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FEDERAL RESERVE BANK OPERATIONS A Presentation by Darryl R. Francis to the Central Banking Seminar at the Federal Reserve Bank of Dallas March 18, 1968 The Federal Reserve System, in addition to conducting monetary policy and supervising banks, performs a variety of regular services for member banks, the U. S. Government, and the public. My assignment is to discuss some of the principal service functions - called operations of the Federal Reserve Banks. In addition to reviewing and briefly discussing a few of the major operations of the Reserve Banks - collecting and transferring funds, distributing currency, handling member bank reserves, and fiscal agency functions - I shall relate some aspects of each to the major function of the System - that is, monetary policy. I note that the discount, research, and supervisory functions of a Reserve Bank are covered in other parts of your program, and therefore will not comment on them. Certain other activities, such as safekeeping of securities for member banks and personnel administration, need little explanation and have little bearing on monetary policy. I will omit these also. Collecting and Transferring Funds The largest operation of a Reserve Bank, measured by number of employees, is that of collecting and transferring funds. Most large -2financial transactions and many small purchases are conducted by transferring bank deposits. By value, over 90 per cent of all transactions are conducted by checks drawn on, or by other transfers of, demand deposits of commercial banks. The use of checking accounts by individuals and businesses is facilitated by the service of the Federal Reserve Banks in clearing and collecting checks, in providing wire transfer services, and by furnishing a mechanism through which commercial banks settle for the funds cleared and collected. The procedure is simple. Suppose a manufacturer in Dallas sells $10,000 of equipment to a dealer in St. Louis and receives in payment a check drawn on a St. Louis bank. The manufacturer deposits the check in his Dallas bank. The Dallas commercial bank sends the check to the Federal Reserve Bank of Dallas for credit in its reserve account. The Dallas Reserve Bank forwards the check to the Federal Reserve Bank of St. Louis, which in turn sends it to the St. Louis commercial bank. The St. Louis commercial bank charges the check to the account of the dealer who wrote it and has the amount charged to its own reserve account at the St. Louis Federal Reserve. The St. Louis "Fed" remits the amount to the Dallas "Fed" through the Interdistrict Settlement Fund. Of course, at times the procedure is shortened and simplified by the Dallas commercial bank sending the check directly to the St. Louis Federal Reserve for collection, but the above description outlines the basic check collection procedure. -3The volume of checks handled by the Federal Reserve Banks has grown rapidly over the years. In 1940, the System handled 1.2 billion checks; in 1950, 2.3 billion; in I960, 4.1 billion; and last year, 6.2 billion. In dollar amount, the upward trend has been even more pronounced, from $280 billion in 1940 to $922 billion in 1950, to $1.3 trillion in I960 andto$2.2trillion in l967. Over the years the process of clearing and collecting checks has been greatly shortened and simplified by innovations such as the conversion to electronic equipment for the processing of checks. At the St. Louis Federal Reserve Sank we are currently processing about 95 per cent of our checks on high-speed computers. Already there is much talk about electronic impulses replacing checks. Some expect this "checkless society" to appear at some dramatic moment eight, ten, or a dozen years from now, when it becomes more economically feasible and the burden of check handling becomes unbearable. Actually, the process of electronic take-over is already far advanced and an essentially checkless society could arrive much sooner than most people expect. One aspect is the growing emphasis on telegraphic transfer of funds - another service which the System provides banks in order to speed the movement of funds around the country. In 1967 there were 7 per cent more checks handled at the St. Louis bank than in 1966, but there were 15 per cent more wire transfers. In terms of dollar amount, more funds are now being transferred by wire than by check. In 1967 -4the St. Louis Bank transferred $147 billion by wire and processed $121 billion of checks, recognizing that much of this growth is associated with Federal funds transfers; nonetheless, automation is an evolutionary process; today it is growing at an accelerated pace. Reserve Banks do not give immediate credit for all checks deposited with them for collection. Credit is deferred for a maximum period of two business days within the continental United States to allow time for out-of-town checks to go through the mail to the banks on which they are drawn. After that, the member bank's reserve account is automatically credited. In our illustration, the Dallas commercial bank would be given credit for the check drawn in St. Louis after one day. Since the time actually taken to collect checks is often longer than that allowed in the schedules, Federal Reserve credit - called float comes into existence, adding directly to member bank reserves just as gold inflows and System purchases of Government securities. The average level of float, approximately $1.5 billion, is no problem for monetary management - the System merely holds fewer securities than it would if float were less or did not exist. However, wide fluctuations in float are of concern to monetary managers. Movements in float are dependent upon any factor affecting the amount of checks handled and their