We will not solve this or our other longer-term problems simply by loosening the Federal purse strings and letting the money roll out. That course would sooner or later accelerate inflation and thereby create other, and perhaps even greater, economic problems. It should be abundantly clear by now that a healthy and prosperous economy can be achieved only by pursuing policies that are consistent with steady progress toward restoration of general price stability.

That principle is continuing to guide Federal Reserve policy. Over the past year, growth rates of the major monetary aggregates have not been excessive, and our projected ranges for the future have been gradually reduced. This course of action, by dampening inflationary expectations, has helped to restore public confidence-both here and abroad-in the value of our currency and in the future of our economy.

Mainly as a result of this lessening of inflationary fears. interest rates have not increased as they usually do in a period of cyclical expansion. In fact, the level of interest rates on short- and long-term securities is appreciably lower now than it was at the beginning of economic recovery in 1975.

Thus, the monetary policy we have pursued has fostered conditions in financial markets that have aided the process of economic recovery. Supplies of credit have been ample. In fact, the volume of funds raised by the nonfinancial sectors of the economy has increased considerably faster than the dollar value of the gross national product. Meanwhile, the financial condition of business firms has improved materially; and financial institutions have rebuilt their liquidity, so that they will be able to accommodate a substantial rise of credit demands in the months ahead.

The growth rates of major monetary aggregates have remained relatively close to those we had expected earlier. In the year ended in the fourth quarter of 1976, M,-that is, the money stock defined narrowly so as to include only currency and demand deposits-rose 5.4 percent. somewhat below the midpoint of the range projected a year ago. In contrast, M2-which also includes savings and consumer-type time deposits at commercial banks-increased 10.9 percent, just above the upper end of its projected range. Growth of M-a still broader measure of money that encompasses, besides the components of M, the deposits at savings banks, savings and loan associations, and credit unions-amounted to 12.8 percent, and also exceeded its range by a small margin.

There was an unusually wide gap during this past year between the growth rates of M, and the broader monetary aggregates. This stemmed in large measure from changes in financial markets that have served to reduce reliance on demand deposits for handling monetary transactions. Recent financial innovations have important implications for the conduct of monetary policy, and it may therefore be worthwhile to comment on them.

Elements of the innovational process currently underway in financial markets can be traced as far back as the early 1950's. When interest rates rose during the cyclical upswing of 1952 and 1953, some large corporations began to invest their spare cash in Treasury bills. In subsequent years, more and more firms increased their efforts to develop better systems of cash management, so as to minimize hold

ings of demand deposits which-under existing law-bear no interest. In time, individuals began to emulate business practices-by shifting idle funds into liquid market securities or savings deposits.

In the late 1950's and early 1960's, the innovational process was accelerated by more aggressive efforts of commercial banks, especially the larger institutions, to bid for loanable funds. Major efforts were made to attract the highly interest-sensitive funds of corporations and other large depositors. For example, banks in the money market centers began in 1961 to sell large-denomination certificates of deposit on a significant scale; and a secondary market, which soon developed for these instruments, enhanced their acceptability.

With inflation pushing interest rates to extraordinary heights dur ing the past decade, both business firms and individuals have intensified their search for ways to minimize holdings of noninterest-bearing assets. Financial institutions, meanwhile, have been competing actively to meet the public's needs. As a consequence, the innovational process has accelerated. An array of new financial instruments and practices has developed that has enable the public to hold an increasing fraction of its transactions balances in interest-bearing form.

For example, the so-called NOW accounts have grown steadily in the New England States, and they serve effectively as checking accounts for many individuals. Smaller businesses and State and local governments nowadays hold a significant part of their cash balances in the form of savings accounts at commercial banks-which only recently were granted authority to accept such deposits. Moreover, many individuals are learning to use savings accounts for transactions purposes by making payments through third-party transfer arrangements, or by telephonic transfers of funds from savings to demand deposits to cover newly written checks. Others are using money-market mutual funds for the same purpose. And still others have worked out overdraft arrangements with their banks to reduce the amount of funds held in demand deposits bearing no interest.

In projecting its monetary growth ranges, the Federal Open Market Committee has had to keep these developments of financial technology carefully in mind, because they affect the rates of growth of monetary aggregates that are needed to sustain economic expansion. At its meeting about 2 weeks ago, the committee adopted ranges for the year ending in the fourth quarter of 1977 that differ only a little from those announced last November. For M1, the previous range of 412 to 612 percent has been retained. For M2 and M3, the lower boundaries of the ranges were reduced by a half percentage point. Consequently, the new range is 7 to 10 percent for M2 and 81⁄2 to 111⁄2 percent for M2.

The downward adjustment of the lower boundary of the ranges for M2 and M, largely reflects technical considerations. By historical standards, growth of the broader measures of money in 1976 was relatively rapid in relation to growth of M1. Over the course of last year. M rose 5.4 percent, very close to the 5.6 percent average of the preceding 10 years. But M2 increased 10.9 percent in 1976, in contrast to an average yearly rise of 8.3 percent over the preceding decade; and M3 increased 12.8 percent, in contrast to an average annual increase of 8.8 percent in the preceding 10 years.

It seems likely that growth rates of these broader aggregates will move back toward historical norms in 1977. Last year the growth of M2 and M3 was influenced by shifts of existing stocks of financial assets from market securities to time and savings deposits. This adjustment of assets may not go much further. Moreover, some banks and thrift institutions, having experienced larger inflows of funds than they can readily invest, have of late taken steps to slow deposit inflows by reducing the interest rate offered on savings certifica.es and deposits, or by curtailing promotional activity, or in other ways. These actions should tend to moderate the growth of M. and M, this year without impairing the flow of funds for homebuilding.

