In the short-run, the most obvious way of dampening business demand for plant and equipment is to suspend the investment tax credit. This would help to insure that housing is not depressed unjustifiably or that attempts to bolster the housing sector do not impinge unfairly on still other economic sectors. There is no apparent reason for giving a special stimulation to business capital outlays at the present time. Obviously, any danger that discussions of suspending the tax credit will accelerate capital expenditures can be avoided by making it clear that any suspension would be retroactive. The suspension might be estimated to reduce plant and equipment expenditures by well in excess of $2 billion over the following year, with some evidence that the effect would be over $1 billion (at an annual rate) by the end of 6 months. The same end result might be achieved by a voluntary restraint program which was associated with the implicit threat of retroactive suspension of the investment tax credit if the voluntary program was not effective.

It should be noted that not only would housing (and other sectors) be helped by such a program of restricting plant and equipment expenditures, but both the businessmen involved and the economy might gain if capital outlays based on unjustified inflationary expectations were not made. However, if the investment tax credit is suspended, it would probably be desirable to ease up somewhat on the present extremely tight money policy so that the suspension does not serve as an additional curb on overall effective demand.

Thank you.

Senator PROXMIRE. Thank you, Mr. Friend.

Our next witness is Mr. James J. O'Leary, executive price president, U.S. Trust Co., New York.

Mr. O'Leary.

STATEMENT OF JAMES J. O'LEARY, EXECUTIVE VICE PRESIDENT AND ECONOMIST, U.S. TRUST CO. OF NEW YORK

Mr. O'LEARY. Thank you very much, Mr. Chairman.

I am going to try to give my testimony without reading it because I think if I do, it will take a little less time.

Senator PROXMIRE. As I say, the entire statement will be printed in full in the record.

(The full statement of Mr. O'Leary follows:)

STATEMENT OF JAMES J. O'LEARY, EXECUTIVE VICE PRESIDENT AND ECONOMIST, UNITED STATES TRUST Co. OF NEW YORK

I am James J. O'Leary, Executive Vice President and Economist, the United States Trust Company of New York, 45 Wall Street, New York City. I am glad to have this opportunity to present my views on the impact of interest rates on the economy.

According to a special OBE-SEC survey on the impact of the investment tax credit suspension enacted November 8, 1966 (and retroactive to Oct. 10, 1966), it was estimated that 1967 plant and equipment expenditures would be reduced by $2.3 billion. This survey was undertaken before the suspension was revoked in June 1967 (retroactive to Mar. 10, 1967). One forthcoming econometric study by Lawrence R. Klein and Paul Taubman implies a similar impact of the 1966 suspension for the year 1967 as a whole (and also provides quarterly estimates) but two others give widely disparate resultsone less, the other substantially larger.

THE BASIC FORCE BEHIND RISING INTEREST RATES

It will be helpful, first, to consider why interest rates have risen so dramatically in the past three years. In my view, the basic force behind the sharp rise of interest rates has been inflation, and more importantly the widespread expectation that inflation will continue at a high rate for the foreseeable future. To illustrate the expectation of inflation, I refer you to the attached chart labeled "Index of the Expectation of Inflation." This is just a schematic chart, because there are no available data to measure the expectation of inflation, but I am convinced that during the past three years, and especially in 1968, there was a sharp increase in the expectation of continuing inflation on the part of investors, corporate planners, the labor unions, and the consumers.

How does inflation and the expectation of inflation lead to higher interest rates? First, the rate of increase in the price level has been particularly strong in the capital goods areas and in housing and construction in general. The increase in prices in these areas has greatly inflated the total demand for loanable funds. Total uses of loanable funds have risen from $79.4 billion in 1965 to $104.2 billion in 1968, or by 31 percent. The expectation of a continuing strong rise in the prices of capital goods and housing has tended to stimulate capital spending in the present in order to avoid the higher prices expected to prevail in the period ahead. The expectation that unit labor costs will continue to rise strongly provides a powerful incentive for management to modernize plant and equipment in order to hold down costs. I feel confident, for example, that the vigorous 14 percent increase in plant and equipment spending anticipated this year is based in part on the expectation of continuing inflation and rising labor costs. Thus, both the actual increase in the cost of capital goods and housing and the expectation of continuing inflation have contributed powerfully to the inflation of demand for money and capital funds.

