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FED E R iLI. RESERVE BA.STS1 OF P H IL A D E L P H Loo kin g into the Eyes of a Giant D iscount P olicy and the D iscount R ate O peratio ns of the B ank / AAUt LOOKING INTO THE EYES OF A GIANT The year 1958 will be remembered by people for other institutions carried total construction expen various reasons. Business news was bad and good. ditures to new high levels. The sharpest but shortest postwar recession came Perhaps, however, in the longer view, 1958 will to an end. Automobile sales were slower than in be remembered as the year when Americans be any peacetime year since 1948; longer, lower, came aware that a new industrial competitor was chromier, and “ finnier” lost some of their magic. on the scene. The chart on page 5 tells the story. Business spending on plant and equipment de clined sharply and cast doubt on the new theory It is not a new story. that such expenditures were oblivious to short- aware that Russia is growing industrially more For quite some time now, most of us have been run changes in business conditions. But housing rapidly than the United States. Our apprehen starts, declining since 1955, turned up and with sions, however, have been soothed by a number gains in spending for highways, schools, and of palliatives: (1) statistics from Russia are of 3 questionable validity; (2) while rate of growth biles, television sets, houses, and T-bone steaks; has been rapid the Russian totals are relatively small; (3) our educational system insures tech or Gross National Product is projected by taking the aveiage increase per year for the past 50, 25, nological superiority even when crude production or 10 years and applying it to the future. Similar totals are challenged. means are used to project personal income, in Over the course of the past year these pallia dustrial production, and a host of other measures. tives have paled somewhat. In November, Mr. The long-run, of course, is made up of a series Khrushchev proclaimed a vast expansion program of short-runs. Shorter-term growth also is fre calculated to cut deeply into the United States quently treated statistically. Budget documents of lead in production by 1965 and surpass it by governments are analyzed for clues to next year’s 1970. Many Americans visited Russia in 1958. Groups studying Russian industry generally at tested to the vigor and growth of the Russian spending. Surveys are conducted to find capital productive system. Academicians came back amazed at the depth and breadth of their edu cational system. spending plans of businessmen, how many houses builders will start, and what consumers are plan ning in the way of major purchases. Deeper, sometimes hidden forces affecting These reports focus attention on economic short-term growth have not been so exhaustively investigated. We’ve measured the giant’s foot growth in this country. It is likely that in 1959, steps but seldom looked into his eyes. We have and for some time thereafter, economic growth more or less assumed that growth will naturally will be a subject studied intensively. evolve out of our happy combination of abundant This article cannot cover all factors and forces that underlie growth. It will, however, discuss capitalistic system. some of the forces that may influence the size of the economy in 1959 in particular, and the near we look into the eyes of the giant— that is, growth. raw materials, large and growing population, and Now, however, the times seem to demand that future in general. In this way, possibly a little The Soviet Union is and has been growing more light may be shed on the broader, general sub rapidly; so mere measurement of our own strides ject of economic growth. yields discouraging conclusions if projected far Some growth comes naturally time that this country is becoming concerned Long-run economic growth is something Ameri about growth, our growth rate seems to have cans take for granted. It is not something we’ve slowed. enough into the future. In addition, at the very had to worry over, plan for, or even think about. It has come naturally and abundantly. For these reasons, perhaps, inquiries into Causes for growth are hard to find It is not difficult to find the forces that make for growth seem concerned mostly with characteris growth in a political dictatorship and Socialist tics. They are static and statistical. They project, from present birth rates and marriage rates, popu economy lation totals for 1965 or 1970 or 1975. From these total product should go to the armed services, projections we are told that in those years there capital equipment, and consumers. More specifi will be a market for x number of shoes, automo cally, industrial leaders are told what and how 4 like Russia’s. Growth is planned. Broadly, the Government decides how much of much to produce. Resources are allocated so that, American political economy sound unnecessarily in theory at least, they can accomplish these complicated. For this reason the following more goals. Workers are told where to work, how much tangible evidence is added. pay they will receive, and what they may buy. Not too long ago the emphasis was on the vol To some extent this works, but it is a brown, ume of investment or business spending as a drab kind of a society that emerges. determinant of economic growth. Consumer Under our political and economic structure, it spending was a function of income; people would is much more difficult to find the forces making for growth, even in the short term. At times our spend a predictable portion of their income— the economy appears to be liberated from any sys spending policies were to be determined with tematic causation. But mostly, there seems a kind these “ truths” as a cornerstone. New theories, of invisible world of cause and effect, mysterious, maxims, and laws were influenced by them. In full of surprises, yet implacable in its course, other words, investment spending was an in ft is necessary, therefore, to probe beyond the dependent variable; consumer spending was a particular scenes and characters for the hidden dependent variable. laws, for the place where the forces take shape, for the rock upon which our economy rests. The above paragraph may seem to make the RUSSIAN INDUSTRY IS GROWING RAPIDLY Index of Industrial Production INDEX 195 3=100 propensity to consume was fixed. Government More recently this theory has been modified by events. The boom in consumer spending in 1955, it is now said, touched off the boom in invest ment spending in 1956 and 1957. The sluggish ness of consumer spending in 1956 and 1957 gets primary responsibility for the decline in invest ment spending in 1958. Without pursuing this further, it is now com monly believed that to a large extent the various sectors of our economy are interdependent. Busi ness spending depends on consumer spending, and on what business thinks the consumer will spend, and on what government spends, and on what business thinks government will spend in case of an economic setback. Consumer spending is influenced by the level of business and government spending. It is also influenced by expectations — expectations con cerning future business spending, jobs or the lack thereof, and potential government policies in the event of a business downturn. Government spending turns on defense needs, welfare benefits, farm prices, the level of unem ployment— which of course is influenced by busi 1929 '35 '40 45 '50 '55 ness and consumer spending— and how much it 5 is decided to allocate to highways, schools, and in late 1957 and early 1958, unemployment was other expenditures. increasing and prices were rising. The thermom Thus, a change in spending in any one of the eters seemed to be making contradictory state three big sectors of the economy might be ex ments: (1) the economy was operating at an pected to bring about changes in one or both unsustainably rapid pace; (2) growth was much of the other sectors. This is especially true in the business and consumer sectors— the private sector too slow. Quite obviously, our thermometers were “ out of touch.” — of the economy. In these sectors, changes have consequences that should grow naturally out of the free, or relatively free, play of market forces. Well then, how can we know if anything is wrong, what is wrong, and why it is wrong? How can we know whether we are growing too slowly, Even this much over-simplified view of our or too fast, or whether in the long-run we would economy in operation gives a notion of its vast be better off not to be growing at all, for the complexities. One thing this should do in addition moment? is to illustrate that we can’t understand anything unless we understand its relations to its context. It is necessary to feel beyond the edges of things. A FUNDAMENTAL IMBALANCE In our society, growth is not a smooth, automatic, predetermined process. Rather it comes in fits Feeling beyond the edges and jerks. At any given time some parts grow A free or relatively free capitalistic economy is faster, some stand still, others decline. But in an many-sided, mixed, and difficult to describe. We economy where interdependence of the sectors can measure, at any given time, how large it is; is of such critical importance a kind of symmetry but we don’t know how large it should be, or even could be. For this reason we never know is required. Growth in certain sectors quite natu rally calls for increases in certain other sectors exactly how fast the economy should grow or of the economy. And, in fact, if this derived could grow. expansion does not develop, an imbalance is We have used certain guideposts that purport to tell us if our rate of growth is appropriate. created which jeopardizes growth in each of the parts. Unemployment and prices are two broad stand At present our economy seems to be somewhat ards most frequently used. When unemployment out of balance, and this imbalance is jeopardiz increases or, if at a high level, decreases only very ing or at least retarding growth. Fundamentally, slowly, we assume growth is too slow. When the imbalance is revealed in our ability to pro prices rise, it is assumed the economy is running duce more than we are willing