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cMonetaryJ^olicy
and the
ZI.X. Sconomy
in 1974
A Prelude to the Annual




Report




1H
Contents
Monetary
Policy and the
U.S. Economy in 1974
3
12

15
18
19
21
23
24
25

• PRODUCTION
D E M A N D S FOR GOODS A N D SERVICES

Consumer purchases
Residential construction
Business fixed investment
Inventory investment
Exports and imports of goods and services
Federal Government
State and local governments

27

E M P L O Y M E N T , WAGES, A N D L A B O R COSTS

33

PRICE D E V E L O P M E N T S

33
36

Sources of inflation
Price movements

39

M O N E T A R Y POLICY A N D F I N A N C I A L

45
47
49

Money and credit aggregates
Bank reserves
Aggregate flows of funds

57

59
64

INTERNATIONAL

DEVELOPMENTS

U.S. international transactions
International financial scene




MARKETS




cMonetary

J^olicy
and. the
C7T CZ Q tinn U11C
CI. A. Cbconomy
^ in 1974







Introduction
The performance of the U.S. economy during 1974 proved extremely
disappointing. The persisting problem of inflation that had plagued
the Nation since 1965 worsened appreciably; the general price
level—as measured by the implicit deflator for gross national product
—rose by more than 10 per cent, the largest increase since 1947.
Equally disconcerting, if not more so, were the substantial declines
that occurred in real output, in productivity, and late in the year in
employment. By year-end the rate of unemployment had risen to
more than 7 per cent of the civilian labor force, and the economy
was in the midst of a general cyclical downturn in business activity.
The character of the forces that led to this unsatisfactory state of
affairs presented a profound dilemma for economic policy. Widespread agreement exists that the United States must come to grips
with inflation if seriously adverse consequences for the structure of
financial, economic, and social institutions are to be avoided. The
task of moderating inflation in 1974 fell largely to general monetary
and fiscal policies; direct controls over wages and prices were eliminated in the spring, after having had only temporary success in
moderating the increase in the average price level—and that at the
cost of increasing distortions in the allocation of resources.
The effect on prices of a restriction of aggregate demand through
monetary and fiscal policy generally lags behind the response of real
output. However, the price response is likely to be elicited sooner
when the proximate source of inflationary pressures is an excess of
aggregate demand relative to aggregate supply and when expectations of further price increases have not become entrenched and
pervasive. In 1974, unfortunately, neither of these conditions obtained.
The year 1974 opened with inflation proceeding at an annual rate
of about 8 to 9 per cent. Expectations were widespread that the pace
of price advance would continue unabated, or worsen. Real GNP
had begun to decline in the first quarter—reflecting largely the effects
of the oil embargo—and the gap between actual and potential real
output widened over the course of the year. The rate of increase in




3

the general price level, meanwhile, rose to the 12 to 14 per cent
range in the first quarter and remained there through most of the
year. Signs of moderation in the pace of inflation did not begin to
appear until the closing months of 1974, after steep declines in real
activity had occurred both here and abroad.

I N D I C A T O R S OF E C O N O M I C P E R F O R M A N C E
Percentage change
REAL

GNF

NOTE.—Changes f o r real G N P (based on data expressed in 1958 dollars) are at annual
rates. Dept. of Commerce data.
Fixed-weighted price index: Change f r o m preceding quarter compounded at annual rates
based on seasonally adjusted data f r o m Dept. of Commerce.
U n i t labor costs are f o r all persons in the private n o n f a r m economy; percentage change
f r o m previous quarter compounded at annual rates.
U n e m p l o y m e n t rate: M o n t h l y data, seasonally adjusted, f r o m Dept. of L a b o r .

4



What accounted for this stepped-up rate of inflation in the face
of a growing gap between real aggregate demand and the productive
capacity of the economy? Three factors deserve particular attention.
First, rising costs of petroleum and other energy products had a
substantial influence on the over-all level of prices. A t the retail level,
prices of gasoline and motor oil in December 1974 were about 20
per cent higher than a year earlier, while costs of fuel oil and coal
were 32 per cent higher. A t wholesale, prices of fuel, power, and
related products rose approximately 50 per cent in the 12 months
ended in December 1974. Moreover, rising prices of energy and
petrochemical products used as inputs in industry were an important
factor driving up the costs of producing other manufactured goods.
For example, prices of chemicals and allied products rose about 50
per cent at wholesale in the year ended in December 1974, and
rubber and plastic products were up about 28 per cent over the same
period.
Second, relaxation and ultimate termination of wage and price
controls in A p r i l 1974 led to a bulge in prices of the sort that has
occurred in other countries when direct controls have been removed.
As noted earlier, controls had had only temporary success in moderating the pace of inflation; in early 1974, and indeed throughout
1973, the influence of the controls program had been waning. Nonetheless, some 2 l / i years of controls had given rise to serious distortions in relative prices and had also compressed profit margins in
some industries. For many individual products, therefore, a substantial adjustment in prices was to be expected. The adjustments were
particularly noticeable for finished goods—perhaps because price1
controls had been more effective in holding down the prices of those
commodities. For example, wholesale prices of producers' finished
goods had risen at an annual rate of around 5 per cent during the
latter half of 1973; in 1974, however, the annual rate of increase
jumped to 13 per cent in the first quarter, to 27 per cent in the
second, and to 32 per cent in the third.
Third, shortages of many industrial materials, component parts,
machinery, industrial equipment, and other commodities continued
to plague the business community through the summer of 1974,
despite the slowdown in general business activity. Excess demand in
particular markets is not an uncommon condition, even when some




5

slack exists in product markets generally. Nevertheless, the acute
severity of shortages in 1974 was quite unusual in view of the sluggishness of consumer spending and the decline in residential construction that had been in process since early 1973.
The reasons for these shortages cannot be dealt with at any length
here. Growth in export demands—reflecting the worldwide boom in
economic activity during 1972 and 1973 and the devaluation of the
dollar in international markets—was certainly a factor; so also was
the relatively slow expansion earlier of productive capacity in major
materials industries. But expectations of price increases and fears of
continuing shortages were themselves a part of the problem, because
they led to speculative buying of inventories to "jump the gun" on
price increases, to hoarding of critical materials and supplies, and to
ordering from several sources in the expectation that deliveries would
be long delayed, if made at all.
While these three factors help to account for the step-up in the
rate of price advance in 1974, they alone do not explain fully the
severity of the inflation during the year. Underlying these special factors was an inflationary process that had begun much earlier and had
become deeply embedded in the structure of wages, costs, and prices.
The rate of increase in compensation per manhour, for example, had
risen to around 8 per cent by the end of 1973, some 5 or more percentage points above the long-term rate of improvement in productivity. By the end of 1973, therefore, unit labor costs were already
rising very rapidly and were putting substantial upward pressure on
prices. Moreover, the rate of advance in unit costs accelerated in
1974—as productivity declined sharply and the rate of increase in
compensation per manhour rose still further.
Unwinding from an inflation as pervasive as that which gripped the
economy in 1974 takes time. Economic policy in 1974 did not endeavor to end the inflation at once, but it did seek to create conditions in which the process of unwinding would begin. To appreciate
the accomplishments of fiscal and monetary policies in this regard,
account must be taken of the significance of inflation for the movements of fiscal and monetary variables.
For example, total Federal expenditures as measured in the national income accounts ( N I A ) rose about 16 per cent from the
latter half of 1973 to the latter half of 1974. This is a relatively large

6




percentage increase by historical standards, but in large part it reflected rising prices. Federal receipts rose an estimated 13 per cent
over the same period. The N I A deficit increased from an annual rate
of about $2 billion in the second half of 1973 to an estimated $9
billion in the second half of 1974—a very modest increase given the
steady slowing of activity over this period.
Despite this deepening of the deficit, the Federal budget may
well have become more restrictive over the course of 1974. This
interpretation is suggested by movements in the high-employment
budget, in which receipts and expenditures are estimated as if economic activity had remained strong, in order to eliminate the effects
on the budget of changes in the pace of the economy. According to
Federal Reserve staff estimates, the high-employment budget was in
surplus to the extent of around $5 billion in the second half of 1973,
and the surplus increased to around $24 billion in the second half
of 1974.
Most of this increase in the high-employment surplus occurred because of the effects of rising prices on Federal tax receipts. Inflation
pushed many individuals into higher marginal tax brackets—even
though their real income may have either remained unchanged or
declined. Many corporations, furthermore, incurred increased tax
liabilities in 1974 on what were in a sense fictitious profits—profits
derived from the first-in, first-out method of inventory accounting,
which fails to make allowance for replacement at higher prices of
goods sold or used up in production. Thus, the inflation, by raising
effective tax rates, significantly reduced the increase in disposable incomes of individuals and after-tax profits of businesses, and thereby
contributed to a slowing of aggregate demand.
Monetary policy also contributed importantly to the moderation of
aggregate demand in 1974. Federal Reserve policy had begun to
move toward restraint in late 1972 and early 1973, but some relaxation of policy was needed during the winter of 1973-74, in an effort
to compensate for some of the adverse effects of the oil embargo on
economic activity. As a result of the reduction in private credit demands and the relaxation of monetary policy, interest rate levels by
February of 1974 had fallen considerably below their pre-oilembargo peaks, and growth rates of the principal monetary aggregates were appreciably above their lows of 1973.




7

SELECTED INTEREST RATES

NOTE.—Monthly averages except f o r conventional mortgages (based on quotations f o r one
day each m o n t h ) . Y i e l d s : prime c o m m e r c i a l paper, dealer offering rates; conventional
mortgages, rates on first mortgages i n p r i m a r y markets, unweighted and rounded to nearest
5 basis points, f r o m Dept. of H o u s i n g and U r b a n Development; A a a u t i l i t y bonds, weighted
averages of new publicly offered bonds rated A a a , A a , and A by M o o d y ' s Investors Service
and adjusted to an A a a basis.

When the threat to the economy from the oil embargo had passed,
the Federal Reserve began again to exert pressure on bank reserves—
chiefly through open market operations—to slow the rapid rate of
expansion in money and bank credit. The Federal Reserve persisted
in applying monetary restraint until late in the summer of 1974. A t
that time growth rates of the money stock and of bank credit were
relatively sluggish, and signs of an impending cyclical downturn were
multiplying. Monetary policy, therefore, began to move toward ease
over the closing months of the year.
The amounts by which growth rates of the major monetary aggregates were reduced in 1974 were not unusually large. For example,

8



total member bank reserves rose nearly as much in 1974 (7.1 per
cent) as they had in 1973 (7.8 per cent). The narrowly defined
money stock—M„ which consists of currency and demand deposits—
increased by 4.7 per cent in 1974, compared with 6.1 per cent in
1973. The growth rate of M:1, which includes also consumer-type
time and savings deposits at commercial banks, declined from 8.8
per cent in 1973 to 7.4 per cent in 1974. The increase in total loans
and investments of commercial banks did show a more appreciable
moderation—from 13.5 per cent in 1973 to around 8.3 per cent
in 1974. Nevertheless, as the following chart shows, the growth rates
for the monetary aggregates in 1974 were well above those recorded
in 1969, a prior year in which monetary policy had been quite restrictive.
I n interpreting changes in these monetary variables, however, account must be taken of the effects of inflation on demands for money
and credit. In 1969 the general price level was rising at a rate of
around 5 per cent; in 1974, the figure was more than twice that
amount. Thus, growth rates of the major monetary and credit

CHANGES I N M O N E T A R Y AGGREGATES

Percentage increase
NOTE.—Mi is currency plus private demand deposits. M-: is MI plus commercial bank
time and savings deposits other than large-denomination certificates of deposit ( C D ' s ) .
Loans and investments are adjusted to exclude domestic commercial interbank loans. RPD's
are reserves available to support private nonbank deposits. Changes are calculated from
December to December.




9

aggregates were actually very low in 1974 relative to demands for
money and credit. I n these circumstances the usual signs of severe
financial restraint began to develop: Interest rates rose to unprecedented levels; stock prices plummeted; the mortgage market came
under severe pressure; and the availability of loanable funds to other
borrowers was curtailed.
Monetary and fiscal restraints worked jointly to moderate aggregate demand in 1974, but the volume of spending in the private sector
was curbed also by several other factors. Prominent among these was
the sharp rise in the price of imported oil, which transferred a substantial amount of purchasing power from U.S. consumers and businesses to the oil-exporting nations. Rising prices also resulted in transfers of real income among various economic sectors within the
United States—although the effects of such transfers on aggregate
expenditures are problematical—and they led to a sharp decline in
the real value of financial asset holdings, which must have exerted
a substantial, depressing effect on current spending and on spending
plans.
A l l of these dampening effects on aggregate demand in 1974,
moreover, occurred at a time when the economic expansion was
losing momentum, and when imbalances were beginning to develop
between inventories and sales and between production of capital
goods and production of consumer goods. Such imbalances are often
the precursors of a cyclical downturn in economic activity, as they
were in 1974. When that downturn began to cumulate in the fourth
quarter of the year, the decline in production and employment proved
to be about as steep as at any other time in the period since World
War II.
Weakness in economic activity seems likely to persist well into
1975—judging by the adverse tendencies evident in recent economic
data. However, corrective forces are under way: Excess inventories
in the auto industry—though still very high—are being worked off;
businesses are making strenuous efforts to cut costs; residential building permits have shown some signs of stabilizing; conditions in financial markets have eased significantly since last summer; and the freeze
in the mortgage market has begun to thaw. Fiscal actions to bolster
purchasing power are under active consideration, and they are likely
to be stimulating consumer and business spending before too long.

