1968-Year of InflationIi)I RODUCTION MD INCOME rose rapidly dur-ing 1968, and employment remained at high levels.The major economic problem of the year was infla-tion, generated by an excessive demand for goods andservices. By the latter part of 1968 average priceswere 4 per cent higher than a year earlier and 12per cent above those in late 1964,

Iki.ck ground. of tn/tati•on~

The current inflationary upswing began aboutfour years ago, after an extended period of near pricestability. From 1957 to 1964 overall prices rose atan average 1.6 per cent annual rate. This was insharp contrast to the rapid 6 per cent rate of infla-tion during World War II and the 3.5 per centaverage rise of prices from 1946 to 1957.

Prices probably increased even less during the1957 to 1964 period than indicated by the trend ratesof the indices. Quality improvements and price dis-counts may not have been given proper weight incomputing average measures, and any shifts ofdemand to new, less expensive, substitute productswould cause the price rise to be overstated by ageneral index.

The relative stability of prices from 1957 to 1964reflected the fact that total demand for goods and

General Price IndexRat a Scale ga,.a Scale1958’l00 1958 :30

515

1 510

ito

1960 596! 5962 1963 1964 1965 1966 5967 1968‘Ac, a,, hfl.lhSc,e.A’ 0, 5,,., e L~

P. ,a~• ,,,,.l,o~e,el l,.,.~.b.s,, ,cp,,.,d si, hey,, p, e~le,emp, ,es000t ,,td.,elyp.,~ffls.tkp. I tend,,e,sd.l,pl,lI.d 3 q.,esr

120

~0s

10

-~

C,t5~,

-I

—~—

~—-~

—(

;—

y o~

V

~3

45,’, ]etfl4I hqc2,d,e.

Ii 4 I~ I

~.:

3d,’

25

y,n

services grew only slightly faster than the productivecapabilities of the economy. From 1957 to 1964 totaldemand rose at an average 5.3 per cent annual ratewhile real output was increasing at a 3.6 per centrate. Total demand did not rise evenly during thisperiod. Although pauses in demand growth in 1958and 1960 were helpful in extinguishing inflationaryexpectations and pressures, there was a cost in termsof unemployed resources.

Since 1964 spending growth has accelerated, andinflationary pressures have again intensified. Totaldemand for goods and services, which had risen ata 5.3 per cent annual rate from 1957 to 1964, increasedat an average 8 per cent rate from 1964 to 1968.Productive capacity increased at an estimated 4 percent rate, Overall prices, after creeping up at the1.6 per cent rate from 1957 to 1964, rose 1.7 percent in 1965, 3.3 per cent in 1966, 3.2 per cent in1967, and about 4 per cent in 1968. Effective pricesmay have accelerated more than these figures indi-cate, for when demands are excessive, discounts andrebates are eliminated, and there is a tendency toreduce quality standards. In the preparation of priceindices, some of these developments may not havebeen detected, since producers do not like to dis-close their complete discount policies or a deteriora-tion of product quality.

(~f: th-~frito! on..

The period of excessive demand for goods andservices paralleled the nation’s growing participa-tion in the Vietnam war. During 1964, before themajor military buildup, total demand for goods andservices was large and expanding, and by year endproduction was at near capacity. Government out-lays for military goods rose from $50 billion in 1964to an estimated $79 billion in 1988, a 12 per centannual rate of increase. Total real output grew at a5 per cent rate during this period, so that a steadilygreater proportion of the nation’s production wasutilized in the defense effort.

Even though national policy allocated an increas-ing share of the nation’s product to war materials ata time when resources were fully utilized, excessivetotal demands could have been avoided. One metbodof financing the Vietnam effort and avoiding inflationwould have been for the Government to reduce other,

Page 3

lower priority programs. However, national policydictated the opposite — a guns plus butter program.Welfare and other Government expenditures wereaccelerated during the military build-up. From 1964to 1968 nondefense outlays of the Federal Govern-ment ro~eat an 11 per cent annual rate. This wasmore than double the rate of increase in real produc-tion and slightly greater than the 9.8 per cent trendrate of nondefense Government spending from 1957to 1964.

Government spending on nondefense activitiesduring the Vietnam conflict has been much greaterthan during the Korean action. At the peak of spend-ing for each conflict, total U.S. Government outlaysamounted to slightly over 21 per cent of gross na-tional product. Defense expenditures during theKorean action rose to over 13 per cent of total prod-uct while in the Vietnam war they amounted toabout 9 per cent. In the earlier period nondefenseGovernment outlays were cut from about 10 per centof total product to about 8 per cent. During theVietnam conflict welfare a n d other nondefensespending continued to take an increasing share oftotal output, increasing from about 10.5 per cent to 12per cent.

A second method of financing the greater expen-ditures while avoiding inflationary pressures wouldhave been for the Government to increase taxes ofbusinesses and individuals as was done in the Koreanaction. Additional revenue would have providedfunds for enlarged expenditures while tax paymentswould have reduced the spending ability of theprivate sector by a roughly corresponding amount.

US Government Spendingas a Per Cent of Toted Spending

PerCent bOde Pa Ce:

llowever, until mid-1968, Federal income tax rateswere not increased. In fact, the Government did theopposite by reducing such taxes in 1964 and againin 1965.

A third method of financing thc increased Gov-ernusent outlays while minimizing inflationary pres-sures would have been for the Government toborrow the additional funds from the private, non-banking sector. This would have required an in-crease in i n t e r e 5 t rates, would have inducedincreased saving and would have curtailed invest-ment. In this way, the larger Government spendingwould have been offset by a decrease in the outlaysof businesses and consumers.

