John paulus is senior vice president for economic services at the Federal Reserve Bank Minneapolis a new arrival to the Minneapolis-Saint Paul area and then come here about to march of the chair. And before that has been with the Federal Reserve System in Washington since 1972 Federal Reserve System, as you may know is the nation Central Bank and as such plays a key role in setting the amount of money that is circulating in the system and that has a good deal to do with the rate of inflation in the country.Will John live two economic developments today firstly released by the Commerce Department of the gross national product figures for the second quarter of this year. The figures indicate that the gross national product grew at an annual rate of 7.4% in the second quarter and that inflation during the second quarter was 10% to see any any surprises in those figures. No, I don't Bob. We were generally expecting a very strong second-quarter performance in real GNP following the strike. And whether I depressed first quarter with you I came in right at the roughly 0% Merino growth during the first quarter in real production in the economy. The inflation figure is about where we expected it. Also. We've been seeing roughly 10% increases in the Consumer Price Index throughout the first five months of this year and the 10% figure you quote. It is for the GNP so-called deflator. It's the average rate of increase of domestic domestic production as opposed to the Consumer Price Index, which also has import prices in it, but they tend to move together. So we had been seeing increases in consumer prices around 10 for And now we've seen that the price of domestic production was about on that same order of magnitude President Carter said last night during opt out for the year if you was at well, I hope that's right this performance in the first half of the year has really been quite dismal rarely. Do we see anything like 10% growth in prices for a. As long as six months. I personally wouldn't expect to see another 10% half year during the last half of this year. I think we'll see something blow that but not not not appreciably below it perhaps in the order of 79% We should get some improvement in the food price that you a shin for one that should help but the inflation outlook on it still looks looks quite bad show me condos have said that inflation by the end of the year will be somewhere in the 78% range over all over the 12-month. If you say if it was 10% during the first six months and you're talking about eight or nine percent of the second I would suggest that it's going to be a little worse than 70% average. That's right. I know you need increases on the order of 4 to 6 in the second half of the year at least in consumer prices in order to get an average of 78. I don't think we going to see that I think we'll see something somewhat higher than that and it's related in parts of the underlying forces of inflation just being very strong and those that relate to Rapid growth in money over the last year the two years and the continuing very large government deficit both of which are very important contributors to the rate of inflation the second bit of news that came out today that I like to get your reaction to is a report today by dr. Seung. Hwan son. Who's the chief Economist for the Northwestern National Bank of Minneapolis saying that the economy will Actually entering a recession sometime in 1979 according to the news account of his view of the federal budget deficit as well as what he calls the cost-push forces of wage games and slower growth and productivity will keep the overall inflation rate at least around 7% And then he says in addition to the high rate of inflation. There is a high debt carried by consumers buildup of unwanted inventory by business and tighten the credit conditions. He says all of these things will push the economy into recession in 79. What's your reaction to that while he may be right about the recession. I hope he's not but I don't I don't agree totally with his his reasons why we may slip into a recession first with regard to the inventory situation. I think businesses have run very conservative inventory policies in the last three or four years since getting caught with a huge overhang in 19/7. 4 and that is with huge inventories at a time when final demands where we're dropping. I don't expect to see a sharp cut back in inventory accumulation on over the next 6 months to a year on the consumer side. It's true the Consumer Debt burdens appear relatively High by historical standards, but they aren't really out of line with what might be expected given the stock of durable goods that consumers have have purchased in the last well throughout this entire recovery economic recovery, which began early 1975. Don't look as unfavorable as soon guys and the inflation problem why I would agree of them on that and we've already talked about that. That's I think I most fundamental problem one that will take some time to solve but with regard to his over-reaction. By the Federal Reserve in trying to constrain the growth of money by pushing interest rates up and thereby reducing the rate of inflation. I would certainly say I would take strong exception to that to that the position that he's taken after all he's admitted that inflation is a very serious problem and he's admitted that he believes that consumers are somewhat overextended If the Fed doesn't tighten money market conditions by pushing short-term interest rates up, both of those conditions will be aggravated consumers will continue to borrow further and perhaps overextend themselves further or overextend themselves if they already aren't and infection picture will be carry right? So I ice i c i need consistency and in a couple of those those arguments You talk about and inflation rate of seven eight nine ten percent of year and everybody can feel the effect of that when they go to the grocery store when they go to buy a car lease put together some figures that took this 7% to inflation rate and averaged it out over a. Of a number of years and they concluded if there is no takers write that in the prices with double every 10 years with inflation rate of 7% So for example of $50,000 house, which is a fairly average price these days we'll be worth $200,000 in 20 years in 800030 years a $5,000 your college education today would