable fluctuations. The Fed offset the April 19.4 percent bulge in the money supply, caused by such transient factors as the monthly deposit of $6 billion in social security payments, by allowing the Federal funds rate to rise rapidly and to remain at higher levels for a number of weeks. This gave some of the large commercial banks an excuse to raise their prime rate even though demand for business loans at their banks was poor.

This technique of basing reserves on 2-week-old deposits, known as "lagged reserve requirements," has been condemned by a large number of economists, including the leading monetarist and Nobel laureate, Dr. Milton Friedman. In testimony to the Senate Banking Committee on November 4, 1975, he said he "does not know anybody who has a good thing to say for the lagged requirements system." Ŏthers who have condemned the lagged reserve requirement include George G. Kaufman, former assistant vice president and economist at the Chicago Federal Reserve Bank and now professor of banking and finance at the University of Oregon and author of "Money, the Financial System and Economic Activity"; Albert E. Burger, assistant vice president of the Federal Reserve Bank of St. Louis and author of "The Money Supply Process"; Warren L. Coats, Jr., economist at the International Monetary Fund, formerly of the Chicago Fed, whose doctoral dissertation spells out the case against lagged reserve requirements; R. Alton Gilbert, economist at the St. Louis Fed; Daniel E. Laufenberg, an economist at the Federal Reserve Board; and William Poole, former senior economist at the Board of Governors and assistant vice president of the Boston Fed who is now professor of economics at Brown University.

It has also been suggested that the use of seasonal adjustment for computing monetary growth may be causing the Fed to react unnecessarily and erratically.

I hope that our July dialog can inquire into both the "lagged reserve" and the "seasonal adjustment" questions. The pain they engender for the economy may not be worth the pleasure they give to their votaries.

Most of all, we shall be interested in the Federal Reserve's monetary plans for the next year. We look for enlightenment not only in the monetary aggregates beloved of the monetarists, but in estimates of future interest rates, velocity. and portfolio composition-as they bear upon our ultimate goals of jobs, production, and prices.

We are fortunate enough this morning to have before us two of the Nation's truly great economic leaders, both widely respected in their profession, both with some experience in government, and, happily, the best of personal friends despite the fact that one of them is usually found in what is called the progressive camp and the other in what is called the conservative camp; and I love them both and thank them for being here.

Without objection and pursuant to our rule, both of their statements will be received in full into the record. I am going to call first on Dr. Heller, and then on Dr. Fellner, to proceed with their testimony.

Let me say that it is the Chair's hope and intention that we will finish with our witnesses in ample time to let them both make engagements later this morning. I think if we stick to the 5-minute rule, that will be possible.

Dr. Heller, would you start out?

STATEMENT OF DR. WALTER W. HELLER, REGENTS' PROFESSOR OF ECONOMICS, UNIVERSITY OF MINNESOTA

Dr. HELLER. Thank you, Mr. Chairman.

What I would like to do is work from my prepared statement, but skip parts of it.

The CHAIRMAN. Proceed in any way that you like.

Dr. HELLER. In appraising the Federal Reserve's economic performance, I want to begin with some left-handed compliments.

Now, the record of the past 22 years, except for the annual spring offensives the Fed's overreaction to the tax cut in 1975 and the April runups in the money supply in 1976 and 1977-is certainly a great improvement over the excesses of 1972-74, over the swing from excessive openhandedness in 1972 to excessive tightfistedness in 1974.

Second, while one can quarrel with the norms or targets of monetary policy over those 21⁄2 years-and I will-one can also compliment the Fed on the relative stability and serenity of policy during those years: First, its success at staying within the bounds, albeit at the low end, of its target ranges; second, its willingness to back off from premature tightening in June 1975 and May 1976; and, third, to the surprise of most everyone but Chairman Burns, money velocity, the rate of turnover of money balances, has obligingly speed up enough during this period to bridge the gap between an average rise of about 6 percent a year in M1, and nearly 12 percent in normal GNP.

Yet, in terms of a reasonable cost-benefit test, the cost in jobs and output set off against the benefits in reduced inflation, the restrictiveor at best, grudgingly expansionary-tilt of monetary policy in 1975 to 1977, has been a poor bargain for the country.

As to benefits, Federal Reserve policies and fiscal policy-relying on the harsh discipline of weak labor markets and weak product markets has given up precious little relief from inflation in the past 21⁄2 years.

Throughout the recovery, since March 1975, basic inflation-that is, excluding food and fuel-has orbited in a 52- to 62-percent range, with no decisive movement either way, while the annual advance in

hourly compensation has held stubbornly at or above 8 percent for the past 30 months; and neither price inflation nor wage inflation has been responsive to this rather grudging monetary policy.

In other words, once the excess demand pressures of 1972-73 and the external shocks of 1973-74 worked their way through the system, the residual inflation boiled down to hardcore, Burns-resistant, cost-push pressures. Triggered by the fierce double-digit inflation of 1973–74, wage advance moved into an obit about 5 to 6 percent above productivity advances.

And, meanwhile, conditioned by the cost passthrough philosophy of the 1971-74 price controls, the business practice of pricing via markup over costs became more and more firmly entrenched, even in the face of weak markets.

Now, the upshot is that the self-propelled cost-price merry-goround-I don't call it a spiral, because we are orbiting in a fairly stable inflationary merry-go-around-is largely imprevious to macroeconomic policies. Now, it may be that such inflation would slowly succumb to the sadomasochism of sustained tight money and tight fiscal policy and I call it masochism because the financial community which suffers from it seems to be the most vocal in calling for it--but even that is doubtful. It defies both the weight of the evidence and the dictates of commonsense to assume that structural inflation arising out of market rigidities and excess market power is going to yield to aggregative policies and overall economic slack.

Now, that bring me to the costs of restrictive Federal Reserve policies. Can one get beyond casual observations about unnecessary losses in jobs and output and the fits and starts of recovery that are in part generated by monetary policy? Can we get beyond that and identify fairly reliably a causal relationship between monetary restriction and retarded expansion?

Well, I turn here to Allen Sinai, of Data Resources, who has really done this rather persuasively with respect to the stall in U.S. economic recovery last year. His study concludes-and I quote:

*** that low monetary growth is a primary cause of the stall in economic activity during the last three quarters of 1976.

An interesting sidelight, Mr. Chairman, is that almost halfway through the slowdown, the Fed did not recognize that it was taking place.

Now, I didn't have any testimony from Dr. Burns to work from, since he is not appearing until tomorrow. So, I went back to what he said to you on July 27 of last year. And when he appeared here, he expressed his belief that "a resumption of the upward trend in retail sales is already underway," that "a larger and more basic source of stimulus to economic activity can be expected from business outlays for new plants, machinery, and other equipment," that "the outlook for our export trade is also brightening."

He concluded that "activity in all major sectors of the private economy thus seems poised for further advances."

Well, now, I cite his testimony of a year ago partly because, as I say, I don't have tomorrow's testimony to address myself to, but more pointedly to suggest that Dr. Burns, like the rest of us, is fallible—