collection time, such as changes in the number of checks written, rail or airline strikes, weather conditions which affect airline schedules, and varying speeds of check handling. -5Float frequently fluctuates as much as $100 or $200 million a day, sometimes moving more than $500 million within a brief period. Because float is the largest factor influencing bank reserves on many days, monetary managers have given it much attention, addressing themselves to such questions as "How can it be practically eliminated or its fluctuations reduced in amplitude?" or "How can its movements be predicted so that offsetting actions can be taken?" Those with the greatest concern about float feel that the prime emphasis in monetary management should be to attain and maintain a given tone or pressure in the money market, as measured by Federal funds rates, other short-term interest rates, free reserves of member banks and feelings of major money market participants. Movements in float affect these variables greatly nearly every day and every week. Another view of monetary management, and one which we prefer, is that the central bank should have only a secondary interest in day-to-day money market conditions. Although float affects the monetary base rather drastically in a short period of time, the subject has probably been given more emphasis than it deserves. Equating short-run fluctuations in the demands and supplies of funds are the function of the commercial banks, especially the large correspondent banks, Government bond dealers, and other money market participants. The central bank should only enter this market so as to avoid serious knots which might cause disruptions in economic activity and not simply to reduce fluctuations in short-term interest rates. -6The prime function of monetary management, according to this second view, is to influence economic activity through controlling the growth of monetary aggregates, such as total member bank reserves, commercial bank credit, the money supply. In this quantitative approach less emphasis is given to short-run control - both because daily data are not available on most aggregates and because our theories of effect on economic activity are based on longer term trends. Injections or withdrawals of reserves because of float are nearly always temporary. Hence, even though float movements do affect monetary aggregates we tend to be less concerned about it because over a relevant period of monetary control, say three or four months, it is likely to have little influence on the rate of change in the monetary aggregates. Distributing Currency A second major operation of a Reserve Bank is the distribution of currency and coin. The ready availability of currency at Reserve Banks enables member banks to provide the amounts and kinds of currency that people in their communities desire. When member banks need to replenish their currency supply, they order it from their Reserve Bank and have it charged to their reserve account. Conversely, if a bank has excess currency on hand, it may deposit currency in the Reserve Bank and receive credit in its reserve account. Last year the Federal Reserve banks handled $1.2 billion of coin and $38 billion of currency. -7Movements of currency into and out of the banking system have a two-fold monetary impact. First, movements of currency between the public and banks affect the volume of bank reserves, the base upon which monetary expansion is built. Second, currency in the hands of the public is part of the money supply, a crucial monetary variable according to some. Without denying these very real impacts, we suggest again that measuring and offsetting or supplementing these movements are not among the more important duties of monetary managers. The effect of currency on member bank reserves can easily be overemphasized. Currency movements, unlike those in float, may proceed in one direction for an extended period. For example, for several months every fall there is a pronounced flow of currency into circulation, reaching a peak just before Christmas. Also, an expanding economy will produce a trend flow of currency into circulation. These broad seasonal and trend movements can be readily detected and their impact offset, and generally they do not cause the monetary managers much concern. On the other hand, like float, there are many irregular movements of currency between banks and the public. Such movements raise grave problems for those seeking to foster a given degree of money market restraint from day-to-day or even week-to-week. To those of us focusing on growth rates of bank reserves, bank credit and money over several months, however, these movements are of much less importance since -8they are largely offsetting. Currency - as previously stated - has a second implication for monetary management. Currency is part of the nation's money supply, and consequently some feel it is of particular importance to monetary authorities. Although we are strong believers in the quantitative approach and follow money developments closely, we fee! that currency has been overstressed in the literature on money and banking. Our studies indicate the varying growth rates of currency have reflected primarily changes in the demand for a hand-to-hand medium of exchange. When transactions which typically utilize currency have risen, currency in circulation has usually increased. When the volume of these transactions has declined, currency has declined. Actions of the Federal Reserve in supplying reserves to the banking system have had little direct influence on the volume of currency outstanding. On the other hand, the rates of change in demand deposits are related to changes in member bank reserves available for demand deposits. The desire by the public for