1974 - a year of inflation, production cutbacks, and oil

1974 — A Year of Inflation, Production Cutbacks,and Oil-Induced Payments Deficits

NORMAN N. BOWSHER

~1 -

k. N TERMS of economic achievement, the year 1974was like a “hangover”, with current performance be-low potential as a result of previous excesses. Inflationintensified, production declined, and the unemploy-ment rate rose. It was a year characterized by numer-ous adverse developments as well as one of adjushnentfollowing a prolonged expansionary spree beginningin the mid-1960s.

Economic developments in any year are heavilyinfluenced by actions taken in previous years. Priceincreases in 1974, which were sizable indeed, re-sulted, in part, from previous actions which stimulatedaggregate demand. At the same time, the ability ofthe economy to satisfy this expanding demand wasreduced by developments such as the adverse world-wide food situation, the limiting of oil output by pro-ducing nations, and price controls. Although most ofthese developments occurred before 1974, they hadimportant impacts on the liming and magnitude ofprice increases in 1974.

Production in 1974 also reflected earlier develop-ments. Previous expansionary actions had pushedup output rapidly to levels above maximum efficiencyin many industries. This situation was aggravated bythe combination of price controls and environmentalimprovement regulations which discouraged expan-sion and caused abandonment of some marginal pro-ductive processes. Also, sharply higher prices for someitems iii late 1973, gasoline for example, caused con-sumers to alter their consumption patterns. This, inturn, caused production to decline in certain lines,while in other markets shortages could be avoidedonly by sharply higher prices.

Judged solely by output and price performances,the year 1974 was a dismal failure. Prices rose fasterthan in any year since the inflation began in 1965,and real output of goods and services fell substan-tially. Yet, despite the course of events leading up tothe year and the momentum of inflationary pressuresas the year began, there \vere some encouraging de-velopments during the year. Acceleration of inflation

was apparently halted. Although production declined,a deep recession was avoided. Economic freedom wasrestored with the removal of restraints on wages andprices, and the process of eliminating shortages in-duced by the controls began as firms once again re-sponded to incentives provided by market forces.

The chief monetary development in the years pre-ceding 1974 was a sustained rapid growth in thenation’s money stock. This earlier growth in the moneystock is reviewed here because it is consistent with theview that the trend growth of money over a fom- orfive-year period hasa dominant effect on the trend ofprices. Marked changes in the growth rate of moneyaround a trend, lasting about two quarters or more,

have a significant influence on production and em—ploymnent, but as the new trend is fully reflected in

prices, the production and employment effectsdisappear.

The analysis used here does not deny the existenceof many exogenous forces which may have short-run

General Price IndexR,ti, S,&, Ran, Scale1958’IOO 99581900975 TT~r

905 71

___ II~J~J±L966 9961 9968 9969 9970 9979 1971 1973 9974

~ SD,,,’,,

Page 2

FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1974

economic impacts. These forces include the operationof an oil cartel, a widespread crop failure, and someinstitutional changes, such as elimination of price andwage controls. Similarly, fiscal actions have economiceffects which generally last for several quarters.

BACKGROUNIJ

On balance, the actions of the Government werevery stimulative to the economy in the four yearspreceding 1974. The nation’s money stock was in-creased at an average 7 percent annual rate fromearly 1970 (a period marked by recession) to the endof 1973. By comparison, from 1964 (the last year ofrelatively stable prices) to 1970, the money stock rose,on average, at a 5 percent rate; in the previous decademoney increased at a 2 percent average rate.

The growth of the money stock is determinedwithin a narrow band by the growth of the monetarybase. The base, the primary sources of which areFederal Reserve credit and monetary gold stock, roseat a 7.5 percent rate from early 1970 to the end of1973. Earlier, the base had risen at a 5 percent ratefrom 1964 to 1970. and at a 2 percent pace in theprevious ten years.

Fiscal actions of the Government were also expan-sionary in the four years preceding 1974. Governmentexpenditures, using the national income accountsbudget, rose at about a 9 percent annual rate fromearly 1970 to the end of 1973. This was about thesame as the rapid pace of the 1964 to 1970 period,

which included the sizable military build-np for Viet-nam. From 1955 to 1964, Government outlays in-creased at a 6.3 percent rate. Average tax rates hadbeen reduced through tax reform, cuts in excise taxrates, increases in personal tax exemptions and restora-tion of an investment tax credit. The combined effectof these fiscal actions was to shift the national incomeaccounts budget from an $8 billion surplus in 1969to four consecutive deficits in the period from 1970through 1973, averaging over $14 billion per year.

The stimulative policy actions in the 1970 through1973 period came in response to a number of factors.It was widely thought in 1970 and 1971 that economicstimulation was desirable in order to spur productionand employment. In addition, from August 1971 nntilearly 1974, the nation went through various phasesof controls on wages and prices. With the apparentrestraint on prices, it was felt by some that the moreconventional tools of policy might be devoted to en-couraging economic expansion and growth without therisk of more inflation. This view was reinforced by thefact that unemployment was 5 percent or more ofthe labor force until the spring of 1973. For a briefperiod in the summer and early fall of 1973, restraintwas exerted; for example, the money stock rose at aslow 1.5 percent annual rate from June to October.However, later in the year, with the sharp markup ofoil prices, relaxation of policies again appeared de-sirable to some analysts in order to attempt to mod-erate production cutbacks.

In response to the expansionary monetary arid fiscaldevelopments, total spending on goods and servicesaccelerated markedly after 1970. Gross national prod-oct had risen at a 4.2 percent annual rate from thefall of 1969 to the end of 1970, or at about the samepace as productive capacity. During 1971 GNP rose9.2 percent, during 1972 it climbed 11.2 percent, andin 1973 it expanded 11.6 percent.

