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Council of Economic Advisers
June 28,1963
The Beaaestic Effects of an Increase in the Discount
Rate and Accompanying Measures
2.
The Proposal
It is proposed that the discount rate he raised from 3 to 3-1/2
percent in order to provide more rocm for probing operations to raise
the Treasury bill rate, and the other associated short-term interest
rates.
It tjould, of course, be possible to raise the bill rate, which
Zs now about 3 perc&at, without raising the discount rate.
But a rise
;.s the discount rate itself vould have some psychological benefits from
a balance of payments standpoint.
Moreover, in order to raise the bill
rate significantly above the discount rate, it wuld be necessary to
reduce free reserves substantially below present levels, vith probable
undesirable effects.
Consequently, if the Treasury bill rate is to be
raised further, it is generally agreed that an increase in the discount
rate vould be desirable from both an international and a domestic point
of view.
Dace the discount rats had been raised to 3-l/2 percent, the objec
tive would be to raise the Treasury bill rate to a level of 3~l/^ to
3-3/8 percent.
{The possible effects on short-term capital flows and
resulting benefits to the UoS. balance of payments from such a rise in
the bill rate are appraised later on in this paper.) The rise in the
discount rate vould itself cause seme increase in the bill rate, since
'oaaks would be less inclined to borrow at the Fed at the higher discount
rate and more inclined to cake reserve adjustments by selling bills or
borrowing Federal frauds. The reduced bank demand for bills ijculd cause
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the bill rate to rise, and at the same time the reduced propensity to
■borrow night well, other things equal, raise free reserves scs&evJh&t,
thereby reducing total reserves.
It is raost unlikely, however, that the increase in the discount
rats would itself suffice to raise the bill rate to the new target
rasge of 3-1/4 to 3~3/8 percent.
2a order to achieve such a level of
hill rates, therefore} it wold probably be necessary to increase the
market supply of Mils.
2his could be accomplished either by sales of
bills by the Federal Reserve out of its portfolio or by a shift on the
part of the Treasury toward proportionately greater issuance of bills
and other short-tern securities in its cash financing and refunding
operations.
Sales of bills by the Federal Reserve (unless offset by
purchases of longer-term securities} would have the undesirable effect
of further reducing the total supply of bank reserves, whereas a shift
in ’
treasury financing toward shorter-tera issues would not have this
effect.
AccordiagLy, it is understood that if the discount rate is in
creased, the treasury will shift its financing to bill issues as may be
necessary to achieve the bill rate objective of 3-1/4 to 3*3/8 percent,
even to the extent — if this should be required — of financing the
entire deficit by bill issues in the coming months.
In order to avoid
any constriction in the availability of bank credit and at the same time
to avoid, or at least miaiaize, upward pressures on long-term interest
rates, the Federal Reserve, for its part, will provide the banli reserves
needed for seasonal expansion, together with a normal reserve growth of
3 percent per annum, if necessary entirely by purchases of securities of
intermediate and long isatarities.
3t would also "be desirable tc raise
the interest rate ceilings on tiaie deposits under Regulation Q in order
to permit the banks to continue to compete for time deposits in the face
of rising Treasury bill rates, thereby minimizing the Inducement for
investors to shift funds from time deposits to bills.
IS,
Secaosle Effects
If the proposal outlined above is put into effect, there appears to
be a gccd possibility that the Treasury bill rate can be raised to the
indicated level of 3-l/k to 3-3/8 percent with little or no adverse
effect on the doaaestie economy.
Other shcrt-ters opea-aerket interest
rates. s'aeh as the rates on casaaercial paper end bankers’ acceptances,
«ouId doubtless rise meats or less In line with the treasury bill rate;
but there is no reason to ea&eet that such increases in these rates
would have any appreciable effect on business activity. The prime rate
cn b&slsaao loans at U-l/2 percent is now 1-1/2 percent above the dis
count and Treasury bill rates — a rather ’wide margin by historical
standards for a period of expanding business activity.
For this reason,
there is a gocd possibility — although not a certainty — that the in
dicated increases in the discount and Treasury bill rates would not new
trigger a. rise in the prise loan rate and in the general level of interest
rates cn b-asiress leans associated therewith.
Other factors minimizing
the danger of a rise in loan rates are the fact that bank loan demand is
not particularly heavy, end -She good possibility tisat with the Treasury
bill rate at 3-l/h to 3"3/3 percent and the discount rate at 3-l/2 percent
free reserves could be ss&intaiaed at or above the levels now prevailing
-;?hen the tyc rates are egt^l at 3 percent.