10




The tasks for economic stabilization policy in 1975 are indeed
formidable. Clearly, a prime requisite is to cushion the forces of
recession and to enhance the chances for an early and vigorous recovery in real economic activity. But great care must be taken to
avoid releasing a new wave of inflationary forces.
These two objectives are not necessarily inconsistent. The special
factors giving rise to a stepped-up pace of inflation in 1974 are now
largely behind us, and the rate of increase in prices has begun to
moderate in recent months in response to growing slack in labor
and product markets. In this environment, temporary fiscal and
monetary stimulants could be expected to have their principal effects
in 1975 on real output and employment, and not on prices. But
fiscal and monetary policies must not be permitted to depart too
much, or too long, from the posture needed over the longer term
to ensure an eventual return to price stability.
•




11

Demands for
and Services

Goods

In 1974 the economic expansion that had been under way since late
1971 came to a halt. For the year as a whole, GNP in current dollars increased about 8 per cent, but this rise was more than accounted
for by higher prices; real GNP declined by more than 2 per cent
compared with a 6 per cent increase in 1973.
The sources of the recessionary trend that developed during the
year were diverse. Early in the year the weakening of economic activity appeared to be selective, affecting mainly energy-intensive and
related activities. As the year progressed, however, reduced demands
became the dominant factor. By autumn the weakness in purchases
and in industrial production began to spread to nearly all sectors of
the economy. Employment dropped sharply in November and December, and by the year-end unemployment had risen to 7.2 per cent.
Employment fell further in January 1975, and the unemployment
rate rose to 8.2 per cent.
A major factor accounting for the dampening of demands in 1974
T a b l e 1: GROSS N A T I O N A L P R O D U C T

1974 i
Type of measure

1972

1973

1974
Ql

Q2

Q3

Q4

1,416
823

1,430
804

I n billions o f dollars
Current dollars
1958 dollars

1,158
793

1,295
839

1,397
821

1,359
831

1,384
827

Percentage change f r o m preceding period
(at annual rate)
Current dollars
1958 dollars

9.8
6.2

11.8
5.9

7.9
-2.2

4.5
-7.0

7.6
-1.6

9.7
-1.9

4.0
-9.1

Implicit deflator

3.4

5.6

10.3

12.3

9.4

11.9

14.4

1

Quarterly data are seasonally adjusted annual rates.

NOTE.—Dept. o f Commerce data.

12




was the severe and pervasive rise in prices—the worst inflation since
the period immediately following World War II. Consumer prices in
December were 12 per cent above a year earlier. Wholesale prices
had risen even more than that, and for industrial commodities the
increase was more than 25 per cent. However, by year-end there were
indications of some abatement in price pressures, with prices of
sensitive industrial commodities down sharply and slower rates of
increase in wholesale and consumer prices.
The reduction in total output early in 1974 was associated largely
with the effects of the oil embargo. Most adversely affected were sales
of large-size cars, but recreational and other activities closely related
to the use of fuels were also hard hit. However, output of materials
and business equipment remained close to record levels. Shortages of
many products continued to be widely reported.
After the embargo ended in April, demands that had been

PRICES A N D C O M P E N S A T I O N
Percentage change f r o m previous quarter

1971

1972

1973

1974

NOTE.—Changes based on quarterly data at seasonally adjusted annual rates. Compensat i o n per m a n h o u r is f o r private n o n f a r m economy. Dept. of L a b o r data.




13

depressed by the scarcity of oil showed signs of recovery; at the same
time output of business equipment and materials continued at high
levels. Nevertheless aggregate demand remained weak, and the economy as a whole never resumed its upward momentum. As time went
on, shortages became less acute, delivery times were shortened considerably, and pressures on capacity eased.
A l l major sectors of private final demand weakened appreciably in
the final quarter of the year and the drop in real GNP—9.1 per
cent at an annual rate—was the largest since before World War I I .
With real incomes continuing to fall, real personal consumption
expenditures for goods dropped sharply further—paced by a plunge
in sales of 1975-model automobiles. Outlays for residential construction continued to deteriorate, and housing starts fell to an 8-year low.
Around midyear, many firms began to cut back on their capital
spending plans, and by the fourth quarter outlays for business fixed
investment were down sharply in real terms.
The intensification of recessionary forces brought with it a marked
change in business inventory policies. Inventories had been rising
relative to final sales in real terms since early 1973. Even so, businessmen did not move quickly to trim excessive stocks. I n the last

INDUSTRIAL PRODUCTION
1967=100

NOTE.—Federal Reserve indexes, seasonally adjusted.

14



quarter, however, as final demands declined and the supply situation
improved, they made strenuous efforts to reduce stocks by cutting
production. Nevertheless, there was a sharp, involuntary build-up of
inventories, which resulted in further cutbacks in output and employment.
Through the summer, employment had continued to rise moderately,
even though output drifted downward. The labor market was slow to
adjust to sluggish demand conditions during this period, apparently
in part because of the inability of businesses to perceive the developing decline in economic activity in the face of continuing shortages of
materials and of the steady increases in prices.
By the final quarter of the year, however, pervasive weaknesses
in demand were unmistakable, and extremely rapid adjustments
occurred in the labor market. Large layoffs began in the automobile
industry and quickly spread to other industries, and employment fell
by a record 1.1 million in the final 2 months of the year. Unemployment rose among all labor market groups, and the rate reached 7.2
per cent by year-end. Nevertheless, output fell even more sharply
than employment, and productivity continued to decline; this suggested the probability of further reductions in employment in early
1975.
CONSUMER

PURCHASES

A dominant factor in the dampening of over-all economic growth in
1974 was the weakness in consumer spending. Acceleration in prices
caused a significant drop in the real purchasing power of wages and
in the real value of financial assets, which in conjunction with the
rise in unemployment led to a severe loss of consumer confidence.
Real consumer spending deteriorated very rapidly in the fourth quarter, and for the year consumer purchases of goods and services declined 2 per cent in real terms compared with an increase of close to
5 per cent in 1973.
I n late 1973 and early 1974, new car sales were sharply reduced
because of the gasoline shortage. After the oil embargo was lifted,
more fuel became available, but at much higher prices, and with auto
prices also higher than in 1973, sales improved only moderately.
Sales of 1974 models were boosted during the summer mainly
because of manufacturers' announcements of sharply higher
prices for the upcoming 1975 models. But the increase proved to be




15

short-lived; in the fourth quarter total auto sales plunged by 29 per
cent to a 7.4 million annual rate and sales of domestic models
dropped to a 6 million annual rate. This was the lowest sales rate in
14 years except for the strike-induced decline in 1970. Sales in early
1975 remained weak and further cutbacks of production and employment were instituted. However, the introduction of price rebates in
late January helped to provide some support for sagging automobile
sales.
Real outlays for other durable goods, such as furniture and appliances, also weakened in 1974 but the decline was less than for autos.
Similarly, spending in real terms for nondurable goods such as food,
clothing, and gasoline was reduced. In contrast, although expenditures for services slowed, they continued to increase at a faster pace
than the rise in prices.

AUTOS

NOTE.—Sales, quarterly data at annual rates, seasonally adjusted by Federal Reserve;
domestic types include sales i n the U n i t e d States of cars produced i n Canada. Dealers'
stocks, seasonally adjusted, f o r domestic-type cars only. Sales f r o m W a r d ' s
Automotive
Reports; dealers' stocks f r o m M o t o r Vehicles M a n u f a c t u r e r s Association.

16



Curtailment of real consumption was largely the consequence of
a large and rapid decline in real disposable income. From the fourth
quarter of 1973 to the fourth quarter of 1974 this decline amounted
to 4.2 per cent and was more than three times as severe as the loss
during the 1958 recession—up to then the largest erosion in real
income since the period immediately following World War II. Reductions in real disposable income were not caused solely by the failure of wages to keep pace with inflation; an increase in the social
security tax base and the impact of the progressive income tax levied
on inflated nominal incomes also reduced real income after taxes in
1974.
The adverse effect on consumer attitudes of sharply declining real
income and of rising unemployment was underscored by consumer
surveys during the year. By the fourth quarter consumers' appraisals

DISPOSABLE I N C O M E ,
SPENDING, A N D S A V I N G
C h a n g e , b i l l i o n s of d o l l a r s

1971

1972

1973

1974

NOTE.—Expenditures and income are i n terms of 1958 dollars; changes f r o m preceding
quarter are based on quarterly data at seasonally adjusted annual rates. Saving rate is
personal saving as a percentage of disposable personal income. Dept. of Commerce data.




17

of their financial condition and of the outlook for the economy were
more pessimistic than in any previous survey. While a fairly high
proportion of the respondents had indicated earlier in the year that it
was probably a good time to buy because of anticipated price increases, by year-end many consumers held the view that it was necessary to curtail spending because prices had become too high.
In each of the first three quarters of 1974 consumers lowered their
saving rate from the high rates associated with the oil embargo of late
1973. The rate increased again in late 1974 when consumers sharply
reduced their outlays for goods—in part in an attempt to maintain
liquidity as unemployment worsened, inflation remained acute, and
uncertainty about the future increased. Early in 1975 the administration began to take action to provide tax relief for both consumers
and business, which, if enacted, could increase confidence and provide some stimulus to consumer spending.
RESIDENTIAL

CONSTRUCTION

The extremely sharp decline in private residential construction
activity, which had begun in 1973, continued to depress final demands during 1974. In real terms, outlays fell more than a fourth
from the 1973 total. Private housing starts dropped from a peak rate
of 2.4 million units in early 1973 to about 1 million units in the

PRIVATE HOUSING STARTS
R a t i o scale, m i l l i o n s of u n i t s

1970

1972

NOTE.—Quarterly averages based on m o n t h l y
Dept. of Commerce data.

18



1974
figures

at seasonally adjusted annual rates.

fourth quarter of 1974—the steepest decline in the post-WorldW a r - I I period.
Record mortgage rates and curtailment of credit availability were
major depressants in the housing market. In addition, the increasing
costs of new homes, as well as the unusually large stocks of unsold
units still held by builders, constrained single-family starts in 1974.
Federal Government programs aimed at providing additional mortgage financing, generally at rates below those prevailing in the market, were expanded considerably from the low level of 1973, and
these programs helped to cushion the decline in starts.
Much of the slump in housing starts in 1974 was in multifamily
units. This reflected higher costs of land, labor, and materials, as well
as the fact that many rental units—including those still under construction—continued to overhang the market. Financial factors also
played a major role in reducing starts of condominiums and other
multifamily units during the year. Builders in recent years had
depended rather heavily on the real estate investment trusts for construction financing, but the financial difficulties experienced by these
intermediaries in 1974 helped to cause a sharp decline in the availability of funds for construction and development purposes; under
these conditions, pressures on costs of such mortgage credit continued.
Prospects for housing activity improved toward the end of 1974,
as deposit flows to mortgage lending institutions increased—due to
declines in market rates of interest—and mortgage markets eased.
The likely extent of a recovery in housing, however, remains clouded
by the exceptionally large inventory of units still under construction
and the depressed levels of consumer confidence.
BUSINESS F I X E D

INVESTMENT

Business capital spending slowed and then declined during 1974,
marking the end of the investment boom that had provided expansive support for economic activity since early 1972. Although current-dollar investment outlays rose by about 9 per cent during 1974,
prices of capital goods increased by almost 10 per cent; thus real
outlays were off fractionally. In contrast to the pattern of the previous
2 years, spending for business construction was stronger than spending for equipment, reflecting in part the severe decline in business
purchases of motor vehicles.




19

I N V E S T M E N T A N D ORDERS
Percentage change f r o m previous period

1971

1972

1973

1974

NOTE.—Changes i n investment based o n Dept. o f Commerce data at seasonally adjusted
annual rates. Orders based on quarterly averages of seasonally adjusted m o n t h l y data f r o m
Dept. of Commerce; deflation by Federal Reserve.

The downturn in real capital expenditures came late in 1974 and
reflected a variety of factors—the falling off in consumer and housing
demands, the sharp increase in the cost of capital equipment following the lifting of price controls, the cumulative impact of tightened
financial markets, and the weakened cash-flow position experienced
by many business firms. Shortages, which had played a part in holding down capital expenditures early in 1974, became less of a problem as demand weakened; and as use of capacity eased, the need
for expansion of productive facilities became less urgent.
Capital outlays of most manufacturing industries remained strong
in 1974, supported to some extent by sustained worldwide demands
for materials during most of the year. Producers of capital goods,
nonferrous metals, paper, and chemicals increased their plant and
equipment expenditures substantially for the second year in a row.
Sharp gains were also recorded by petroleum and iron and steel pro20



CAPACITY UTILIZATION IN MANUFACTURING
Per cent

1970

1972

N O T E . — U t i l i z a t i o n is average o u t p u t ,
capacity. Federal Reserve data.