The benefits of non-inflationary borrowing of fundsfrom the public must be weighed against the dis-ruptive effects of rapidly changing interest rates.At times of heavy borrowing, interest rates probablywould have risen sharply in order to attract therequired funds from reduced private spending. Nev-ertheless, financing the Government deficit fromsaving might have fostered lower average interestrates over the past four years since total demandsfor goods and services and inflationary pressureswould have been less. The problem of instability ofinterest rates was intensified by the fact that theGovernment (the largest borrower) concentrated itsfund raising in a few large issues, most of whichwere at pre-determined rates. Concentration of bor-rowing not only tended to aggravate short-run fluc-tuations in market rates, but the rigidity of termsplus the presumed desirability of avoiding any Gov-ernment financing failures placed an “even keel”constraint on monetary actions.

Interest rates rose but not sufficiently in the shortrun to attract enough new saving and to discourageenough private investment to finance the Govern-ment outlays. Yields on highest-grade corporatebonds increased from 4.40 per cent in 1964 to 6.15per cent in 1968. However, in view of the inflation,real interest rates may have risen litfie, if at all.When prices are expected to rise, potential suppliersof loan funds must be offered a higher return toprotect the purchasing power of their funds. Busi-nesses are not discouraged from borrowing at thehigher rates if they expect to repay in cheaper dollarsand if they anticipate that postponed projects willcost more later.

A fourth way of financing expenditures is to createmoney. A large portion of the greater Governmentoutlays was accompanied by creation of fundsthrough an expansion of bank credit, The Federal

Page 4

1962 W4~ 1944 594 W~8 19~7 988 5969hmafaso at’ stere I r ew ebta,,adW sebtyotti,rpø ‘seal rota af,, eetsthauotpl tG$Ppc,ce clettotar Inthep’ecede,tg eweniy late maclid ctnthema etwit ancarpo ataaoabasdl,It, pyrtadeltato I,. the cc as itS n,at,ltnateacendea a ntmiotedhliee r telpalaithe Imp5 ,rpocadaflaiarl* iavrIhsea,is945 esettemated

Will lit on,,, oidr,t~hn..oe,stwcthe n p.rtoctogeeedvpomwti’ alviming olltpee.estmgil andlie .e .,ny can,

5. edonlltosl,atb*na

appre teet,ar,*twhatid b.sngo’tnson.tat. dotsplat,ed !~avse

Reserve System was able to moderate upward move-ments in interest rates temporarily by buying securi-ties, and these actions provided commercial bankswith reserves which permitted them to expand theirloans and investments. Federal Reserve credit ex-panded at a 9 per cent annual rate from 1964 to1988 after rising at a 7 per cent rate from 1957 to1964. Commercial bank credit, other than thatmatched by an increase in time deposits, rose at a4 per cent annual rate from 1964 to 1968. From 1957to 1964 this credit had grown at a 1.8 per cent rate.

“Manufacturing” money seemed less painful thancutting desired Government programs, raising taxes,or permitting an early increase in interest rates.Creation of spending power by expanding bankcredit increased the ability of the Government tospend without reducing other dollar outlays. As aresult, total dollar demands became excessive, andthe rationing of the limited supply of goods andservices was accomplished in the market by risingprices.

From 1964 to mid-1968 there was only one brief

period of about six months when increased Govern-ment expenditures were not accompanied by a largeexpansion of the money supply. This was during thesummer and fall of 1966, when the money supplychanged little on balance. At first, interest rates rosemarkedly as the competition for available funds be-came keen. Some private projects could not befinanced and had to be postponed. Partially becauseof legal ceilings on certain interest rates, the ration-ing severely affected financial intermediaries and thehousing industry.

The 1966 period of financial “crunch” receivedmuch adverse publicity, and the moderation inmoney growth was not pursued long enough to elim-inate the inflation. Yet, in late 1966 and early 1967inflationary forces moderated, and, with reduced in-flationary expectations, interest rates fell. Conditionsfor financial intermediaries and the housing industryimproved as market interest rates declined belowlegal ceilings.

Effects of Inflation

Inflation, by reducing the purchasing power ofdollars, bonds and other fixed dollar claims of con-sumers and businesses, is one way of financing Gov-ernment spending. Some observers believe t h ainflation may be the most acceptable alternative.Since some effects of inflation are apparent only witha lag, it seems easier to spend from created fundsthan to reduce other Government outlays, raisetaxes, or permit interest rates to seek their equilibriumlevels. Inflation, like higher taxes, spreads the burdenof Government expenditures broadly. As long as de-mands for goods and services are excessive, mostworkers find employment, and businesses appear tothrive.

Some individuals and businesses may reduce theadverse effects of inflation on themselves by holdingassets in the form of equities rather than debt in-struments, by borrowing, and by putting cost-of-livingescalators in wage and other contracts. However, thesuccess of inflation as a means of financing Govern-ment expenditures depends upon a great manyholdings of fixed dollar assets by a public whichcannot or does not find alternatives.

Inflation reduces the value of the dollar and fixeddollar claims relative to other assets, redistributingwealth.’ Declines in the relative value of fixed dol-

1lrving Fisher noted on page 61 of his book The MoneyIllusion (New York: Adelphi Company, 1928), that: “Itmight be argued that no harm can be done to society as awhole either by inflation or deflation since the average wealthwould not be changed. But one might as well reason thatwhen a bank vault is robbed or when your house isburglarized, society is none the poorer.”

Page 5

Ear claims reduce the attractiveness of placing fundsin financial intermediaries. Since those with smallsavings have few satisfactory alternatives to financialinstitutions for their savings, the total amount ofreal saving may be reduced. Changing relativevalues of assets also makes speculation in inven-tories, stocks, and land more attractive relative toproduction.

Since inflation encourages the demand for savingrelative to its supply, market interest rates are drivenup. Much of the rise in nominal interest rates in theUnited States since 1964 may be explained by in-creasing inflationary expectations. Market interestrates have usually been higher in countries whereprices have risen faster than in the United States.

