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Considerations Bearing on a Reserve Requirement Reduction.

1
.

The economy is on dead center.

It cannot be said that

business activity is either increasing or decreasing at
present.

The probabilities are for some recovery in the

months ahead, ignoring the effects of a likely auto strike,
but there is virtually no chance that this would put
pressure on resources, given the present level of under­
utilization.
2.

The resumption of even moderate real growth ( 3 - 4

percent)

depends importantly on a recovery in housing and State-local
construction.

Business capital spending clearly is on the

decline— although there is still no evidence of a precipitate
cut-back--and defense spending is scheduled to be falling for
some time yet.

The availability of funds for both housing

and municipal finance has improved considerably, and chances
are that an upturn in both types of spending is now under way.
Credit terms--both interest rates and conditions of lending-are still tight, however, and lenders are not yet aggressively
seeking outlets for funds.

Additional stimulus, therefore,

would not be unwelcome.
3.
^




Labor market conditions continued to ease into July, and
there is not much prospect for improvement--given the
probability of only modest real growth in the economy and
the cyclical tendency for productivity to gain--in the months




-2-

itnmediately ahead.

Indeed, we are projecting a further rise

in the unemployment rate, to 5.1 percent in the 3rd quarter
and 5.3 percent in the fourth, in the current greenbook.

The

September-October period may be particularly;troublesome, both
because there is an observed tendency for unemployment to rise
more than allowed for in the seasonal adjustment then and
because of the possibility that secondary layoffs will develop
in connection with an auto strike.

An upsurge in unemployment

in the fall months--just before elections— would create strong
pressures to do something to reverse the trend, in fiscal or
monetary policy or both.
Financial market conditions, though somewhat easier, have not
moved as quickly in this direction as ordinarily would be
indicated by the current and prospective slack in the economy.
Thus we have been having trouble keeping the money supply
growing at a satisfactory rate, with the current projection
for the third quarter appreciably below the 5 percent or
more rate of growth envisaged by the FOMC.

Moreover, the

decline in long-term market rates has stalled recently,
partly because of a continued heavy volume of offerings, and
significant
the prospects for a resumption of a / rate decline in the
near-term do not seem particularly good.

An overt monetary

policy action, in the form of a net reduction in reserve
requirements, would be helpful in both areas.

It would

-3-

undoubtedly bring an Initial decline in interest rates, as
Investors anticipated easier monetary conditions, and it

i
would encourage the banks to bid more aggressively for

I

investments^ which would tend to increase money balances
of the public as securities are sold, net, into the banks.

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'

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Technical features of the financial markets also suggest
the desirability of a restructuring in reserve requirement
burden.

Banks have increased further their net outstandings

of commercial paper in recent weeks, despite freedom to sell
short-term C D fs, and the total has now reached $7.7 billion.
It appears that there is a marginal cost advantage associated
/^with commercial paper, and this is hightened by the reserve
requirement differential--6% on C D ’s and zero on commercial
paper--which should be worth on the order of 50 basis points
^-in savings to the paper issuing banks.

If the Board wishes

to encourage banks to raise funds directly rather than indirectly-which I think is desirable on regulatory and supervisory grounds-then it should move to close this commercial paper cost advantage.
The application of equal reserve requirements on both types of
instruments clearly is indicated, and there is nothing to be
gained by waiting in doing this.

All of the economic and financial market arguments that I can
think of thus are on the side of making a cut in reserve requirements,
and preferably one that would equalize the requirements on C D fs and




-4-

commercial paper.

There is very little risk of overstimulating

thV economy in doing this, and the'action should provide some
insurance that financing conditions, particularly with respect
to housing, and municipal spending,' will, in fact continue to improve.

There are, however,

some arguments against a reserve

requirement reduction at this time, four of which are outlined
below.




1.

An overt easing action in the monetary sphere,

combined with the public sense of a continuous process
of easing in fiscal policy, will tend to heighten the
impression that there is an inflationary bias in public
policy.

There is nothing very specific that can be cited

that would happen in the short-run as a result of this
feeling, but it would probably tend to weigh marginally on
the side of encouraging private expenditures that could not
be fully justified on other economic grounds.

Over the

long-run this could be a considerable factor in stimulating
aggregate demands, but of course there would also be many
future opportunities to reverse the monetary signals when and
if aggregate demand seems to be mounting excessively.
2.

An overt action toward ease in monetary policy

could be regarded as a submission by the Board to welladvertised pressures from the Administration for increased
rates of monetary growth.

This could add to the impression

of permissiveness cited above, even though a reserve
requirement reduction does not necessarily signify a




-5-

faster rate of monetary growth.

There is no way around

this problem that I can see, and my personal view is that
such considerations should not prevent us from doing
what is right and appropriate on economic grounds.
3.

Current labor negotiations in the auto industry

conceivably could be influenced marginally by an overt
easing in monetary policy.

The union might feel that

this indicates official concern about the effects of a
strike, and the employers might believe that the better
markets promised in time by more monetary stimulation
would tend to increase their ability to absorb a larger
settlement.

To conclude that our action could have any

appreciable impact takes a very long stretch of the
imagination, but I mention it as a possibility because
of the great current sensitivity of this particular
negotiation.
4.

The effect of reducing reserve requirements,

other things being equal,

is to transfer earnings from

the Federal Reserve to the member banks.

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This follows

from the fact that fewer interest-free reserves are

1 $

required to support any particular level of deposits.
Since the Federal Reserve pays all of its net earnings
to the Treasury, while banks pay a little less than half,
the direct effect of a reserve requirement reduction is




-6to reduce Treasury revenues.

The effect is small--in .

this case, assuming a 4-1/2 percent requirement on
both commercial paper and time deposits, and assuming
a 6-1/2 percent interest rate, it would be on the order
of $25 million per annum--but it is sometimes commented
upon by the Congress.

The obvious answer is that the

anticipated stimulative economic effects of the action
would generate far more in revenue than is forgone
directly, but it can still be argued that the same result
could be achieved through open market operations which
would not involve any revenue loss.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102