1974
seasonally

adjusted, as a percentage of

potential

ducers. In sectors other than manufacturing, however, signs of a
downturn in real spending were evident fairly early in the year. The
energy crisis had a pronounced impact on outlays in the already
depressed commercial sector. Also, public utilities curtailed their
plant expansion programs as projections for long-term growth were
scaled down and as their financial positions deteriorated because of
increased fuel prices, higher interest costs, delays in obtaining authority for higher rates, and a slowing in demands for power.
A t the year-end, surveys of anticipated plant and equipment expenditures suggested that there would be a significant decline in real
capital expenditures in 1975, with only industries in the materialsproducing sector showing any significant year-over-year increases.
Pointing in the same over-all direction was the marked decline in
real new orders for nondefense capital goods and in contracts for
nonresidential structures. Early enactment of the administration's
proposal for increasing the investment tax credit, however, could
bolster prospects for capital spending by the latter half of 1975.
INVENTORY

INVESTMENT

Realization that an extensive adjustment was under way throughout
the economy caused businessmen to modify their inventory policies




21

during the second half of 1974. The stock of inventories relative to
real final sales rose rather sharply until the summer when firms began
to make vigorous efforts to trim excessive stocks. Although consumer
and business demands deteriorated and there were sharp reductions
in output and employment in the fourth quarter, the ratio of inventories to final sales rose even further—evidencing unintended accumulation. Thus, there are prospects for a substantial liquidation of
stocks early in 1975, as businesses make further attempts to bring
inventories into line with sales.
During the first half of 1974 producers built up stocks of goods
that had previously been in short supply. This was true particularly
for materials, of which there had been widespread shortages since
mid-1973. But stocks of work-in-process also rose, in part because

BUSINESS I N V E N T O R I E S A N D SALES
B i l l i o n s of dollars
CHANGE

IN

INVENTORIES
30

Ratio

1971

1972

1973

1974

NOTE.—Inventory change ( N I A ) , Dept. of Commerce quarterly data at seasonally adjusted
annual rates.
I n v e n t o r i e s / f i n a l sales, based on Dept. of Commerce seasonally adjusted data for end-ofquarter b o o k value of business inventories (estimated f r o m inventory-change series) and
total G N P final sales expressed at m o n t h l y rates. Ratio calculated by Federal Reserve.

22




of remaining production bottlenecks and also because sales expectations were still relatively optimistic. Late in the year, stocks of
materials rose sharply further, as did those of finished goods. The
accumulation of finished goods was involuntary for the most part and
was especially pronounced in the automobile industry where dealer
stocks reached record highs despite sharp cutbacks in production.
EXPORTS A N D IMPORTS OF GOODS A N D SERVICES
After having shifted from a deficit to a surplus in 1973, the U.S.
balance on goods and services moved back into deficit in 1974. Much
of this change was due to merchandise trade developments, but an
important part was also attributable to service-account transactions.
I n the first half of 1974 the merchandise trade deficit totaled $3V2
billion at an annual rate. Most of the weakening in the first-half balance reflected the dramatic increase in the price of imported oil, particularly beginning in the second quarter after the Arab embargo on
oil shipments to the United States was lifted. I n the second half the
trade deficit rose to about $8 billion at an annual rate. Although the
average price of imported oil leveled off at about $11.60 per barrel,
the value of oil imports rose as the volume increased. Meanwhile,
both the value and the volume of agricultural exports declined. Average prices of these exports rose, particularly in the fourth quarter,
but the volume of shipments was reduced because of disappointing
harvests.
For the year the value of merchandise imports rose by nearly 50
per cent, and the value of exports by about 40 per cent. In real terms,
however, imports declined somewhat while the volume of exports
increased by nearly 8 per cent. Some of these changes are due to
developments in agricultural and oil commodities, but 75 per cent of
all U.S. trade is in nonagricultural and nonfuel commodities. The
net of these transactions for the latter two groupings had a positive
effect on the over-all trade balance; that is, such transactions showed
a steady improvement during the year.
The volume of U.S. nonagricultural exports remained strong
throughout the first half even though foreign economic activity weakened somewhat; in the second half there were sharper reductions in
economic activity abroad, and the volume of U.S. nonagricultural
exports began to decline. Weakening U.S. economic activity through-




23

out the year resulted in a decreasing volume of nonfuel imports beginning in the second quarter. Prices of both nonfuel imports and
nonagricultural exports increased by about 25 per cent during the
year.
The surplus in the balance on services increased in 1974 as a result
of sharply improved investment income, especially for the foreign
affiliates of U.S. oil firms. Partially offsetting this increase were higher
U.S. interest payments to foreigners as interest rates in this country
rose steeply.
FEDERAL

GOVERNMENT

During periods of decline in economic activity, it is expected that
reduced incomes will tend to slow the growth in Federal receipts and
that the Federal deficit will increase, thereby partially cushioning the
effect of reductions in spendable incomes. But this did not occur
during the first three quarters of 1974. Instead, a large growth in
nominal incomes, generated mainly by a high rate of inflation, resulted in a sharp increase in Federal revenues. I n the face of continuing curbs on expenditures, the Federal budget thus tended to become
somewhat more restrictive. However, a $7.6 billion deficit was
recorded, on an N I A basis, for all of 1974—a little more than the
deficit of almost $6 billion for 1973. The N I A deficit was quite small
through the first three quarters of the year, but during the final quarter it increased sharply, sparked by higher unemployment benefits
and a moderation in the growth of tax receipts—each a result of the
deepening recession—as well as an increase in Federal pay scales.
Federal purchases of goods and services rose by almost 10 per cent
in 1974, substantially above the 1.6 per cent gain in 1973. In real
terms, however, total Federal purchases were down for the year. Defense spending, after having decreased slightly in 1973, rose moderately, but in real terms it declined for the second consecutive year.
Real nondefense purchases, however, are estimated to have increased
sharply in 1974.
Federal transfer payments continued to grow much faster than
purchases of goods and services, reflecting in part a rapid rise in
unemployment benefits. The two-step, 11 per cent increase in social
security benefits and the Federal takeover of welfare for the aged,
blind, and disabled also added to the growth in transfer payments.

24



T a b l e 2: C H A N G E S I N M A J O R C O M P O N E N T S OF GROSS
N A T I O N A L PRODUCT
I n billions o f dollars

1974 i
Item

1972

1973

1974

Ql
GNP

Q2

Q3

Q4

103.1

Personal consumption expenditures. . .
Durable goods
Nondurable goods
Services
Saving rate (level in per cent). . .
Fixed investment
Residential structures
Nonresidential
Inventory change
Net exports of goods and services
Exports
Imports
Govt, purchases of goods and services
Federal
Defense
Other
State and local

136.9

101.8

14.8

25.0

32.5

11.7

61.9

76.2

71.8

16.7

28.5

32.2

-4.5

14.5
21.3
26.1

11.9
38.3
26.0

-2.5
42.2
32.2

- .4
12.3
5.0

5.6
11.4
11.4

6.6 - 1 4 . 6
13.2
2.5
12.4
7.6

6.6

8.2

7.8

8.9

7.4

6.6

8.5

23.4

23.2

1.6

-1.9

4.7

-1.2

-3.9

11.2
12.2

3.2 - 1 1 . 2
20.0
12.8

-5.2
3.3

.4
4.2

-2.6
1.5

-5.7
1.8

2.2

6.9

-2.0

-12.0

-3.4

-4.8

5.7

-5.8

9.9

-1.9

2.0

-12.8

-1.6

4.3

7.0
12.8

28.0
18.0

39.0
41. 1

17.6
15.6

7.3
20.1

5.1
6.7

.7
-3.5

21.5

20.7

32.4

9.9

8.1

7.9

10.1

7.3
3.6
3.6
14.2

1.7
- .4
2.1
19.0

9.8
4.2
5.7
22.6

3.1
.5
2.6
6.9

2.8
.8
2.0
5.3

2.9
1.8
1.1
5.0

5.6
5.1
.5
4.5

1
Derived f r o m quarterly totals at seasonally adjusted annual rates.
NOTE.—Dept. of Commerce data.

Federal receipts grew by $33 billion in 1974, exceeding the previous record rise of $31 billion in 1973. Personal income tax receipts
increased 15 per cent—partly because of inflation; and contributions
for social insurance rose by 12 per cent, reflecting in part a further
increase in the taxable wage base.
Corporate profits tax accruals grew by 12 per cent, slightly less
than in 1973; a sizable number of firms appear to have shifted during
the year to the last-in, first-out method of inventory accounting.
STATE AND LOCAL

GOVERNMENTS

State and local government purchases of goods and services rose by
13 per cent in 1974, a bit more rapidly than in 1973. I n real terms,
however, the year-over-year increase was only about 3 per cent, and
by the final quarter real purchases were at about the same level as
they had been in the fourth quarter of 1973. Higher payments for
employee compensation accounted for a large part of the current-




25

dollar increase, and construction outlays—boosted in part by Federal
revenue-sharing funds—also showed a noticeable gain over 1973.
The rise in average earnings of State and local government employees
was off slightly from the 7 per cent increase in 1973. Employment
was moderately above 1973, but very little of the increase was the
result of Federally funded public employment programs.
Slackened growth in receipts reinforced the negative impact of very
stringent credit conditions on the fiscal position of States and localities during 1974. For the State and local sector as a whole there was
a surplus of about $2 billion—down from the $9 billion surplus in
1973. The small over-all surplus in 1974 resulted entirely from continued net accumulations of savings in State and local retirement
funds, which were largely offset by deficits in other activities. I n
1973 Federal revenue-sharing funds had resulted in a significant
accumulation of financial assets and a reduction in the amount of
long-term borrowing. State and local governments in 1974 used their
revenue-sharing funds largely to increase outlays for construction and
to reduce tax burdens.
•

26




Employment,
Wages,
Labor
Costs

and

The demand for workers weakened during 1974, particularly in the
latter months of the year. Although real output declined throughout
the year, total employment and the labor force continued to advance
moderately through the summer, and unemployment remained close
to 5.2 per cent. In the fall, when general demand and output
slumped, the unemployment rate began to climb rapidly; and by early
1975 it had reached a 34-year high of 8.2 per cent. Layoffs were
widespread, affecting experienced workers as well as other groups in
the labor force.
Most of the growth in the labor force in 1974 occurred in the late
spring and summer as increasing numbers of adult women entered
the labor market. Some of this growth reflected the availability of
jobs—for employment was still increasing—and some the need to
help maintain real family income in the face of sharply rising prices.
However, labor force growth came to a halt late in the year when
employment fell sharply. With jobs scarce, many unemployed workers became discouraged and left the labor market, and the number of
new entrants also declined.
While total employment rose slowly and unevenly during the first
three quarters of 1974, employment in goods-producing industries
remained weak throughout the year. Manufacturing employment,
which had shown a vigorous expansion in 1973 before slowing late
in the year, declined by about 165,000 in the first 9 months of 1974.
Meanwhile, total nonfarm payroll employment rose by 900,000, significantly less than in the same period of 1973 but a large gain for a
period when real GNP was declining. Growth in employment was
confined to service-producing industries. State and local government
employment also expanded through the summer at a somewhat faster
rate than in the preceding year, and Federal Government employment edged up modestly for the first time since 1970.
In the autumn factory jobs began to decline rapidly, especially in
the auto and auto-related industries and in the heavy machinery,




27

EMPLOYMENT
Change, millions of persons

1970
1972
NOTE.—Payroll employment, seasonally
f r o m preceding half-year.

1974
adjusted data f r o m

Dept. of

L a b o r . Change

is

textile, and apparel industries; at the year-end manufacturing employment was nearly 1.2 million below a year earlier. The factory
workweek also declined significantly as overtime work was curtailed
and many workers went on part-time schedules. Labor demand in the
construction industry was weak, reflecting the depressed conditions of
the housing market. Demand for workers in nonmanufacturing sectors also softened considerably, and total payroll employment fell by
more than a million in the late fall.
The unemployment rate rose from 4.8 per cent at the end of 1973
to an average of about 5.2 per cent during the first half of 1974,
largely because of job cuts in specific sectors directly affected by the
energy crisis. In contrast, the rapid rise in unemployment in the fall
of 1974 affected all categories of workers, particularly experienced
workers in manufacturing industries. By December the unemployment rate for adult men had increased to 5.1 per cent from 3.0 per
cent the previous year; women and teenagers had also experienced
substantial increases in unemployment. Employment of minority
groups declined over the year, and their unemployment rate—at 12.8
per cent at the end of 1974—remained double that of white workers,
who had also experienced sharp increases in joblessness.
The increase in unemployment was one of the most rapid of the
postwar era, and much of the rise was accounted for by experienced, full-time workers who had lost their jobs. In contrast, the

28



impact of layoffs of teenagers was moderated to some extent by their
withdrawal from the labor force—a typical cyclical phenomenon.
Adult women, however, have experienced a relatively larger increase
in unemployment than in earlier cycles, probably because they had
stronger labor force attachment than previously.
T a b l e 3: L A B O R F O R C E , E M P L O Y M E N T , A N D U N E M P L O Y M E N T

Item or category

1971

1972 i

1973 i

1974

Change during year, thousands of persons
Total labor force
Civilian labor force
Total civilian employment

1,191
1,544
1,350

1,568
1,830
2,305

2,543
2,687
3,041

1,844
1,917
148

M o n t h l y average rate in Q4, per cent

White
Negro and other

Heads o f household
Full-time workers

5.9
4.3
5.7
16.9

5.3
3.6
5.2
15.5

4.7
3.0
4.7
14.3

6.5
4.7
6.5
17.5

5.4
10.1

4.7
9.9

4.2
8.6

5.9
11.8

7.3
3.4

Unemployment rates—-Total
Men, 20 years and over
Women, 20 years and over
Teenagers, 16-19 years

5.8
3.3

5.2
2.8

8.3
3.7

3.6
5.6

3.0
4.7

2.8
4.3

4.0
6.2

1
Data on changes f r o m 1971 to 1973 are adjusted to allow for the introduction of new estimates for
the population.

NOTE.—Basic data f r o m Dept. of Labor.