In 1971 and 1972, the rate of inflation was lowerthan in the two previous years, despite the accelera-tion in the pace of total spending on goods and serv-ices. Overall prices, as measured by the GNP deflator,had risen at a 5.3 percent annual rate from the end of1968 to the end of 1970. During 1971, prices increasedat a 3.5 percent rate, the slowdown reflecting at firstthe delayed effects of monetary discipline in 1969 andearly 1970. Later in the year reported prices also re-flected the initial impact of controls on wages andprices which began with the freeze in August 1971.During 1972, under the continuing pressure of con-trols, reported prices rose at a 3.7 percent rate.

Money Stock and Monetary BaseAnnool Roles .f G,,wtt,

Sel,ctod Pccicdo

Percent Money Monetary Base PercentL ii~ikearly 9964 9954 earl! 9964 19549970 ~0 to 9970 to to

to late 9970 9964 to late 9970 99649971 9973

Page 3

~AL RESERVE BANK OF ST LOUI DECEMBER 1974

In 1973, however, as underlying inflationary pres-sures intensified, controls on prices began crumbling.In addition, prices were jolted upward by a numberof random shocks, such as the reduced internationalprice of the dollar and poor harvests in many coun-tries which led to an increased foreign demand fordomestically-produced food. Moreover, an energy sup-ply problem increased sharply the prices of energyand energy-related products late in the year. As a re-sult, the rate of inflation during 1973 accelerated dur-ing each quarter, rising from a 4 percent rate in late1972 to an 8.6 percent pace in the final quarter of1973. On average, the rate of inflation was 7.4 percentduring 1973.

Production, employment, and real income expandedmarkedly in 1971 and 1972. From the fourth quarterof 1970 to the fourth quarter of 1972, total real output,for example, rose at a 6.4 percent annual rate, ordouble the rate experienced in the previons five years.

Although production had been rising rapidly, dur-ing 1971 and 1972, growth in productive facilities hadbeen hampered by an outlook for diminished profitson invested capital resulting from price controls andenvironmental laws, As a result, 1973 found a numberof firms operating at levels exceeding long-run maxi-mum efficiency. Also, near year-end a reduction inoil supplies and the effects of energy conservationmeasures affected output adversely. Hence, growth inreal output, which was at a high 9.5 percent rate inthe first quarter, slowed to a 2 percent pace in thelast three quarters of 1973.

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As 1974 began, economic problems were numerousand appeared to be intensifying. The growth rate intotal spending had been rapid, probably excessive,for several years. As a result, production had risen tolevels where marginal costs were rising rapidly inmany industries, and prices were being bid-up atprogressively faster rates. At the same time, price andoutput developments continued to be affected ad-versely by a number of exogenous forces, such as theoil and food situations, controls on prices, and en-vironmental improvement and safety regulations. Add-ing to the economic woes was uncertainty over thepolitical situation in this country. In brief, strong de-mands for goods and services were pressing againsta limited and contracting supply of goods and serv-ices, a situation conductive to an inflationary surge.

In such a climate, restraint was believed appropri-ate. Monetary developments became less stimulative,

but the shift was, on the whole, moderate.’ Inflation,which was rapid, did peak and appeared to be re-ceding late in the year. A severe depression, whichmany feared would develop if the inflation were re-sisted, did not occur, although cutbacks in outputdeveloped.

:,renctmng

In most years the key economic variable has beenthe rate of growth of demand for goods and services,In order to sustain expansion in output, employment,and real income, demand for goods and services mustbe increasing. In 1974, however, it was demonstratedthat an increasing demand is not sufficient to preventa decrease in output and real income, especially in theshort run. Although growth of aggregate demand forgoods and services decelerated somewhat in the year,supply constraints and the costs of adjusting to chang-ing spending patterns retarded production. Outputand real income declined, demand remained exces-sive, and prices were bid-up even higher.

Total spending on goods and services expanded ata 7 percent annual rate in the first three quarters of1974. This was less than the 1970-73 surge, whichaveraged 10 percent, but slightly greater than the 6.2percent trend rate from 1955 to 1970; it also exceeded

iChais-mnan Arthur F. Bums of the Board of Governors of TheFederal Reserve System testified on October 10 to the JointEconomic Committee of Congress: “The policy that we havepursued represents a middle course. We have tried to applythe monetary brakes firmly enough to get results, but wehave also been mindful of the need to allow the supply ofmoney and credit to keep expaading moderately.”

Demand and ProductionReals Soole - ‘ — I ~ tatlo Seal,Ill otDllr Id 7 1,0 0909

ll1.61 . . . . -- . 19.6

Tolodlo9~ 1

Real Prodoct 2.6 - - - , - - - .6

.5 ___________________ -~ 1- ‘9966 9967 1960 0969 9970 0979 0973 9973 0974H GNP7,,,,,,,177,i,.s

-Ic,.-,,Ic..I,,-,Id,7,di,,’,d

Page 4


the 3.5 to 4 percent estimated long-run trend growthpotential of productive capacity. New orders of man-ufacturing firms rose at a rapid 16 percent annualrate in the first nine months of 1974 (latest data avail-able). During the period it was reported that a siz-able portion of these firms were operating at effectivecapacity.2

Market forces allocated the increases in aggregate

demand broadly. However, since the distribution wasinfluenced by factors such as energy limitations, inter-est rate ceilings, price controls, and Governmental sub-sidies, some types of purchases rose much more slowlythan others or even declined.

Consumers, on balance, increased their spendingsubstantially. Personal consumption expenditures roseat a 12 percent annual rate in the first three quartersof 1974, despite marked cutbacks in spending on auto-mobiles. The decline in auto sales can be explained,in part, by the fact that production could not shifttoward models that use less gas as rapidly as con-sumer demands changed in response to higher gaso-line prices. Also, higher costs of producing autosbrought about by required environmental and safetyequipment contributed to the depressed sales. Out-lays for new housing also declined, reflecting customerreaction to the higher costs of construction and land,and the large supply of unsold units. There were mar-ket interruptions to the financing of houses, resultingfrom state usury laws, regulations of interest rates paidby savings institutions, and the higher market interestrates accompanying the inflation.