Inflation has been a regressive “tax,” tending tobear more heavily on those in the lower incomebrackets than a progressive income tax. Those withlittle wealth have not been able to protect them-selves as well as those with greater means. In-dividuals with little net worth derive most of theirincome from wages, pensions, and other sources,many of which adjust slowly to inflation. By con-trast, the wealthy derive more of their income fromprofits, which respond quickly to excessive de-mands and price changes. Savings of those withrelatively small means are mostly in fixed dollarliabilities of financial institutions and U.S. savingsbonds. The wealthy hold a larger portion of theirassets in stocks, land, and commodities. Most privateborrowing is by businesses and individuals with sub-stantial net worth, and with inflation repayments aremade in depreciated dollars.

Greater profit opportunities and higher levels ofemployment which accompany early stages of infla-tion are probably temporary. Although an accelera-tion of the demand for goods and services tends tostimulate production and employment, these bene-fits probably cannot be maintained without contin-ually accelerating the rate of inflation. Once theinflationary expectations are fully anticipated anddigested, interest rates and other prices rise to levelswhere investment and employment tend to fall backtoward their long-run equilibrium even though therate of inflation continues unabated.

Trade-offs between prices and employment (theso-called Phillips curve) occur because of a moneyillusion of spending power. However, as pricesadjust to the new supply and demand conditions,the stimulative effects of the existing rate of inflationare dissipated. Ultimately, total employment de-pends on the number of people in the labor force

and their ability to produce compared with wagessought, together with a great multitude of institu-tional arrangements. Prices, on the other hand, re-flect the relationship between total dollar demandand the volume of goods and services available.

Rising domestic prices and costs of production re-duce the value of the dollar relative to foreigncurrencies. With higher costs of production, compe-tition with foreign producers becomes more difficult.In 1964 the nation’s exports of goods and servicesexceeded imports by $8.4 billion. After 1964, asinflation accelerated, this excess declined, graduallyfalling to an annual rate of $1.7 billion in the firsthalf of 1968 (See chart on page 16 of the article “U.S.Balance of Payments in 1968” in this Review.) Dur-ing this period imports of goods rose at a 16 per centannual rate, while exports increased at a 7 per centrate,

1 Ofl.UOtV)fl •A .scar ;4r;r,

As the year 1967 ended, the greatest domesticeconomic problem appeared to be inflation. TheDecember 1967 issue of this Review pointed out:

“Conditions at year-end indicate that stabiliza-tion problems will present a formidable chal-lenge during the year 1968. Late in 1967,spending is rising twice as fast as productiveresources, prices are increasing in response toboth past and current demands, market interestrates have risen to the point where many con-cerns were threatened by legal and institutionalrigidities, balance of payments problems con-tinue, and both monetary and fiscal influencesare more stimulative than at any time in twodecades.”An initial problem in 1968 will probably be tocontain excessive demands for g o o d s andservices.”

The Economic Report of the President, released inearly 1968, stated that:

“Most experienced observers agree that the pace(of economic activity) now is — and in themonths ahead will be — too fast for safety. Thegain in gross national product in the currentquarter is generally expected to be one of thelargest in our history — a record we could gladlydo without at this time. . . . I therefore urgentlyrenew my request that Congress enact a tem-porary 10 per cent surcharge on corporate andindividual income taxes.”2

2Economie Report of the President, Febmary 1968, pp. 9and 10.

Page 6

On December 12, 1967, to the Federal Open Mar-ket Committee, “it appeared highly probable thatgrowth in overall activity would accelerate in early1968 and the upward pressures on prices would per-sist as the effects of higher costs were reinforced bythose of rapidly expanding demands.” Asa conse-quence, the manager of the monetary system’s OpenMarket Account was directed “. . . to moving slightlybeyond the firmer conditions that had developed inthe money markets. . . “3

Stabthzoti.on z4eti.onsn~.the First I.ioff of 1968Despite the recognized desirability of taking ac-

tions to reduce the excessive demands, both fiscaland monetary influences continued expansionary inthe first half of 1968. Fiscal restraint was delayedwhile Congress and the President debated the rel-ative merits of a tax increase or spending cuts. Mone-tary authorities, observing rising interest rates andfearful of the effects on the nation’s financial institu-tions, on construction, and on other sectors if interestrates rose substantially further, continued the rapidmonetary growth.

The high-employment budget, a measure of Gov-ernment fiscal policy, was at an annual rate of deficitof $14 billion in the first half of 1968. This was $2billion greater than in the corresponding period ayear earlier and $8 billion more expansionary thanin 1964, the year of the tax cut designed to en-courage economic expansion. The first half rate ofdeficit amounted to a shift of about $25 billion fromthe 1960 through 1964 period of balanced economicexpansion when there ‘vas an average surplus of $11billion a year.‘lAt,rcuol R port of the Board of Governors of the Federal

Re. en~ Sy ton for 1967 pp. 199-205.

Federal Budget Infiuence$ttmute or Reefro tat

O,eemdy at, atA,taatt ategtlttanrafoattor, aet,e A~t ‘I Stittoet ofOattors

10

.5 5

I D

1960 5967 1968e,eefle,k I

‘TI,. el, Imp art, “I d ‘cm,t.ts.tdermplctted ,q..p,’,,

mlii, Iontnbutton o} Va,4ous factors to

tates* hangtkiet$eMoney totktMlintilyAv s*tOtIv US 54

a is. I anqe inMøa Stock

Items 8 MoacI~68 *4ev *714 1* a

t2ct 8 ita6S Mtr 68tili9~ tnI*

tcess fiqiewac 0.7 0 0 a02 01 0620 07 02

isis Bs,ktn~ 29’ t~ 02 PUbtL

Ce 1kW 1 ItT 9.an 41

kMçtbet ~sttk 4.4 01 40*1 bIte —*29 40-

StI.

