Recessions ; Inflation (Finance) ; Monetary policy - United States ; Interest rates

Adrian W. Throop

English

Research Papers in Economics

July 4,1980 
Money, Prices, and Interest Rates 
Monetary policy is currently at a critical 
juncture, since it must deal simultaneously 
with the twin problems of  continuing high 
inflation and a developing recession. Some 
observers suggest that the Federal Reserve 
has given up the battle against inflation, be-
cause it has allowed a sharp drop in interest 
rates without first finding substantial evi-
dence of any moderation in price behavior. 
Others worry that the Fed is contributing to a 
more severe recession, because the growth of 
the monetary aggregates has lagged below 
the lower bounds of  their annual target 
ranges. Putting these concerns into proper 
perspective requires a realistic assessment of 
1) the tightness of current monetary policy, 
2) the lags between money, output, and 
prices, and 3) the relationship between mon-
ey and interest rates. 
The Federal Reserve has taken a strong anti-
inflation stance by attempting to reduce 
money-supply growth -specifically, by 
choosing a 5 %-percent midpoint for the tar-
get rate of growth of M-1  B, and associated 
targets for the other monetary aggregates. 
(M-1 B equals currency plus bank demand 
deposits plus other check-like deposits at 
banks and other financial institutions.) These 
targets represent a marked deceleration from 
the money-growth rates experienced previ-
ously, such as M-1 B's 8-percent annual 
growth rate over the 1977-79 period. Thus, 
according to this monetarist approach, the 
underlying inflation rate eventually should 
respond to the slowdown in money 
growth -although this development may be 
masked attimes by sudden price movements, 
such as occurred in the consumer-price ac-
celeration of first-quarter 1980. 
lags and the long view 
Past experience would suggest that a 
5Y4-percent rate of growth of M-1 B will, in 
the long run, tend to produce about a 
7Y4-percent rate of growth of nominal GNP. 
That 7%-percent nominal growth in turn 
cou Id be divided into a 3-percent real growth 
rate (the long-term trend) and an inflation rate 
of around 4 % percent. But past experience 
again would suggest that this effect of mon-
etary deceleration wi  II be felt on Iy after a 
substantial lag, lasting four to five years for the 
final effects to occur. Thus, if current 
money-growth targets were to be hit 
consistently -and were to remain un-
changed for several years' time -the 
inflation rate (measured by the GNP deflator) 
should decline from the 91f2-percent ~ate of 
early 1980 to perhaps 6Y2  percent in 1982 
and (finally) 4 % percent in early 1984 (see 
chart). However, the Federal Reserve has ex-
pressed its intention to reduce money growth 
gradually over time, which would imply an 
even lower inflation rate by the mid-1980's. 
Wh  i  Ie not perfect, the close association be-
tween inflation and lagged money growth 
vividly demonstrates the importance of  tak-
ing a long view in the battle against inflation. 
That relationship also suggests an important 
related point -the  substantial lag between 
the trough in economic activity and the low 
point in inflation. Following the 1970 reces-
sion, the inflation rate did not bottom out 
until the third quarter of 1972; and after the 
1974-75 recession, the low point in inflation 
was not reached until the third quarter of 
1976. Similarly, even if  the current recession 
is of normal duration and ends early in 1981, 
the trough in inflation generated by the cur-
rent rate of monetary growth may not occur 
until over a year later. 
Interest-rate controversy 
Deceleration in inflation implies a prior 
deceleration in money growth -yet  some 
analysts argue that the Federal Reserve has 
already given up in the fight against inflation 
by allowing a sharp drop in interest rates 
before seeing any tangible evidence of a 
moderation in price behavior. This point of 
view assumes, however, that interest rates are 
a good measure of current monetary policy, JFCBcdl~ffSln ~~~~JfW~ 
IP1©'lf)l~  ~  TI 
§  ~\1I1 JF  rr  ~\JTIl  CC li ~  CC (G) 
OpinioilS expressed in this liewsletter do not 
necessarily rI.::,f\ect  the vievvs of the management 
of the Federal Reserve Bank of San  Francisco, 
nor of the Board of Govern()rs of the Federal 
Reserve System. 
which simply is not the case. Interest rates 
reflect current policy only to the extent that 
they reflect the liquidity effects of monetary 
acceleration or deceleration -that  is, by faIl-
ing in a period of rapid money growth or 
rising in a period of slow money growth. But 
such liquidity effects often tend to be 
swamped in practice by changes in the de-
mand for money and credit resulting from 
past policy changes and other influences. For 
example, in recession periods such as the 