Business spending on plant and equipment rose ata 12 percent annual rate in the first three quartersof 1974. Many firms operated at or above optimumlevels most of the year with sizable order backlogsreported. Partially reflecting the strong demands,many firms found it difficult to maintain or build in-ventories until the fall of the year. In the aggregate,the rate of inventory accumulation slowed from $15billion in 1973 to a $9 billion annual rate in the thirdquarter of 1974.

Government purchases of goods and services alsorose at a 12 percent annual rate in the first threequarters of 1974. Spending by state and local gov-ernments continued their upward trend, and therewas an increase in Federal defense outlays. Socialprograms and other nondefense spending increased at

2A sun’ey of 155 economists from manufacturing finns by theNational Association of Business Economists in August andSeptember found that 65 percent of the firms were currentlyoperating at effective capacity, 29 percent were below effec-five capacity and 6 percent did not know.

a 14 percent rate, despite the “austerity”implemented to resist inflation.

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program

The growth in spending was facilitiated by a sub-stantial expansion of credit outstanding. Total com-mercial bank credit rose at a 10.3 percent annual ratein the first eleven months of 1974, compared with a9.6 percent trend rate in the previous decade. In addi-tion, sizable amounts of credit were extended by lifeinsurance companies, mutual savings banks, and sav-ings and loan associations. There was also a substan-tial volume of borrowing in the money and capitalmarkets on commercial paper and bonds. Most of theadditional funds supplied caine from saving, but a partwas created by the banking system. Business ad-vances, residential mortgage loans, consumer credit,and Government indebtedness (including agencies) allexpanded. Partially reflecting the market constraintsmentioned above, real estate loans grew at a rela-tively slow pace.

The demand for credit increased more rapidly thansupply in the first seven months of 1974. The hugedemands for funds reflected not only a high level ofactivity in many sectors, but also rising prices and ex-pectations of still higher prices .As a result, interestrates rose sharply, especially on short-term obligations.The average rate at which commercial banks lent day-to-day Federal funds rose from about 10 percent inDecember 1973 to nearly 1.3 percent in July. Over thesame period, the average yield on prime 4- to 6-monthcommercial paper went up from 9 percent to 11.7 per-cent, and interest rates on highest grade seasonedcorporate bonds increased from 7.7 percent to 8.7percent.

After July, interest rate developments were mixed.Rates on most short-term instruments moved lower,while yields on long—term obligations continued to riseuntil late in the year, when they too began to decline.The average Federal funds rate fell from almost 13percent in July to less than 9 percent in early De-cember, and the commercial paper rate dropped from11.7 percent to 9 percent in the same period. The yieldon highest grade corporate bonds, however, continuedto rise from the 8.7 percent July average to 9.4 percentin the week ended October 11. After mid-Octoberthese rates also declined, and averaged about 8.9 per-cent in early December.

During 1974, there were somewhat fewer institu-tional obstacles distorting credit flosvs than there werein the 1966 or the 1969-70 episodes of rapidly rising

Page 5


interest rates. For example, ceiling rates on large CDs(over 30 days) were lifted, some state usury lawswere relaxed, and rates that thrift institutions couldpay to attract savings were slightly higher. These de-velopments may have permitted market interest ratesto be bid higher than they otherwise would have been,but credit was generally available and the severewrenching of a widespread “credit crunch” wasavoided.

iProd-ucfton

Production declined markedly in 1974, From thefourth quarter of 1973 to the third quarter of 1974,gross national product in real terms fell at a 3.6 per-cent annual rate. Data available in early Decemberindicate a further drop will be recorded in the fourthquarter. By contrast, real output rose at a 4 percentaverage rate in the decade from 1962 to 1972, andslowed to a 2 percent rate from the first to the fourthquarter of 1973. During the last previous economiccontraction, from late 1969 to late 1970, real outputdeclined at only a 1 percent annual rate, despite anaccompanying major automobile strike.

There has been considerable controversy regardingthe basic causes of the reported slowdown in outputgrowth in 1973 and the sharp decline which occurredin 1974. Some analysts contend that the slower growthand decline resulted in large measure from weak ag-gregate demand. Other analysts contend it was duemainly to factors affecting overall supply.

Both demand and supply factors probably contrib-uted to the production cutbacks, but supply factorsplayed a much greater role than in other post-WorldWar II production declines. Aggregate demandgrowth, as noted before, remained fairly strong in1974, although it was more moderate than during the1970-73 surge in spending. The chief explanation thenas to why the response of real output to demandgrowth differed from earlier experiences appears to bein a changed supply situation. Numerous constraintshad been placed on the ability of business firms toproduce, and these restrictions have become muchmore burdensome in the last few years.

For example, environmental and safety require-ments were imposed on a broad scale. Without at-tempting to evaluate their net desirability, there is noquestion but that they increased costs of productionas well as potential social benefits, Then, too, theGovernment imposed price controls on business firmsfrom the summer of 1971 to the spring of 1974. Theprice increases that were permitted on final productsdid not always generate a return which was sufficientto justify additional outlays to meet the Government’senvironmental and safety requirements. The con~-bined result of these Governmental interferences inthe production process led many firms to close downmarginal production facilities and to postponeplanned expansion. Bottlenecks developed becausesome key inputs were unavailable.

Domestic price controls encouraged firms to exportcommodities, one of the most notable being fertilizer,and thereby aggravate “shortages” here. This situationwas compounded, in the short run, by the deprecia-tions of the dollar against other currencies since 1971.The depreciations changed the relative prices ofdomestically-produced goods and imports such thatimports became more expensive in relation to U.S.goods. This led to the substitution of domestically-produced goods for imports, and foreign demand forU.S. products increased relative to our demand forimports. As a result, resources available to domesticindustry as well as consumers have been reduced orbecome higher priced.