to consume. This too fast and growth cannot be sustained. These is not too unusual. In nearly every recession and guideposts have been useful. In themselves, how its immediate aftermath, productive capacity out strips demand. What is unusual is that this condi ever, they don’t tell us enough. They are like thermometers for the economy. tion has persisted for more than a year now, and They tell us what our temperature is; from this many analysts think it will persist to a degree we are supposed to be able to tell what is wrong, for some time to come. If it does, it could be a but they don’t say why it is wrong. Sometimes drag slowing the rate of growth. they don’t even tell us what is wrong. For months 6 It is important, therefore, to examine closely the causes of this imbalance. Uncovering these, up $8 billion in 1956, up $7 billion in 1957, and it may be possible to suggest how the imbalance about even in 1958. may affect the course of the economy in the near future. Parenthetically, it should be mentioned that consumer spending for new housing is not in A lopsided economy ment spending. In real terms, this type spending There is current a popular explanation of how peaked in 1955 and slumped in 1956 and 1957. this imbalance came about. Briefly, it says that Unlike total consumer spending, it came back the disproportion is directly related to the pre somewhat in 1958. Therefore, spending for hous ceding boom. It goes like this: ing, too, sustains the idea that demand was dis cluded in the totals. Housing is treated as invest In late 1954 and on into 1955 there was a spectacular upswing in consumer demand. When appointing after 1955. Getting inside the broad consumer spending operations in most industries neared capacity total yields even more information. The charts levels in 1955, business set out on a massive in on page 8 show that in real terms— correcting vestment program that continued into 1956-57 dollar totals for changes in price— spending for in response to the upsurge in consumer demand durables was down from 1955 levels in 1956 and that had taken place and to keep pace with ex 1957, and down sharply in 1958. pected growth. But the expected growth in con The picture is a little clearer now. What is sumer demand after 1955 did not develop, and the sometimes called disappointing consumer spend economy found itself with an overhang of excess ing subsequent to 1955, is largely disappointing capacity. Now the economy is faced with a situa consumer spending on durable goods. Much of tion in which demand has to “ grow up” to present the overhang of productive capacity that is a productive capacity. This explanation begins to feel beyond the potential threat to growth is confined to the dura edges. It tells us something is wrong— the growth rate is stunted; and why it is wrong— the econ omy is out of balance due to a lopsided boom. But it doesn’t say why the boom was lopsided. Why did consumer spending fail to live up to the promises implied in 1955? In 1955, total consumer spending was rebound ble goods sector of the economy— confined, in other words, to automobiles, appliances, furni ture, and allied industries. So much for the facts and figures. They have helped to focus attention on the sources of the fundamental imbalance. But we should go further. We should ask, how might balance be restored and the economy’s posture improved for growth? ing from the recession of 1954. It increased by Broadly, there are two ways to restore the bal nearly $19 billion. In 1956, it rose by $12.5 bil ance. It can be restored by a substantial rise in lion and in 1957 by $15 billion. Final figures spending by consumers for durables. Is this for 1958 are not yet available but it looks as likely? Or it can be restored by a shift in spend though spending will have increased by about $6 billion. Prices were fairly stable in 1955, however, ing and resources to meet other needs and demands of the economy. Is this likely? and rose in subsequent years. If spending figures are adjusted for changes in the value of the CONSUMER DURABLES UP? dollar, the changes read: up $18 billion in 1955, Of course, it is impossible to say just what con- 7 CONSUMER EXPENDITURES In 1954 Dollars BILLIONS $ http://fraser.stlouisfed.org/ 8 Federal Reserve Bank of St. Louis sumers are going to spend for in 1959 and the CONSUMER EXPENDITURES near future. But if a projection is required, it is difficult to foresee a level of demand capable of absorbing all of the excess capacity. This is said, in part, because sales in 1955 — it is demand levels in that year on which current productive capacity is predicated— were augmented by many nonrecurring special factors. "One-shot pushes" In 1955 much was said about “ borrowing sales from the future.” The automobile industry in particular was depicted as doing this. Automobile sales did fall far below 1955 levels in subsequent years. How much is there to this theory? Let’s briefly review the situation. Competition in the automobile industry prob ably hit a post-war peak in 1955. For a few years following World War II car sales seemed limited only by output. Each maker pretty much was able to sell all he could manufacture. By about 19491950 the situation began to change. But the change was obscured for a while by the Korean war, Regulation W, and material priorities. Com petition returned in earnest in 1954. But Federal spending declined sharply, and the general busi ness climate was not wholesome enough for a banner car-year. In 1954, however, Ford showed Chevrolet it was a real challenger for the popularity cham pionship which “ Chevy” had held since 1931. It was apparent that each would resume the com petition in 1955. They did. Others in the industry joined in. Dealers were loaded— they said overloaded— with cars. They “ wheeled and dealed” to get rid of them. Finance companies and banks were en treated to lower down payments and to stretch maturities. Dealers shaved their profit margins. Cars were sold. Factory sales hit an all-time peak CONSUMER EXPENDITURES In Current Dollars BILLIONS $ 290 280 of 7.9 million units. Sales have not reached much beyond 6 million units since, and in 1958 reached 270 about 4.2 million. CONSUMER EXPENDITURES 260 Were sales made in 1955 borrowed from future years? Yes — but not simply because too many 250 cars were sold. They were borrowed largely be cause many things that happened in 1955 cannot 240 occur each year. Dealer protests against 1955 practices reached 230 sympathetic ears in Congress. New franchise arrangements, more favorable to dealers, were 40 negotiated. Dealers probably cannot be “ loaded” with cars the way they were in 1955. Terms, 38 stretched to 36 months in 1955, cannot be stretched indefinitely. They haven’t stretched 36 DURABLES since. Dealers can shave profit margins only so far— probably not beyond the shaving done in 34 1955. What all this means is that automobile sales in 1955 got a lot of “ one-shot pushes.” In retro spect, 1955 was an unusual year for car sales and it is probably unfortunate that capital spending plans in that industry and allied industries were 32 i _________I_________ I_________ I_________ L 115 105 k’3. SERVICES influenced by what happened. To some extent, what was said about automo 95 biles in 1955 pertains to appliances. Competition among manufacturers was at a peak that year. 85 This competition was reflected at the retail level. Discount houses achieved new prominence. Prices 142 were cut at other retail establishments. Aggressive use was made of credit terms to sell products. Derived demands still not satisfied 138 134 While the foregoing explains, in part, the reason for some caution about prospective demand for 130 consumer durables it is not the whole story. If car sales in 1955 borrowed from 1956, 1957, and 126 NONDURABLES even 1958 totals, they surely won’t borrow from 1959. That’s stretching it out too far. But how 122 many business analysts think 1959 is going to be 118 1954 1955 1956 1957 1958 9 a banner car year? The post-war relationship of disenchantment or dissatisfaction with automo automobile sales to income and other factors sug biles quite naturally has developed. People seem gests that more than 6V2 million cars should be to be less inclined to trade for a new car as sold in 1959— even without “ one-shot pushes.” long as the old one is adequate. When a new car But most forecasts put sales in the 5 ^ to 6 mil is sought, they are likely to consider a smaller lion range. What accounts for the disparity? (foreign) car. It takes less space. It is an obvious There is little agreement on an answer to this way of protesting about the failure of streets to question. In general, however, there is agreement that consumers have become somewhat disen widen and parking lots to enlarge as cars have gotten bigger. chanted with cars. It is said that the swing to smaller European cars is a measure of the disen Automobiles are not the only consumer goods that seem to have outgrown some of their ancil chantment. Possibly, in addition to serving as a lary facilities. Appliances of all sorts are more measure, the swing reveals a little about the ori numerous and complicated. Repair and service gins of the disenchantment. It was said above that facilities for our tricky gadgets have not kept pace. growth in our economy requires a certain sym metry. Growth in certain parts of the economy Suburbs filled with new houses have sprouted quite naturally calls for increases in certain other in what were formerly rural and semi-rural areas. sectors of the economy. Apply this to automobiles. In the postwar washes have moved to the suburbs with con Department stores, banks, supermarkets, and car period a tremendous rise in the number of auto sumers. But some suburban schools are over mobiles in use has occurred. In addition, their crowded, water supplies inadequate and sewer average size has increased by maybe one-third. pipes non-existent. This spectacular growth in number and size of Unsatisfied derived demands are probably caus automobiles calls for more service stations, repair ing some consumer discontent. The problem has shops, parking lots, mechanics, highways, traffic developed out of the extremely rapid growth