April 10, 1974
Our directors forecast for 1974 is getting less gloomy as business continues to be very good.
Current business orders are very strong in the capital goods areas and very weak in leisure, auto, and apparel industries, according to our directors. Only one director explained his very good sales in March as largely due to strike hedge buying and to anticipatory buying before an announced price increase for April. In general, business is considered to be quite good, and the continuation of this situation has shaken our directors feelings that 1974 would inevitably be a year of stagflation, with a rapid rise in unemployment. Their current feelings about the outlook are "confused" because they feel that the economic picture is "muddled."
Our bank directors ascribe the recent rise in the prime rate to the rising Federal funds rate and to a sudden surge in business loan demand. The major banks are so heavily dependent on Federal funds, according to a director from a large Boston bank, that a rise in the Federal funds rate assumes major importance in determining the cost of bank funds. This director also reports that business loan demand is booming across the board. Real estate investment trusts in the past 3 to 4 weeks have been pulling down their bank lines because they have not been treated well in the commercial paper market. Major corporations have been coming in for their full lines in the last few weeks, and foreign banks have also been heavy borrowers.
Our academic correspondents, Professors Eckstein, Samuelson, Shapiro and Tobin, were sharply divided in their policy recommendations this month. Eckstein, Samuelson, and Tobin were all prepared to accept significantly higher rates of monetary growth in order to curb the rise in short-term interest rates, while Dr. Shapiro favored continued moderate money growth regardless of the accompanying interest rate pattern.
In Shapiro's view, the current restriction is a desirable measure to make sure excess pressures on capacity will not build up later in the year. Continuation of this policy would lead him to reduce his estimate of housing starts at year-end by about 200,000 units. However, except for the weakness in consumption, the other components of spending remain strong. The job for monetary policy is to hold down inflationary pressures by insuring that the recovery in consumption will be a gradual one. Dr. Shapiro expects output declines over the first half of the year to be offset by increases in the second half. The unemployment rate is predicted to rise to 6 percent by year-end and average to about 5.8 percent in 1975 with real growth of 4.2 percent. He feels a Federal funds rate of about 10 percent would cause a reversal of short-term capital outflows and of the recent tendency for loans which would have been acquired in the Euro-dollar market to come home.
Samuelson feels the tightening of short-term interest rates have been over-done. He notes that the public and business community have come around to the experts' view that we are in a mini-recession which will be near its bottom in the second quarter, but have not accepted the unanimous view that the rate of inflation will be tapering down in the second half. However, "unless money grows at about 8 percent between now and year end, the fourth quarter recovery will not occur as disintermediation will abort the housing recovery," Eckstein said.
Both Samuelson and Eckstein argued that a monetarist approach to policy need not be associated with a 5.5 to 6 percent money growth target in the present context. Noting that monetarist James Meiggs of the Argus Corporation favors a higher growth rate at the present time, they both argued a 5.5 to 6 percent money growth would be appropriate now only if we want a genuine recession, only if the Fed intends "to beat inflation by itself." The current inflation has no particular relationship to excess demand spending and can be brought down only gradually by aggregative policy. Not to accommodate any of this special inflation is an extremely tight policy which will generate a recession of some severity and exceptional duration. "Even if the Fed wished to do this, the political process would not go along with it," according to Eckstein.
Tobin argued that lower interest rates would be necessary to achieve even the administration's hopes for a rather modest recovery this year. With rising rates, this prospect is in jeopardy. The Fed cannot "solve" the problem of inflation without prolonged stagnation and unemployment. The first casualty of rising rates is expected to be housing, where the turnaround was predicted or reintermediation as opposed to the increasing disintermediation associated with higher rates. Tobin stressed the role of the stock market in setting the cost of capital for business fixed investment. While tighter money and higher capital costs now might not preclude this year's investment boom, its consequences would surely be felt in the form of weakened capital spending in 1975. Tobin advocated a Federal funds target of 8 percent.