cost $80,000 after 40 years a $7,000 car a hundred $12,000.80 pack of cigarettes almost $13 after 40 Years of inflation at 7% How long can we go on with this how dangerous is inflation? Anyway with other pretty scary numbers. They inflation increase in prices as if it were at a steady rate and if incomes increase at a steady rate along with prices in a ball prices increased at roughly the same rates might not be a terribly serious problem. It would be the kind of textbook problem that we many of us learned years back. I would said that things don't change very much when you have an inflation, but the prices don't change at the same rate that is all prices in the economy don't change and information under running during inflationary. That is inflation causes some very serious disruptions in the economy. The essence of a market economy is choice. Is that a decision making and making choices between different Alternatives and in order to make wise choices a businessman or a consumer? To have a lot of information about relative prices of goods and services and during inflationary. It's very difficult to process so that relative price information, because prices are changing much more rapidly turn to see into the future. That's right. That's right and consequently decisions and whether to purchase a new car today car for a businessman weather to build a plant today where he has to estimate future costs and future prices that he can sell his goods for our Complicated by inflation. And as a result, I think the overall economic performance of an economy deteriorates when it's operating in a constant inflationary environment. How did all this get started? Anyway in 1977, I think inflation was somewhere in 6 7% something like that. And then in the first half of this year the figures now, she'll 10% inflation did anybody for see that? a year ago No, they didn't the forecast for inflation was somewhat lower around a year ago. Then then the actual rate that we have observed but in answering how we got into this. I I would have to go back a little further than just the last year for the last 18 months and go back into the 60s when it became very fashionable to cancel policy makers with there was a trade-off between inflation and unemployment. That is if the policy maker was willing to permit the inflation rate rise a bit we can get two more jobs created in the end of or unemployment rate. That was that's the so-called Phillips curve relationship that there is a permanent trade-off between inflation and unemployment and policymakers reason that unemployment was worse than inflation. So they decided while we were willing to absorb a little more information in order to get to go around employment, right? well It turns out I think that's the empirical relationship would have been reserved been observed earlier did not hold up. And I think we're good reasons which an option get into the other somewhat technical but let me just cite some statistics on whether you get more or less a lower unemployment with with higher inflation in the 19 fifties and sixties at 20 year. Combined. The average inflation rate was a little over 2% in the average unemployment rate was a little over four and a half percent now in the sixties, we began to think in terms of an inflationary economy improving the employment situation in the inflation rate began to move up in the late sixties, and it's been very high throughout the whole decade of the 70s in the seventies. The the inflation rate has averaged about six and a half percent which is about three times higher than it averaged in the 50s and 60s. The unemployment rate is is average the little over 6% quite a bit higher than the average in the fifties and sixties and another alarm flashing problem is the rate of business investment. I think businessmen have shown that they are somewhat reluctant to commit resources to long-term investments in an inflationary environment because of the uncertainty that inflation breeds during the fifties and sixties when we had low inflation. We had an average increase in the Capital stock of a little over 4% per year. In the current decade with the higher inflation rate that rate of growth of capital has dropped to about 3% with slower growth in the Capital stock. You reduce productivity gains and you generally a cut into your increasing standard of living cuz we in order to see it continuing rise in the standard of living. We need an increase in Capital stock. And we we were seeing instead score growth in capital being associated with an inflationary environment. Isn't that at least partly due to the fact that businesses have had to spend a lot of money on pollution control equipment and we're sort of face to the question of either building equipment or plant that would provide more productivity or cleaning up the environment. That's a part of the problem, but I don't think it accounts for the the drop more than a Percentage point in the rate of growth capital is particularly Troublesome because the labor force is growing very rapidly in the 1970s about twice the rate. It is grown earlier. So we're seeing at the same time. The Capital stock is growing more slowly. We're seeing more and more people coming into the market to work and consequently the the ratio of capital to labor that it's the amount of machinery and equipment that we can apply to the typical worker. It is is growing very slowly. Not much much more slowly than it did earlier and that's that ratio has played an important role in pan productivity increases Let's move on and try a little bit about what it is. The Federal Reserve System does or can do can try to do to combat inflation. Why is it that an interest rate increase will help dampen in place while I'm at 9 technically. Yeah, I'll try. First of all, I wanted to stay weeks between short and long-term interest rates what we're talking about in trying to slow. The rate of inflation is an increase in short-term interest rates interest rates on treasury bills on bank cd's and so on and not necessarily increases in interest rates on long-term corporate or government bonds or perhaps not even long-term or not even interest rates on mortgages, which typically of course run 20 to 30 years. But what what happens the way that the FED attempts to constrain the rate of inflation is basically and fundamentally through the growth of money. And in