in lights, and motorcycle police, among other things. These “ derived demands” called forth by more purchases of cars, appliances, houses, and some other consumer items. It has not been possible and larger cars have not all been satiated. Cars, in number and size, have outgrown some of their to spend for everything at once. Now a relative ancillary facilities. other spending to “ catch up.” slowing in the demand for these items will permit Grumblings about inadequate parking facili ties, bumper-to-bumper traffic, and huge repair The new consumer bills are heard everywhere. It was amusing when Finally, there is a good reason to believe that postwar cars protruded beyond prewar garages other deep-seated forces are changing the pattern — it was even fashionable. But the laughing has of consumer spending— changing it in a way that stopped. Power steering helps, but it is still hard could affect growth in 1959 and the years imme to park a postwar car in a prewar parking lot. diately following. Automatic shift helps, but it’s still frustrating to In the period since 1946, consumer spending crawl along in bumper-to-bumper traffic with 300 has emphasized automobiles, houses, and appli horsepower under the hood. A general feeling of ances. It has been said that there is no other coun 10 try in the world in which it is more difficult to possibly have arrived at a “ reaching out” point. guess one’s income from his consumption pattern. Conspicuous consumption of “ standard luxuries” Everybody has seemed to want and be able to doesn’t provide all the satisfactions sought. Liv buy substantially the same things. Of course, the ing patterns are beginning to catch up with wealthier tend to buy better cars, television sets, money incomes. and wife-saving kitchen and laundry appliances — but almost everyone has them. This pattern of demand is explained, in large Changes in the age composition of our popu lation are also tending to alter buying patterns. Between 1957 and 1965 the number of people part, by the virtual dearth in the output of these in the 25-44 year old category is expected to items during the war years. In addition, from decline somewhat. This age group emphasizes 1932 to about 1950 (and particularly from 1940 spending for houses, cars, and home appliances. to 1950) there was a great leveling trend in in As this age group becomes a smaller part of the comes. From the war period onward, this level total population, the pattern of spending will veer ing took the form of a leveling upward. The effect away from its area of emphasis. was to move a great many more families into In addition, most consumers are well stocked the middle income range, enabling them to satisfy with durable goods, and consumer debt is fairly demands for durable goods. high. This combination of factors tends to change Now, very slowly, the emphasis could be shift the direction of spending. ing away from these “ standard luxuries.” This is not to say that in 1959 and later years cars and RESTORING THE BALANCE appliances will sell poorly. It is to say, however, that over a period of years, spending on these These have been background forces which will militate against a sharp upsurge in demand for items may form a somewhat smaller part of total durables. To repeat, this does not mean that de spending. What are the reasons for this shift in buying emphasis that could be taking shape? mand for durables will stay at 1958 levels— 1958 There are a multitude of forces which influence have been expected from what happened in 1955. consumer buying decisions. Trying to isolate was a year of recession. Durables will bounce back. But they won’t bounce so high as might Excess capacity will not all be absorbed. those that are causing a shift in the composition Other areas of spending will have to lead the of consumption is an ambitious if not impossible economy if substantial growth is to be attained. undertaking. What follows can be nothing more All of these other areas of spending have not than a presentation of a few factors and forces emerged clearly as yet. It may be possible, how that might be causing spending patterns to be ever, to sketch the dim outlines of the direction altered. of the new spending emphasis. History tells us that there has been a more or Teenagers are forming the fastest growing age less continuous trend toward increasingly com segment of our population. This will continue into plex living patterns. As a society becomes wealth the near future. Spending in our economy can’t ier and more knowledgeable, its members tend help being bent somewhat by this bulge in the to reach out for new ways to enrich their lives. population. Teenagers love ice skating, popular Americans, wealthier now and better educated, records, swimming, soda pop, boating, food, and 11 bowling, among other things. Spending associ ours, resources do not shift smoothly into and out ated with these teenage likes should benefit. of areas of greater and lesser demand. If our Oldsters over 65 are the next fastest growing segment of our population. Their spending tend productive resources prove rigid and incapable encies should carry more weight in the total move into this period of change. of smooth shifting this could slow growth as we economy, too. They emphasize travel, vacation, hobbies, medical care, books, and the theater. Inhibiting a smooth shift In addition, the topping out of the boom in It is not possible to be precise about shifting spending for “ standard luxuries” will lead to an intensive search for new products. Business will resources. But it is possible to say that relative changes in prices and profits have a great deal probably spend more for basic research for new products to tempt the new sophisticated con to do with the flow of resources. Theory has it that an increase in demand for a product tends sumer. Companies that stand pat are going to get a smaller share of the consumer’s dollar. to cause the price of the product to rise. A rising price brings a higher profit. Resources, then, tend Spending for education may increase appreci ably. The fast growing number of teenagers and to flow in the direction of rising prices and profits. At present, prices and probably profits, other school-age children are putting emphasis too, are distorted in a way that tends to nullify on this spending. Also, spending by business on theory. Large differences in the size of the cor basic research should indirectly lead to emphasis porate units characteristic of our various indus on education. Finally, Federal Government spend tries, in part, cause this distortion. ing seems to be evolving away from spending on In some industries large size is a real advan “ military hardware” and toward emphasis on tage. It enables the use of huge cost-cutting ma basic technology. This trend, too, tends to make chinery and mass-production methods. In other for more spending on education. industries there is little or no advantage deriving The large number of cars on our roads, and from ultra-large size. As a consequence, some in the changes they have brought in our living dustries are characterized by a few firms that habits, mean that highways, bridges, parking account for all or nearly all of the activity. Other areas, and drive-in facilities are areas of potential lines of business have numerous small firms each increases in spending. Residents of many of our contributing a rather small share to total output. new suburban developments need more adequate When industries characterized by a few large water and sewage facilities, and larger schools. firms suffer declines in demand they do not nec To put it briefly, our economy is not wanting essarily reduce prices. In some cases prices have for areas of promise and potential growth. But risen in the face of declines in demand. in order to take advantage of this change in Industries in which a fairly large number of the direction of spending, certain fundamental firms is characteristic seem to have more of a changes in the allocation of our resources have tendency to behave according to theory. Declines to take place. We need flexibility in our produc in demand seem more apt to bring declines in tive resources. These resources must be respon prices. sive to changes in our desires and needs. Of course, in a modern industrial economy like 12 In addition, price and profit distortions may grow out of differences in economic power held by the various industries. Frequently, industries International tensions have produced defense re in which there are only a few large firms will quirements that demand high-level spending on seem to “ swing more weight” in our economy. the part of the Federal Government. Heavy spend This is natural enough. Firms in these industries ing for defense needs has caused the Government are larger, better known, and make news more to take a large tax bite out of our total economy. readily. For example, wage agreements arrived at Tax dollars remaining for other kinds of Govern by huge corporations ment spending have been smaller as a result. bargaining with huge unions tend to set a pattern for all industry. Wage rates in different industries have a cer Spending on highways since 1946 has formed a smaller part of total spending than in the 1920’s tain relationship to each other. Increases granted or the 1930’s. Expenditures for sewage systems, in one sector often result in rises all along the water facilities, schools, and police protection are line. If profit positions are to be protected, some not receiving the attention they would receive if of the wage rises can be granted only if accom we didn’t have to spend so much for defense panied by a rise in price. Industries with only a needs. few large firms seem better able to “ set” their prices. What all this means is that our price system does not work in textbook fashion. Price rela International tensions have not abated. It is likely that tax dollars for these “ housekeeping” functions of Government will continue relatively scarce. tionships are distorted by the size and power of It is unfortunate, too, that state and local units the various firms within different industries. are sometimes so numerous and overlapping as These price