Besides these technical considerations, the adjustment of the lower limit of the projected ranges for M, and M, reflects the Federal Reserve's firm intention to continue moving gradually toward rates of monetary expansion that over the long run are consistent with general price stability. The step we have taken on this occasion is a very small one, but it may still bolster the confidence of the public in the commitment of the Federal Reserve to do what it can to unwind the inflation from which our economy continues to suffer.

The projected range of M, in the year ahead reflects our assumption that the financial innovations now in train will continue to reduce materially the proportion of transactions balances that are held in the form of currency and demand deposits. If our assumption is correct, the range we have projected for M1, together with the ranges projected for M2 and M3, should be adequate to finance a faster rate of growth of physical production in 1977 than we experienced in 1976. I must note, however, as I have repeatedly in the past, that profound uncertainties surround the relationships among the various monetary aggregates, and between rates of monetary expansion and economic performance. We shall therefore monitor emerging developments closely, and stand ready to modify our projected growth ranges as circumstances may dictate.

Let me also take this opportunity to state once again that substantial further reduction in growth rates of all the major monetary aggregates will be needed over the next few years if our Nation is to succeed in halting inflation. The long-run growth rate of physical production at full employment has declined in recent years, and is probably around 31% percent at present. Judging by the experience of the past two or three decades, a stable price level would require a rate of expansion in M, that over the long run is well below the growth rate of total output. Growth rates of the broader monetary aggregates consistent with general price stability might be somewhat higher than long-term growth of output; but in any event they would have to be far below the rates experienced in recent years.

Our Nation needs to make progress during 1977 in creating more jobs and in expanding our industrial capacity. We at the Federal Reserve fully recognize this fact, as our recent policy actions have made clear. We are also mindful of the need to make further progress in the battle against inflation. Highly expansionist policies that seek to achieve striking gains in economic activity with little or no regard to their inflationary consequences are apt to fail. Once inflationary expectations are inflamed, conditions in financial markets will deteriorate,

and the confidence of businessmen and consumers will be eroded. Hopes for a sustained economic recovery would then be undermined.

Public policy must find a middle ground. Deficits in the Federal budget must be scrupulously watched and gradually reduced. Growth in supplies of money and credit must also be brought down gradually to rates consistent with general price stability.

Our Nation has paid a heavy price for permitting inflation to get out of control in the late 1960's and early 1970's. We must not lose sight of that fact. The substantial progress we have made in slowing inflation since 1974 has helped to heal our economy. Gradual restoration of price stability is within our means. Unless we stay on that course, the lasting prosperity to which the American people aspire will continue to elude us.

The CHAIRMAN. Thank you very much, Chairman Burns. I find myself in perfect accord with your twin goals of creating more jobs and making further progress in the battle against inflation.

Now, let us talk about the specific stimulus programs forwarded by the Carter administration. You are familiar with it? $15 or $16 billion of additional direct or tax expenditures in what remains of fiscal 1977 and in fiscal 1978 each.

Yesterday I asked Secretary Blumenthal-and I am glad to learn he's established cordial, diplomatic relations with the Federal Reserve what his view was with respect to the monetary implications of the President's program. I asked, what about interest rates? We are hopeful that interest rates can stay about where they are.

Mr. Chairman, I don't believe that this moderate program of additional stimulation, given the overall state of the economy and the general excess of capacity which exists should result in any increase in interest rates. Indeed, I would think that if interest rates were about at the present level, it would be accommodative and enable us to achieve the goals that we have in mind of accelerating the economy and reducing unemployment. I do not see why the program should lead to significantly higher interest rates.

Would you agree with Secretary Blumenthal, who I believe speaks for the administration?

Dr. BURNS. I have established good personal relations with Secretary Blumenthal. They are not merely diplomatic.

But I must remind you that the Treasury is auctioning a 7-year issue today and will be auctioning a longer term issue tomorrow. I am a little concerned that any pronouncement that I might make about interest rates could influence markets at a rather sensitive time. The CHAIRMAN. Fair enough. Would you deliver to this committee at 9 a.m. Monday morning, next your answer to the question?

Dr. BURNS. I certainly shall do so, and it will be a full answer. [In response to the request of Chairman Reuss, the following letter was received from Dr. Burns for inclusion in the record.]

I am writing in response to your question concerning interest at last Thursday's hearing.

Recent experience indicates that credit markets have become very sensitive to changes in the budgetary and economic outlook. of course, nervous markets tend to overreact to the flow of economic information. As a result, marked fluctuations in interest rates may be expected as economic prospects--concerning the Federal budget, the private economy, and monetary policy--are appraised and re-appraised in the money and capital markets.

Since the beginning of the year, interest rates on market securities have generally risen. The increases have been especially large in the case of Treasury notes and bonds. Since last Thursday, however, the yield increases have been partially reversed.

There are three major causes of the rise in interest rates

since the turn of the year.

First, most market participants seemed to believe that the interest rate on Federal funds--the rate that most immediately reflects pressures on bank reserve positions--would decline further in early 1977, after having dropped over the last three months of 1976. In fact, the Federal funds rate has remained quite steady since the beginning of this year; the average funds rate in January was virtually the same as in December. Once the market realized that the Federal funds rate was not declining, other short-term rates rose, as did intermediate- and long-term rates to a degree, since interest rates generally had earlier moved to levels that were only sustainable on the expectation that the Federal funds rate would drop further.