present, interest rates fall because of  a decline 
in the real demand for money and credit-
and also because of a decline in expected 
inflation, and hence in inflation premiums 
that become built into interest rates. 
Of  these several factors operating on interest 
rates, expected inflation historically has gen-
erally been dominant But in the past two 
recessions, real demand effects have also 
been significant, leading to a fall in interest 
rates prior to the decline in the inflation rate. 
As in past cycles, current declines in in-
terest rates are entirely consistent with a fu-
ture moderation in the inflation rate, despite 
what some observers now contend. These 
individuals mistakenly believe that they are 
seei ng the I  iqu  id ity effects created by a mone-
tary acceleration, when in fact they are wit-
nessing a fall in the real demand for money 
and credit flowing from a weak economy. 
Overly slow growth? 
If anything, liquidity effects are currently 
tending to raise, rather than lower, interest 
rates. Recently the narrowly defined mon-
etary aggregates have lagged below the lower 
bounds of their target ranges. A prolonged 
undershoot of current monetary targets 
would constitute unwarranted tightness, and 
could be counter-productive in achieving 
both inflation and real-output goals. 
The recession could be aggravated, with 
higher-than-expected unemployment, if the 
Federal Reserve consistently failed to meet its 
money-growth targets. However, that situa-
tion could also set the stage for future ac-
celerated inflation, because the Fed would 
2 
come under pressure in a severe recession to 
abandon its current monetary-growth 
targets -in  effect, to abandon its anti-
inflationary policy. 
Policymakers thus see the wisdom of  bringing 
the monetary aggregates back on path in 
coming months. That course of action, by 
providing the economy with sufficient liquid-
ity, helps to moderate the severity of the 
recession -and  also enhances the credibility 
of  the Fed's policy stance. In contrast, exces-
sively slow money growth would not be 
helpful, because in view of the lags involved, 
it would not bring any substantial improve-
ment in prices until after the advent of 
double-digit unemployment, which presum-
ably cou  Id lead in tu rn to pressu res for exces-
sively stimulatory public policies. 
A procyclical pattern of money growth (i.e., 
one that accentuates instead of dampens the 
business cycle) can be avoided, provided that 
all sectors of the economy recognize that 
cu  rrent interest-rate decl  i  nes stem from a de-
cline in the demand for money and credit 
generated by a weakening economy, rather 
than from the liquidity effects of a monetary 
acceleration. Current monetary-growth 
targets wi  II contribute substantially to a mod-
eration of inflation after a period determined 
by the usual lags, and a stable rate of 
monetary growth consistent with these 
targets is the best guaranty against a severe 
recession. A more stable pattern of business 
activity, in turn, will provide the best environ-
ment for making further progress against in-
flation in the future. 
Adrian W. Throop Percent 
14~----------------
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1962  1965  1975  1980  1984 
Shaded areas indicate recessions 
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial Banks 
Loans (gross, adjusted) and investments* 
Loans (gross, adjusted) - total # 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.s. Treasury securities* 
Other securities* 
Demand deposits - total# 
Demand deposits - adjusted 
Savings deposits - total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Amount 
Outstanding 
6/18/80 
136,176 
114,693 
33,202 
46,439 
23,699 
1,014 
6,323 
15,160 
42,919 
30,508 
27,407 
63,583 
54,722 
22,533 
Change 
from 
6/11/80 
142 
- 76 
- 149 
- 75 
- 9 
21 
- 50 
- 16 
- 504 
- 732 
224 
- 504 
- 401 
- 361 
-
-
-
Weekly Averages  Weekended  Weekended 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves (  +  )/Deficiency (  - ) 
Borrowings 
Net free reserves (  +  )/Net borrowed( -) 
* Excludes trading account securities. 
#  Includes items not shown separately. 
6/18/80  6/11/80 
73  110 
1  1 
73  109 
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Change from 
year ago 
Dollar  Percent 
8,081  6.3 
9,281  8.8 
2,137  6.9 
8,270  21.7 
1,325  5.9 
666  - 39.6 
1,368  - 17.8 
168  1.1 
218  0.5 
61  - 0.2 
2,609  - 8.7 
13,174  26.1 
13,128  31.6 
5,276  30.6 
Comparable 
year-ago period 
9 
16 
25 
Editorial comments may be addressed to the editor (William Burke) or to the author ....  Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Section, 
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Money, prices, and interest rates

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Money, prices, and interest rates

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