Ansi if the Federal Reserve
kept total member bank reserves expanding at the norEsl pace called for
by seasonal and growth requirements by opensaarket purchases of longert g m secrorities* the total supply of hank credit would not be restricted.
■mere is also a good possibility that the proposed program — which
T/O’
Ciid place major emphasis upon a shift in the maturity structure of the
psafeliciy held debt through treasury and Fed operations — would not cause
say appreciable increase £a Xong-terra interest rates.
In the first place^
as indicated above, the program would not involve any coatraetioa in the
ever-all credit supply.
Sa addition* the shift of treasury borrowing
fresa, the long- to the short-term sector of the market aculd reduce the
dssastl for Icag-texa funds, aad the concentration of Federal Reserve
open sarlset pisrchases in tke longer-term sector taould add to the supply*
ThsiJii the prcgraci would have a subs'feaatial "twist” effect on the interest
rate straetare, simed at raising short-term rates -stile avoiding or
greatly ssiaiuiisajig upward pressures on long-tersi rates.
Barring the possibility of setting off a sharp shift in the expecta
tions of investors {ahlch is discussed below), it is estimated that the
pro;:csed progrsa would not produce a rise in long-ters interest rates of
more than 1/8 percent, and there appears to be a good possibility that
no appreciable increase wcrold result.
To the extent that long-term
rates did rise? there vsovld be some cutbacks in residential construction*
business outlays ca plant and equipment, and perhaps State and local
genrerxsneat expenditures.
It a l/8 percent rise in long-term rates were
to occur, it is estimated that the total cutbacks in expenditures might
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add up to an annual rate of $1 to $1-1/2 'oiilion at a nsax±nnm. These
effects
t o
M , of course, be spread, over a period of time. Using a
factor of 3 to 4 to alio**? for indirect multiplier and accelerator
effects, the outside estimate of the ultimate effect on GNP might be
a dec-line (below levels that vould otherwise be reached) of $3 to $6
billion. ;
Ihe probability is that the effects would he smaller than
this* hcwrer — aad they riight he non-existent — because long-term
rates sight well, rise less than l/S percent.
Furthermore, if the
sconcffijyV aad pa^rtiealarly investment demand, is eoaianding fairly
vigorously — due perhaps to the effects of tax reduction or anticipa
tion of sueh reduction — the effects of a rise in interest rates would
also probably be reduced, hecause demand is likely to be less sensitive
to interest rates when, it is expanding rapidly than when it is less
ebullient.
m,
Possible Hisks
The proposed program of raising short-terra interest rates inevits&ly
runs seme outside risk of isving more serious effects on the domestic
eco:acany than, are indicated above.
As a result of past increases in
short-ters interest rates, the Treasury bill rate at 3 percent is now
only about 1 percent below the average yield on long-term Government
securities.
As the 2jargin between short- and long-term rates narrowsf
it becomes increasingly difficult to insulate long-tera mrkets against
the effects of further increases in short-term, rates.
If investors
should interpret the rise in short-term interest sates as a forerunner
of ■& general rise in rates- they might begin to shift funds from the
long- to the short-term sector la anticipation of tbs rise, thus causing
long-term rates to go up.
If this should happen^ it would increase the
supply of funds in the short-term market, thus requiring increased sales
of sh©rt*«term securities in order to raise short-teim rates to the
desired level. Although not likely, it is conceivable that the flood of
funds from the long- into the short-term market vould be so great that
a f u H practicable use of Treasury Borrowing in the short-term market
not raise the M U . rate to the desired level and that the Fed*s
purchases of long-term securities would not "be sufficient to keep long
term ratss frcza rising unduly.
The resulting rise in yields on Treasury
securities vcnild probably then cause a substantial rise in yields on
corporate and nrauisipal bonds and in interest rates on mortgages. In
this case-, the effects might well be commnieated to the prime loan
rate and associated sank leading rates.
While such a series of developments is possible, the danger that
it t-Jiil happen appears to be minimal if all of the elements of the pro
posed program are implemented vigorously.
The dangers can be further
minimized if the program is announced in the context of other steps that
are being taken to iiaprove the balance of payments and if its objectives
are E&de clear to the public.
And if the progrsia should appear to be
having an undue effect on long-term interest rates and on credit avail
ability, it would be promptly halted or perhaps even partially reversed.
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