WILLIAM POOLE Brown University Monetary Policy during the Recession THE DEPTH of the currentrecession makes it clearex post that government stabilizationpolicy shouldhave been less contractionaryin 1974.In fact, both monetaryand fiscal policy were extremelycontractionary not only relativeto the needs of a decliningeconomy but also relativeto policy duringthe 1972-73boom. During 1974,the full employmentbudget sur- plus rose sharplyand monetaryexpansion slowed markedly.My task in this reportis to analyzethe monetarypart of recentstabilization policies. A sharpdeceleration of moneygrowth (both M1and M2)since mid-1974 is evident in figure 1.1 Economistsgenerally agree that money growthin the secondhalf of 1974 was too low, but split over the propositionthat moneygrowth in the firsthalf-6.2 percentfor M1from December 1973 to June1974-was aboutright.2 As I argueda yearago, an M1 growthtarget of about6 percentwas appropriateon the basis of informationavailable in earlyand mid-1974.3 Therefore, I applaudthe FederalReserve for restrain- Note: I want to thank the FederalReserve Bank of Boston for researchsupport and especiallyRuth Kupfer and Redenta de Leon of the Bank for researchassistance and typing.The views expressed,however, are mine and do not necessarilyreflect those of the FederalReserve Bank of Boston. 1. I am inclinedto believethat M2 is more closely relatedto businessconditions than M1, but have decidedto use M1 in most of my analysis because the Federal Reserve tends to emphasizeit and because the differencesin the recentbehavior of the two mea- sures are relativelyminor. 2. All growth rates in this report are continuously compounded annual rates of growth. 3. William Poole, "Reflections on U.S. MacroeconomicPolicy," BPEA (1:1974), pp. 233-46. 123 124 Brookings Papers on Economic Activity, 1:1975 Figure 1. Money Stock and Selected Interest Rates, Monthly, January1971-March 1975 Billions of dollars (ratio scale) Billions of dollars (ratio scale) 325 300 . 600 275275 10 -]550 MeMa,~-(rightscale) ~ 250 500 225 Z 450 200 400 Percent 13 12 10 Federaliunds f rate 9. 7 Yield on Aaa corporate bonds 6 S 4 3 1971 1972 1973 1974 1975 Sources: Federal Reserve Bulletin, various issues. a. Ms plus time deposits except large certificates of deposit. b. Currency plus demand deposits at commercial banks. WilliamPoole 125 ing moneygrowth and permittinginterest rates to rise sharplyin the first half of 1974. The next sectionis devotedto a defenseof the propositionthat a 6 per- cent M1 growthwas appropriatein 1974.There follows an analysisof the FederalReserve's explanation of monetarypolicy in the second half of 1974.The reportconcludes with a few generalcomments on whatthe Fed- eral Reserveshould do, givenrecent experience. Judgingthe Appropriatenessof MonetaryPolicy Policymakingis inherentlya problemof decisionmakingunder uncer- tainty;an ex post analysisof policy ought,therefore, to be cast in the same terms.Judging the performanceof policymakersrequires that somethingbe said about preferencesfor possible outcomes,especially those relatedto unemploymentand inflation;about the effect of events known to policy- makerswhen decisionsare made on the odds of various outcomes;and about the impacton the odds of policy adjustments. Althoughopinions differ on the relativecosts of unemploymentand in- flation,I know of no statementsby publicofficials suggesting that the cur- rentrapid reduction in inflationhas been worththe cost in termsof unem- ployment.On the contrary,public officialshave stressedrepeatedly that inflationmust be reducedslowly in orderto avoida depression,and that the unavoidablecost was a modestrise in unemployment. Differencesover the role of preferencesarise largely because of varying views of how the worldworks. I assignvery little importanceto inflation per se but feel that the economicand politicaldynamics of inflationcom- bine to rule out any significantchance of simplystabilizing the rate of in- flation at 1973 or 1974levels. Furtheracceleration of inflationvery likely would have generatedvastly increasedodds of deeper recessionin the future. I basicallyagree, then, with Milton Friedman'sargument that the real choiceis not betweeninflation and unemployment,but betweenunemploy- ment now and unemploymentlater.4 This is an empiricalstatement-cor- rect or incorrect-about the way the world works and not about prefer- ences. Nevertheless,the tradeoffbetween unemployment now and unem- 4. Milton Friedman,"The Role of Monetary Policy," AmericaniEconlomic Review, vol. 58 (March 1968), pp. 1-17 (especially7-11). 