distortions could inhibit a smooth flow of resources. These price distortions, there to almost preclude efficient spending of funds. fore, could slow growth. occurred in our major metropolitan areas— 97 Most of our population growth since the war has per cent of the population increase from 1950 to Not all spending conies naturally A good part of the change in spending emphasis 1955 took place in these areas. In some regions, new suburbs spring up in concentric rings until that is evolving will come naturally. As consumers they collide with suburbs from the city beyond. we will probably emphasize spending for vaca These booming suburbs are still divided politi tions, water sports, phonograph records, and soda cally into bits and pieces. One large metropolitan pop, and relatively de-emphasize certain other area frequently has hundreds of governmental kinds of spending. But increased spending for units— counties, cities, townships, boroughs, vil some other kinds of goods and services may not lages, school districts, sanitation districts. The come about so readily. nation’s 174 major metropolitan areas contain Spending for highways, schools, water facili 15,658 governmental units. Some of these local ties, and sewage systems possibly needs to be governments are reluctant to give up even a part increased if our economy is to grow rapidly. But of their autonomy. Working in virtual isolation, this spending is done for consumers by a govern it is difficult and uneconomic for a small segment ment body, usually a unit of state and local of a large homogeneous area to solve its water government. At the present time, however, funds supply, traffic, mass transportation, health, crime, for this kind of spending are hard to come by. and air-pollution problems. 13 Some metropolitan areas have achieved a high will be slower in 1959. And it is made despite degree of cooperation, unity of action, and unity of planning among the governments within their the fact that the basic imbalance may not be com pletely corrected 12 months hence. Recovery from each previous postwar recession was stimulated borders. Economic growth in these areas has not been slowed by the multiplicity of governmental by random forces. Recovery in 1959 seems as units. In other areas, however, growth has been though it will be based on deeper, longer-lasting inhibited. forces moving through the economy. Ultimately, The diseconomies which grow out of a frag however, the veracity of this statement depends on mentized approach to local government problem solving are magnified by the aforementioned the flexibility of our economy as it changes to meet new spending demands. trends in total government spending. It is impor tant that these diseconomies be minimized when CONCLUSION ever possible. Our traditional institutions of For most of our history the United States has government should accommodate themselves to seemed an exceptionally well-gifted economy— lots of land, natural resources, and business current developments. Tax dollars must stretch to do the job. know-how. We’ve seemed so well gifted as to be blessed with an enormous margin for error. The Growth: Solidly based country has been like an athlete so richly endowed Earlier it was said that no one knows how much that he can train very casually and still beat the growth should or could take place. Possibly, now opposition. This enviable position may not last we can say growth in 1959 will not be so large much longer. as it could be— could be if we weren’t faced with Industrial activity in the Soviet Union is grow the fundamental imbalance between capacity to ing rapidly. More growth is planned. Suddenly, produce and willingness to consume. But how we find ourselves in the position where possibly large will it be? Precise answers to this question have been only our best will be good enough. given in numerous publications and speeches. No best? How do we know whether the current level But how do we know when we are doing our addition to the number will be made here. Suffice of economic growth is appropriate for our free it to say that the economy will grow in 1959. society? Traditionally, we’ve looked at unemploy Possibly the increase in total spending will not ment and prices as temperature gauges of eco be so large as in 1955 or 1950— other years of nomic activity. Recently these temperature gauges cyclical recovery. To some this will be disappoint have been transmitting conflicting and confusing ing. But remember that in each of these earlier reports. Obviously, they are not the reliable indi years total spending was augmented by special cators they once were. Changes in our political factors. In 1955, it was the “ one-shot pushes” economy probably have rendered them less sen already discussed; in 1950 the Korean war scare sitive. They give sluggish and sometimes inaccu provoked a buying wave. rate indications. Actually, economic growth in 1959 could be This means we have to look beyond them and more solidly based than was the case in 1955 or try to determine why growth is what it is, and 1950. The statement is made not because recovery what will influence growth in the near future. 14 Upon looking it appears that at present our enced by prices and profits. growth rate is being slowed by a basic imbalance Highways, education, water facilities, and sew which exists between our capacity to produce and age systems are among the segments of the econ willingness to consume. This imbalance, pretty omy on which there seems to be an observable much, is confined to consumer durables and allied need for more spending. These are areas of gov industries. ernment spending — mostly by state and local The imbalance can be cured by a sharp rise governments. The high level of spending and tax in demand for consumer durables or by a rela ing for defense needs that arise out of interna tive shift of resources toward new or growing tional tensions make it difficult to get more funds segments of demand. There is little that suggests for these “ housekeeping” that consumers will get back to 1955-like buying nately, too, sometimes the multiplicity of local of durables in the near future. A shift of resources units of government and their unilateral actions with more emphasis on some of the areas of the preclude the efficient spending of funds. economy that should grow faster seems to be in order. purposes. Unfortu Despite these problems, 1959 will probably be a year of rising business activity. And what is There are a few important factors, however, more, the start we make in 1959 possibly may be that are tending to inhibit a smooth shift of more solidly based than in 1950 or 1955 — the resources. Some industries seem to “ swing more years following our other two postwar reces weight” in our economy, largely because of vast sions. This will be true if our economy is able differences in size of firms that characterize dif ferent industries. Industries in which there are to develop greater flexibility in its productive resources. Ultimately, it is change which un a few large firms seem better able to maintain prices in the face of dramatic declines in demand. leashes the forces of growth within a free society. Growth will depend, in part, on how well our The allocation of resources, of course, is influ economic system responds to change. is DISCOUNT RATE AND THE DISCOUNT POLICY In 1958, member-bank borrowing from the Re of supporting the prices of Government securi serve Banks declined as conditions in the money ties, particularly the % per cent rate on Treasury market became easier. Daily average borrowings bills, gave member banks ready access to Reserve reached a low of about $100 million in July, and Bank credit. Thus, for almost two decades, little then rose as business activity improved and the use was made of the discount window. money market tightened. There were five changes The importance of discount policy and the dis in the discount rate— three reductions in the first count rate re-emerged following termination in half and two increases in the latter part of the year. 1951 of the policy of supporting the prices of Discount policy refers to the conditions govern Government securities. Member banks turned to ing discounting and borrowing from the Reserve the discount window in increasing numbers to Banks. It establishes the framework within which obtain funds to cover reserve deficiences. The dis member banks may have access to Reserve Bank count rate regained a position of importance as credit. The discount rate is a means of influenc an instrument of monetary policy, although not ing the willingness of member banks to use the the preeminence of earlier years. The revival of interest in discount policy and access to Reserve Bank credit afforded them by discount policy. the discount rate has stimulated questions as to Both discount policy and the discount rate their significance and as to their use. This article played prominent roles in the early history of the deals with three related questions: (1) Why do Federal Reserve System. Their importance waned member banks sometimes borrow from the Re in the thirties, however, as an inflow of gold and serve Bank? (2) When is borrowing from the a weak demand for credit resulted in banks accu Reserve Bank appropriate and when is it inap mulating large excess reserves. During World propriate? (3) What are the effects of a change War II and the early postwar period, the policy iii the discount rate? 16 WHY MEMBER BANKS NEED TO BORROW We all have the problem of keeping enough cash on hand or having ready access to cash sufficient to meet current payments. Sometimes cash re ceipts exceed, at other times fall short of expenses. To be in a position to meet expenses, therefore, we have to accumulate funds when receipts are larger than payments or borrow when our pay ments are larger than receipts. Most individuals and business firms turn to commercial banks or to other financial institu tions to balance out these short-run fluctuations in receipts and payments. The process of balanc ing short-run changes in receipts and expendi tures thus tends to converge on commercial banks. crease in the reserve balance of the receiving bank. Business firms and other