order to there's a a positive relationship between the growth of money and the rate of inflation in order to bring the inflation rate down. One of the things we have to do it. So the girl with the money the only way we can do that is by going the growth of Bank Reserves because the money stock is basically based upon while let me Define the money stock that were most interested in its called him one at sequel the currency plus demand deposits in the checking account in the biggest part of that is the way we can so the girls in that or if we wanted to reduce the growth is to supply fuel reserves to the banking system and we do that by buying fewer security. On the banks and giving them an exchange Federal Reserve money order deposits with us, which they in turn can use to create. Bank deposit demand deposits in the private economy by making loans with the money that we provide them when they sell us Securities we can so we can we can saw that rate of growth reserves down by buying fewer of their Securities, but that tends to put less money in the economy and for a given amount of credit demands. I will push Credit Union interest rates up in short-term interests are in short-term markets because you got you got less money to lend to the same number of a blender so you ration it by basically by charging higher interest rate. That'll push rates up temporarily. So what happens is you simply make less money available to the banks and they can make their for less money available to businesses and consumers who would like to call and borrow money. That's absolutely right. And in the short run it does push interest rates up in the long run short-term rates in the long run. The only way you can get short interest rates down is by reducing the rate of inflation. However, very stable relationship between short-term interest rates and inflation rate. And if you if you really want low interest rates, you need to get the inflation rate down. How much does the FED increase interest rates over say the last six months during this 10% to inflation. Well, since April leave increased interest rates short-term interest rates by Between a percent and a percent and a half. Is that enough? Well, I don't think it's enough. I know you may think that a seven or an eight percent interest rate is really very high. But I think that you have to adjust interest rates just as you adjust wage increases for the inflation factor and the seven or eight percent interest rate when we have an 8% inflation or 10% as we've seen in the first half of the year is really quite a low interest rate so I can answer that question though. I don't think it is enough. How high is the interest rate likely to go? Well, I wouldn't I wouldn't want to speculate on that. That's that's a very difficult question. I think that we need to push interest rates up higher in order to choke off some marginal credit demands, even though the system is being accused by some of putting pushing interest rates to very high levels. If you look at the behavior of Market participants, you look at the business borrowing short term business borrowing and borrowing by consumers on an on an installment basis, which is short-term credit. You'll see that they're borrowing everything they can get their hands on their borrowing. Virtually at record rates at roughly 20% annual rates over the last three or four months. That doesn't suggest to me that interest rates are very high. And I think that businesses and households are making an adjustment for inflation. They're recognizing it at 7% interest rate on 8% rate is really quite attractive against the background of an eight or nine percent and play. Well, how high is too high and interest rates? Well, I bet that's that's another very tough question. I could give you a hug if we are ridiculously high rate, but in order to constrain the growth rate of money so that we can make some progress against inflation. We need interest rates which are at least as high as the inflation rate and perhaps higher. No one of the reasons that question is so hard to answer is it in part of depends on what the US Treasury does depends on what happens to the deficit as long as the treasury runs a a large deficit the interest rate level required to keep the economy moving and too. Well, I should say to try to avoid an overheating of the economy. maybe higher if we can get some help from the the treasury and the size of the deficit then the level of interest rates that we can maintain would you are you say that you need an interest rate at least as high as that of inflation the interest rate for consumers is already higher than 10% consumer installment credit is 12% in some states 18 automobile loans are in the 11 to 12% range so who money market which would be the right that the u.s. government pays and the large corporations pay for say commercial paper so installment credit rates are really very sluggish I suspect they wouldn't move very much at all in the reason they were much higher than the rights to corporations pay of course is that When you go into your bank to get $1,000 loan or a $2,000 loan, there's relative to the size of the lawn is a lot of paperwork and there is there a lot of expenses generated and basically you you're probably paying 7 or 8% or 9% for the credit and then another several percentage points to cover the banks cost of processing alone that cost of course disappearance for large corporations for dealing in hundreds of millions of dollars at 1 crack. So the pressure would be on the market rates that large corporations in the treasury pay not too much in the rights of you or I would pay to buy a car or a new TV set or new radio. Well, if Cora says interest rates go up and businesses are discouraged from borrowing this can lead to a dampening of inflation. And in fact, it turned down in the economy and there are some Economist who has been quoted as saying that higher interest rates are almost inevitably followed by recession. Is there any reason to believe that won't happen again next year as happened and say 74 and 5 when we had the recession following the the big inflation caused by the Arab oil embargo. I like to try to make the case that Higher short-term interest rates this time won't necessarily be followed by a recession because one of the things that's constraining this economy is uncertainty about inflation businessmen