With respect to the supply of funds, the pattern of inflation during the past few years and the expectation of continuing inflation for the foreseeable future have led to a marked increase in the proportion of long-term investment funds flowing into equities-common stock and real estate. At the same time, the proportion of total funds going into straight bonds and mortgages has been declining. The result, then, is that inflation and the expectation of inflation have led to a huge increase in total demand for loanable funds at the very time that the same forces have been decreasing the attractiveness of interest-bearing obligations. It is little wonder that interest rates have risen to record levels. They now carry a substantial "inflation premium" which must be paid in order to attract funds into bonds and mortgages. Another manifestation of the forces involved is that a rising proportion of bonds and mortgages on income properties now carry an "equity kicker" as well as an interest return. The popularity of the convertible bond reflects the same forces.

The powerful effect of the expectation of inflation upon long-term interest rates is illustrated by the experience in late 1966 and in 1967. Following the "credit crunch" in 1966, the Federal Reserve authorities moved quickly and strongly to ease the availability of bank credit. This may be seen in the chart, "Excess Reserves and Borrowings of Member Banks." As you will note, there was a pronounced swing from a large "net borrowed reserves" position of the banks toward the end of the third quarter in 1966 to a sizable "net free reserves" position by early 1967. As the national economy "paused", the Federal Reserve moved quickly and strongly to ease credit. The following chart, labeled "Assets and Capital Accounts of Commercial Banks in the United States," shows how the total loans and investments of the commercial banks, after leveling out in the second half of 1966, rose sharply again in 1967 as the lending and investing. capacity of the banks increased. The following two charts show the response of interest rates to the change in Federal Reserve policy toward aggressive ease following the "crunch." As will be noted, there was a sharp decline in shortterm rates in the latter part of 1966 and well into the middle of 1967. But it will also be noted that the decline in long-term rates, as shown by Aaa corporate bond yields and the average yield on long-term Government bonds was very short-lived and much more moderate. By the end of February 1967 the decline of long-term rates came to an end, and after a sidewise movement, long-term rates rose strongly throughout most of 1967. The same pattern was traced by the yields on new offerings of corporate bonds and on mortgages. This is the first and only time in the financial history of the United States in which the rate of business expansion slowed down to a walk and monetary policy became very easy without producing a marked decline in both short- and long-term interest rates. Indeed, long-term rates rose strongly in the face of the Federal Reserve's determined effort to bring them down.

What is the explanation for this phenomenon? I think that a large part of the explanation was the expectation of continuing inflation. Borrowers and lenders both pursued the following line of reasoning. With the Vietnam War escalating and likely to escalate further, and with the Federal Reserve easing credit aggressively, the "pause" in economic expansion was likely to be only temporary to be followed by a resumption of vigorous business expansion in the second half of 1967. This meant to borrowers and lenders that prices were likely to escalate again in the second half of 1967 and that by year-end the monetary authorities would probably have to begin tightening credit, with the result that interest rates would be on the rise again. With this set of expectations, after the decline of long-term rates in the first two months of 1967, corporate treasurers began flooding the market with new bond issues in order to fund short-term debt built up in 1966 and to repair their liquidity.

The long-term lending institutions had the same set of expectations. They had just been through a painful "crunch" in 1966. As interest rates rose in 1966 the life insurance companies were hit with a flood of policy loans touched off by the very low 5 percent contractual rate in their policies and the mutual savings banks and the savings and loan associations experienced a sharp net outflow of funds. These nonbank lending institutions were apprehensive that, as the economy rebounded in the second half of 1967 and prices began to escalate further, the monetary authorities would be forced to tighten credit again and that rising interest rates would touch off another serious "disintermediation" process. This view was strengthened by the expectation that the Federal deficit would rise sharply and that there would not be a tax increase. The result, then, was that in early 1967 the primary purchasers of bonds and mortgages were reluctant to build up their commitments to buy bonds and mortgages. Instead, as the "crunch" ended in 1966 they set about to repair their liquid asset position. Thus, based largely upon expectations about what was going to happen in 1967, the longterm lenders were very cautious about increasing their commitments to buy bonds and mortgages, while at the same time borrowers crowded into the market with long-term issues to take advantage of the modest decline that had occurred in long-term rates. The inevitable outcome was a rise in long-term rates at the very time the Federal Reserve was trying to bring them down.

