Federal Reserve dilemma: 1974.

Tuttle, Mark ; Stretcher, Robert

INTRODUCTION

The U.S. macroeconomy was considered relatively healthy at the end of 1973, but some problems loomed. Growth of real output was robust and the unemployment rate was on the decline. By the fourth quarter of1973, the U.S. was enjoying significant growth in Gross Domestic Product (GDP), growing at an annualized rate of 3.9 percent in the fourth quarter. In fact, real output had increased in thirteen of the fifteen quarters following the 1969-1970 recession, which ended in the first quarter of 1970.

It certainly wasn't the longest expansion following World War Two. Yet, real GDP had grown at an average annual rate of 4.8 percent, which exceeded average real GDP growth of 3.9 percent following the Second World War. National unemployment rates fell as the real GDP grew. Unemployment reached a forty-two month low of 4.6 percent in October, 1973. This rate was down substantially from the post-recession high of 6.1 percent during the summer of 1971.

The positive increase in real output fueled a faster rate of increase in prices. Inflation had decreased following the 1969-1970 recession, and reached a low of 4.5 percent in 1972. However, inflation rose through 1973 (measured as the percentage change in prices for Gross Domestic Purchases), averaging 5.8 percent. A higher rate of growth in the money supply contributed to higher inflation rates. Additionally, M2 (one measure of the money supply) increased 13.4 percent in 1971, almost double the average annual rate of growth for the 1959 through 1970 period. This high rate of money growth was sustained through 1972, increasing 12.9 percent in that year. Consumers to a large extent bore the cost of these price increases. One measure of consumer prices, the Consumer Price Index (CPI), grew 8.9 percent in 1973. Therefore, inflation became a considerable concern at the end of 1973.

POLITICAL INSTABILITY

Political instability in the U.S. and abroad complicated the situation in late 1973. President Nixon was battling for his political life over the Watergate scandal. As a result, active fiscal policy waned and monetary policy became the primary means to alter the short run path of the macroeconomy. The U.S. began the withdrawal of all combat troops from South Vietnam in 1973. One side-effect of reduced involvement in Vietnam was a reduction in the budget deficit as defense spending fell. The lessening of fiscal stimulus aided in cooling aggregate demand during 1973.

International instability followed the domestic political instability and the withdrawal from Vietnam. Egypt and Syria attacked Israel on October 6, 1973, the day of Yom Kippur. Initial Arab gains were reversed after two days of fighting. By the time the U.N. cease-fire went into effect on October 24, the Israelis were driving towards Damascus and Cairo. The U.S. fully supported Israel during this conflict, which infuriated the Arab nations that supported Egypt and Syria. During October, 1973, these Arab members of the Organization of the Petroleum Exporting Countries (OPEC) initiated an oil embargo against the countries that supported Israel. As a result, energy prices in the U.S. soared. Prices paid by the consumer for energy rose 7.6 percent in the last two months of 1973 (an annualized rate of 55.6 percent). This supply shock rippled through the U.S. as suppliers' marginal costs (especially for energy inputs) increased at the end of 1973.

WEAKENING AGGREGATE DEMAND

Despite the strong growth in real output, there were signs of weakening aggregate demand. Business fixed investment growth was anemic by the end of1973 due to rising interest rates. By the end of that year, the Aaa bond rate rose sixty basis points to 7.68 percent in December and the yield on the ten-year treasury was nearly seven percent (a rise of thirty-eight basis points). Even more alarming was the change in short-term interest rates. The three-month treasury yield rose an astonishing 238 basis points over the year, and the yield of 7.45 percent by the end of 1973 was seventy-one basis points greater than the long-term treasury yield. The yield curve inversion convinced bond market participants to expect higher inflation in the short run relative to the long run. Mortgage rates were also rising substantially. The rate on thirty-year mortgages increased from 7.44% at the end of 1972 to 8.54% by the end of 1973. The side-effect of the mortgage interest rate rise was a decline in residential investment during 1973.

Another sign of slumping aggregate demand was the drop in real consumer spending. Real personal consumption expenditure growth was strong through 1972 at 6.1 percent. For 1973, the change in consumer expenditures was 4.9 percent. However, most of this change came in the first quarter. During the last three quarters of 1973, real consumer spending was stagnant, rising 0.01 percent--consumers were reducing spending on durable and nondurable purchases. One contributing factor to this fall in spending was the decline in the growth of household wealth. During 1971 and 1972, real household wealth grew at an average annual rate of 7.2 percent, which helped to fuel consumption and aggregate demand. By 1973, however, real wealth grew 3.0 percent.

The health of the U.S. macroeconomy was certainly questionable at the start of 1974. The U.S. had experienced exceptional growth in real output in the years following the 1970 recession, but the growth was slowing. One reason was declining aggregate demand. Rising interest rates and falling household wealth softened business and household spending, respectively. The end of the Vietnam War and rising tax revenues reduced the budget deficit, therefore reducing fiscal stimulus on aggregate demand. On the supply side, the oil embargo increased energy costs, which raised marginal costs and reduced aggregate supply. Unemployment was low, but the potential for a weakening economy suggested that the reductions in unemployment were potentially at an end.

EXHIBITS

Table 1 provides several macroeconomic variables mentioned in this case.

Mark Tuttle, Sam Houston State University

Robert Stretcher, Sam Houston State University

Table 1: Important Macroeconomic Variables Provided to Students
(Dollar Values in billions)

Variable                                  1972       1973       1974

Real GDP growth                           5.3%       5.8%      -0.5%
Inflation [CPI (1982-1984=100)]           3.4%       8.9%      12.1%
Inflation [Core CPI (1982-1984=100)]      3.0%       4.7%      11.3%
Inflation (Percentage Change in Price     4.5%       5.8%      10.2%
  Index for Gross Domestic Purchases
  (2000=100))
Real Household Wealth growth             11.3%       8.6%       0.8%
Real Household Real Estate Wealth         8.3%       8.8%      -5.8%
  growth
Ten-Year Treasury Rate                   6.21%      6.84%      7.56%
Three-Month Treasury Rate                4.07%      7.03%      7.83%
Corporate Aaa Rate                        7.2%       7.4%       8.6%
Unemployment Rate                         5.6%       4.9%       5.6%
Net Federal Government Savings           -24.4      -11.3      -13.8
  (Billions $)

Source: Wealth data provided by the Board of Governors of the
Federal Reserve System. All other data is provided by the Federal
Reserve Bank of St. Louis.