Wage increases accelerated sharply in 1974, mainly because workers were attempting to offset losses in purchasing power, but also
because of a heavy collective bargaining schedule and the termination
of wage controls on April 30. However, late in the year some moderation in wage increases seemed to be developing in many industries,
probably reflecting the deterioration in the demand for labor. For all
of 1974 the average hourly earnings index—the best available measure of wage rates—grew by more than 9 per cent compared with a
6.5 per cent increase in 1973; the increase in 1974 was led by largerthan-average gains in manufacturing and construction.




29

The continued erosion of purchasing power in 1974 was apparent
in all measures of real income. Average real spendable earnings of a
production worker with three dependents—the most widely used
measure of take-home pay—continued to decline, and the reduction
was the largest for any postwar year. A t the year-end such earnings
were more than 9 per cent below the peak in the fall of 1972. As a
result, an increasing number of workers involved in contract negotiations demanded, and received, cost-of-living escalator clauses,
which tied future wage increases to future price increases. In 1974
about 5.5 million workers were covered by collective bargaining contracts that included escalator clauses; this number, the highest on
record, was about 600,000 more than in 1973.
The collective bargaining schedule in 1974 was heavy, and it included major contract settlements in the steel, aluminum, can and
container, telephone, and mining industries. In their efforts to offset
rapid price inflation, union bargainers obtained first-year pay raises
of 11 per cent, up sharply from 6 per cent in 1973. Although wage
catch-up pressures are likely to continue, the combination of slack
labor markets and a relatively light collective bargaining schedule in
1975 may result in the moderation of wage pressures—especially if
inflation slows.
Reflecting large increases in wages and fringe benefits, hourly
compensation in the private nonfarm economy accelerated from the
already rapid pace of 1973 to about a 9.5 per cent increase during

REAL WEEKLY EARNINGS

1971

1972

1973

NOTE.—Index based on earnings i n terms of 1967 dollars f o r w o r k e r w i t h 3 dependents.
Seasonally adjusted data f r o m Dept. of L a b o r .

30



1974 although some slowing was evident in the final quarter of the
year. Productivity declined throughout the year in one of the most
pronounced and prolonged downturns of the postwar era. Nonfarm
output per manhour had begun to drop after early 1973, and it
has declined for seven consecutive quarters; between the final quarters of 1973 and 1974 nonfarm productivity was off a total of 3.6
per cent.
It is possible that data problems may have led to some overstatement of the erosion in productivity. Nevertheless, the unusually weak
productivity performance in 1974 is consistent with the hesitancy on
the part of businessmen to make cost-cutting adjustments in employment in the face of rising prices and profits at a time when the initial
softening of demands was quite selective.

P R O D U C T I V I T Y A N D COSTS
Percentage change from previous ye

10

5
+

0
5

10

5

0
1970

1972

1974

NOTE.—Annual rates of change f r o m corresponding quarter a year earlier f o r the private
n o n f a r m economy; based on seasonally adjusted data f r o m Dept. of L a b o r .




31

Although manufacturing productivity was not so weak as productivity in the nonfarm economy as a whole, there was little growth in
the factory sector during 1974. Due to the combination of declines
in productivity and of increases in hourly compensation, unit labor
costs for the private nonfarm economy in the fourth quarter were
about 14 per cent above their year-earlier levels. This too was a
record increase for the postwar period. Rising unit labor costs tended
increasingly to exert upward pressure on prices.
Q

32




Price

Developments

Inflationary pressures in the economy have been persistent since the
mid-1960's, but they have become much more intense in the past
few years. In 1974 the impact was particularly acute as prices continued to climb at an accelerated rate, operating through a number
of channels to dampen demands for goods and services.
The increase in prices during 1974 exceeded to a significant degree
the 9 per cent rise in wages, and the purchasing power of wage
earners continued to drop. Revenues from the very large increase
in the price of oil accrued largely to foreign producers—thereby reducing spending in this country; only a relatively small portion of
this revenue was reflected in the increased sales of U.S. exports.
Furthermore, the progressive feature of the personal income tax,
combined with rising nominal incomes, served to reduce real incomes
during the year. On a per-household basis real disposable income
began to decline about mid-1973, and since then it has fallen more
than in any comparable period since that immediately following
World War II. Moreover, the real value of the financial assets held
by consumers has been depressed by a falling stock market.
As a consequence, there was a substantial, adverse reaction to
rising prices among most income groups during 1974, and consumption expenditures weakened considerably. Purchases of autos, mobile
homes, and other consumer durable goods fell sharply, as higher and
higher prices for essentials forced families to allocate a larger proportion of their budgets to food, fuels, and housing.
The business sector was also adversely affected by inflation.
Corporate profits before taxes in 1974 were higher than in 1973
because of enormous inventory gains. However, since replacement
of inventory stocks had to be made at inflated prices, the true corporate financial position was much less favorable than suggested by
before-tax profits data. This probably had a significant impact on the
realization of investment plans.
SOURCES OF

INFLATION

The current inflation had its roots in a number of volatile and at
times unanticipated developments, some originating in this country




33

W H O L E S A L E PRICES
January

I
1971

i
1972

1971=100

0
1973

1974

1971

1972

1973

1974

NOTE.—Dept. of L a b o r data.

and some abroad. World demands for U.S. farm products continued
to be strong during 1974. Furthermore, with disappointing harvests
in the United States, stocks of both food grains and feeds continued
to be low, and prices remained at high levels. Food grains and feeds
occupy a strategic position in food production, and their advanced
prices have had far-reaching repercussions on prices of meat and
other foods in this country.
More important in 1974, however, was the impact of the extraordinary increase in the price of fuel, which extended well beyond the
rise in oil and gasoline prices—contributing substantially to the ongoing inflation and exerting a major influence in ending the 1971-73
economic expansion. By the summer of 1974 the price of imported
crude oil had more than tripled from its pre-embargo level, and
prices of domestically produced oil had risen sharply too. Since imports of crude and refined oil account for more than one-third of
domestic consumption, the average cost of crude in U.S. markets
more than doubled, and price increases for refined products exceeded
80 per cent. Prices of coal also soared, and natural gas and electric
rates climbed by about a third during the year.

34



CONSUMER PRICES

1971

1972

1973

1974

High levels of international demand also helped to fan inflationary
trends in the U.S. economy well into 1974. Foreign demands on
U.S. suppliers—particularly for food, basic materials, and business
equipment—remained exceptionally strong. These pressures arose
from a number of factors, including the boom in industrial activity
in the major industrialized nations, the continued impact of the
dollar devaluations, and the effects of U.S. wage and price controls,
each of which made U.S. products more attractive on the world
market.
The phaseout of price and wage controls by the spring of 1974
was also a factor. Wholesale prices of major industrial commodities
surged—particularly for metals, chemicals, producers' equipment,
and some consumer goods. Metals contributed about as much to the
rise in wholesale prices in 1974 as any other major commodity group.
Wholesale prices of many consumer nonfood items, such as furniture,
apparel, and household appliances, also moved up at a brisk pace,
in part a response to the higher post-controls costs of materials.
Inflation was also intensified in 1974 by the exceptionally sharp
jump in unit labor costs, which was noted earlier. In 1972 and 1973




35

such costs had risen by 2.7 and 5 per cent, respectively, but during
1974 the rate of increase was at a record 11.6 per cent.
The combination of these diverse factors—the special situation for
fuels and food, continuing strong domestic and international demands, the removal of controls, high rates of capacity utilization, and
accelerating labor costs—led businessmen and consumers alike to
expect widespread price increases in the future. In particular, the
higher rate of inventory accumulation undoubtedly reflected a good
deal of hedge buying in anticipation of continued sharp increases in
prices. Similarly, growth of unfilled orders through late summer—
some of which may have been the result of multiple ordering—probably reflected efforts to circumvent shortages and rising prices. A t
times during the year consumers also attempted to purchase in advance of price increases. A striking example was the surge in sales
of 1974-model cars after the announcement of large price increases
for the 1975 models.
Inflation gathered momentum during 1974 in part because of these
heightened price expectations. But late in the year, as demand weakened on a broad front and uncertainty increased, the inflationary
expectations of businessmen probably became a less dominant force
and rising costs a relatively more important one in sustaining the
increases in prices. Consumer attitudes also shifted, and as noted
above, by the end of the year many thought it was a bad time to buy
because prices were too high.
PRICE

MOVEMENTS

Inflation in 1974, as reflected by broad measures such as the implicit
GNP deflator, the consumer price index, and the wholesale price
index, increased substantially faster than in 1973—indeed faster than
in any other year since early in the postwar period. By the end of
1974, the implicit deflator for GNP had risen 12 per cent from the
end of 1973 compared with 7 per cent during the previous 12-month
period. The consumer price index also showed a 12 per cent increase
in 1974, compared with a rise of less than 9 per cent in 1973. Nonfood commodities led the advance in consumer prices, but prices of
services also accelerated significantly. Wholesale prices rose even
more rapidly—21 per cent during 1974 compared with 15 per cent
during the previous year.

36



Following the run-up of oil prices that began in the autumn of
1973, accelerating prices for industrial materials paced the rate of
inflation. Wholesale prices of fuel and power rose at an annual rate
of about 70 per cent from September 1973 to midyear 1974 but
then slowed to about a 10 per cent rate by the fourth quarter. Higher
fuel prices had a substantial impact on prices of other materials,
which had been compounded by very large post-price-control adjustments and intense international demand pressures earlier in 1974.
By September prices of steel mill products and nonferrous metals
were more than 40 per cent above a year earlier. Prices of other
materials rose sharply too—especially paper and paper products, and
most chemicals. By the year-end, however, there were signs of considerable moderation in the materials component of the wholesale
price index. This was in sharp contrast to the extremely rapid rates
of gain that had been registered in the first three quarters.
The extraordinary increases in materials prices, as well as postcontrols adjustments, led to sharp advances in prices of finished
goods. Prices for producers' machinery and equipment accelerated
during the year, influenced also by strong foreign demand; the annual
rate of gain in such prices rose from 6 per cent in the fourth quarter
of 1973 to more than 30 per cent during the third quarter of 1974.
In the fourth quarter these price increases also began to slow.
Although food prices were not so important a factor in inflation
in 1974 as they had been in 1973, advances continued at high rates
during the year. Because the U.S. harvest of feed crops was disappointing and stocks were never rebuilt from depleted levels, prices of
grains and feeds continued high during most of the year. Dramatic
rises in sugar and sugar-based products as well as in fats and oils contributed disproportionately to the advance in food prices at retail;
prices of sugar and sweets more than doubled during the year. However, late in the year prices of sugar and oils declined at the wholesale level. By the second quarter the farm-retail spread had increased
to about one-fourth above its year-earlier level, and it continued high
throughout the year, contributing also to the advanced levels reached
by retail food prices despite declines at the farm level for livestock
and other products.
Fuels led the advance in consumer prices of nonfood commodities
in the early months of 1974. Although fuel prices peaked about mid-




37

year, accelerated advances for other goods led to sharp rates of rise
in consumer prices in the third quarter. Prices of nonfood items at
retail were up about 13 per cent in 1974; in addition to fuel, large
increases were recorded for household durable goods, paper products,
and a wide variety of other goods. Service costs also rose faster after
the lifting of controls, and particularly large increases were registered
for gas and electricity and for medical and household services.
In the last quarter of 1974 levels of economic activity fell and the
impact of post-controls adjustments and rising materials costs tapered
off. Prices of several industrial materials had actually declined since
the spring—notably textiles, metal scrap, and copper, as well as
lumber and hides, which were well below their 1973 highs. The rise
in wholesale prices of industrial commodities was at an 8 per cent
annual rate in the final 3 months of the year, down from the average
annual rate of rise of about 30 per cent in the earlier three quarters;
the gain in consumer prices slowed to a 10 per cent rate in the fourth
quarter, compared with the 13 per cent average posted over the first
9 months of the year.

T a b l e 4: P R I C E C H A N G E S
I n per cent

Group

Dec.
1971Dec.
1972

Dec.
1972Dec.
1973

Dec.
1973Dec.
1974

1974
(seasonally adjusted compounded
annual rates)
Dec.Mar.

Wholesale prices, total
Industrial commodities
F a r m products
Processed foods and feeds
Consumer prices, total
Foods
Commodities less foods
Services

Mar.June

JuneSept.

Sept.Dec.

6.5
3.6
18.7
11.6

15.4
10.7
36.1
20.3

20.9
25.6
-1.9
20.9

24.5
32.3
6.2
13.1

12.2
35.7
-48.0
-12.0

35.2
28.3
56.6
60.2

13.4
8.2
7.4
33.7

3.4
4.7
2.5
3.6

8.8
20.1
5.0
6.2

12.2
12.2
13.2
11.3

14.2
19.4
16.0
9.2

10.3
3.1
13.7

14.2
12.3
16.2
13.9

10.1
14.6
7.3
10.9

11.0

NOTE.—Based on data f r o m Dept. of Labor. Services are not seasonally adjusted.