depositors with draw cash to meet payrolls and other needs. United States Treasury receipts and expenditures, which nowadays are in large volume, constantly shift funds among banks. These are only a few of the many transactions that result in daily changes in a bank’s reserve balance and the vol ume of its deposits against which the reserve is held. As a result, a bank’s reserve position— whether in excess or below the legal requirement — is constantly changing. Even though many factors affect a bank’s re serve position, certain patterns of behavior are frequently discernible. First, most banks experi ence sudden irregular shifts of only one or a few Factors affecting a bank's reserve position days duration. A bank may have a reserve defi ciency one day, an excess the next. It is extremely Commercial banks are required by law to main difficult to anticipate these day-to-day changes tain a reserve equivalent to a prescribed minimum with reasonable accuracy. Second, seasonal trends frequently result in an inflow of funds in one percentage of their deposits. Member banks of the Federal Reserve System are required to hold this season and a persistent drain on reserves in minimum reserve in the form of deposits in a another. Banks in agricultural areas, for example, Reserve Bank. A great variety of transactions affects a mem usually have a substantial inflow of funds during ber bank’s reserve balance and the deposits the crop-marketing season. They lose funds as farmers draw on their deposit balances for living against which the reserve is held. Many checks are deposited in banks other than the banks on expenses and the costs of producing next year’s which the checks are drawn. Banks send these vacation season and lose funds in the off-season. checks drawn on other banks through regular Third, a bank’s reserve position may reflect clearing channels for payment. If a bank has an longer-term trends arising from its own policies. crop. In resort areas, banks gain funds during the adverse clearing balance, it loses funds to other If a bank is expanding its loans and investments banks; if the balance is favorable, it gains funds more rapidly than other banks in its market area, from other banks. A corporate depositor may it is likely to suffer a persistent loss of funds authorize its bank to transfer a large sum to a through clearings. Banks expanding less rapidly, bank in another city where additional funds are on the other hand, tend to gain reserves. Finally, needed to meet expenses. The transfer, made over regional differences in the rate of economic ex the Federal Reserve’s wire transfer facilities, pansion and growth cause some banks to gain results in an immediate reduction in the sending deposits and reserves, others to lose them. Crop bank’s reserve balance and a corresponding in failure, floods, or some other form of disaster 17 may drastically curtail economic activity and put local banks under severe reserve pressure. statement the following day. By comparing the amount of reserve which would be required on the basis of net demand deposits and time deposits Estimating the reserve position at the opening of business with the actual reserve Bankers have a profit incentive for keeping close balance at the close of business on the same day, tab on their reserve positions. A reserve balance a bank can determine with reasonable accuracy in excess of the legal requirement earns no whether it is running a deficient or an excess income; a deficiency incurs a penalty. Certain features of the legal reserve require reserve position. ment are especially important in managing a bank’s reserve position. A member bank is not their reserve position than others. Large banks in financial centers watch their positions very Some member banks keep in closer touch with required to maintain a reserve balance equal to closely to avoid having excess reserves that earn the specified percentages of its demand and time no income. They prepare estimates, as early in deposits every day. The requirement is in terms of averages over the computation period— of a the morning as possible, of their reserve positions for the day. Most of them, on the basis of these bank’s reserve balance each day and of daily totals of its demand and time deposits. (The estimates, make daily adjustments in their reserve positions, putting an excess into some income- reserve computation period is one week for mem producing asset or acquiring funds to cover a deficiency. ber banks in central reserve and reserve cities, and semi-monthly for country member banks.) These large banks usually try to avoid having The reserve balance may drop below the required excess reserves. Their percentage of excess to minimum for one or a few days, provided excess required reserves is quite small. Smaller banks reserves on other days are sufficient to offset the hold deficits. required reserves but the dollar amounts of their Another point is that certain deductions are allowed in computing the legal requirement much larger percentages of excess to excesses are typically small. Small sums cannot be deductions are cash items in the process of col NUMBER OF CENTS EXCESS PER DOLLAR OF REQUIRED RESERVES, BY SIZE GROUPS OF MEMBER BANKS, THIRD DISTRICT lection and demand balances with other banks in First Half November 1958 against demand deposits. The two principal the United States. The minimum percentage CENTS requirement is against net demand deposits, after deductions, not gross demand deposits. To facilitate estimating its reserve position, each member bank is supplied with a form with columns for entering total net demand deposits and total time deposits each day during the re serve computation period. The Reserve Bank sends each member bank a daily statement show ing its actual reserve balance at the close of busi ness that day. Most member banks receive this 18 ALL * 5 OR LESS *5-10 ‘ Deposits in Millions of Dollars * 10-25 * 25-50 * 50-100 *100 AN D O V ER employed in the money market so easily and no risk of price change as in the case of short profitably as large amounts. It is not so conven term securities. Although the mechanics vary ient for many of the small banks located some widely, the essence of a federal funds transaction distance from a money market to make daily is that a bank short of reserves borrows the excess adjustments in their reserve positions. For these reserves of another bank, agreeing to pay a spe and other reasons, officials of many small banks cified rate of interest. maintain a cushion of excess reserves to avoid a deficiency. Because of its advantages for very short-term adjustments, the federal funds market has become widely used by the larger banks in financial cen Alternative media for adjusting reserves ters to make daily adjustments in their reserve Banks can use several methods to adjust their positions. The daily volume of transactions ranges reserves. They can invest excess reserves in Treas from about one-half billion to over a billion dol ury bills, commercial paper, or other securities; they can lend them temporarily to another bank lars. The typical unit of trading is Si million; however, transactions for smaller amounts are or a securities dealer, or deposit them with a cor frequently made, especially in periods of tight respondent bank. To meet a reserve deficiency, money. Banks with only small excesses or defi a bank may liquidate securities, borrow the excess ciencies are thus handicapped in using the federal reserves of other banks, draw on its correspond funds market. ent balance, or borrow from a Reserve Bank. Member banks can borrow from a Reserve Bank preference is influenced by a number of Bank to meet temporary reserve deficiencies, factors. Treasury bills, other short-term securities, using subsequent excesses to repay the indebted and commercial paper are commonly used as ness; however, the Reserve Bank is not a profit secondary reserves. Excess reserves so invested able outlet for excess funds because excess reserve earn income and yet can readily be converted balances earn no income. into cash with a minimum risk of capital loss Relative cost is a significant influence in choos when additional funds are needed. Short-term ing among these reserve adjustment media. Banks paper and securities are especially suitable for naturally prefer to obtain funds as cheaply as meeting seasonal and other longer-term reserve possible. Normally, they will not borrow federal adjustments. Outright purchases and sales are not suitable, however, for daily or very short-term funds if they can borrow from the Reserve Bank adjustments. For such adjustments, a bank may funds rate rarely rises above the discount rate. at a cheaper rate. This explains why the federal need to buy one day and sell the next. The spread Other influences are the attitude of bank manage between buying and selling prices absorbs most ment toward borrowing and toward such factors or all of the interest earned unless the securities as the convenience of the different methods. are held at least two or three days. The federal funds market— the borrowing and DISCOUNT POLICY lending of excess reserve balances— has advan One of the functions of a central bank is to pro tages for daily reserve adjustments. The bulk of vide elasticity in a country’s currency and credit these transactions is for one day, and there is to avoid seasonal and other temporary strains and no spread between buying and selling prices and stresses. This means supplying currency and re- 19 serves to meet the growing demands and absorb is that of regulating the supply, availability, and ing currency and reserves during periods of cost of reserves and credit in such a way as to seasonal slack. help keep the price level stable and to help main Open-market operations are used to adjust the tain economic stability at high levels of produc supply of reserves to the changing seasonal needs tion and employment. To achieve these objectives, of the economy as a whole. For example, the a central bank must have effective control over Federal Reserve usually purchases Government the volume of reserves it creates. This means that securities in the latter part of the year to supply reserves absorbed