In addition, relative commodity prices changedmuch more than usual in 1973 and 1974 because offactors such as the drought, increased foreign fooddemand, and the substantial boost in oil prices. Whenrelative prices change, consumers change their spend-ing patterns in an effort to maximize satisfaction. In-dustry, however, with large fixed investment andproduction plans already in motion, was not able to

Short-Term Interest Rotes

9966 9967 9940 1969 99700o’a,t 45, pI.0.d. N

0970 972 9973 ‘‘74

Page 8


make the required changes (within cost constraints)as quickly as consumers,

Hence, in early 1974 there was a surplus of certainstandard-size automobiles and idle automobile capac-ity while consumers were seeking autos that consumedless gasoline. Also, given the large stock of existinghouses and the change in relative prices, there weremarked cutbacks in housing construction. At thehigher interest rates which prevailed, consumners de-sired more of other goods and services relative tohousing, which usually must be financed by sizableloans for long periods. And even if consumers \verexvilling to pay the higher interest rates to finance hous-ing purchases, market interferences, such as stateusury laws and limnitations on rates paid by thrift insti-tutions, tended to impede further the flow of funds tohousing. In contrast to the excess capacity in the autoand housing industries, firms in many other indusb-ies,such as steel, aluminum, machine tools, paper, chern-ical, and petroleum, were operating at, or near, capac-ity for extended periods. Many, as mentioned earlier,even experienced sizable order backlogs.

In terms of industrial production, there was anabrupt reduction in output from November 1973 toFebruary 1974 during the initial adjustment to the oilembargo. During this three-month period, productionfell more than 2 percent, or at about a 9 percent an-nual rate. From February to October, productionsho\ved little net change, with expansion of some in-dustries matching declines in others. Since October,production has again declined.

Total new construction expenditures, which de-clined slightly in the last half of 1973, remained rela-tivelv unchanged in the first nine months of 1974.Large Governmental outlays and private nonresiden-tial spending about matched declines in privateresidential construction.

Lmi.JtOqmcS:

Trends in emnployment were mixed in 1974. On bal-ance, total civilian employment was about unchangedfrom the fall of 1973 to the fall of 1974. But at thesame time, the unemployment rate increased from anaverage 4.9 percent of the labor force in 1973 to anaverage of 5.4 percent in the first eleven months of1974. In November the unemployment rate stood at6.5 percent. By comparison, unemnployment averaged5.8 percent of the labor foice in 1971 and 1972. Theincrease in nnemployment in 1974 while total employ-ment continued at a high level was possible becauseof a sizable growth in the labor force, both as popula—

tion of labor force age grew and as the participationrate increased, Inflation probably contributed to theparticipation rate increase as, in some families, secondand third members sought jobs to meet the higherliving costs.

Output per nan hour of labor fell sharply in 1974.This resulted, in part, from the sharply higher costsof energy combined with environmental and othercontrols which made existing capital less efficient.This, in turn, probably led some firms to substitutemore labor for capital. In tIme first three quarters of theyear, reported output per man-hour declined at abouta 3 percent annual rate, By marked contrast, fromearly 1970 to the end of 1973, output per man-hourrose at an average 3.3 percent rate.

The drop in labor output per hour was an impor-tant factor in the reported jump in unit labor costs,which were up at a 13 percent annual rate in the firstthree quarters of 1974. From early 1970 to the end of1973, unit labor costs rose at a 3.8 percent rate. Anadditional factor contributing to the sharp rise in unitlabor costs was the 10.3 percent rate of increase inwages and other compensation for the first threequarters of 1974, compared w’ith a 7.2 percent pacefrom early 1970 to the end of 1973.

Income

Together with greater sales and employment, nomi-nal incomes have been rising. Total personal income

Ratio sealsMillia,a 09 Poaso,,95

Ratio Saab09119 laos at P easa as

95

Labor Market Trends

lotal EmploymoM _____________90 - - - 90

15.705 ~ic_. as

a Iinomploomeal Ralo Paroont

9966 0967 9960 9969 9970 9979 9972 0973 09745,.,,,,: 55. i2,pS,I,D.I..! cI L,b,.

P,S-,,I,7,,,,,,,

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Page 7

FEDERAL RESERVE BANK OF ST. LOUIS

increased at an 8 percent annual rate in the first tenmonths of 1974, a rate somewhat below the pace ofinflation as indicated by most measures,

The bulk of total income is in the form of paymentsfor labor services. Total wage and salary disburse-ments rose at a 9 percent annual rate in the first tenmnonths of 1974. In addition, supplements to xvagesand salaries, bolstered by improvements in pensionplans, rose at a 14 percent 1-ate in the same period.

Corporate profits after taxes rose at a relativelyrapid 28 percent annual rate in the first three quartersof 1974. In part, the rise in reported profits reflectedhigher prices permitted after the removal of pricecontrols. In view of the inflation and accounting pro-cedures generally used, however, reported profitswere probably overstated because of an inadequatehandling of depreciation allowances and inventoryvaluation. In the 1965-70 period profits had driftedlower, and the increases in the early 1970s havelargely restored them. Profits in the third quarter of1974 xvere 104 percent above their 1965 level. Bycomnparison, over the same period wage and salarydisbursements rose 113 percent.

In/huhMost analysts agree that inflation has been a serious,

if not the most serious, economic problem of the na-tion:5 The increase in prices which began in themid-1960s was more rapid in 1974 than in any of theprevious years. Average prices, as measured by theGNP price deflator, m-ose at an 11 percent annual ratein the first three quarters of 1974. During 1973 pricesrose 7.4 percent, and from 1965 (when tile inflationbegan) to 1972, prices rose at an average 4 percentannual rate. By sharp contrast, time average level ofprices rose at a 1.5 percent rate from 1959 to 1965.

The consumer price index advanced at a 13 percentannual rate in the first ten months of 1974 after am)average rise of 4.4 percent per year from 1965 to 1973.The wholesale price index jumped at a 24 percentannual rate in the first eleven months of 1974, with theindustrial commodity component ascending at a veryrapid 28 percent rate. By comparison, wholesaleprices increased at an average 4.2 percent rate fronm1965 to 1973, and the industrial commodity comnpo-uent went up at a 3.4 percent rate.