are still somewhat reluctant to invest because they're concerned that they may be facing perhaps wage and price controls your down the road. If a tightening move by the system is seen by the Federal Reserve is seen as removing some of that uncertainty even though it pushes short-term interest rates up and if it's seen as lowering pushing our expectations, which play a very important role in the level in determining the level of long-term, right then you could possibly see long-term right? It's not moving up at the same time the traits move up and you could see I think a very favorable effect on the economy through the elimination of some uncertainty Improvement of inflationary expectations, so I wanted to stay with you between the movement of short and long-term interest rates. They do tend to move together, but they don't have to always move together when this is a time when when they may not when the equation problem is regarded as being so serious that that the investing public May view with some sympathy efforts by the Federal Reserve to constrain the growth rate of money. There a lot of people to complain this to you felt a lot of critics of the Federal Reserve System say that it is entirely too responsive to the business and banking communities and not nearly responsive enough to the needs of labor farm groups of consumer groups and so on pointing out that to you knowing when there's an explanation contraction and businesses have to lay people off. It's the $15,000 a year factory worker that loses his job. Not the $50,000 executive. How does the Federal Reserve System justify policies that seem to have a harsher effect on the less Advantage people then turn those who are higher up. I quoted some statistics earlier about inflation and unemployment. And inflation and capital formation and made some remarks about how Capital formation affects our standard of living. Now if the choice before now is to attempt to make some significant progress with our inflation problem possibly at the expense of slowing economic activity temporarily or continuing a rather generous provision of money to the economy so that we can keep interest rates short-term interest rates down and hope the economy will live another 6 through the recovery will live another 6 or 12 months. I think that breaking it down into the the rich person against the poor person is not a very good characterization of the policy the Lamb of that faces us because I think the poor every bit as much concerned or involved in the fact more so And I'm playing with proposition pointed out as the rich and I guess what I'm getting at is whether whether you want a short run or a longer-term solution to this this problem and I think we need to make some decisions that optimize the long run productive capacities of of this nation and I think that those decisions would that would involve bringing our inflation problem under control and that may require higher short-term interest rates. It may require higher on employment. I'm not convinced of that. How much is this Confederate what will the Federal Reserve System successfully be able to do on its own? Nobody really knows what Congress is going to do with the tax cut bill or with the federal budget for the coming fiscal year, but indication certainly are the deficit will be in the vicinity of 50 or so billion dollars and President Carter is given up on the idea of a balanced budget by 81 and they're talkin maybe about 30 billion dollar deficit by then. What does that portend for interest rates and inflation and recession in this whole economic picture? Well, I hope we don't have to do too much of it on her own because as I noted earlier, the more we have to do in our own the higher interest rates will have to get and the more difficult. It's going to be to make progress against inflation. We need we we desperately need a cart in the government deficit if we're going to make serious progress against inflation without having to push interest rates very high. So it's a two-sided coin. The inflation rate is determined by the stock of money in circulation and and the size of the government deficit and we of course only yet only have control over one of those two pieces. I've got one final question for you. I think it's my last one. And that is what would your advice as an economist be to the individual the individual consumer who faces the prospect of another 9 or so percent inflation by the end of 1978 by now before prices go up or hang on to your money or or what do nothing while I'm not a very firm believer in anticipatory buying because it's the same time the prices are going up at eight or nine percent incomes are going up at the same rate and perhaps even a little bit higher so there is any good reason why a consumer or not to be stocking up so to speak and durable goods. I don't think there's any evidence in fact that he has been so as long as incomes are rising at the same rate to his prices are higher. I don't think there's any really conomic incentive for doing that. You know what all of some of the other problems that we have in the country. I'm thinking of energy for example, there are things that an individual can do to ameliorate their own personal energy problem. They can put in a wood stove that could build solar energy of everything anything an individual can do to ameliorate his own inflation problem. Any individual anything while one of the things I would recommend taking them brought a look at this course is to to make it clear to his elected officials that he's very concerned about it and affect the result in California and Proposition 13. I think send a signal out that people thought the size of government gotten a bit too large and I think the size of the federal government deficit is telling should tell legislators the same thing that people aren't don't seem to be willing to pay for the level of government services are being supplied with and if that can be cut and I realize that's a very tough political issue because it involves a lot of very powerful special interest groups, but if that budget can be caught then I think and a broad sense we can make some progress against inflation. Well, thank you very much. I guess this new and has been John paulus Senior vice president for economic services at the Federal Reserve Bank in Minneapolis. Now the time is about 217 minutes before 1.