demand deposits under the then existing conditions either to hold or to spend has probably had only a slight impact on the total volume of demand deposits. Since 1950, changes in the rate of growth in currency have tended to coincide with, or lag slightly behind, movements in economic activity. Over the same period, changes in the growth rates of demand 9deposits have usually preceded changes in economic activity. The amount of currency holdings — like virtually all other assets — is determined by the holder on the basis of his income, interest rates, prices of other goods, tastes, and other conditions. He is in equilibrium until one or more of these factors change. The aggregate volume of demand deposits, however, does not respond automatically to changes in the public's desire for them. Movements in these deposits initially reflect changes in reserves available to banks. Hence, the public may temporarily hold more or less of its wealth in these balances than it prefers under existing incomes, interest rates and so forth. The resulting disequilibrium position may be a factor in stimulating or dampening economic activity as individuals increase or decrease their spending or investing in an effort to adjust their deposit balances to desired levels. Thus, demand deposits may be a key monetary variable in our economic system, distinct in nature from currency and other assets. We have generally accepted movements in money, as defined to include demand deposits plus currency, as a measure of the thrust of monetary action. This is because money generally moves at about the same rate as the demand deposit component and money is used by a wider group of analysts. However, if movements of currency deviate so greatly that money and demand deposits move in significantly -indifferent ways, our evidence would indicate a preference for relying more heavily on the demand deposit component and largely disregarding movements in currency. Member Bank Reserve Accounts The third operation we might discuss is member bank reserve accounts. A substantial part of the daily work of a Reserve Bank relates to these accounts. Member banks use their reserve accounts — or deposits in Reserve Banks — much as individuals use their checking accounts in day-to-day transactions. Banks draw on them for making payments and replenish them with funds that are received. For example, entries are made in these accounts as member banks obtain currency to pay out to their customers or as they redeposit currency in excess of the amount needed for circulation, and as checks are cleared. Other entries arise as Treasury deposits are transferred from member banks to the Federal Reserve Banks, or as funds are transferred by wire from a bank in one Reserve district to another, or as a bank borrows from, or makes repayment to, a Reserve Bank. By law, member banks must keep a portion of their deposits in reserves, either in the form of cash in vault or deposits in their Reserve Bank. For reserve city banks, reserves at the present time must average at least 3 per cent of the first $5 million of time deposits and 6 per cent of the excess and 16-1/2 per cent of the first $5 million - II of demand deposits and 17 per cent of the excess. For other member banks, reserves must average 3 per cent of the first $5 million of time deposits and 6 per cent of the excess and 12 per cent of the first $5 million of demand deposits and 12-1/2 per cent of the excess. The System derives real benefits in the monetary policy area from handling member bank, reserve accounts. Monetary actions — whether open market operations, discounting or changing reserve requirement percentages — have their initial impact on bank reserves. Bank reserves, in turn, set a maximum on, and determine to a great extent, bank deposits, bank credit and the money supply. These proximate variables affect spending, employment, prices and other economic conditions. Monetary policy, then, is largely a matter of proper management of the reserves of member banks. By processing the flows of funds through these reserve balances, the forces affecting reserves can be isolated, analyzed, and offset or supplemented, if desirable. Much of the effort in monetary management is devoted to examining member bank reserves. Some feel that great emphasis should be devoted to attaining a level and minimizing short-run movements in free reserves (that is, excess reserves less borrowings). We feel that such measures of "tone" and "pressure" are inadequate and frequently • 12 misleading since most changes in market pressures come from credit demands. As a result, growth of bank credit and money may proceed at almost any rate with a given free reserve level, depending on demands for credit. The major focus, in our view, should be on seeking a trend in the growth of total reserves over a period of several months, which will cause the growth rate of bank credit and money to accelerate if economic expansion is desired and to decelerate if economic restraint is desired. In short, we feel monetary actions are more appropriately judged by rates of change in bank credit and money rather than the feel of the market which may be largely influenced by feedback effects from the rest of the economy. Fiscal Agency Functions The last operation I plan to discuss is that of fiscal agency. The twelve Federal Reserve Banks carry the principal checking accounts of the U.S. Treasury, handle much of the work entailed in issuing and redeeming Government obligations, and perform numerous other important fiscal duties for the U.S. Government. The Government is continuously receiving and spending funds in all parts of the United States. Its receipts come mainly from taxpayers and purchasers of Government securities and are deposited eventually -13in the