51n a survey of the National Association of Business Economiststaken in Angust and September 1974, 90 percent of the 514respondents considered inflation to be the most seriouseconomic problem of 1974. Government spending and con-trols received 4 percent of the vote, energy received 2 per-cent, ,enernploynaent 1 percent, and environment, exchangerates, and all others received 3 percent.

Page 8

DECEMBER 1974

As mnentioned earlier, the inflationary surge in 1974reflected both a continued strong demand for goodsand services fostered by expansionary monetary andfiscal actions taken in the 1970 through 1973 periodand cutbacks in production during 1974. In addition,some of the reported price increases in 1974 wereprobably due to earlier inflationary pressures whichwere not reflected in the indexes during the period ofcontrols. Some mnay even have been the result ofmarkups made in anticipation of a reimposition ofcontrols.

IhIS(I;7%I

Fiscal and monetary actions taken prior to the startof 1974 have had a major influence on economic de-velopments in the year. Actions taken during 1974have probably played a significant role also, particu-larly on developments late in the year.

Federal expenditures, using the national incomeaccounts budget, rose at a rapid 9 percent annual ratefrom early 1970 to late 1973, and at a 17 percent ratein time first three quarters of 1974. This sharp rise inspending occurred despite reported efforts by theGovernment to restrain outlays in order to dampeninflationary pressures. Natiommal defense outlays rose atabout a 5 percent rate. Defense spending has changedlittle, on balance, simmee 1968. By contrast, Social Se-curity and other nondefense spending rose at a 19percent rate in the first three quarters of 1974, afterexpanding at a 15 percent pace from early 1970 to theend of 1973.

Prices

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9966 9067 0960 969 1970 0979 1Y72 0973 9974

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Government tax receipts also rose sharply with theinflationary expansion in individual and corporate in-comes. For example, if a married couple with twochildren which had made $8,000 per year had a 10percent increase in income, their Federal income taxwould have increased 25 percent (using the standarddeduction). In the aggregate, Government receipts(national inconme accounts budget) increased at a 14percent annual rate in the first three quarters of 1974.

Expenditures of the Government still managed toexceed the large, and expanding, tax receipts, and, asa result, the Government operated at a deficit of $3billion (annual rate) in the first three quarters of 1974.The deficits in the four preceding years, however,were much larger, averaging $14 billion.

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The nation’s money stock continued to expand rap-idly in the first half of 1974, but it increased onlymnodestly after June. From the fourth quarter of 1973to the second quarter of this year, money rose at a6.6 percent annual rate, or at nearly the same rapidpace as in the previous four years. However, in thethird quarter the growth of money slowed to a 3.6percent rate, and from data available in early Decem-ber it appears that growth in the fourth quarter willhe at about a 4 percent rate.

The monetary base grew at a 7.7 percent annualrate in the first three quarters of 1974, also not sig-nificantly different from the rapid pace in the previousfour years. The multiplier (a mathematical conceptwhich statistically links monetary base and money)declined during the second half of this year, primarily

reflecting a rise in currency relative to demanddeposits.

Money plus net time deposits, a broader measurethat some analysts find useful, rose at a 9 percentannual rate in the first two quarters of 1974. This ratealso was approximately the same as in the four pre-vious years. During the third quarter, money plus nettime deposits increased at a reduced 6.2 percent rate.

()UTLOQK

As 1974 ends, the pace of inflation appears to bemoderating, but production has declined and unem-ployment has been rising. Based on the momentumof business developments and stabilization actionstaken to date, the rate of inflation will probably beless in 1975 than in 1974, Early in 1975, production islikely to remain sluggish, and unemployment willprobably average somewhat higher than in the lasthalf of 1974. However, a major contraction, whichsome persons fear, does not appear likely, and, as theyear progresses, production and employment growthshould gradually improve. (Of course, developmentsin 1975, especially later in the year, will be affected,to some extent, by stabilization actions taken duringthe year.)

Although progress toward price stability and re-sumed economic growth is anticipated during 1975, it

serves no purpose to pretend that there is a quick,easy, and costless cure to our economic disarray. Pro-gress is likely to be slow, since the lagged effects ofpast monetary and fiscal actions and economic devel-opments will impinge on the economy for some time.

RatIo Scat,titlist’ of 0000°,,200

Money Stock

S ,,,,~iI, S~i’” S

Federal Government ExpendituresFloai,,ol beset Rarootta Radgot

tool, nato o,.~Io~Isr&,I,,7 S,,,,Ies, Ratio ScalaOiltiao, at a,11ar, 5,,,,,,sI’ ,S,,s,7,7 tilliat, ,t tottora250 ~ :50

000040

______ - 920

9966 0967 0960 0969 9970 0970 972 0973 09745,I,s,,.U.S. Sap.,,,—,,

5F Cs,,s’,

290

200

270

260

250

240

230

220

Ratio Sooto01111 aas at taltara

300

290555500

- - 270

360

250

240

230

220

390

200

990

290

000

970

- - - - 200

- , - 190

-t

- tao

0966 9967 0960 0969 0970 0970 0972 0973 0974N shs,0

, N, p,,i,.d,

pIsNd. 3,4

+ It

070

060

Page 9


In addition, progress toward price stability andeconomic growth is likely to be slow because theeconomy continues to be hobbled by Governmentalrestrictions, Available resources, such as oil, have beenreduced, and social objectives imave been given aImigher priority relative to economic growth in a num-ber of areas. For example, measures to clean the airand water have been adopted at the cost of less out-put of goods and services. Many of the handicapped,youth, and unskilled remain idle rather than beingpermitted to accept a job at wages below the estab-lished mnimmimunm standard. Also, incentives probablyhave been dulled as a smaller portion of economicrewards go to those who produce and a larger portiongo to others deemed deserving 0mm humanitariangrounds.