38



Monetary
Financial

Policy and
Markets

Policy choices confronting the Federal Reserve were especially difficult in 1974. The need to slow the rapid advance in prices remained
urgent. But as recession emerged, so too did questions as to how soon
and how much the policy of strong resistance to inflation should be
modified. Efforts by the System to restrain credit expansion—and
thereby inflationary pressures—were also complicated in late spring
when the interaction of tight money and rapid price advances excited
fears in market circles of a general liquidity squeeze. To dampen
these market apprehensions, Chairman Burns announced the System's
readiness to serve, if needed, as a lender of last resort to nonbanking
firms as well as to banks. This helped to calm concerns in financial
markets regarding the possibility of serious financial instability, even
though no widespread reliance on System emergency credit actually
materialized.
In seeking a workable trade-off among the year's changing—and
sometimes conflicting—requirements, the System's policy targets and
the mix of instruments used to implement them had to be modified
at several points along the way. During the early part of the year,
when the economy was still being depressed by the Middle East oil
embargo, the System continued the posture of lessened monetary
restraint that had been initiated in late 1973 when dislocations from
the embargo began. Implementation of this less restrictive approach
led to continuation for a time of the declines in short-term interest
rates that had begun in late 1973. The Federal funds rate, for example—which is watched closely in financial circles as a bellwether of
System policy intentions—dropped from around 9% per cent at the
turn of the year to about 85/s per cent in mid-February.
By late February, however, it was becoming evident that all of
the monetary aggregates were again expanding at rapid rates. Therefore—once a lifting of the oil embargo had been assured—the System moved to counter this accelerating growth of the aggregates. In
the months that followed, the combination of increased monetary




39

restraint, continuing rapid inflation, and ballooning business credit
demands produced a sharp, general tightening of credit markets.
Interest rates rose well above earlier historical highs—in the case of
the Federal funds rate, to a peak of around 13Vi per cent shortly

INTEREST RATES
Per cent per a n n u m

6

0
12

10
8

0
10

8

6

0
'73

1974

N O T E . — M o n t h l y averages except f o r home mortgages (based on quotations f o r one day
each m o n t h ) , F . R . discount rate, and p r i m e rate (predominant rate quoted by commercial
banks to large businesses). Y i e l d s : U.S. Treasury bills, market yields on 3-month issues;
c o m m e r c i a l paper, dealer o f f e r i n g rates; conventional mortgages, yields on first mortgages
i n p r i m a r y markets unweighted and rounded to nearest 5 basis points, f r o m Dept. of
H o u s i n g and U r b a n D e v e l o p m e n t ; A a a u t i l i t y bonds (Federal Reserve series), averages of
new, p u b l i c l y offered bonds rated A a a , A a , and A by M o o d y ' s Investors Service and adjusted to an A a a basis; U . S . G o v t , bonds, market yields adjusted to a 20-year constant
m a t u r i t y by U.S. T r e a s u r y ; State and local govt, bonds (20 issues, m i x e d q u a l i t y ) , Bond
Buyer.

40



after midyear. With the whole complex of short-term rates moving
rapidly higher, the Federal Reserve discount rate was raised in late
A p r i l from IV2 to 8 per cent.
The general tightening of credit was accentuated during the spring
and summer by a shift of lenders to more conservative loan policies.
This process was triggered by the publicized difficulties (and eventual
failure) of the Franklin National Bank in the United States and the
failure of two smaller banks in Germany—one of which was a major
factor in foreign exchange markets. A l l of these failures resulted from
loose management practices that led to heavy trading losses on foreign exchange. A t about the same time a major electric utility company in this country announced that it was forgoing its quarterly
dividend payment for the first time in history and was selling two
partly completed electric generating plants because it could not borrow the funds needed to complete them.
There was widespread concern in financial circles that such evidence of financial difficulty at a few firms might represent the tip
of the iceberg, presaging additional business failures in future months.
Lenders responded to this anxiety by tightening their credit standards. In the squeeze that followed, many lesser-rated borrowers found
their access to securities markets partially or completely curtailed,
and they were forced to fall back on standby credit lines at banks.
Since banks experiencing these unexpected loan demands were also
finding it necessary to pay sharply higher costs for money market
funds, they increased their own loan rates to cover the added costs.
In the process the rate on prime business loans at major banks was
pushed to a peak of 12 per cent early in July, well above the year's
low of 83A per cent reached in late February. For borrowers with
quality ratings of less than prime, interest charges on bank loans—to
the extent that credit was available to such borrowers—rose in some
cases to levels as much as 4 percentage points above the prime rate.
The severe problems being created for some firms by tighter and
more costly credit, as well as the possible implications of this tightness for future economic activity, were strongly reflected in the performance of the stock market. While stock prices had posted moderate net advances early in the year when interest rates were still
declining, they turned down as interest rates began to rise again, and
then fell dramatically during the spring and summer period of maxi-




41

mum financial strain. From its midwinter high to its early fall low, the
composite stock index of the New York Stock Exchange dropped 3S
per cent—and at the low was nearly 50 per cent below the recorc
high reached in early 1973.
As typically happens in periods of general monetary restraint
However, special financing problems that resulted from the very rapic
inflation made the squeeze more pervasive in mid-1974 than in some
earlier periods of tight money. The types of institutions most affectec
included some—such as the nonbank thrift institutions—that are typically disadvantaged in periods of general monetary restraint because
of their inability to compete effectively for funds against high yield;
on market securities; others—such as the relatively new real estate

were beset with special problems that had not been present in the
earlier periods.
The fears of a liquidity crisis that had developed in financial circles
the summer progressed. Although statistical indicators were still

earlier patterns of rapid growth. At the same time expansion in the
with a lag the steep^dvances in interest rates and thl adjustment
in institutional lending policies that had developed earlier in the
year. Average growth in the narrowly defined money stock, for example. slowed to an annual rate of 1.6 per cent from the month of
June to the month of September. Expansion of the money stock as
savings deposits at banks and other thrift institutions dropped
abruptly.
The Federal Reserve reacted to these changes by shifting to a
was quickly reflected in a sharp, general decline in Ihort-terJ interest

42



rates, as illustrated by the Federal funds rate, which fell more than
200 basis points between early July and mid-September. I n September the Board of Governors removed the 3 per cent marginal reserve
requirement from large time deposits and comparable nondeposit
bank liabilities whose maturities exceeded 4 months—thus providing
a modest supplement to the reserves made available through open
market operations.
The marked third-quarter drop in the complex of short-term
market interest rates began to be reflected in some general pick-up
of growth in the monetary aggregates during the fourth quarter, when
sizable net inflows of savings were resumed following a short period
of substantial disintermediation during the summer. The improvement
was most pronounced at nonbank thrift institutions. Late in the
fourth quarter, however, the unexpectedly sharp deterioration in
economic activity tended to slow demands for money and credit and
thus to offset some of the stimulus to growth in the aggregates stemming from earlier declines in interest rates. This was especially evident in the narrowly defined money stock, which grew at an annual
rate of only 2 per cent during December and then declined in January 1975.
To help counter this weakness, the System made use of all of its
major policy instruments: open market operations, to expand the supply of nonborrowed reserves available to banks; reductions in reserve
requirements, to increase the credit-expansion potential of the existing supply of reserves; and cuts in the discount rate, to reduce the
cost of reserves borrowed from the System. Cuts in the discount rate
were made in three stages: a Va percentage point reduction, to 7%
per cent, effective December 9; a l / i percentage point reduction, to
1XA per cent, effective January 6, 1975; and a V2 percentage point
reduction to 63A per cent, effective February 7, 1975.
The reductions in reserve requirements were also made in three
stages. One, already noted, reduced the marginal reserve requirement
on longer-dated bank obligations in late September. The second, in
late November, was applied to selected categories of both time and
demand deposits; it released about $700 million of reserves to the
banking system 2 weeks later. The third lowered the structure of
graduated requirements applicable to demand deposits, beginning in




43

the week of January 30, 1975; it released about $1.1 billion of
reserves 2 weeks later. 1
The weaker credit demands that developed as a consequence of
the recession, together with the more expansive course of monetary
policy, triggered further sharp declines in short-term interest rates
over the fourth quarter. By year-end the Federal funds rate had
dropped to 8 per cent, and by early February 1975 it was close to
6V4 per cent. Long-term rates—which had continued to rise on balance during the third quarter despite the large general decline in shortterm rates—also turned down in the fourth quarter. However, large
current and prospective borrowings by businesses in capital markets
and the prospect of unprecedented deficit financing by the Federal
Government in the months ahead limited the extent of these declines.
Moreover, yields on State and local government securities reached
their yearly highs during December when serious questions developed
regarding the ability of certain key municipal borrowers to continue
to service their large and growing debt burdens.
By early 1975 the widespread concerns of the preceding summer
about the possibilities of a full-scale liquidity crisis had dissipated.
But the unexpectedly sharp deterioration in over-all economic activity
posed broad questions about credit quality and encouraged institutional lenders to continue maintaining relatively conservative loan
policies despite the general easing of money market conditions.
Although interest rates had declined substantially further after the
turn of the year, the unprecedented volume of Federal deficit financing that loomed ahead was raising some questions in market circles
about the likely course of interest rates over the somewhat longer run.
1
The November action included a reduction of Vi percentage point in the
requirement on that portion of net demand deposits in excess of $400 million,
the elimination of the remaining marginal reserve requirement on large-denomination time deposits, and a restructuring of the basic requirement on time
deposits. The reserve requirement on all time deposits with original maturity of
at least 180 days and on the first $5 million of shorter-maturity time deposits
was set at 3 per cent; the requirement for the remainder of shorter-maturity
deposits was set at 6 per cent. The lower reserve requirement on longer-term
deposits was intended to provide an incentive for banks to improve their
liquidity by lengthening the maturities of their liabilities.
The January 1975 action included a reduction of 1 percentage point on
that portion of net demand deposits in excess of $400 million, and a reduction
of Vi percentage point on that portion of such deposits under $400 million.

44




MONEY AND CREDIT

AGGREGATES

The various measures of money and credit growth continued to
exhibit occasional periods of erratic movement in 1974. This was particularly true of the narrowly defined money stock at key points in
the year. As a result, although the Federal Open Market Committee
continued to place important emphasis on the behavior of M r as a
target of monetary policy, the performance of M x —particularly in
the short run—had to be carefully evaluated in relation to growth
patterns of other major aggregates as well as to changes in interest
rates.
For 1974 as a whole, the key measures of money experienced
slower growth rates than in 1973, whereas the adjusted credit proxy
continued to expand at about its 1973 pace. However, these annual
averages mask rather substantial quarter-to-quarter changes in growth
patterns, particularly for
and the adjusted credit proxy. In addition, the annual growth rate shown for M 1 included rather different
patterns of change for its two components—demand deposits and currency in circulation. Whereas expansion in demand deposits slowed
to only 3 per cent for the year, currency expanded by an unusual 10
per cent as the continuing rapid inflation created growing public
needs for cash to pay for consumer outlays.
The quarterly growth rates for the aggregates shown in Table 5
identify significant patterns of change within the year. In the first
quarter, for example, the relatively rapid growth rates of M 2 and M 3
mirrored inflows of savings to banks and other depositary intermediaries that were being encouraged by the further over-all decline
in short-term market rates. First-quarter growth in Mu on the other
hand, reflected the combination of contraction at an annual rate of
nearly 3 per cent in January followed by growth in February and
March at an annual rate of roughly 9.5 per cent. The January contraction was attributable chiefly to a sharp reduction in foreign
demand balances at the start of the year from the extraordinarily
high levels reached at the end of 1973.
The dramatic increase in bank credit during the second quarter—
when growth in the bank credit proxy rose to more than a 20 per
cent annual rate—was attributable chiefly to three factors. Over-all
business needs for funds were exceptionally large; high interest rates




45

T a b l e 5: G R O W T H I N M O N E T A R Y A G G R E G A T E S
I n per cent

Measures o f money

Adjusted
credit
proxy

Period
Mi

Mi

Ms

1972

8.7

11.1

13.1

11.3

1973

6.1

8.8

8.7

10.4

1974

4.7

7.4

6.7

10.2

1974—Q1
Q2
Q3
Q4

5.5
7.0
1 .6
4.6

9.3
7.9
4.5
7.0

8.8
6.6
4.0
6.9

8.2
20.4
6.6
4.3

M i = Currency held outside the Treasury, F.R. Banks, and the vaults of all commercial banks, plus
demand deposits other than interbank and U.S. Government.
Mi = Mi plus time deposits at commercial banks other than large negotiable certificates of deposit
at weekly reporting banks.
M.i = Mi plus deposits o f mutual savings banks and savings capital o f savings and loan associations.
Adjusted credit proxy = Total member bank deposits subject to reserves, plus Euro-dollar borrowings, loans sold to bank-related institutions, and other nondeposit items.
NOTE.—Incorporates revisions in money stock and related measures based on benchmark data for
nonmember banks derived f r o m Reports of Condition through October 1974, as well as revisions in
seasonal adjustment factors. Seasonally adjusted quarterly rates of growth derived f r o m daily-average
data for last m o n t h of the quarter relative to those for last month of preceding quarter, annualized.