Stab. Is 6 44 to4 05 19S TóMsS

it 173 *88iier

let 1~\*~iI’ tO 14 76

1 248

toTab daSt

0 15,0 23mars tat

batlijsis ss4d ~o

Sri ISba~ Ste ~

tamaleS, JameS namoneniefa

t~ macabet bitt reeen otitet than PelSe I, tie - (loveinmeab Macmires teentiiet banas trait K Sinks, maO esutesy lieu it tie ja*bc

Government debt management operations werealso more expansionary in the first half of 1968. Because of the I gal maximum interest rate of 4¼percent on new issues with matunties over seven yearsthe Treasury was forced to finance with relativelyshort-term issues adding to the liquid assets of thepublic. Average maturity of the public debt de-clined from 62 months in 1964 to 53 months in 1967and to 50 months in June 1968.

Monetary aggregates ‘iceelerated during the springof 1968 from an already very expansionary rate.Growth in the nation’s money supply consisting ofprivate demand deposits and currency after slow-ing from November 1967 to March quickened inthe se cond quarter. Fluctuations in the growth rateof money reflected m’iny developments (See Table I).One factor was a build-up of Treasury deposits (notincluded in mone supply) in the winter, followedby a sharp decline in the spring and early summer.

Page 7

Money StockRatio ScaleRat,, ScaIc M.’t~’,Aee ..,tt.,tO. I, F,q’,t’ B,II,ons ot Doltars

BoIcnu at Doh’s 5.~.’,’.h’,Atu.•~d

The money supply increased at a 6.8 per centannual rate in the first half of 1968, following a riseof 6.4 per cent in 1967. From 1964 to 1967 themoney stock increased at an average 4.1 per centrate, and from 1957 to 1964 the trend growth wasat a 1.9 per cent rate. The major factor causing thesharp rise in money in the first half of 1968 wasFederal Reserve System actions. Federal Reservecredit by itself provided for an increase of moneyat a 19 per cent annual rate.

The supply of money rose faster than the amountof money demanded. When money exceeds the de-mand for money to hold, there are incentives toeliminate the discrepancy by spending the excesson goods, services or financial assets, A review ofchanges in the money supply and spending sinceearly 1953 indicates that the demand for money tohold has usually risen at a fairly steady rate.4 In thefirst half of 1968, the demand for money as an assetmay have risen more than usual, as income, wealthand transactions rose. A partial offset was probablycaused by the fact that rising interest rates increasedthe alternative cost of holding money balances.

Not only the quantity of money but other mone-4See “Economic Pause, Acceleration and Excesses — 1967in Retrospect” by Norman N. Bowsher in the December1967 issue of this Review, pp. 14-16.

tary aggregates as well rose very rapidly in early1968, compared with the 1957 to 1964 trend ratesor the 1964 to 1967 rates when inflationary pressureswere building up.

Money plus time deposits and bank credit, al-though increasing substantially in the first half of1968, rose less rapidly than in the 1964 to 1967period. The slower growth rates of these broadmeasures can be attributed chiefly to the behaviorof time deposits in the second quarter of 1968. Therates of interest that commercial banks are permittedto pay on savings and other time deposits are gov-erned by Regulation Q. In the spring of 1968 marketinterest rates rose relative to the ceiling rates ofRegulation Q, and banks could not effectively com-pete for these funds. Consequently, the normalchannels of the flow of funds from saver to investorwere disrupted, and some funds bypassed commer-cial banks by going directly into Treasury bills, com-mercial paper and other instruments. Growth of totalcommercial bank deposits and of total bank creditwas moderated, but total liquid assets and totalcredit extended (bank plus nonbank) was probablyaffected little by Regulation Q. The interruption ofthe normal flows probably reduced the efficiency ofthe financial system, and may have favored the Gov.ernment and other large borrowers, who obtain funds

Table II

Growth Rates of Selected Monetary Aggregates(Annual Rates of Change)

Dec. 1967 to 1964 to 1957 toJune 1968 1967 1Q64

Feao,at R,tuerve Credit 13.0”, 8.1% 7.4~”Total Mambor Bank Reserves 5.3 4.8 2.8Reterve, Avalablo for

Priv’,tc, Demand Deposits 6.3 2.8 1.2Monetary Bose 6.6 .4.9 2.7Demand Deposit

Component of Money 6.5 3.7 1.8Monoy Supply 6.8 4.1 1.9Money St~pplyplus

T,me Deposits 6.0 8.2 5.3Bank Cred,t 8.3 8.8 6.4

Table IllPercentile Rank of Growth Rates of

Monetary Aggregates1

June 1968 Dec. 1967to to

Oct1968 June 1968Foderol Reserve Credit 70 86Total Mambo, Bank Reserves 89 78Reserves Avoiobie for Prvote

Demand Depouits 39 91Monetary Bate 90 92

Demand Depost Component of Money 72 92Money Supply 80 93Money Supply plus T,me Deposits 97 62Bank Credit 98 68

‘All ~ ir.ur.r,,,,r.th tIll ,n_n,, nth 1.r’:.’d~ fl’..rn.1 tim.t,rv 3943 to October 1905.

Changes in the Treasury’s cash balances cause op-posite movements in private deposits (money), butover longer periods they have had little net effect,since the Treasury seeks to keep its average cashholdings at a practical minimum which changes littleover time.

Page 8

in the capital markets, relative to consumers, smallbusinesses and real estate buyers, who rely moreheavily on local financial institutions,

The rapidity of growth of monetary aggregatesduring the first half of 1968 may be measured bycomparing their growth rates at this time with thoseof all other six-month periods in the last two decades.For example, the 6.8 per cent rate of increase inmoney in the first half of 1968 (See Table II) rankedin the 93rd percentile among 238 consecutive six-month periods (Table III).