At times, however, interferences to real economicexpansion lmave been reduced or eliminated, During1974, for example, a reversal of policy occurred whichshould contribute significantly to the resiliency of theeconomy and inmproved economic growth. In thespring of 1974 wage ammd price controls were removed.These controls had been ineffective since they treatedonly the synmptoms of inflation and not the basiccauses. The controls \vere easily evaded, if not byopen defiance or black markets, then by reducing

quality or service or by redefining products. Controlswere a drag on the economy since they reduced workammd production incentives. As a result, productivitydecreased and capital investnment was discouraged ormisdirected into areas where controls were weakest.Since there was a cost of administration, those tlmatdid produce were taxed to support the system.

CONIIATSIONIInflation, which began in the nmid-1960s, has been

the nation’s most serious econommmic problem this past

year. The acceleration of inflation was moderate inthe 1980s, but in 1973 and 1974 there was a pro-nounced upward surge in prices, reflecting both acontinuation of rapid spending increases combinedwith a reduction in output.

During 1974 policies were implemented to moder-ate the spending increases and to foster a more rapidexpansion in production. Monetary actions have be-come somewhat less expansionary. Wage and pricecontrols were eliminated. In addition, the private sec-tor of the economy has mnade great strides towardadapting to the higher prices of energy and energy-related products.

The rate of inflation could be slo\ved more quicklyand production could be expanded more rapidly byimproving the market system, but such improvementsmay conflict with other objectives. Actions to improveeconomic efficiency and incentives include reducingsubsidies, tariffs and import quotas, widening therange of anti-trust laws to cover more monopolisticpractices of business as well as labor, eliminating out-dated building restrictions and other barriers togreater productiomm, inmproving skills of workers andinformation on job openings, and modifying minimumwage laws in the interest of improving job opportuni-ties for the inexperienced and handicapped.

A “fine-tuning” of the economy cannot be attainedwith the present state of economic knowledge, andvigorous efforts to do so may actually he destabilizing.Policymakers have incomnplete and delayed informa-tion on economic developments, and there are lags inthe effect of stabilization actions taken. However, ifdestabilizing actions can be avoided, substantial pro-gress should be made during 1975 toward the goalsof high employment and stable prices.

THE U. S. BALANCE OF PAYMENTS DURING 1974

HANS H. HELBLING

During 1974 U. S. international transactions wereaffected mainly by four forces

1) the sharply increased petroleum prices in worldnmarkets,

2) the adjustments to exchange rate changes whichhave occurred since 1971,

3) the cyclical downturn in many industrialcountries,

4) and the high, though differential, rates of mone-tary growth and inflation throughout the world.

These factors are interrelated and have exertedboth favorable and unfavorable pressures on the U. S.

Page 10

FEDERAL RESERVE BANK OF ST. LOUIS

Consumer Prices of Selected Countries

Mo,,bI, 5.’,,

tools ScaO,,t970~l00060 - -‘55 - -

050 - - - -

045 -~ .--._-

040 - - -

035 -

030 - - -

125 - ‘ -

020 - -

105

II,

005 -

95

90

as

00

75

0 atia 5o,bo09 70 ~19O

5557/

055ISO

045040

030Unilod Kio

9dom 125

1170065

U,ot,d fobs j160

055050045040

935

70,~,::~/

~rI

7005

1966 0967 0960 0969 0970 0970 0972 0973 0974S,,S&J,p,,. C,,,SN, 5,s5,lSeS 0_sI,.., U,,’5550U55,ib,,S 5EC5 UK Co’s—I

5t,tIo~5oI055,. 556 U.S. 5,p,,’555 ,i CUss’s,.Ce,,,,,IeU sIso,5: J,p,,.Ns.

555,,,,,I,,,,,d-U5 ,,d C,,,,,isQusb,,. 0,,’U,DUK

international accounts; it is not always possible, how-ever, to isolate time individual effects quantitatively.The higher oil prices and a relatively inelastic demandfor oil imports lmad the effect of increasing sharply thevalue of U. S. nmerchandise imports. The dollar depre-ciation since 1971 changed the relationship betweenthe price of imports atmd the price of domestically—produced goods. Tlmis encouraged exports of donmesti-caily-produced goods anci discouraged imports. Thecvclicnl downtunm in botim the United States and itstrading partners had the effect of retarding the growthrates of both U. S. demand for imports and foreigndenmand for our exports. The differential rates of infla-tion, to the extent timat they were not alrendy ac—counted for in exchange rate nmovemnents, had atendency to promote U. S. exports simmce the U. S. rateof inflation was lower, on average, than that of itsconmpetmtors.

Trade BalanceAfter substantial trade surpluses in December 1973

and January 1974 the U. S. trade balance moved into

DECEMBER 1974

Merchandise Trade50550CC DATA

7 55 A N J 5 A U 0 N 0

1973

Let,,, d.,I, plotted. 0,’ob,,

P 5AM US AS050

‘974So,,,,,. U.S. Dop,ait,oe,tU+C,,oee,ee

deficit.1 For the first ten months of this year thecunmulative trade deficit anmounted to $2.8 billion,Import prices of petroleum increased at a very rapidrate while the quantity imported was only slightly be-low 1973 levels, This suggests that the trade deficitwas affected substantially by the rise in oil prices.Removal of petroleum transactions from the tradebalance reveals tlmat the balance on other transactionsis still in substnntinl surplus, although the surplus de-clined somewhat from its peak ill March 1974.

A reduction in the value of agricultural exportssince mid-1974 also contributed to the decliningtrade l.vilaoce. TIns occurred as both the quantity andthe price of exports declined from time extrenmely highvalues of 1973. Since mid-1974, however, prices ofU. S. agricultural eonmnmodities have been rising again,such that the recent decline iam the value of agricul-tural exports should he reversed in eonming months.