by the outflow of currency into access to the discount window may have to be limited; otherwise, the amount of reserves created circulation and other seasonal factors; it reduces would be at the initiative of member banks, not its holdings of Governments in the early part of the central bank. In practice, access to central- the year to absorb some of the reserves created bank credit has usually been limited in two prin by the return flow of currency. cipal ways: (a) by establishing certain condi The discount window is more effective than tions under which banks can borrow, and (b) by open-market operations for meeting the seasonal changing the discount rate, making it more or reserve needs of particular banks or particular less expensive for them to borrow. regions. Seasonal trends are not uniform for all banks. The peak needs of some banks may occur Historical development during a period of seasonal slack for the economy There has been a number of amendments to the as a whole. Through the discount window, the provisions of the Federal Reserve Act relating to Reserve Banks can supply reserves directly to the discounting and member-bank borrowing from member banks which need them. Another advan the Reserve Bank; however, the principal devel tage is that the reserves are supplied “ with a opments in the philosophy of discount policy can string attached.” Once the temporary need is over, be summarized briefly. the reserves are absorbed as member banks repay their indebtedness to the Reserve Banks. Another important function of a central bank The dual nature of the discount function was recognized in the provisions of the Federal Re serve Act relating to the extension of credit to member banks. To provide the elasticity required in meeting seasonal and other temporary needs, BORROWING FROM FEDERAL RESERVE BANK BY COUNTRY MEMBER BANKS IN AGRICULTURAL AREAS, THIRD DISTRICT the Federal Reserve Banks were given authority Semi-Monthly Average of Daily Figures to discount commercial paper for member banks. M ILLIO N S $ Access to the discount window was limited, how ever, by making only certain types o f paper eligible for discount. Originally, the Federal Reserve Act defined eli gible paper as notes, drafts, or bills of exchange maturing within 90 days (except agricultural paper which could have longer maturity) and drawn to provide funds for commercial, indus trial, or agricultural purposes. Paper was ineli- 20 BORROWING FROM FEDERAL RESERVE BANK BY COUNTRY MEMBER BANKS IN RESORT AREAS, THIRD DISTRICT Semi-Monthly Average of Daily Figures The supply of eligible paper had been declining and was especially low during the crisis of the early thirties when deposit withdrawals were put ting a heavy strain on the banks. The scarcity of MILLIONS $ eligible paper severely restricted the capacity of the Reserve Banks to issue Federal Reserve notes and to make discounts and advances to member banks. Finally, it became clear that eligibility requirements did not result automatically in a volume of reserves appropriate for maintaining stable prices and business stability at high levels of production and employment. Current provisions gible for discount if the proceeds were to be used Experience led to significant revisions in the Act for speculative purposes, for fixed investment of which broadened member-bank access to Reserve any kind, or for the purpose of trading in securi Bank credit. Member banks may now obtain ties except United States Government securities. credit directly from a Reserve Bank for short In short, the philosophy of discount policy em periods by: (a) discounting eligible commercial bodied in the Federal Reserve Act was that the paper maturing in 90 days (except for agricul Reserve Banks should extend credit to member banks only for short terms and for commercial, tural paper which may have a maturity up to nine months) ; (b) borrowing on their own notes se industrial, and agricultural purposes. It was also cured by eligible paper or Government securities; believed that by confining discounts to eligible or (c) borrowing on their own notes secured by paper, as defined, the quantity of Reserve Bank any other assets satisfactory to the Reserve Bank credit would adjust automatically to the varying needs of commercial and business activities. but at a rate a/2 per cent above the discount rate. As a matter of convenience, member banks obtain Experience, especially in the thirties, revealed shortcomings in this early philosophy. Eligibility credit from the Reserve Banks almost entirely by borrowing on their own notes collateraled by requirements Government securities. proved ineffective in confining Reserve Bank credit to certain uses. Member The importance of administering the discount banks discounted or borrowed against eligible window in order to help maintain sound credit paper to meet reserve deficiencies. The type of conditions was also recognized. Borrowing from paper offered was no indication of the use made a Reserve Bank was clearly established as a privi or to be made of the proceeds. Actually, discounts lege, not a right. Section 4 as amended states that and advances supplied member banks with addi a Reserve Bank may extend to each member bank tional reserves. These reserves might be used for such discounts and advances “ as may be safely appropriate or inappropriate purposes. and reasonably made with due regard for claims A second difficulty was that eligibility require ments proved to be unduly restrictive at times. and demands of other member banks, the maintenance of sound credit conditions, and the 21 accommodation of commerce, industry, and agri general principles, however, that serve as guides culture.” Furthermore, each Reserve Bank is directed to in administering Reserve Bank loans and dis counts which can be summarized briefly. keep informed as to the general character and Even the most prudently managed bank may amount of loans and investments of its member experience reserve drains for a few days which banks to determine whether undue use is being made of bank credit for speculative purposes or occasionally reduce its daily average reserve bal ance below the legal minimum. Borrowing from for any other purpose inconsistent with the main the Reserve Bank is one way of meeting these tenance of sound credit conditions. In determin ing whether to grant or refuse credit to a member bank, the Reserve Bank shall give consideration short-term reserve deficiencies. Should the defi to such information. Finally, a Reserve Bank is to administer the adjustments in its assets as may be necessary. discount window, as well as its other affairs, “ fairly and impartially and without discrimina case of appropriate borrowing from a Reserve tion in favor of or against any member bank.” Authority was given to the Board of Governors pated and prepared for so long as they conform to past experience. But deposit losses may be to issue regulations further defining the condi exceptionally heavy, loan demands unusually tions under which Reserve Bank credit is to be strong, or both. Secondary reserves may not be extended to member banks. The latest revision sufficient to of Regulation A governing member-bank borrow requirements. Member banks may rightly turn to ing was made in 1955. The principal change was the discount window for additional funds. to put in a foreword to the regulation a statement ciency prove to be for a more extended period, borrowing gives the bank time to make such Unusual seasonal requirements are another Bank. Seasonal needs can be pretty well antici meet such unexpected seasonal There may be occasions when it is appropriate of general principles governing Reserve Bank for a member bank to borrow for a more extended loans and discounts to member banks. period. Sometimes local or national emergencies put severe pressure on banks’ liquid resources. Appropriate borrowing Considerable time may be required to make the Many member banks have been able to manage necessary adjustments and work out a solution. their asset and reserve positions without having It is recognized that in such infrequent and unus to borrow from a Reserve Bank. Over one-half of ual situations, borrowing for an extended period the member banks in this district have not bor may be appropriate in order that a bank may rowed since 1950. better meet community needs. It is not possible to pinpoint every case in which it is appropriate or inappropriate for a Inappropriate borrowing member bank to borrow from the Reserve Bank. Many member banks borrow from a Reserve Bank One of the lessons of experience is that the dis only as a last resort. Few attempt to borrow for count window cannot be properly administered inappropriate purposes. Those instances usually by mechanical rules. The conditions and needs arise from misunderstanding of the true function which give rise to borrowing vary. Each must be of the discount window. Final decision as to considered on its own merits. There are certain whether borrowing is inappropriate must take 22 into consideration the particular circumstances short maturities assumes the risk of incurring a of the individual borrower. There are certain larger capital loss should the securities have to general types, however, which usually fall in the be liquidated to meet expanding credit demands inappropriate category. or other purposes. The inducement of a higher Borrowing to finance speculative activities— return on longer maturities should be weighed whether in securities, real estate, or commodities against the risk incurred. Extending credit to — is an inappropriate use of Reserve Bank credit. member banks to enable them to meet loan Paper drawn for such purposes has been ineli demands without liquidating investments is incon gible for discount from the beginning of the sistent with the Federal Reserve’s responsibility System. Such use of Reserve Bank credit is unde for “ maintaining sound credit conditions.” This sirable from the standpoint of both the individual kind of discount policy would seriously weaken bank and monetary policy. Commercial bank offi efforts to curb inflation during periods of strong cials have long frowned on loans to finance spec credit demand. ulative