.Fconomic Activity in the First Half YearStimulated by the expansionary fiscal and mone-

tary developments of late 1967 and early 1968, totalspending accelerated in the first half of 1968. De-mand for goods and services rose at an 11 per centannual rate, a sharp acceleration from the 8 percent rate of the previous six months. From 1964 to1967 demand had increased at a 7.7 per cent rate,and from 1957 to 1964 it grew at a 5.3 per centtrend rate.

The demand for goods and services was strongin every major sector of the economy. In the firsthalf of 1968, consumer spending rose at a 10.5 percent annual rate, business spending at a 9.2 percent rate, and Government purchases at a 16.4 percent rate. Business outlays on inventories were par-ticularly heavy in the second quarter, but the in-ventory-sales ratio was lower at mid-year than it wassix months earlier.

In response to the strong demand, production con-tinued to expand in early 1968, despite shortages ofefficient workers, bottlenecks due to capacity limi-tations, and labor strikes. Total real output increasedat a 6.4 per cent annual rate in the first half of1968. During the Vietnam build-up from 1964 to1967, production increased at a 5 per cent rate, andfrom 1957 to 1964 it grew at a 3.6 per cent rate.Over the long run the maximum growth in produc-

Table IV

Growth Rates of Selected Business IndicatorsAnnual Rates of ~hange~

Dec. 1967 to 1964 to 1957 toJune1968 1967 , 1964

Total Spcndirg 10.6. 7.7 . 5.3Business Spending 9.2 67 4.8Canst.’mer Spendtng 10.5 7.1 5.2Governmert Spending 164 11.5 5.8

Peat Product,on 6.4 5.0 3.6Industrial Prad~ction 4.1 6.1 4.0Total Employment 1 3 2.4 1.1Poyroil Employment 2.9 4.2 1.4Personal Income 9 8 8.1 5.1Consbmer Prices 4.6 2.5 1.4Wholesale Prices 3 6 1.8 0.2Overall Prices 3.9 2.5 1.6

Demand and ProductionRuto Scc,~. ~ A?~’t~~~ Rot,o Scale5 hl,o.,c oh DrI Crs ~ Riltions oh Dollars

, )_.“---

—

—

—

.

750

703

.

Istal Sptrding

~

‘

Real Pro

. .

flcct ,

•

‘Qoj 06 ~co2 ‘C63 ~964 965 ~66 I 967 :955--

SGNF

tion is determined primarily by improved technologyand by increases in the labor force and capital goods.From recent growth rates in these resources it isestimated that capacity has been going up at abouta 4 per cent annual rate in recent years. Rates ofincrease in output in excess of the trend growth incapacity are unsustainable.

Employment rose at about the same pace as thepopulation of working force age in the first half of1968. Most entrants into the labor force were able tofind work, many jobs remained unfilled, and unem-ployment remained a relatively low 3.6 per cent ofthe labor force. Among married men, unemploymentaveraged 1.6 per cent.

The strong demand for qualified workers tendedto drive up wage rates, creating an illusion of un-usually large increases in real income. Averagehourly earnings in manufacturing rose at a 6 per centannual rate in the first six months of 1968 comparedwith a trend rate of 3.3 per cent from 1957 to 1967.Disposable income (income after taxes), measuredin current dollars, increased at a 10 per cent annualrate in the first half of 1968. From 1964 to 1967after-tax income rose at a 7.6 per cent rate whilefrom 1957 to 1964 it increased at a 5.1 per centrate. Yet, in terms of purchasing power, disposableincome grew little faster in early 1968 (5.6 per centrate) than in the previous decade (4.2 per centtrend), and many on relatively fixed incomes foundtheir real income declining.

Although funds available for lending rose in early1968, demands for credit were sufficient to drive upinterest rates. Nominal incomes were large, and theproportion saved was high. Saving amounted to 7.4

Page 9

Interest RatesRatio Scale Ratio Scale,.fv-,1. u,,...,—o, ~,.t’’ ntY.ple~c

2

3-Month Tretsury BtlIs

— ‘1961 1962 1963 964 1965 1966 1967 1968 1969

:.,c’’,.tc,.sc’G.,,e-,u.s,’E,’.,,., ~.

per (slit (hI income after taxes in the first half of1968, compared with an average rate of 6 per centfrom 1959 through 1967. Bank credit expansion, notmatched by increased time deposits, was sizable,rising at a 6.5 per cent annual rate compared witha 2.4 per cent trend rate from 1957 to 1967.

Interest rates on highest-grade corporate bondsaveraged 6,28 per cent in June compared with 6.19per cent in December 1967, 440 per cent in 1964,and 3.89 per cent in 1957. Yields on three-monthTreasury bills averaged 552 per cent in June com-pared with 4.96 per cent in December 1967, 3.54per cent in 1964, and 3.22 per cent in 1957. TheFederal Reserve Banks increased their discount rates,the interest rate on advances to member banks,from 41/2 per cent to 5 per cent in March and to 5½per cent in April in an effort to keep these rates inline with other rates.

The strong demand for credit reflected the largeGovernment deficits and inflationary expectations aswell as the relatively high and rising level of produc-tion. The Federal Government’s borrowings from thepublic, seasonally adjusted, amounted to an $8 billionannual rate during the first half of 1968. From 1960through 1967 net borrowings averaged $2 billionper year. Further, with the growing expectations forinflation, private borrowers were willing to pay higherrates since repayments were expected to be madein cheaper dollars and any project postponed wouldbe likely to cost more later.