Use of somewhat more detailed trade data (avail-able at timis tinme only through the second quarter of1974) reveals that manufactured goods contributedpositively to the U. S. trade balance, The sustainedstrength of expoo’ts of U. S. mmmanufactured goods wasprobably tile result of contnmued U. S. conmparative

1AII balance-of-payments data are reported at seasonally ad-justed annual rates. Monthly trade data are available onlythrough October. All other data, except for the basic andgoods and services balances, are available throngh the thirdquarter.

Page 11


advantage in the production of these goods combinedwith large imivestment spending by major industrialcountries.

is mainly accounted for by oil related transactionswhile other foreign direct investment inflows changedlittle relative to J973~4

!Jkrsle fj(j.Idi.ttU~~•P

In addition to the trade balance, the basic balanceincludes net income from investments abroad andother services, unilaterial transfers, and the balanceon long-term capital flows.2 For the first half of 1974,the basic balance was in deficit by $1.9 billion, com-pared to a $0.9 billion deficit during 1973.

A major factor contributing to the basic balancedeficit was the shift in the trade balance from asmall surplus in 1973 to a deficit in 1974. Net invest-ment income, however, increased from $5.3 billion in1973 to $9.7 billiomi for the first half of 1974. Incomefrom U. S. investments abroad amounted to $24.8billion in the first half of 1974, considerably greaterthan the $14 billion recorded in 1973. At the sametime, income payments to foreigners on their invest-ments in the United States amounted to $15.1 billionover this period, compared to only $8.7 billion in1973,

Part of the increase in U. S. investment incomefrom abroad is related to the fact that interest ratesabroad were higher in 1974 than in 1973. Also,higher U. S. interest rates and larger stocks of foreignassets held in the United States (both direct and port-folio investment) influenced the sharply higher in-come payments to foreigners. Both the increased U.S.investment income and the increased income pay-ments to foreigners were significantly influenced bypetroleum-related transactions. The sharply increasedoil prices contributed to increased earnings of U. S.oil companies operating abroad while the larger de-gree of participation of oil exporting countries inU. S. oil company assets added to the increased in-comne payments to foreigners. On the whole, $7 billionof the $9.7 billiomì net investment income from abroadduring the first half of 1974 resulted from petroleum-related transactions,3

U. S. direct investment abroad unmounted to $4.4billion in the first half of 1974, slightly lower thanthe 1973 outflow of $4.9 billion. Inflows of foreigncapital for direct investment in the United States in-creased sharply to $5.6 billion in the first half of 1974,compared to $2.5 billion in 1973. The change inforeign direct investment inflows from 1973 to 1974tm

Data for the basic balance, at this time, is available only

through the second quarter of 1974.3Survey of Current Business (September 1974), p. 37.

The U. S. basic balance is generally considered tobe an indicator of underlying, or long-term, trends inthe U. S. international economic position. However,because of the special influence of increased oil prices,this balance should be interpreted with caution, asshould be the trade balance.

:h,c.’~rt~Tec-~m,Capita.l

Net outflows of nonliquid short-term capital,mainly U. S. bank loans to foreigners, increased

~Ibid., p. 40.

Billitt100 —

U.S. Balance of Payments and Components+ ISurplss; I—lDoflclO

So,.s,edUy Adj,sied ,t As,,,I 0,0,, . -59 Dollars 0,.,tsU, 0U’U. ItIloans

100

90~ —

ao

of Dollars

~ ~ll0

‘Sot100

70

90

60

.1

00

50

70

40

60

30

so

20

40

ID

30

0

20

00

-20

-30

Ilel Liqaidily Balotct-90

-20

-50

Iv -30

Olliciol Stlllametis Bolotce~

-40

-so

.609965 9966 967 9960 1969 1970 0971 9972 9973 9974

55,. Sk,,ei IUs5,iUty6,U,,oois ~

,U’ooolUq.id,ho,Lt,,,,p,U,sS,oopS,loIi,,,,U,,,,id.,slso ,Ushu. ,,,d ‘N’’’o,,o’d o,,U,,io,,.

5,55,,, U, ‘ho se 55 ih, ‘Us’ sso,’o p1.,,,’ II,,, of S5oUU

Cot,,’ d,ssIe,,,d. O,Iso, otosd, ,,d S,,,U,,,,2,d so,,,,,.oiho,,.3e5 Cs,,,, po,IUeis,y

Page 12


sharply during the first three quarters of 1974. Theyclimbed from $4.5 billion in 1973 to $14.2 billion sofar in 1974. A number of factors contributed to thisdevelopment: higher interest rates in many foreigncountries (including the Eurodollar market) relativeto U. S. rates, increased loan demand on the part ofmany countries to meet oil import payments, and theremoval of U. S. controls on capital outflows early inthe year. During the third quarter, however, U. S.hank loans to foreigners were considerably smallerthan in both the first and second quarters, despite therelatively lower U. S. interest rates. The third quarterreduction may be related to a leveling-off in foreignloan demand from the second quarter. The secondquarter hank loan figures were affected by a verysharp mn-up in the volume of oil shipments, followedby a return to more amormal volumes in time thirdquarter.

~.‘S~io;ot f j.rn.~idrta/°-.‘d.S

Sc ttlerae:nty Balan.ees

The net liquidity deficit may he thought of as thetotal of U. S. dollar balances which accrue to for-eigners during an accounting period as a result of allof the above transactions. For the first three quartersof 1974, this balance was in deficit by $16.1 billion,compared to a $7.6 billion deficit for 1973.

The official settlements balance, on the other hand,is inteomded to measure only dollar balances whichaccrue to foreign official institutions. During the firstthree quarters of 1974 the official settlements bal-ance registered a deficit of $5.1 billion, compared toa .55,3 billion deficit for 1973.

The difference between the net liquidity balanceand the official settlements balance is due to dollarbalances held by private foreign residents. Thus, forthe first three quarters of 1974 private foreign resi-dents acquired dollar balances amounting to $11billion.

A word of caution is in order with respect to thesetwo balaimces. The official settlements balance wasoriginally designed to reflect the extent of officialintervention in the foreign exchange market duringa given period. Under time previous system of fixed ex-change rates, monetary authorities were required tointervene in foreign exchaimge markets in order tomaintaiim the agreed upoom dollar exchange rate. Underthe current system of flexible exchange rates, suchofficial intervention is no longer required.