were discouraging bond financing; and as the quarter progressed,
investors in commercial paper and corporate securities tended to back
away from obligations of borrowers with less than top quality ratings.
T o accommodate this upsurge in demands for bank credit, banks
themselves were forced to bid aggressively for funds through expanded sales of large CD's and increased borrowing from nondeposit
sources. As a result, the outstanding volume of large CD's grew nearly
$13.5 billion over the quarter, contributing substantially to the
upward pressure on short-term rates. In contrast to the credit proxy,
growth of M-, and Ma slowed during the second quarter as the attractiveness of yields on competing market securities increased relative
to maximum rates payable on thrift accounts.
While growth of M , continued to show considerable variation from
month to month, it expanded rapidly over the second quarter, as
Table 5 shows. Both the variability and the rapid growth were significantly influenced by the ebb and flow of foreign deposits. This
reflected temporary accumulations of demand deposits resulting from
the transfer of greatly expanded payments to oil producers. Because

46



some producing countries had not yet perfected procedures for making timely investment of the expanding proceeds from oil sales, a
significant part of these proceeds were accumulated for brief periods
in demand balances, causing growth rates for M1 to show noticeable
short-run changes. As the year progressed and the processing of oil
funds became more routine, the erratic impact of foreign transactions
on the money stock became less significant.
Growth in all of the key money and credit aggregates slowed substantially in the third quarter. This change was attributable both to
the lagged impact of earlier, steep advances in interest rates and to
the developing weakness of the economy. With loan demands falling
off, banks were able to cut back significantly on both their sales of
large CD's and their acquisitions of nondeposit funds, so growth in
the adjusted credit proxy dropped abruptly. A t the same time, high
interest rates on market securities were cutting deeply into flows of
funds to thrift accounts at banks and other intermediaries. Thus, for
both Mo and M : t growth was also appreciably slower.
During October and November further declines in short-term
interest rates from their early summer highs tended to encourage
more rapid growth of both Mx and M-,. In the two succeeding months,
however, this pattern of expansion was substantially modified, as the
marked general deterioration in over-all economic activity tended to
offset much of the stimulus to money demands arising from further
declines in interest rates. The failure of the adjusted credit proxy to
expand with other aggregates during the fourth quarter was attributable in part to the general weakening of demands for bank credit as
economic activity slowed. In addition, however, many borrowers
were adjusting their debt structures and were turning to new capital
market financing in lieu of bank borrowing.
BANK

RESERVES

Total reserves of commercial banks grew almost as rapidly in 1974
as in 1973, and nonborrowed reserves grew significantly faster, as
Table 6 shows. Much of the growth in nonborrowed reserves occurred
in the fourth quarter, however, when member bank borrowing
dropped off sharply. Patterns of change in total reserves also varied
considerably from quarter to quarter, as did those of the money and
credit aggregates they supported.




47

T a b l e 6: G R O W T H I N B A N K RESERVES
1974
Item

1973

1974
Ql

Q2

Q3

Q4

Annual rate, in per cent
Total reserves
Nonborrowed reserves
Reserves available to support private nonbank deposits ( R P D ' s ) .

7.8
7.2

7.1
9.1

1.3
1.2

20.1
.8

8.2
5.6

4.1
34.4

9.3

7.2

5.7

19.1

9.1

.7

793

58
274

In millions of dollars
Memoranda:
Total change in RPD's 1
By type o f deposit:
Required reserves f o r —
Private demand deposits 1
Time deposits other than large
negotiable CD's 1
Large negotiable C D ' s and nondeposit sources of funds l . . . .
Excess reserves
1

2,706

2,896

467

1,578

527

406

19

110

3

883

790

193

208

245

144

1,272
25

1,751
-51

428
-173

1,197
64

548
-4

-422
62

Figures have been adjusted for changes in reserve requirements.

Growth of total reserves was particularly dramatic in the second
quarter when heavy demands for bank credit were being financed by
expanded sales of large-denomination CD's and when System concerns about possible general malfunctioning of credit markets were
greatest. Nonborrowed reserves showed very little growth in the
second quarter, however, because a sizable part of the over-all
increase in demand for total reserves during this period was being
met by the large emergency credits advanced by the Federal Reserve
to the Franklin National Bank. Franklin was forced to borrow heavily
starting in May—substantially raising the average level of total borrowing from the System; this reduced the need for provision of
reserves through open market operations.
While growth of total reserves was less dramatic in the third quarter than in the second, it remained above the average for the year,
with general growth in business demands for bank funds still sizable.
By the fourth quarter, however, reduced demands by businesses for
short-term funds, together with the continuing more cautious approach of banks to lending, were reflected in a commensurate reduction in bank needs for reserves. Consequently, the growth in total
bank reserves slowed somewhat further.

48



Early in the fourth quarter nonborrowed reserves showed a sharp
spurt when the Franklin National Bank was closed through regulatory action. As a part of this action, Franklin's large outstanding debt
to the Federal Reserve was transferred through agreement of the
regulatory agencies to a form that was reflected in the banking statistics as nonborrowed reserves. Over the rest of the quarter, however,
and in early 1975, nonborrowed reserves continued to grow rapidly.
Much of this expansion reflected System provision of reserves needed
to offset heavy reserve drains arising from member bank repayment of
borrowings at the Reserve Banks. Reduced member bank borrowing
was encouraged by the sharp reductions in private money market
rates to levels at or below the System discount rate. I n late January and early February member bank borrowing at the Federal
Reserve averaged only a little over $100 million, most of which was
attributable to emergency lending by banks that were experiencing
difficulties acquiring funds from private sources.
AGGREGATE FLOWS OF

FUNDS

The nonfinancial sectors of the economy raised an estimated $176
billion in credit and equity markets during 1974, or about $12 billion
less than they had raised in 1973. Since GNP increased 8 per cent
from 1973, there was a large decline in the ratio of funds raised to
GNP. Although declines in this ratio have marked other periods of
credit stringency, the extent of the drop in 1974 can be viewed as a
measure of the tautness that characterized financial markets during
most of the year.
In addition to the shrinkage in total credit flows during 1974,
there were marked changes in the structure of funds provided
relative to 1973. Most notably, private domestic financial institutions accounted for an appreciably smaller share of total funds placed
in credit and equity markets than in 1973—62 per cent versus 72 per
cent—and of total funds supplied to nonfinancial sectors—65 per
cent versus 75 per cent. Foreigners, on the other hand, supplied
a substantially larger volume of funds, primarily to the Government
securities market, as a sizable portion of the receipts from oil exports
were invested in the United States.
Households also accounted for a larger proportion of funds supplied in credit and equity markets during 1974—11 per cent versus




49

T a b l e 7: F U N D S R A I S E D I N C R E D I T A N D E Q U I T Y M A R K E T S
B Y N O N F I N A N C I A L SECTORS
I n billions o f dollars
1974 i
Sector, or type o f
instrument

1973

1974
Ql

Total funds raised
By sector:
U.S. G o v e r n m e n t 2

187.4

175.7

Q2

Q3

Q4

174.5

207.2

174.7

146.4

9.7

13.0

11.3

1.4

18.2

21.0

177.6
85.1
12.3
72.8
7.5

162.7
88.9
15.8
42.5
15.5

163.3
91.5
14.3
42.3
15.3

205.8
111.0
17.7
52.6
24.5

156.4
87.0
14.4
47.4
7.6

125.5
66.0
16.9
27.8
14.7

9.7
10.2
7.2
13.7

13.0
20.9
3.3
17.0

11.3
19.6
6.3
15.6

1.4
20.7
4.5
20.0

18.2
18.2
- .4
15.1

21.0
25.1
2.8
17.0

Mortgages
Residential
Other

73.2
51.7
21.4

55.0
38.8
16.1

56.5
38.7
17.9

69.3
47.5
21.7

47.4
35.3
12.1

46.9
34.0
12.9

Bank loans n.e.c
Open market paper
Consumer credit
Other loans

38.6
1.8
22.9
10.0

29.9
14.9
9.6
12.1

36.4
12.2
8.2
8.4

47.8
18.6
17.2
7.8

21.3
21.2
15.8
17.7

14.1
7.7
-2.6
14.4

Other
Nonfinancial business
State and local government
Households
Foreign
By type of instrument:
U.S. Government securities
Corporate and foreign bonds
Corporate equities
State and local government d e b t 3 . . .

1

Quarterly data are at seasonally adjusted annual rates.
Public debt securities and budget agency securities.
Includes both long- and short-term borrowing.
SOURCE.—Federal Reserve flow o f funds accounts.
2
3

9 per cent in 1973. This reflected the continued allocation of a
sizable share of the increase in their financial assets to market
instruments as opposed to deposits and currency. Of their 1974 net
gain in financial assets, households placed 18 per cent directly in
stocks and credit market instruments, roughly the same as in 1973.
In contrast, during 1970, 1971, and 1972—when rate relationships
did not encourage disintermediation—direct investments in market
securities had been negligible or even negative.
There were also significant changes in the sectoral breakdown of
funds used. The weakness in sales of consumer durable goods and
the rising ratio of household indebtedness to income were reflected
in a marked decline in consumer credit flows. And reduced deposit
growth at thrift institutions contributed—along with rising building
costs and peak mortgage rates—to a shrinkage in flows of residential
mortgage credit. As a result, aggregate flows of funds to households

50



fell sharply, whereas funds raised by other nonfinancial sectors—
especially businesses and foreigners—rose substantially.
As pronounced as the year-to-year changes in the composition of
fund flows were, they were not nearly so dramatic as the shifts that
occurred within 1974. Abrupt changes in economic conditions—and
in some instances, the adjustments in monetary policy made in
response to those changes—caused remarkable shifts in the level and
composition of financial flows from quarter to quarter.
Early in the year when the oil embargo was depressing both economic activity and interest rates, businesses were encouraged to
expand their borrowing in long-term markets. Firms that had postponed such financing in 1973 were particularly active. As a result, corporate and foreign bond sales—net of redemptions—which
had been running at an annual rate of $10.5 billion in the fourth
quarter of 1973, rose to a $19.6 billion rate in the first quarter of
1974.
Declines in market interest rates early in the year also helped to
sustain the improved flows to nonbank thrift institutions that had
developed in late 1973. This stimulated an increase in commitments
to make future residential mortgage loans and accounted in part for
the upswing in such loans during the second quarter.

B O R R O W I N G BY SELECTED SECTORS, 1974
Billions of dollars
60

40

20

40

20

Q1

Q2

Q3

NOTE.—Short-term is bank loans and other
mortgages. F l o w of funds data.




Q4
loans.

Long-term

is corporate

bonds

and

51

Demands for credit intensified over the second quarter, particularly
in short-term markets, as the slide in economic activity slowed temporarily and rapid inflation augmented business needs for inventory
financing. Commercial banks were the focus of much of this increase
in credit demands.
T a b l e 8: F U N D S S U P P L I E D I N C R E D I T A N D E Q U I T Y M A R K E T S
I n billions o f dollars

1974 1
Sector supplying

1973

1974
Ql

Q2

Q3

Q4

A l l sectors

239 4

216.7

208. 4

254. 3

242.3

161. 8

A l l sectors to nonfinancial sectors

187 4

175.7

174. 5

207. 2

174.7

146 4

23
19
9
3

3
6
2
5

29.9
21.6
6.2
13.2

15 2
9 3
— 9
5 9

30. 2
24 3
13 1
17 4

39.0
33.9
10.7
6.4

35
19
1
23

3
2
7
1

172
86
35
37
13

3
1
4
0
1

134.3
61.8
27.8
40.3
4.3

114.1
41 .4
17.2
40.8
15.0

9.5
30
23
46
-4

.5
3
2
3
3

32 4

19.4

24 6

Private domestic nonfinancial investors
Households
Nonfinancial businesses
State and local governments

31 1
21 5
9 2
4

33.1
22.8
6.4
3.9

35
12
16
6

MEMO: Net change i n deposits and currency held
by private domestic nonfinancial sectors

88 8

77.9

97 3

U.S. G o v e r n m e n t and sponsored credit agencies.. . .
Less funds raised by sponsored credit agencies
Federal Reserve System
Foreign sources
Private financial intermediaries
Commercial banks
T h r i f t institutions
Insurance and pension funds
Other
Less funds raised by private
mediaries

financial

152
78
43
30
—

9
7
9
8
4

174
96
27
43
7

7
8
1
5
3

inter4
0
8
7

22 8
18
16
9
-7

9
8
4
4

109 0

33.7

-3 9

6
72.0
8
54.6
10.9 - 1 1
6.5
9
29.0

/
0
6
8

lb 2

1
Quarterly data are seasonally adjusted annual rates.
SOURCE.—Federal Reserve flow o f funds accounts.

Demands for bank credit in the spring were also augmented
because financial investors were placing increased emphasis on the
creditworthiness of borrowers. Lower-rated companies often found
that they had to pay a much higher rate than prime issuers in order to
sell commercial paper. Even for issuers of medium-grade paper, the
premium over the prime commercial paper rate rose from roughly
Vi percentage point in the winter to IV2 percentage points in the
early summer. A n d some firms found that they could not sell commercial paper at all. Firms whose access to the paper market was
thus restricted had to fall back on lines of credit at banks.
Bank loans to foreigners also expanded at a faster rate in the
second quarter. But so too did deposits of foreigners, since com-