Stabilization Actions During the SummerOn May 30, President Johnson delivered an ad-

5

3

dress to the nation, reasserting a need for andstrongly recommending a 10 per cent surtax on cor-porate and individual incomes. In this speech hestated a willingness to accept planned Governmentspending for fiscal 1969, some $6 billion less thanprovided in the budget message, in order to obtainthe tax increase. The fiscal package was subsequentlysigned into law in late June and was implementedshortly thereafter.

Last spring most analysts felt that a tax increasewas essential.5 Chairman William McChesney Martinof the Federal Reserve Board told the AmericanSociety of Newspapers Editors in late April that:“We must have a tax increase, reduce the budgetarydeficit and correct the adverse balance of payments..

Despite the strong feeling that a tax increase wasessential, once the tax was passed many analystsfelt that the action was too vigorous, and a fear of“overkill” developed. In the August 5 issue of U.S.News and World Report, Arthur Okun, the Presi-dent’s chief economic adviser, stated, “I know of noone who would say now that our worries are stillthose of expanding too fast. If anything, the balancehas shifted a bit in the other direction.” Most econ-ometric models of the economy indicated a quickand marked slowing in activity as a result of thefiscal a c t i on. The University of Pennsylvania’sWharton School model was typical; it forecast onMay 23 that if the fiscal package were adopted onJuly 1, total spending would rise at an $8.7 billionannual rate from the second to the third quartercompared with the $21 billion rate in the first half.Also, it was predicted that most of the increase inspending would be matched by price rises, and totalreal production would change little.

Reflecting the marked shift in sentiment and ex-pectations after the tax increase and cut of plannedGovernment spending, monetary policy was relaxed.The Federal Open Market Committee’s instructionsto the desk manager on July 16 stated in part, “Thenew fiscal restraint measures are expected to con-tribute to a considerable moderation of the rate ofadvance in aggregate demands.” The desk managerwas asked to conduct operations “. . . with a view toaccommodating the tendency toward somewhat lessfirm conditions in the money market...”°

51n a speech in late March, Professor Paul Samuelson statedthat “tax increase is needed to check the exuberant andinflationary trends in the economy.” In May, Professor PaulMcCracken said “the tax increase mnst be passed; the basicneed is for a policy of disinflation to cool the overheateddomestic economy and regain an environment in whichthere is some possibility of less costly wage settlements”

6Federal Reserve Bulletin, October 1968, p. 866.

Page 10

a~

BC -- -— --80

- -

70 - - ~LJ,~2!”i - - - 70

:~Ar

~ ti ~!~IHI_J

Interest rates moved lower during the summer,partly in response to the new expectations of lessGovernment borrowing, of less rapid increases in totalspending and of reduced inflationary pressures.Three-month Treasury bill rates declined from about5.75 per cent in mid-May to around 5.00 per centin mid-August. Yields on highest-grade corporatebonds went from about 6.30 per cent to less than6.00 per cent. Following the decline in market in-terest rates, the Federal Reserve Banks lowered thediscount rate from 5½per cent to 5¼per cent inAugust. In the fall it gradually became apparentthat spending was not slowing abruptly, and marketinterest rates rose, retracing most of the earlierdeclines by early December.

Despite the moderate decline of interest rates inJune and July, it now appears that during the sum-

mer months there was a shift in monetary influencetoward less stimulus. Because of the tax increase andspending cuts, the Federal Government borrowedless than it otherwise would have. Other demandsfor credit became less intense, perhaps reflecting alowering of expectations for future economic activityand prices. As a result, while interest rates declinedfrom May to August, the rate of System purchasesof securities was not accelerated. Total Federal Re-serve credit continued to increase at roughly the 10per cent annual rate that it had risen since early1967. Similarly, the monetary base continued to riseat the 8 per cent rate of the earlier period.

A reduced rate of money expansion after July re-flected primarily the fact that more of bank reservesand the monetary base were utilized for non-monetary purposes. Treasury deposits in memberbanks, which are not included in the money stockbut which must be supported by the base, rose froma low level of about $1.5 billion in early July toabout $5 billion in November. Time deposits in com-mercial banks, which also are supported by the basebut are not money, began rising rapidly after mid-year when market interest rates on competitive in~struments fell below Regulation Q ceilings whichbanks are permitted to pay on time deposits. Timedeposits, after climbing at a 5 per cent annual ratein the first half of 1968, increased at an 18 per centrate from July to November.

Money StockRatc Scale . - h - . Ratio ScaleBi’lio’s of Dollars - .; . •~ .~ ‘ B;ll~~of DaflcrsLI/V

155

Icn

~~T/di~

155N

I$F I FtF I sçcspAa

I,, 7

I I I ItI El I 41 II FrIll FF1

- - 1945 1966 1967 1968 - -10 or a ,,,oF ‘Fe oh ~ b,ta, a pe’,od “di a, 4 Th’yore

p e ,iiedi e,di’coepo ,gmo t ec ritdaye 0 meat P0 t’i,e,d,

ate ‘no o F 4 No,emb r oil ‘ned

As a result, the money supply of the nation, de-fined as private demand deposits and currency, roseat a 3.5 per cent rate from July to November afterincreasing at a 7,4 per cent rate from early 1967 toJuly 1968. The demand deposit component of money

Monetary BaseSRo~o5cc Ia ,.,..._ A....eges_.t~i,.yiorb Rolto ScaleB tJ hio ns of Dollars a u I• Ad ....‘ 8 IIions of Dollars

N_______ ____________ F$45 964 1967 1968

‘V ilte pryba ‘a eiabe bank, ad cy (db it,epvbkcdil aeatbe a .4~oi a itSle tees vleia the, SshiFter, F COn late a hot, tlbteo ceit I yih, beck

I neaseea a t ttangeb~ts, cpa 4 indkaacd.Theya pre reedtatiSsacan,pa t ttd etepase ithpat ad

do p aft It easbe time

Table V

Growth Rates of Selected Monetary AggregateslAnnual Roles of Change)

July 68 Jon. 67 1937to to to

Nov. 681 July 68 1966federal Resor’.e credit 10.0 9.8’~ 7.7~-Total Mombor Bark Rescues 9.5 7.6 3.2Reser,es Available to’

Private Demand Deposils 1.8 6.4 1.6Monetary Base 6.2 5.9 3.2Demand Deposit

Component of Money 2.6 7.6 2.2Money Stock 3.5 7.4 2.4Money Stock plus

tme Deposits 10.7 9.5 6.0Bank Crodit 17.0 10.6 6.9Time Depesils 18.2 11.8 12.1

Lcrqe COr 40.0 13.9 —

Othor lime &Savings 16.0 11.6 —

‘i~.tlmated.