Federal Reserve Banks to the credit of the Treasury, its funds are disbursed mostly by check, and the checks are charged to Treasury accounts by the Reserve Banks. When the Treasury offers a new issue of Government securities, the Reserve Banks send out subscription forms; receive applications from those who wish to buy; make allotments of securities in accordance with instructions from the Treasury; deliver the securities to the purchasers; receive payment for them; credit the amounts received to Treasury accounts; make exchanges of denominations or kinds; pay interest coupons by charging the Treasury's account; and redeem securities as they mature. Each Federal Reserve Bank administers for the Treasury the "tax and loan" deposit accounts of the banks in its district. Tax and Joan accounts are merely Treasury demand deposits in commercial banks. The main purpose of these deposits is to permit the withdrawal of funds from commercial banks by the Treasury to be timed closer to Treasury expenditures which inject funds into the System. Thus, some tax funds and receipts from security sales are left temporarily in tax and loan deposits in commercial banks. When it appears that the Treasury is about to spend them, they are "called" into the Reserve Banks. In this way the impact on the money market of Treasury receipts and expenditures that come at different times is reduced. -14When Treasury funds are transferred from commercial banks into the Reserve Banks, member bank reserves are absorbed. On the other hand, Treasury expenditures from funds in Reserve Banks add to member bank reserves. These activities have an impact on reserves similar to that of float movements and irregular fluctuations in currency. As with float and currency, those monetary managers who desire a prescribed market tone, as a measure of monetary action, find these short-run fluctuations in the Treasury's balances at the Reserve Banks of extreme importance. But, as you probably realize by now, I feel monetary management should concern itself much more with trends in total reserves and other aggregative measures over a much longer period. Because of the relationship between the Treasury and Federal Reserve and the need of the Treasury to borrow very large amounts of funds from time-to-time, a practice called "even keel" during periods of Treasury financing has developed. Even keel means not changing, or giving the impression of changing monetary policy, during a period of Treasury financing. In practice, it means attempting to prevent significant changes in market interest rates and other market conditions for a period beginning just before a new issue is announced until it is distributed and a reasonable time has elapsed for "digestion." Even -15keel has the disadvantage of shifting to periods before or after such financings whatever changes in monetary action may be appropriate in the prevailing economic situation from the standpoint of the public interest. There is no legal authority for even keel, but it has a long tradition both in this country and abroad. It is primarily based on a lack of faith in the ability of a free market to handle efficiently large Government financings. We feel the practice should be discontinued or at least moderated greatly. The Treasury is a frequent borrower, and when combined with other periods of constraint on action, it was found that 55 per cent of the time from early 1962 to the end of 1966 the Federal Reserve was "even keeling." Even keel is a serious impediment in the path of monetary action, and for those of us who fee! that proper monetary action is desirable for the public good, the price of even keel seems high. Oddly enough, even keel, although it does constrain monetary policy, has not been effective as a market stabilizing device. Short-term interest rates have fluctuated nearly as much under even keel as in other periods. There does not appear to be any benefit to the Treasury from such operations in terms of obtaining funds at a lower average rate; the ultimate buyer of securities is not fooled by such activities. -16In conclusion, I have reviewed briefly four of our major service functions - collecting and transferring funds, currency and coin, member bank reserve accounts and fiscal agency. They all relate to the primary objective of the System - that is, sound monetary actions. Reference has been made to the two broad schools of monetary management. First, those who believe monetary authorities should focus on market forces in the short-run, seeking firmer conditions when the economy is booming and seeking easier conditions when the economy has slack. These analysts are constantly examining movements in float, currency, Treasury deposits and the other forces affecting money market conditions. The other school places stress on controlling monetary aggregates over a period of several months, increasing the rates of growth if expansion is desired and reducing them if restraint is desired. Concentration on the market forces from day-to-day, according to this group, may be misleading since with any degree of pressure in the money market the aggregates may expand at any rate, depending on the strength of credit demands. Consequently, those in the second school place much less emphasis on the day-to-day movements in float, currency and Treasury deposits. The difference between the two views is more than academic or semantic. Last year, the "pressure" school said monetary actions -17became more restrictive, as evidenced by the rise in interest rates. The "aggregate" group came to the exact opposite interpretation, that is, monetary actions became more expansive, as evidenced by the rapid rate of growth in bank reserves, bank credit and money.
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