In the light of the behavior of interest rates during the past three years, it is evident that long-term interest rates will not come down again until it is clear that public policy has brought inflation under control and the expectation of continuing inflation has been dampened down. This is the objective of fiscal and monetary policy and it is my judgment that the fight against inflation is vital to the health of our economy. If the expectation of inflation is not dampened down but is permitted to strengthen, interest rates are bound to move on to greater heights. This is not to deny that in the short-run the policy of credit restraint is an important factor in the rise of interest rates. But I would submit to you that, if the Federal Reserve should now begin to relax its policy of restraint, the expectation of inflation would strengthen and interest rates would surge to higher levels. It should be clear, then, that I am enthusiastic about the objective of the Administration and the Federal Reserve-to slow down the rate of business expansion gradually and thus to dampen down the expectation of inflation, but to do this within the framework of a fully employed economy. Moreover, I thoroughly agree that the principal instruments of public policy to accomplish this objective must be fiscal restraint and general credit restraint.

THE MOMENTUM OF THE ECONOMY

We are all bothered by the slowness of business activity to respond to fiscal and monetary restraint. The rate of business expansion did show some signs of slackening a bit in the fourth quarter of last year, but the momentum of the economy continued to be strong in the first quarter of this year. Consumer spending seems to be leveling out a bit, but capital spending and housing remain very strong. There continues to be a strong upward pressure on prices.

The effectiveness of the 10 percent tax surcharge has so far been disappointing, probably due to the delay in its enactment and the fact that it was discounted in the very large wage settlements in the past year. Yet, it seems certain that the swing from a $25 billion Federal deficit to a small surplus is bound to exert a braking effect on business activity. We know also that there is always a lag in the restrictive effect of general credit restraint because it takes time to squeeze the liquidity out of the financial system. In addition, much of the financing now being employed was arranged for months ago on a forward commitment basis and this backlog must be eaten into before credit restraint takes hold.

GENERAL CREDIT RESTRAINT IS BEGINNING TO BITE

There has been a major change in monetary conditions during the first quarter of this year compared with the fourth quarter of last year. The monetary authorities have really put on the credit brakes. During the past quarter the money supply of the country increased at only a 1.7 percent annual rate, compared with a 7.6 percent rate in the fourth quarter of last year, and an increase of 6.5 percent for all of last year. Money supply plus time deposits actually decreased at a 2.5 percent annual rate in the first quarter, compared with an 11.8 percent annual rate of increase in the fourth quarter of last year, and an 8.5 percent rate of increase for last year as a whole. Total outstanding loans of the commercial banks are lower today than in early January. It is true that the banks have preserved their capacity to lend by borrowing deposits in the Eurodollar market, by liquidating assets, by selling loan participations to banks with excess reserves, and by borrowing at the discount window. But the supply of Eurodollars is not unlimited and the rate on 3-month Eurodollars has risen to 8.5 percent. The monetary authorities are slowly but surely squeezing the liquidity out of the monetary system. As this continues, credit policy will bite more and more into the rate of business activity.

The high level of interest rates is beginning to set in motion the familiar disintermediation process in the nonbank financial institutions. Many life insurance companies are already experiencing a large increase in their policy loans and this is beginning to cut into their capacity to buy corporate bonds and mortgages on commercial properties. There is a distinct slowing down of the net inflow of funds into mutual savings banks which is beginning to reduce their ability to buy corporate bonds and commercial mortgages. This trend is expected to intensify in the second quarter. The net inflow of funds into the savings and loan associations is also beginning to decrease and here again the availability of funds for the purchase of income mortgages is on the decline. Thus, the policy of credit restraint by the Federal Reserve, through the medium of rising market interest rates, is beginning to affect the lending ability of the nonbank institutions and to reduce their capacity to make new commitments to buy corporate bonds and business mortgages, as well as home mortgages.

The process of slowing down the rate of business activity through credit restraint is bound to be gradual, but this is in line with the strategy being followed. Care must be taken by the authorities to avoid touching of a new "crunch." With the momentum of the economy continuing to be so strong, there is a possible danger that too much of a burden may be placed on general credit restraint.

MEASURES TO COMPLEMENT GENERAL CREDIT RESTRAINT

The danger that too much of a burden in the fight against inflation may be placed on the monetary authorities makes it clear that the 10 percent surtax must be extended for a year. Beyond this, we need a larger measure of fiscal restraint and a bigger Federal surplus for fiscal 1970. I appreciate that cutting back Federal expenditures will be difficult, but everything possible should be done to cut them and to increase the surplus.