52



mercial banks were serving as intermediaries for enlarged oil payments to foreigners.
The steep, general rise in short-term interest rates resulting from
the spring and early-summer accumulation of pressures on banks was
not reflected in the market for short-term U.S. Treasury securities
where yields showed little net change during the first half of the year.
I n this period the supply of Treasury bills available to the public was
reduced substantially by heavy buying on the part of both foreign
central banks (partly with dollars obtained in foreign exchange
market intervention) and the Federal Reserve (through open market
purchases to supply reserves). As a result, rate spreads between
Treasury bills and private instruments of similar maturity widened to
almost 4 percentage points.
This rate spread had important repercussions on credit flows.
First, funds of foreign central banks, which previously had been
placed almost entirely in Treasury bills and other Government obligations, were placed to some extent in bankers' acceptances, which
at that time were still being guaranteed by the Federal Reserve. Supplies of acceptances available for purchase grew very rapidly in the
second and third quarters, when credit demands of foreigners were
being diverted to U.S. sources by the credit and balance of payments
policies of foreign governments. Second, the higher rates available
on private instruments encouraged the growth of mutual funds that
invest in liquid assets; these institutions pooled the funds of smaller
investors and purchased diversified portfolios of large CD's, commercial paper, and other short-term assets.
The rise in private short-term rates from late winter to midsummer
was accompanied by an increase in long-term rates, but as typically
occurs in periods of sharp, general advances in rates, the yield curve
took on a pronounced downward slope. As long-term rates and the
cost of equity capital in the stock market moved upward, many companies put off long-term financing—favoring bank loans or commercial paper. Some firms, however, had no real option but to proceed with bond or stock financing—especially in the public utility
industry where long-term funds were required for fixed investment
expenditures. Thus, despite the high costs of capital, the volume of
long-term financing was maintained through the second quarter.
Even in the third quarter, when yields on new top-quality corporate
bonds reached record levels above 10 per cent, the aggregate volume




53

of new offerings remained large for a summer period. The sale of
a sizable volume of floating-rate notes—primarily by bank holding
companies—accounted for much of this sustained volume. These
securities proved very attractive to small investors because of the high
initial rates and the option of redemption on specified dates.
The combination of high market yields and the availability of
attractive new types of financial instruments cut deeply into the supply of funds flowing to thrift institutions during the second and
third quarters. The summer attrition was also augmented because
the Treasury, at congressional insistence, restored the low, $1,000minimum denomination on high-coupon note issues that it offered
in the August refinancing. Even though the Federal home loan banks
made advances to savings and loan associations totaling $5.7 billion

THRIFT INSTITUTIONS' GROWTH,
A N D I N T E R E S T RATES
Per cent

6

0
1973

1974

NOTE.—Net flows are q u a r t e r l y changes, at seasonally adjusted annual rates, i n consumertype t i m e and savings accounts at c o m m e r c i a l banks, i n total deposits at m u t u a l savings
banks, and i n savings c a p i t a l at savings and loan associations.
Interest rates: M o n t h l y data. Rate o n Treasury bills is average o f yields at weekly auctions. T h r i f t i n s t i t u t i o n s , highest rates payable on consumer-type deposits at m u t u a l savings
banks and savings a n d l o a n associations f o r longest certificates ( 2 years t h r o u g h June 1973,
4 years t h r o u g h Dec. 22, 1974, and 6 years beginning Dec. 23, 1974).

54



during the second and third quarters and other Federally sponsored
agencies provided funds to the mortgage market, residential mortgage rates rose nearly as much as bond rates, reaching 10 per cent in
the fall, and loan commitments fell sharply. Although subsequent
declines in market rates brought a resumption of net deposit inflows,
the smaller backlog of loan commitments and the reduction of demands for mortgage loans associated with the deterioration of the
economy resulted in a slowing of mortgage debt formation over the
second half of the year. Thrift institutions therefore used their improved flows of funds to repay debt and to rebuild liquid asset
holdings.
The limited supply of Treasury bills available to the public that was
characteristic of the first half of the year began to be reversed in
August, as the Treasury became a substantial net borrower. This
caused a sizable late-summer advance in bill yields, which sharply
narrowed the earlier, wide spreads between them and other shortterm rates. Then, as other short-term rates declined, Treasury bill
rates shared in the downtrend.
Consumer reluctance to purchase new autos and other largeticket durable goods cut deeply into consumer credit flows during the
fourth quarter, reducing both direct demands on banks for instalment
credit and indirect demands from finance companies. Consumer credit
growth was also limited by the stricter quality standards being applied
by lenders in response to the rising rate of loan delinquencies and the
negative outlook for employment.
In addition to the Government sector, the principal area of credit
markets where demands picked up toward the year-end was the
corporate bond sector. Cyclically depressed tax revenues and rising
expenditures forced the Federal budget into deeper deficit and
required increased issuance of debt. In the corporate sector businesses took advantage of the general easing of bond market pressures
to sell a near-record volume of long-term debt. Much of the corporate
bond volume was in the intermediate-term maturity range—5 to 10
years.
The weakness of the economy and the repayment of short-term
debt with the proceeds of longer-term financings were reflected in a
sharp slowing of short-term business credit expansion in the fourth
quarter. The sum of bank loans to nonfinancial businesses and of




55

T a b l e 9: U.S. G O V E R N M E N T F I N A N C E
In billions of dollars
Calendar year
Item
1972
Deficit

1973

1974

17.4

7.9

10.9

Amount financed by changes in cash assets and other items...

2.1

Total borrowing from public 1
Net Federal Reserve purchases of Government securities 2 . .
Net Treasury borrowing f r o m private investors—
Marketable:

15.3
-.2

7.9
8.6

11.8
2.1

4.5
3.3

-5.4
-4.1

6.8
3.2

3.9
3.8

5.6
3.2

-3.2
3.0

3.5

16.3

16.6

.6

.5

2.5

Other
Nonmarketable:
Other
Memoranda:
Net borrowing by Government-sponsored agencies
Federal Reserve outright purchases of sponsored agency

-.8

1
Includes Treasury securities as w j l l as securities issued directly by budget agencies. The ownership
distribution is approximate.
2
Includes repurchase agreements.

commercial paper issued by such firms, which had grown at seasonally adjusted annual rates of from 18 to 25 per cent in the first three
quarters of the year, rose at a rate of less than 3 per cent between
September and December. The deceleration of the bank component
of short-term credit also was attributable in some measure to conservative lending postures by banks in light of prospective loan losses,
reduced liquidity, and concern about the adequacy of bank capital.

56



International

Developments

A series of dramatic events combined to make 1974 a year of great
economic stress in the world economy, foreshadowing major challenges for economic policy in the year ahead. In retrospect, the force
initiating much of the difficulty was the coincident surge in demand
in nearly all industrial countries beginning in 1972 and reaching a
peak after mid-1973. That surge exposed bottlenecks in the supply
of many basic commodities, and rising costs of materials aggravated
demand inflation and facilitated the raising of prices by the Organization of Petroleum Exporting Countries (OPEC). Adding to pressures
on consumer prices, world production of foods fell as demand rose,
and food inventories were reduced to dangerously low levels.
Faced with these problems, industrial countries had shifted toward
policies of demand restraint in 1973. This shift added to the already
strong depressing effect on demand of higher oil prices, bringing a
slowdown in industrial production by early 1974. By the end of the
year industrial countries were operating well below capacity. For the
industrial countries (other than the United States) as a group, it
appears that real GNP rose only slightly over 1 per cent in 1974 (in
the 1960-70 period growth had averaged 6.3 per cent annually) and
would be far below the long-run average in 1975. If the U.S. performance is included, real GNP growth for the 2 years would be
considerably lower.
Policymakers are constrained in their efforts to revive demand by
rates of inflation that are far too high in every country, though some
countries have been more successful than others in restraining inflation. I n terms of GNP deflators, industrial countries as a group experienced a price increase of 1 2 ^ per cent in 1974 compared with a
3.6 per cent annual average in 1960-72. Weaknesses in prices of
many industrial commodities began to show up clearly by mid-1974,
but upward pressure on prices was sustained by several factors: escalating wage settlements as labor attempted to maintain or restore
purchasing power; declining productivity as capacity utilization fell
off; short supplies of foodstuffs; and the maintenance by OPEC of the
high price of oil despite declining demand and great excess capacity.




57

FOREIGN INDUSTRIAL PRODUCTION
~ '
"
100

1971

1972

1973

1974

NOTE.—Seasonally adjusted quarterly data f r o m Organization f o r Economic
and Development. Q4 p a r t l y estimated.

Cooperation

When the oil producers quadrupled the price of oil, they created
not only pervasive stresses on world prices and economic activity but
also a challenge to the stability of world capital markets and to international economic cooperation. Financial markets have been strained
as oil-consuming countries have borrowed on a long-term basis to
finance their deficits, while OPEC countries have tended to concentrate on those kinds of assets that best meet their needs for liquidity,
safety, and yield.
To satisfy these needs, the OPEC countries placed their investible
surplus (the amount left from receipts from exports and investment
income after payment for imports and outlays for military purposes
and aid)—probably amounting to some $55 billion in 1974—mainly
in money market assets in the United States (20 per cent) and in the
U.K. and the Euro-currency markets (50 per cent). They also made
large investments in direct loans to industrial oil-consuming countries
(10 per cent) and in loans to the special oil facility established in the
International Monetary Fund and to other multinational institutions
(6 per cent). The remainder was dispersed through many channels,
including some longer-term investments in industrial countries.

58



F O R E I G N CONSUMER PRICES
R a t i o scale, 1970 = 100

160

150

140

130

120

110

1971

1972

1973

1974

NOTE.—Seasonally adjusted quarterly data
t i o n and Development. Q4 partly estimated.

from

Organization

for

Economic

Coopera-

The world's banking system faced multiple problems in 1974.
Commercial banks needed to adjust not only to the vast inflow of
OPEC funds and the financing requirements of oil consumers, but
also to the weakening of confidence caused by the failure of a few
banks with large losses in foreign exchange and other dealings. In
addition, banks generally recognized that they had been expanding
their operations more rapidly than was prudent in relation to their
capital resources. Reacting to this situation and to the measures taken
by concerned monetary authorities to preserve sound banking systems, banks tightened both their domestic and their foreign lending
operations.
U.S. I N T E R N A T I O N A L

TRANSACTIONS

The course of U.S. international transactions is reflected in the balance of payments accounts and also, under a system permitting substantial exchange-rate movement, in changes in the exchange rate for




59

the dollar. In terms of broad aggregates of international transactions,
the surplus on goods and services declined slightly from 1973 to
1974, with a sizable drop in the trade balance partly offset by higher
net income on foreign investments. Private long-term capital outflows
rose sharply in 1974, and the combined balance on goods, services,
remittances, and long-term capital registered a deficit of about $8
billion, compared with $1 billion in 1973. Short-term private capital
outflows, net, were only slightly larger than in 1973, though the gross
flows through banks were extraordinarily large. Official transactions
included an increase in U.S. liabilities to foreign official accounts of
$9.4 billion—almost entirely for OPEC account, with changes in
holdings by other countries netting out to only a minor change for
T a b l e 10: U.S. I N T E R N A T I O N A L T R A N S A C T I O N S
In billions o f dollars, seasonally adjusted

1974
Item

1973

1974«
Q2

Q3

Q4*

1
22 3
-22 3

-1 6
24 1
-25 7

-2 6
24 6
--27 2

-1.5
26.1
-27.6

3 1
1

1 8
4

2 2
m

1.7

Ql
Merchandise trade balance
Exports
Imports
Investment income, net
Balance on goods and services

.5
-5 8
70.3
97 1
-69.8 -102 8
5.3
- 1.4
4.3

8 8
5

_

2 6

-1.9
-3.5
. 1

-1 9
-3 8
-5 0

Balance on current account and long-term
capital

-1.0

-8 1

Short-term private capital, net
Of which- Foreign assets o f U.S. banks. . .
Foreign liabilities o f U.S. banks.

-2.0
-5.0
4.2

-3 3
-17 1
15 0

Liabilities to foreign official agencies
Of which- Oil-exporting (OPEC) countries,
not seasonally adjusted

5.1

(9.4)

2 9

3

.2

5
9
1 0

5
— 8
-2 0

-.5
-.9
-2.5

1 8

-2 5

-3 6

-3.7

-1 8
-5 0
4 7

-3 8
-6 6
2 8

2 6
-2 0
4 0

-.2
-3.6
3.4

_

9 4

(.4)

Remittances and pensions, net
U.S. Govt, grants and capital, net
Long-term private capital, net

4
-1 2
5

2

-

_

8
1

4 9

1 4

3.9

0

(2 4 )

(3.9)

(2.1 )

_

i
1 0

Change in U.S. reserve assets
Errors and omissions

-i
-2.3

-1 4
3 4

MEMO: Official settlements balance
Official settlements balance excluding
liabilities to OPEC countries, not
seasonally adjusted

-5.3

-8 0

1 0

-4 5

-4.9

1 4

2 0

-2 2

' Less than $50 million,
e Estimated.
NOTF.—Details may not add to totals because of rounding.
SOURCE.—U.S. Dept. o f Commerce and F.R. estimates.