Page 11

Money Stock Plus Time Deposits

Polio ScoleRatio Scale MonthhyAe,r,gnetDcihyFi;,’.. Billions of DollorsBillions of Dollars 5.,.eneI , Adhiteted 43043C 420

42C

,..

aF_Iv

400390 — ~b380

376

--—--—- -~—- 38037(3

360 360

350 —- - 350

3405,

340

at — 330

at

216

——-

-9

326

310

$~ 300

~90 290

2Bc~Apr

IlItIlIFlIlI

Apr68 , 7

1141 FIl IItFIIIIIFIFIII

4, 68

I II IIIFtFI2g6

1965 1966 1967 1968P,,,ercge’.,r.sir,..ci -s~e.&r.a,iecEe,..’ei pariassi’.’ a Th,yrr—u,esr-,d

00 I fl~ pci.’~ fl,I..,....i .J,~”-p’...ts— ti t..a.tt~.’i..i’

te.rda•eetsttcd No-,rrp,’,tirnv’ts

rose at a 2.6 per cent annual rate from July to No-vember, following a 7.6 per cent rate of increase inthe previous eighteen months. Broader measures, suchas bank credit and money plus time deposits, wereheavily affected by the reintermediation of time de-posits and rose at even faster rates than before (SeeTable V).

Economic Activity Since Mid~Year

Despite the change in fiscal policy at mid-yearand the more restrictive monetary developmentsthat began in July, spending continued to rise atan excessive rate during the last half of 1968.Total demands for goods and services rose at a 9 percent annual rate in the third quarter, and preliminaryfigures for October and early November indicate thata rapid pace was maintained early in the final quar-ter. The slightly reduced pace in spending from the11 per cent rate of increase during the first half of1968 to the 9 per cent rate after mid-year wasaccounted for by a shift from stockpiling of steelbefore the strike was averted to inventory reductionsafterwards. Final sales, i.e., spending other than forinventories, has continued to rise rapidly. Final salesincreased at a 10 per cent annual rate in the thirdquarter, about the same as in the first half.

With increases in spending continuing to outpacegrowth in capacity, inflationary pressures continued

strong after mid-year. Preliminary data indicate thatreal output has risen at about a 5 per cent annualrate and overall prices at nearly a 4 per cent ratesince the second quarter.

Continued spending at an excessive rate in theJuly to early November period, despite earlier ex-pectations of a quick and marked slowing after thetax increase, was not inconsistent with stabilizationactions taken. Monetary growth was very rapid untilJuly, and the expansionary effects of such growthusually continue to be strong for about five monthsafter it moderates. Fiscal actions were not large com-pared with the size of the economy, and much oftheir effect was either delayed in implementation orcould easily be offset.

The impact of monetary influence on spendingmay have been very expansive in the third andearly fourth quarters of 1968. From January 1967 toJuly 1968, the money stock had risen at a 7 per centannual rate, about three times the trend rate from1957 to 1966, Studies indicate that changes in thegrowth rate of the stock of money have a significanteffect on changes in the growth of spending, withmuch of the impact coming in the following twoquarters.’ Hence, even though monetary expansionslowed around mid-July, monetary influence duringmost of the last half of 1968 probably continued tobe excessively stimulative.

Because of the financing constraint, questions havebeen raised as to the strength of fiscal actions alonein resisting inflation. Higher taxes may merely re-

7See “Monetary and Fiscal Actions: A Test of Their RelativeImportance In Economic Stabilization,” by Leonall C. Ander-sen and Jerry L. Jordan in the Noveisiber 1968 issue ofthis Review.

Final Salesletel Spanding Less Changes in Business Ineenleries

Ro’io Scale a, i, ,,,i,,i’.aI,RFt., Ratio Scot.1.11 ons ofDollors •u.e.,sI,sdi.,in d Billions oF Dollars

960 196’ 1962 5963 964 1965 t966 1967 196B

as.,,,. usc.m,s..,eic,m—.,,.

J ~

Page 12

place borrowing from the public, leaving total spend-ing, public and private, about unchanged. Similarly,a drop in Government spending may be offset bymore private spending since the Government bor-rows less from the private sector. It has been foundthat “. . . either the commonly used measures of fiscalinfluence do not correctly indicate the degree anddirection of such influence, or there was no meas-urable net fiscal influence on total spending

The fiscal package when fully implemented wouldamount to about $17 billion, or roughly 23 per cent,of the increase in gross national product in theprevious year. 1-lowever, the fiscal stance of theGovernment would still he approximately the sameas in the early ‘sixties when economic activity wasexpanding rapidly. Even when the surtax and spend-ing cuts are fully implemented, the Government’shigh-employment surplus will amount to less than 2per cent of total spending. By comparison, in 1983the budget surplus amounted to 2.2 per cent ofspending, and in that year spending rose faster (6per cent) than the growth of capacity.