activities. Experience has demonstrated Continuous borrowing, except in an emergency that such loans are risky and all too frequently or some unusual situation, is also inconsistent lead to financial difficulties. Even if safe for the with the principles embodied in the Federal individual lender, loans for purposes of specula Reserve Act. The purpose of the discount window tion have a disruptive influence on the economy. is to make Reserve Bank credit directly available Certainly, supplying member banks with reserves to member banks for temporary needs. Borrow to support speculative loans is inconsistent with ing for a short period also gives a bank time to administering the discount window in such a way as to “ maintain sound credit conditions” as pro make such adjustments in its assets and lending policies as may be required in meeting longer- vided in the Federal Reserve Act. Borrowing to finance a member bank’s own term requirements. investments is contrary to the spirit of the Federal intended to be a source of capital to supplement Borrowing from the Reserve Bank was never Reserve Act. Investment is not a short-term, tem a bank’s own resources. Even before the Federal porary need which bank management cannot Reserve System was formed, continuous borrow reasonably anticipate. Borrowing to purchase ing from correspondent banks was frowned upon securities for its own account is, in essence, an because experience had clearly demonstrated that open-market operation conducted at the initia a bank with a large debt was in a poor position tive of the member bank instead of the Federal to cope with hard times. Continuous borrowing, Reserve System. Such borrowing, if widely prac it should be noted, refers not only to consecutive ticed, would seriously impair Federal Reserve days but also to consecutive reserve periods. A member bank borrowing $7 million for one day control over the supply of reserves and therefore its ability to regulate credit and the money supply increases its daily average reserve balance by the in the interest of price and economic stability. same amount as by borrowing $1 million for Similar in principle is borrowing from a Reserve Bank to avoid liquidating investments at seven days. Borrowing to earn a rate differential or to gain a capital loss. Bank management in deciding to a tax advantage are other purposes which are invest surplus funds in longer-term rather than considered inappropriate. 23 THE DISCOUNT RATE The policy of a penalty rate, long adhered to by the Bank of England, is based on the cost effect of Discount policy is designed to promote sound the discount rate. The objective is to keep the dis banking practices and to maintain sound credit count rate above the rates received by the bor conditions. It establishes the framework within rower on its own loans and investments so that the which member banks have direct access to central bank will be used only as the lender of last Reserve Bank credit. The principles followed in resort. In England this means keeping the Bank administering the discount window do not change rate (the discount rate) above market yields on from recession to boom. The discount rate, however, is one of the prin Treasury bills and short-term paper, which ac count for the bulk of the assets of the discount cipal tools used in combating inflationary and houses. Commercial banks in need of funds call recessionary tendencies. There are three principal channels through which changes in the discount some of their loans to the discount houses, forcing them to borrow from the Bank of England. The rate may influence the volume of reserves, the discount rates of the Reserve Banks have rarely, cost of credit, and the flow of total spending. The direct effect is to raise or lower the price of admission to the discount window. An increase in the discount rate makes it more expensive and tends to discourage member-bank borrowing; a reduction tends to have the opposite effects. if ever, been used as a penalty rate in this sense. To serve as a real penalty rate, the discount rate would have to be higher than the rates received by member banks on the bulk of their loans and investments. A second and more important channel is the The cost effect of a change in the discount rate influence of the discount rate on the whole struc cannot be isolated from other factors influencing ture of market rates. There is a close interrelation the volume of member-bank borrowing. Obvi ship between the discount rate and short-term ously, an important influence is whether condi market rates because the Reserve Banks and the tions are such that banks feel the need for money market are alternative media for adjust additional funds. Given such needs, cost is a ing cash and reserve positions. If the discount factor influencing their willingness to borrow rate is above market rates on Treasury bills and from the Reserve Banks. As the discount rate is other short-term securities, there is an incentive increased, the rising cost of borrowed reserves for banks to liquidate short-term investments in is an incentive for bankers to screen their loan stead of borrowing from the Reserve Bank. applications more carefully to reduce the need Increased liquidation of short-term securities for borrowing. The discount rate, if raised high tends to push short-term rates up to the discount enough, can be a strong deterrent to obtaining rate. If the discount rate is below market rates, it additional reserves by borrowing from the Re is cheaper for member banks to borrow from the serve Banks. On the other hand, a reduction in Reserve Banks than to obtain funds by liquidating the discount rate tends to increase the willingness securities in the market. The availability of of banks to borrow so long as they need addi reserves at the discount window at a lower rate, tional reserves. The discount rate is an essential by diminishing the sale of securities, tends to but not in itself an adequate tool for regulating lower short-term rates. The discount rate has the supply of member-bank reserves. little influence on market rates when reserves are 24 so plentiful that member banks do not need to borrow. Changes in the discount rate, mainly through Developing recessionary tendencies had created uncertainty as to the future of business and inter est rates. The reduction in the discount rate the more direct effect on short-term rates and seemed to remove all doubt that the future course expectations (which will be discussed later) also of interest rates was downward. As a result, influence intermediate and long-term rates. A rise investors and speculators moved promptly to in in short-term rates, for example, makes short crease their holdings of Government securities maturities more attractive relative to intermediate and other fixed income obligations. The shift in and longer maturities. As investment funds are expectations was an important reason for the diverted into shorter maturities, intermediate and sharp decline in market rates. long-term rates tend to rise. Thus a change in the The effect on spending and the volume of busi discount rate tends to be reflected in the entire ness activity is not so clearly discernible. A reduc structure of market rates, although the effect on tion in the discount rate, by inducing expectations the rates of shorter maturities is more direct and of easier money and lower interest rates, may also usually more pronounced. A change in the dis result in more favorable anticipations with respect count rate sometimes induces banks to make a to the volume of business and tend to bolster similar change in their rates on customer loans. spending. It may be interpreted, however, as an The effect on market rates is one of the more indication that Federal Reserve officials anticipate important channels through which discount-rate slackening business activity and the initial effect action affects spending. The impact is likely to be on spending may be adverse. Public reaction to a greater on borrowing for capital expenditures than borrowing for working capital purposes. change in the discount rate is often capricious. The effect on expectations, therefore, cannot be When long-term rates are relatively high and the accurately anticipated. bond market is weak, borrowers are more reluc tant to float new bond issues to finance capital The role of the discount rate is such that a expenditures. There is a tendency to defer new change does not always represent a change in Federal Reserve credit policy. It may be only a offerings pending a more favorable market. Ris technical adjustment to bring the discount rate ing long-term market rates, by making bonds closer into line with market rates as a means of maintaining the existing degree of restraint or more attractive relative to mortgages, also tend to reduce the flow of funds into mortgages. Declin ing long-term rates, on the other hand, tend to ease. If as a result of open-market policy, reserve stimulate the flow of funds into capital expedi- market rates above the discount rate, an increase tures and mortgages. in the latter may be required to maintain the exist availability relative to credit demands has lifted The effect on expectations is a third channel ing degree of restraint. Otherwise, member banks through which changes in the discount rate may would seek relief from the higher rates by bor influence spending and the volume of business rowing at the discount window, thus relieving activity. The public tends to interpret a change in some of the pressure on the market and market the discount rate as a signal of Federal Reserve rates. credit policy. The reduction in the discount rate The close interrelationship between open- in November 1957 was an excellent illustration. market operations and the discount rate is the 25 reason use of these two instruments is coordi financial transactions which are constantly shift nated. In a period of expansion, when the objec ing funds among banks. As a means of meeting tive is one of restraint, open-market operations temporary reserve needs, such loans have the may be directed toward supplying less reserves advantages of channeling reserves directly to the credit banks which need