During the Korean War period three types of selective credit controls were employed to complement general credit control: (1) The Regulation X control over home mortgage credit; (2) The Regulation W control over consumer credit; and (3) The Voluntary Credit Restraint Program. Regulation X applied control over the maximum loan-to-value ratio for eligible home mortgage loans, as well as control over the length of the amortization period. This type of control seemed necessary in the latter part of 1950 because a boom in housing developed with the outbreak of the Korean War. The circumstances are quite different today and I think that general credit control can be counted upon to slow down housing to the extent desired. I shall comment further on the mortgage market presently. So far as Regulation W control over consumer credit is concerned, it also operated by controlling the amount of down payment and the period for loan repayment. Here again the circumstances are different from those in 1950. This time there has not been a bulge in consumer buying on credit, as in 1950. It may be that as the year goes on a case will develon for the institution of a Regulation W type of control, but so far it is difficult to make any case for it.

The Voluntary Credit Restraint Program was instituted in the latter part of 1950 under the authority of the Defense Production Act. It onerated under the general control of the Federal Reserve and its objective was to encourage commercial banks, life insurance companies, mutual savings banks, savings and loan

associations, and other lending institutions to cooperate on a voluntary basis in avoiding the extension of inflationary loans and capital issues. The big problem was to define an "inflationary loan" or a "capital issue." The program was exceedingly difficult to administer and the contribution of VCR to curbing the inflationary extension of credit was at best very limited. The money and capital markets today are infinitely more complex so that the administration of such a program today would be much more difficult.

I would conclude that the use of selective credit controls at this time is not necessary and would not be helpful. In my view it is proper to place our reliance upon fiscal and general monetary restraints. If firmly applied, they are fully capable of slowing down the rate of business expansion to a more healthy level.

THE IMPACT OF INTEREST RATES ON HOUSING

There is not much danger this year that tight credit and high interest rates will sharply curtail housing as in 1966. There as many reasons for this view. For the past year or longer mortgage lending institutions have regarded loans on apartments as highly attractive. The reason is that such loans not only pay a market interest rate but in many instances permit the lender to participate in the gross rents on the apartments. As a result, there is a large backlog of forward commitments by mortgage lenders to buy apartment mortgages. This backlog, plus a continuing high rate of new commitments, provides assurance that apartment building will continue to remain very strong throughout this year. For many reasons, the demand for housing is shifting toward apartments, so that availability of financing is matching the demand. It is reasonable to anticipate that better than 50 percent of housing starts this year will be in apartment units. With the "disintermediation" developing in the mortgage lending institutions, the availability of funds to finance single-family homes is threatened. Even here, however, there are important changes which have occurred since 1966 which should help to cushion any decline in financing of single-family homes. For one thing, the Secretary of Housing and Urban Development now has the power to change the maximum interest rate on Government-insured and guaranteed mortgages to keep it in line with market forces. The ceiling rate was increased to 72 percent early this year, helping at that time to make FHA and VA mortgages competitive in the market. In 1966 the rigid ceiling rate and the huge discounts which developed on these mortgages were important factors in the housing cutback. The most recent rise of long-term interest rates has again made the 72 percent ceiling too low, but the Secretary does have the power to raise it if necessary. Perhaps more importantly, the new auction market technique of FNMA is permitting that institution to be more effective in supporting the home mortgage market. The rising volume of commitments which FNMA is making at market prices to purchase FHA and VA mortgages is giving a much greater liquidity and fluidity to the home mortgage market this year. By giving FNMA the power to commit as needed, I feel confident that Congress can do much to help stabilize the home mortgage market. To support the market, FNMA and the Federal Home Loan Banks (through advances to member savings and loan associations) will be in a better position this year to sell short-term securities in the market to raise the necessary funds. In 1966 the rising Federal deficit and large Treasury financing crowded the Federal agencies out of the shortand intermedite-term money market. This year the shift toward a Federal surplus will give the Treasury the opportunity to pay off $12 billion of debt in the next few months so that there should be room for FNMA and FHLB issues in the market.

Thus, although it is likely that the single-family housing starts will decline in coming months, I think that this decline will be gradual and it is subject to cushioning by Government policy measures. Apartment building will be strong in any event. A gradual decline in housing starts this year will help to slow down the rate of business expansion, but it does not have to be cut back the way it was in 1966.

CONCLUSION

In conclusion, interest rates will not come down again until the expectation of inflation is dampened down. The principal tools to accomplish this are fiscal and monetary restraints. We need more fiscal restraint, if possible, to relieve some of the strain on general credit restraint. But I feel confident that, given time to work, the present policies will succeed in slowing down the rate of business expansion gradually and in cooling inflationary pressures and expecta