126 Brookings Papers on Economic Activity, 1:1975 ploymentlater applies only within a certainrange. After a point, more unemploymentnow clearlybrings more unemploymentlater, again for a mixtureof economicand politicalreasons. When firmsgo bankruptand are dismantledor fall far behindin their capitalspending, an irreversible loss occurs,and productionand employmentcannot be returnedeasily to full employmentlevels. In addition, some governmentactions taken in responseto unemployment,as well as in responseto inflation,reduce eco- nomicefficiency and interferewith the returnto full employment. I also agreewith the Modigliani-Papademosargument that the desirable path for the economyis one involvingthe fastestpossible recovery con- sistentwith maintaining low odds of overshootingfull employmentand re- acceleratinginflation.5 I differwith Modiglianiand Papademosnot over goalsbut overthe odds of achievingany giventarget path for the economy. Thispoint will be discussedfurther in my commentson currentpolicy, but it is centralto my analysisof FederalReserve policy in 1974. THE EVIDENCE OF 1974 Whateverlessons evolve from the sharprise in unemploymentin late 1974and early1975, an analysisof monetarypolicy in 1974should be lim- ited to the evidenceavailable at the time the policy decisionswere made. The consensusforecast in early 1974 was for a flat economy.Pessimists arguedthat a couple of quartersof decliningreal gross nationalproduct werelikely and optimiststhought a recessionwould be avoided.No one foresaweither a deep recessionor a boom.6 By June the forecastsbecame, if anything,a bit more optimistic.The disruptiveoil embargohad been lifted, the unemploymentrate was the same as in January,and the index of industrialproduction actually had risena bit sinceApril. From what is known now, the businesscycle peak may be tentatively placedat November1973. However, after a significantdecline in the early monthsof 1974,the economyremained basically on a plateauuntil autumn. As the yearcontinued, the consensusforecast was reviseddownward, but 5. See their paperin this issue. 6. It is fair to say that a year ago many economists were concernedover the possi- bility that maintaininga 6 percent trend of money growth would lead to a prolonged periodof economicslack, with unemploymentremaining above 6 percent,and perhaps risingslowly, for severalyears. No one I know, however,assigned any significantproba- bility to a 1975 unemploymentrate of the currentmagnitude. WilliamPoole 127 this plateauled most forecastersto believe that any furthercontraction wouldbe relativelymild. Indeed,even as late as fall, manyforecasters an- ticipatedonly a moderaterecession. The "TypicalQuarterly Forecast for 1975"-the medianquarterly forecast among twenty-three surveyed by the FederalReserve Bank of Richmond-had a quarterlypattern of unemploy- mentfor 1975of 6.8, 7.0, 7.2, and7.3 percent,respectively.7 Since seventeen of the twenty-threeforecasts are dated December 1, 1974,or later,it is clear that the magnitudeof impendingunemployment was completelyunfore- seen by the professionalforecasters, or at least not foreseenwith enough confidenceto be includedin the publishedforecasts. Criticsof monetarypolicy in the firsthalf of 1974point to threereasons why unusuallyrapid money growthwould have been appropriate:exog- enous shocksin the form of the oil embargo,and shortharvests in 1973; the sidewaysmovement of the economy;and the rapidescalation of interest rates. Shocks.Those who emphasizethe importanceof the recentshocks from farmand fuel productshave not, as far as I know, referredto similarpast episodesin supportof theirposition favoring a more expansionarymone- tarypolicy. The KoreanWar experience presents some intriguing parallels, at least on the surface.Raw materialand farm pricessurged sharply up- wardfollowing the outbreakof the war,transferring income to foreignpro- ducersof primaryproducts. However, most of this income transferwas probablysaved in the shortrun, and the U.S. balanceon goodsand services (excludingmilitary) declined by $4.3 billionbetween 1949 and 1950.Even the high-employmentfederal budget surplus rose untillate in 1950.But the KoreanWar shock did not producea recessionand the 1950acceleration of money growthhas to be viewed, in retrospect,with regret ratherthan pleasure. My pointis not to offerthe KoreanWar experience as a counter-example, but ratherto arguethat the case for a more expansionarypolicy in 1974 oughtto rest on morethan simplyfeeding an assumedsurge in the aggre- gate pricelevel into a standardmacro model. The underlyingmicro be- havioralequations reflect the holding of inventoriesand precautionary balancesby individualeconomic units preciselyin order to cushion the effectsof unforeseendisturbances. The advocatesof a policy responseto the oil shockought, therefore, to displaysome evidencethat outsizemicro 7. FederalReserve Bank of Richmond,Business Forecasts, 1975 (February 1975), p. 5. 128 Brookings Papers on Economic Activity,