60



_

4
1 8

—

-1 0
6

_

.1
-.1

4

-4.1

3 6

-2.0

the year. There was also an increase of $1.4 billion in U.S. reserve
assets. During the year errors and omissions in the accounts were
generally on the receipts side, suggesting some net unrecorded inflow
of capital.
As in the case of other countries, the jump in oil prices was the
greatest single influence affecting both current and capital transactions
in 1974, but other factors were also at work. The effective depreciation of the dollar since 1970 by about 16 per cent was probably still
having a significant effect on the trade balance, supporting a strong
export performance and restraining imports. On the other hand, the
removal of controls on outflows of U.S. private capital in January
(while barriers to inflows were coming down in other countries), together with declining interest rates in the United States early in the
year and again toward the end of the year, tended to encourage the
outflow of capital from the United States.
Despite an additional cost of over $18 billion for imports of
fuels in 1974, the over-all trade balance declined by only $6 billion.
Exports, in value terms, rose by $27 billion, including a rise of about
$4 billion for agricultural exports. In volume terms agricultural ex-

B A L A N C E O N GOODS, SERVICES,
A N D REMITTANCES
A n n u a l rate, b i l l i o n s of d o l l a r s

1970

1972

1974

NOTE.—Dept. of Commerce data at seasonally adjusted annual rates. Q4 partly estimated.




61

ports were about 10 per cent lower in 1974 than in 1973, but nonagricultural exports were up by 12 per cent, following a strong—22
per cent—increase in 1973. The 1974 performance was especially
impressive, given the weakening of demand in other industrial
countries.
On the import side, nonfuel imports rose about $15 billion in
1974, but in volume terms they were cut back by about 2 per cent,
reflecting in large part the decline in domestic economic activity. The
volume of fuel imports was about 3 per cent less in 1974 than in
1973, but the price (unit value) of a barrel of imported crude oil
rose from an average of $3.33 in 1973 to $11.00 in 1974.
It appears that net receipts of investment income scored a substantial gain in 1974—rising to a record of about $9 billion, compared
with $5.3 billion in 1973. Most of the increase reflected larger profits
by the petroleum companies from their foreign operations, though
these may now diminish as initial inventory profits will not be repeated and ownership of the crude-oil-producing properties is relinquished to the host countries.
Long-term private capital transactions appear to have resulted in
a net outflow of about $5 billion in 1974, based on incomplete data.
This would be the largest net outflow since the imposition of capital
controls in the early 1960's and a considerable shift from the nearbalance in these flows in 1972 and 1973. Early in the year the net
flow was inward, reflecting primarily the collection of funds in this
country by international petroleum companies from their worldwide
sales in advance of disbursements to the oil-producing host countries.
Payments of taxes and income shares as the year progressed sharply
raised the rate of outflow. The removal of the interest equalization
tax in January 1974 did not spur major new offerings of foreign
issues now relieved of the tax, but there was a sizable increase in
offerings of Canadian bonds.
Foreign private investors sharply reduced their net purchases of
U.S. securities other than Treasury issues in 1974—to about $1
billion, compared with more than $4 billion in 1973. Purchases of
U.S. corporate stocks fell off as the U.S. stock market weakened,
along with markets in other countries. In addition, U.S. corporations
offered much smaller amounts of their bonds in foreign markets since

62



they no longer needed to borrow abroad to satisfy the requirements
of the controls on outflows of funds from the United States. Foreign
direct investments in the United States, apart from special transactions related to certain petroleum companies, were substantially
less than the 1973 peak amount.
Short-term private capital flows were very large in both directions
in 1974, but preliminary data suggest that there was only a small
increase in the net outflow from the United States. U.S. banks provided large amounts of credit to foreign countries, especially Japan,
increasing their short- and long-term claims on foreigners by $ 18 billion in the year. The elimination of controls at the beginning of the
year and the lower cost of borrowing in the United States for part
of the year tended to raise the outflow from the U.S. offices of banks.
After August there was some reduction in the rate of bank lending,
in part because a number of the early borrowers had taken care of
their needs for the year or had arranged borrowings from OPEC
sources, and in part because of the general tightening of banks' lending policies. However, bank lending to foreigners was stepped up
again in the closing months of the year. Although the increase in
banks' foreign claims was enormous by past standards, it was nearly
matched by a $15 billion increase in their liabilities to private foreigners—primarily through their branches and other banks in the
Euro-dollar market.
I n addition to magnified flows of private short-term capital, a major
new element in the U.S. balance of payments in 1974 was the direct
acquisition of U.S. money market assets by authorities of the OPEC
countries. Such acquisitions amounted to about %9Vi billion for the
year, mainly in purchases of U.S. Government obligations.
Funds held in the United States by monetary authorities of nonOPEC countries were nearly unchanged for the year as a whole. A t
times during the year some countries—notably the United Kingdom,
Italy, and Japan—drew on their dollar reserves, as well as on
borrowings, to limit depreciation of their currencies. Toward the
end of the year countries with strengthening currencies added to their
holdings of dollar assets in the United States. U.S. reserve assets rose
mainly as a consequence of drawings of dollars by some countries
from the I M F .




63

INTERNATIONAL

FINANCIAL

SCENE

International financial markets were under strong pressures in 1974
arising from the uncertainties created by the flow of oil payments
and revenues; by rampant world inflation; and toward the end of the
year, by the onset of worldwide recession. Exchange rates showed
considerable variability as the market reacted to each new bit of
information in this uncertain environment. The weighted-average
exchange value of the U.S. dollar varied by about 10 per cent over
the course of the year, and rates of exchange between the dollar and
some continental European currencies varied by much more than
that.
These fluctuations in exchange rates encouraged a number of
banks—notably European banks—to take large open positions, particularly in the first half of the year, and some of these banks reported large foreign exchange losses. Such losses were directly responsible for the failure of a German bank that was relatively small
in terms of its total assets but was a major participant in the
exchange market; hence its failure had widespread effects. After that
failure the volume of interbank trading declined sharply, as banks

I N T E R N A T I O N A L V A L U E OF T H E U.S. D O L L A R
M a y 1970 p a r i t i e s = 100

NOTE.—Monthly-average m a r k e t exchange rate of U.S. dollar against 10 m a j o r f o r e i g n
currencies weighted by f o r e i g n trade in 1972. The weight for each currency is the share o f
that c o u n t r y ' s t o t a l trade (exports plus i m p o r t s ) i n the total trade of the 10 countries plus
the U n i t e d States.

64



restricted their dealings to only those banks deemed most creditworthy and reduced their limits on foreign exchange lines to nonbank
as well as bank customers.
This extreme contraction of the market subsequently eased, but
in general, banks have maintained a more1 cautious attitude toward
exchange market transactions and have substantially tightened internal control procedures related to such transactions. I n some major
countries the authorities have increased their surveillance and/or
control over banks' foreign exchange operations in the aftermath of
the experience of foreign exchange losses by some banks in their
jurisdictions.
After appreciating very sharply in the fourth quarter of 1973 and
into January of 1974, the dollar depreciated from the end of January
through mid-May, declining by 10 per cent on a weighted-average
basis. Major factors in the dollar's depreciation in this period included the removal of controls on capital outflows by the United
States and the relaxation of restrictions on inflows by most major
foreign countries; the demonstration by several European countries
of their willingness to engage in large-scale official borrowing in the
Euro-currency markets to support their currencies while paying more
for oil; and the continuation of large export surpluses in Germany,
despite sharply higher oil payments, at a time when the trade balances of most other industrial countries were moving heavily into
deficit.
The dollar's slide ended in mid-May with reports that the Federal
Reserve, the German Federal Bank, and the Swiss National Bank
had agreed upon the desirability of concerted exchange intervention
in markets. Sharp increases in U.S. interest rates relative to foreign rates and, after June, market uneasiness stemming from the
difficulties of some German banks contributed to a strong dollar until
early September. At that time U.S. interest rates began a rather
steady decline that continued into 1975, and the dollar's exchange
value followed U.S. interest rates downward. By the year-end the
dollar had depreciated by some 4.4 per cent from the beginning of
the year on a weighted-average basis. Contributing to this decline in
the dollar's exchange value was the asymmetry in intervention
policies between countries with weaker currencies and those with
strengthening currencies. Intervention sales of dollars by countries




65

supporting weaker currencies exceeded purchases of dollars by countries resisting the appreciation of their currencies. The net effect of
these operations was to add to the market supply of dollars, depressing the dollar's average exchange rate.
The Euro-currency market continued to expand at a very rapid
rate during the first 4 months of 1974. The disclosure in May of the
financial difficulties of a large U.S. bank, followed in June by the
aforementioned failure of a German bank, led to greater caution on
the part of lenders in the market and brought the market's growth
to a halt. Between the end of April and the end of September there
was a slight decline in the external foreign-currency liabilities of
banks in London, the market's largest center. I n part this leveling
reflected an actual cutback in interbank redepositing. During this period lenders began to discriminate more sharply among borrowers
and to evaluate risks more carefully. This caution produced a rate
structure involving many more tiers than before, with smaller or
lesser-known banks paying substantial premiums for funds, and also
brought about a greater concentration of deposits with the larger
banks.
I n the fourth quarter, growth of the market resumed as concern
for the safety of banks engaging in the Euro-currency business lessened somewhat. A factor that may have contributed to this easing
of tensions in the Euro-currency market was the statement issued by
the Governors of the Bank for International Settlements on September 9 to the effect that the Governors were satisfied that means were
available to provide temporary liquidity to sound banking institutions
and that those means would be used if and when necessary.
The rise in oil prices had a variety of impacts on the Euro-currency
market. The oil-exporting countries placed perhaps 40 per cent of
their estimated $55 billion surplus on current account in the Eurocurrency market in 1974, generally at call or in other very short
maturities. In London the oil-exporting countries' share of the gross
total of Euro-currency deposits rose from 5 per cent at the end of
1973 to 14 per cent at the end of September 1974.
I n the first quarter of 1974 new commitments of longer-term Eurocurrency loans rose dramatically as several European governments
sought funds to pay for oil. But commitments declined in the next
two quarters, partly because lending banks became more wary of

66




lending for balance of payments purposes. Italy, which had borrowed
heavily in the market for longer-term loans in recent years, did not
enter the market for further loans after early spring. I n indirect
reflection of swollen bills for oil imports, Japanese banks increased
their takings from the Euro-currency market very sharply in the first
half, for which they were obliged to pay substantial premiums. But
their net borrowings do not appear to have increased much, if at
all, in the second half of the year as the Japanese authorities moved
to curb additional net foreign borrowings by the banks.
Reflecting the tightening of credit availability, spreads on Eurodollar loans to nonbank borrowers widened by about V2 to Va percentage point between May and October, and there was a marked
shortening of the average maturity of Euro-dollar loans of more than
1 year.
Gold was the subject of heightened interest as its dollar price
nearly doubled from the middle of the fourth quarter of 1973 to the
end of the first quarter of 1974 when the price reached $180 per
ounce. As inflation in the major countries accelerated, people apparently sought refuge in gold. In the second and third quarters prices
for gold fell sharply, influenced in large part by soaring interest rates,
particularly on dollar assets. In the fourth quarter, however, interest
rates declined, again particularly on dollar assets; this decline, together with the anticipation of U.S. residents' newly legalized purchases of gold at the close of the year, pushed the price to a new
high in London of $195.25 per ounce in late December. When
demand by U.S. residents for the 2 million ounces of gold offered
by the U.S. Treasury in early January 1975 turned out to be unenthusiastic, the price dropped to a range of $170 to $180 per ounce
in mid-January.
A t the turn of the year many acute problems beset the world economy that will test severely the determination of countries to deal with
their domestic concerns while contributing to the achievement of
common interests. Many countries are faced with sagging economies
and would normally look to an improved trade balance as a source
of support—and many will do so with the added incentive of covering the cost of imported oil. But many industrial countries will have
to revise their customary view of what constitutes an acceptable
trade balance. Even though a considerable gain in exports to the oil




67

producers can be expected, the industrial oil-consuming countries as
a group must accommodate a large deficit with the OPEC countries,
and any individual country's efforts to gain a trade advantage through
restrictive devices would be at the expense of other oil-consuming
nations. I n addition to the matter of oil imports there are major discrepancies in the balance of payments performance of individual
industrial countries that will require adjustment.
Apart from the adjustments needed to accommodate differences
in economic performance, some of the industrial countries, and many
of the less-developed countries, will need to finance continuing incremental payments for oil and related products. Such financing
requirements could go beyond the limits of their ability to borrow on
reasonable terms from the market.
Recognizing such needs, the Ministers of the Group of Ten at a
meeting in Washington in January 1975 agreed that a solidarity
fund open to all members of the Organization for Economic Cooperation and Development should be established, and the Interim
Committee of the Board of Governors of the I M F agreed that the
Fund's Oil Facility should be continued for 1975 with new resources
of SDR 5 billion to be sought—primarily from the OPEC countries.
Also in connection with the energy problem, the International Energy
Agency was organized in 1974 for the purpose of implementing a
program designed to deal with shortages of oil and to develop substitute energy sources.
I n this period of severe economic change, it is especially difficult
to make progress on the basic issues of the international monetary
system. Nevertheless, discussion has continued on those issues; tentative agreement was reached in January on an increase in I M F
quotas to SDR 39 billion, and the Executive Directors of the Fund
were instructed to draft a number of amendments to the Articles of
Agreement involving most of the outstanding issues, including the
role of gold and the legalization of floating exchange rates. Through
effective use of these institutional structures it should be possible to
act in cooperation to meet the many acute problems of the world
economy.
Q

68




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