1mm addition, it should be kept in mind that foreignofficial institutions may acquire dollar holdings for

reasons other than those relating to exchange marketintervention. The rapid accumulation of claims on theUnited States by the members of OPEC (Organiza-tion of Petroleum Exporting Countries) is a case inpoint. The increased holding of dollar claims byOPEC goveromments reflects a conscious investmentdecision to hold dollar denominated assets, ratherthan the effects of nmarket intervention in support ofthe dollar exchange rate.

Moreover, the magnitudes of both the net liquidityand the official settlements balances are affectedstrongly by the recycling of oil funds. For example, ifforeigners borrow in the United States to finance theiroil import bill, these transactions would be recordedas capital outflows giving rise to a net liquidity deficit.Ultimately, however, the proceeds from such borrow-ing may end up with the governments of oil export-ing countries who would place these funds on depositin the United States. This type of transaction wouldtherefore give rise to U. S. deficits on both the netliquidity and the official settlements balances, when infact they reflect the role of the United States as anexporter of the services of a financial intermediary.

U.S. Oil Import Prices

U.S.Billioas of Dollars

Oil Trade Balance . -

MONTH V DACA Bollocos of Dollars

.0.0

-9.2

-I .4

-0.6

\\

-l.a

-2.0

-9.2

-I .4

-2.2

-2.’

-~

-I .6

-l.a

-2.0

1973SPMAMS SA3OMO SPMAMSJ ASOND

L &os~d,~,pLotted. 0,’, 6,,

-2.2

-2.4

19745,,,,,,. U.S 0, p,s,’se,t,fC,,,m,’,e

Page 13


OPEC Oil Iicvenues

There has also been cobmsiderable interest concern-ing the total dollar accrual of oil revenues by OPECand the disposition of these oil revenues. The U, S.Treasury Department reports that between Januaryand September 1974, the members of OPEC collec-tively acquired dollar balances amounting to $35 bil-lion. About $8 billion was placed directly in the UnitedStates while the remainder was invested in othercountries aTmd in time Eurocurrency market.

It should be noted that although only $8 billion ofOPEC funds was placed directly in the United Statesby OPEC members, at least a portion of the remaindercould have heeim placed in the United States by otherparties. For example, if an OPEC member desires todeposit its dollar balaimces in the Eurodollar market,then immediate control of timose dollar balances wouldbe transferred to the Eurodollar banks instead of theOPEC member. If Eurodollar banks extend dollardenommminated loans such that the loan proceeds areused to buy real and financial assets in the UnitedStates, indirect investment of OPEC dollar balanceswould have occurred.

Sum~nur~rvj(J.~n.(~Outi.ook.

The U. S. trade balance was in deficit by $2.8 hi]-lion in the first ten months of 1974. The basic balancedeficit for the first half of 1974 amounted to $1.9billion, and for the first three quam-ters the netliquidity aimd official settlements deficits amounted to$16.1 and $5.1 billion, respectively.

The trade deficit can be attributed to the sharpincrease in oil prices. In fact, when the immfluence ofhigher oil prices is removed there emerges an im-proved U. S. trade balance as compared to last year.Prospects for 1975 suggest that the U. S. merchan-dise trade halammce, because of oil payments and asomewhat lower volume of agricultural exports, canhe expected to remain in deficit.

The basic balance, however, will he imeavily influ-enced by the actions of OPEC regarding the dis-position of their large and accumulating dollar bal-ances. Should they decide to invest their dollarbalances in long-tenn instrunments, and depending ontheir nmagnitude, the basic balance could be lim equihb-riunm or perhaps even in surplus. The net liquiditybalance nmay be expected to be much the same as thebasic balance if U. S. hank lending to foreign oilimporting countries subsides. At this time it is not

~i

~‘~H275

~ — I

~_~3~j~~-.__—_0--,4-- - ‘ — 250

— r / “, - - ~‘t_~, -~ 225

- I- , ‘4—__ 200

/ ‘ Al tdoslrial Commodtfies

~‘~T -\ -k-I -_

Mefol “,

—~- - - I -j” ~i125

~ ,,iii,,iiiii’Iiiiiji,ili.ii E,,,/lli’

250

225

200

:~925

no

clear how U. S. participation in any new oil financingfacility would be recorded in the U. S. balance ofpayments. To the extent that any such U. S. partici-pation would be recorded “below the line,” nettingU. S. claims against U. S. liabilities, a net liquiditydeficit would not materialize as a result of these U. S.oil loans.

In addition, if foreign oil exporting countries dodecide to hold their dollar accruals in long-termform, rather than short-term, the official settlementsbalance could also be expected to be in equilibrium.In fact, a possibility exists that the official settlementsbalance might even be in surplus. This possibility isenhanced if foreign countries, who now possess stocksof liquid dollar reserves, transfer them to OPEC, whoin turn would place them in the United States aslong-term investments.

Projections concenming the dollar exchange rate aredifficult at this time. As a result of a strong demandfor U. 5. dollars on the part of many foreign countriesto finance oil deficits and the relatively low rate ofmonetary growth in the United States, the dollarcould be expected to appreciate somewhat. However,due to a general reluctance on the part of countriesto allow their currencies to depreciate relative to thedollar, this dollar appreciation might not be enoughto offset fully the effect of differential rates of moneygrowth and inflation.

t970’tOORoUt Scolt

World Commodity PricesDollar Itfec 09100100WPPXITC400 Rotia Stole

JAM P0O MAR APO MAT JUNO SUIT AUO SEPT OCT MOO SEC

974Ss,,o. ‘ho 01000550, I0M9oo;~~

Jot,,’ 4551, pSoT,d. ,,.k ‘~‘0S.o,sbo, 4. ISJ’4

I Page 14

1974 - a year of inflation, production cutbacks, and oil

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