The fiscal package was not immediately imple-mented in full, reducing the likelihood of a quickslowing response in spending. It takes time to re-duce the momentum of Federal programs, and mean-while, activities not under the Expenditure ControlAct of 1968 have continued to expand. As a result,total Federal expenditures have not been cut andare now expected to be about $188 billion in fiscal1969, 5 per cent or $10 billion above fiscal 1968,and about $2 billion more than the level proposedbefore imposition of the $6 billion cut. Further, sincethe full amount of the increased tax was not with’held from wages and salaries in 1968, much of theimpact of the tax was delayed until the spring of1969 when the retroactive liabilities must be paid.

Some of the restraining effect of the tax on pri-vate spending may be offset. The surtax is highlyprogressive, falling mainly on those in the upper-middle and higher income brackets. These are theones most likely to maintain their standards of livingafter imposition of the tax, especially in view of thehigh rate of saving early in 1968 and the possiblytemporary feature of the tax (scheduled to he re-moved in mid-1969).

Summary and Outlook

Nineteen sixty-eight was the fourth successiveyear of accelerating inflation. Prices rose about 4 percent after going up 3.2 per cent in the previous

~Ibid,p. 22.

year. By contrast, from 1957 to 1964 prices rose at a1.6 per cent annual rate. The inflation resultedfrom an excessive demand for goods and serviceswhich was nurtured by stimulative fiscal and mone-tary developments.

At mid-year the Government imposed a 10 percent surtax and provided for a $6 billion cut inplanned expenditures with a view to moderatingtotal spending. Monetary developments also becameless expansive; since July the money stock has in-creased at a 3.5 per cent annual rate after rising at a7 per cent rate in the previous eighteen months.

Despite these actions, total demand for goods andservices has remained excessive. The continued ebul-lience has reflected the delayed effects of the earlierrapid monetary expansion. The fiscal package wasmoderate in size, slowly implemented, and partiallyoffset by a lower saving rate.

Economic activity in the first half of 1969 is likelyto be greatly influenced by stabilization actions al-ready taken. The slower growth of money since Julymay act as a restraining force on the growth of totaldemand in early 1969. In addition, the gradual im-plementation of the surtax and Government spend-ing cuts will increase the probabilities of continuedmoderate monetary growth and may cause someslowing in total spending, especially in March andApril when retroactive tax payments are made.Social security taxes are scheduled to increase onJanuary 1, withdrawing an estimated $1.5 billion an-nually from employees and a similar amount fromemployers.

Even if spending slows markedly in early 1969,inflationary forces will probably remain a seriousproblem throughout the year. Price markups usuallycontinue for an extended period after growth inoverall demand for goods and services moderates,reflecting “cost-push” forces generated by earlier ex-cessive spending. Some prices, such as bargainedwages and those set in other contracts, which havebeen relatively inflexible during recent periods ofexcessive demands, will probably move up later attimes of renegotiation. Other price adjustments havebeen retarded by lack of knowledge of costs, bypublic opinion, and by inertia. As these wages andprices advance, the increase in production costs willplace upward pressure on other prices.

Because of the basic imbalances caused by pastspending excesses and price rigidities, the economymay simultaneously experience rising prices and areduced rate of growth of resource use for an ex-tended period. At such times, pressure frequently

Page 13

builds up for imposing controls on wages and prices.Such controls, however, are of little value in aidingthe economy to reach equilibrium at stable prices.The problem of current price increases resulting frompast excessive demand is a reflection of the relativeinflexibility of prices, and imposing more rigiditiescan prolong the adjustment process. Controls alsoraise problems of resource allocation, interfere withfreedom, and are difficult to administer.

A major consideration for stabilization policy-makers in 1969 will be to determine how rapidly theexcessive rate of increase of total demand should bereduced. If fiscal and monetary actions are adoptedwhich will slow the rise in total demand for goodsand services abruptly, inflationary pressures may berapidly reduced. However, the cost in lower produc-tion, employment, and incomes would be large. Onthe other hand, if total demand is moderated slowlyenough to permit the growth in production, employ-ment and income to continue at near their long-mntrends, moderation of the inflationary pressures maybe a long, slow process.

Some appreciation of the task confronting policy-makers can be obtained by reviewing the last periodwhen inflationary pressures were significantly dimin-ished. From 1947 to 1953 total demand rose at anaverage 8 per cent annual rate, with real productexpanding at an unsustainable 5 per cent rate andprices at a 3 per cent rate. In the following eightyears, from 1953 to 1961, total demand grew at amuch slower 4.5 per cent rate. Average gains in realoutput fell to a relatively low 2.4 per cent rate, butprice increases were only gradually reduced from the

3 per cent pace to 1.1 per cent in 1961. Inflationaryexpectations may be easier to eliminate now than theywere in the fifties, since they have existed only aboutfour years compared with over a decade in the ‘fortiesand early ‘fifties. Also, a gradual reduction of totaldemand may be more effective in combating infla-tionary expectations and less costly in terms of reducedreal output than the actual stop-and-go influences ofthe ‘fifties. Nevertheless, elimination of inflationarypressures appears to take considerable time, with realoutput falling below long-run attainable rates.

Problems of domestic economic stabilization in1969 may be aggravated by unforeseen changes indefense spending as international developments un-fold. Varying moods of optimism and pessimism,changes in tastes and preferences by consumers andbusinesses, strikes, weather, institutional and legalrigidities, and technological change all increase thetask of economic stabilization. Also, there is a con-tinuing balance-of-payments problem which might actas a constraint on policies designed for domesticpurposes.

Other obstacles to economic stability include in-complete and delayed information on economic de-velopments and a lag in effect of stabilization ac-tions taken. A complete “fine tuning” of the economyprobably cannot be attained in the present state ofknowledge, and vigorous efforts to do so may actuallyhe destabilizing. However, if extremely destabilizingactions can be avoided, we should make progresstoward the goals of a continued high level of em-ployment and reasonable price stability in a basicallyfree economy.

NonMs1~ N. Bowsimi

Page 14