them, and with a string demands, thus forcing member banks to obtain attached. Once the need is over, member banks additional reserves by borrowing. The reluctance repay their indebtedness and the reserves are of many banks to be in debt to the Reserve Bank extinguished. causes them to screen their loan applications more carefully. For maximum effectiveness, however, Unlimited access to the discount window would be inconsistent with maintaining sound credit the discount rate should be kept close to or above conditions and an effective monetary policy. Dis market rates. When the objective is easier credit, the effect of reducing the discount rate can be count policy is designed to afford member banks ready access to reserves for temporary and emer substantially augmented by supplying enough gency needs but without impairing the ability of reserves through open-market operations to re the Federal Reserve to regulate reserves and the duce substantially member-bank indebtedness to money supply in order to help maintain sustain able economic growth without inflation or defla than are needed to meet expanding the Reserve Banks. tion. If it were not for discount policy, the discount rate would probably have to be raised IN CONCLUSION higher — perhaps much higher — in periods of The principles underlying current discount policy strong credit demand to restrict sufficiently the and use of the discount rate developed from many availability of reserves to prevent excessive credit years of experience both here and abroad. The expansion. The result might well be a severe discount window was the primary source of penalty on member banks needing to borrow to reserves, and the discount rate the primary instru cover short-term deficiencies which could not ment of monetary policy in the early years of the reasonably be anticipated. Federal Reserve System. Although open-market The discount rate, although not the preeminent operations have since become the principal instru tool of the early years of the Federal Reserve ment for regulating the total supply of reserves, System, is an important instrument of monetary the discount window and the discount rate con policy. Directly, it operates as a cost, influencing tinue to play significant roles in Federal Reserve somewhat the willingness of member banks to policy. borrow from the Reserve Banks. Indirectly, it Reserve Bank loans to member banks make a affects the structure of market rates. Use of the significant contribution toward smoothing out the discount rate and open-market operations are day-to-day and month-to-month stresses and strains generated by a multitude of business and 26 coordinated because each helps to make the other more effective. OPERATIONS OF THE BANK Less pressure on reserve positions was reflected in were outstanding exceptions. Transactions in a sharp drop in the volume of credit extended to marketable Treasury securities also increased slightly in dollar volume, but not in number. member banks— from a daily average of $66 mil lion in 1957 to $13 million in 1958— although the The non-official staff, including part-time em number of borrowing banks declined only from 198 to 182. In line with a somewhat lower level ployees, decreased from 1,056 to 997. This de crease was principally in the check collection of general business activity, the dollar volume of department, due in part to discontinuance of part- transactions also declined in several other de time employees in the twilight force and a change partments of the Bank. Decreases were reported in the issuance of Treasury checks which reduced in checks handled, currency counted, clearing the number of card checks processed here. operations incident to direct sendings and wire Many steps have been taken in past years to and group clearings plans, the processing of improve operating efficiency and the services postal receipt remittances, and in savings bond rendered to banks and the Treasury. One of the transactions. Substantial increases in transfers of funds handled by the Bank and in coins counted latest innovations was the introduction of equip ment to speed up and facilitate the inscription of 27 savings bonds. Possibilities for the use of more national security preparedness programs. These advanced equipment and electronic methods are programs are designed to assure continuity of the constantly being explored, including active prepa nation’s banking system and the maintenance and ration for electronic check handling. Three com stabilization of the economy under emergency conditions. mittees— operations, training and rotation, and space— were set up early in 1958 to promote over all efficiency and flexibility. The Internal planning at this Bank for the re-estab- operations lishment and conduct of essential operations committee acts in an advisory capacity on prob lems assigned to it that involve internal proce under emergency conditions includes the daily dispatch of copies of vital records to a relocation dures. The development of employee capabilities office, the development of simplified manuals of and opportunities is the concern of the training operating procedure for use at that office, and the and rotation committee. Effective utilization of preparation of emergency operating circulars for space and the best placement of departments with distribution to all banks in the Third Federal respect to the flow of work and public contacts Reserve District, and instructions to Third Dis are the field of the committee on space. trict banks selected to act as emergency agents of Informational services and the maintenance of mutually rewarding relations with banks and the this Bank for certain functions. Discussions are public continue to be one sector of the Bank’s program. In part this involves the dissemination associations relative to the designation of check and cash agent banks. being held with member banks and clearing house of data on current banking and business condi The general program of emergency planning tions and publications helpful to an understanding by individual commercial banks received added of Federal Reserve operations. Other facets in impetus this year by the distribution to all banks clude numerous addresses before business, bank of five of a series of nine booklets on emergency ing, and educational groups; field meetings which planning to be published under the auspices of the reach bankers in all parts of the District; tours of National Committees on commercial bank pre the Bank; and the lending of films dealing with the Federal Reserve System. paredness. Greater emphasis is also being given in this District to such planning by state super Emergency planning visory agencies and the various state, county, and local banking associations. As a part of this pro The Federal Reserve System has been charged with certain responsibilities in the development of gram, officers of this Bank have already addressed several associations on the subject. 28 DIRECTORS A .N T D o: The election of directors to serve for terms of three years from January I, 1959 resulted in the election of O. Albert Johnson, President of the First National Bank of Eldred, Pennsylvania, by banks in Group 3 to serve as a Class A director, succeeding Lindley S. Hurff. Banks in Group I elected Frank R. Palmer, President of the Carpenter Steel Company, Reading, Pennsylvania, as a Class B director to succeed Charles E. Oakes. The Board of Governors of the Federal Reserve System reappointed Henderson Supplee, Jr., as a Class C director of the Bank for a term of three years from January 1, 1959. Mr. Supplee will continue as Chairman of the Board and Federal Reserve Agent during 1959, and Lester V. Chandler as Deputy Chairman. Casimir A. Sienkiewicz was reappointed by the Board of Directors of the Bank to represent the Third Federal Reserve District on the Federal Advisory Council during 1959. Retirements over the past year included Alfred H. Williams, President of the Bank, W . J . Davis, First Vice President, and two Vice Presidents— William G . M cCreedy and Ernest C. Hill. Karl R. Bopp was appointed President and Robert N. Hilkert, First Vice President. Other changes in the official staff are reflected in the list given on page 31. 29 Term expires December 31 Group CLASS A 1 GEOFFREY S. SMITH President, Girard Trust Corn Exchange Bank, Philadelphia, Pennsylvania 1959 2 WILLIAM B. BROSIUS President, National Bank of Chester County and Trust Company, West Chester, Pennsylvania 1960 3 0 . ALBERT JOHNSON President, The First National Bank of Eldred, Eldred, Pennsylvania 1961 CLASS B 1 FRANK R. PALMER President, The Carpenter Steel Company, Reading, Pennsylvania 1961 2 R. RUSSELL PIPPIN Treasurer, E. I. du Pont de Nemours & Company, Wilmington, Delaware 1959 3 BAYARD L. ENGLAND President, Atlantic City Electric Company, Atlantic City, New Jersey 1960 CLASS C HENDERSON SUPPLEE, JR.,Chairman President, The Atlantic Refining Company, Philadelphia, Pennsylvania 1961 LESTER V. CHANDLER, Deputy Chairman Professor of Economics, Princeton University, Princeton, New Jersey 1959 WALTER E. HOADLEY, JR. Treasurer, Armstrong Cork Company, Lancaster, Pennsylvania 1960 JA N U A R Y 1059 KARL R. BOPP President ROBERT N. HILKERT First Vice President HUGH BARRIE Assistant Vice President JOSEPH R. CAMPBELL Vice President NORMAN G. DASH Assistant Vice President WALLACE M. CATANACH Vice President ZELL G. FENNER Assistant Vice President DAVID P. EASTBURN Vice President GEORGE J. LAVIN Assistant Vice President and Assistant Secretary MURDOCH K. GOODWIN Vice President, General Counsel and Assistant Secretary HARRY W. ROEDER Assistant Vice President PHILIP M. POORMAN Vice President JOSEPH M. CASE Chief Examiner JAMES V. VERGARI Vice President and Cashier RALPH E. HAAS Assistant Cashier RICHARD G. WILGUS Vice President and Secretary ROY HETHERINGTON Assistant Cashier EVAN B. ALDERFER Economic Adviser WILLIAM A. JAMES Personnel Officer CLAY J. ANDERSON Economic Adviser FRED A. MURRAY Director of Plant JOHN R. BUNTING, JR. HENRY J. NELSON Assistant Cashier Business Economist EDWARD A. AFF Assistant Vice President RUSSELL P. SUDDERS Assistant Cashier HERMAN B. HAFFNER General Auditor 31 STA.TEME2XTX OF CONDITION FEDERAL RESERVE BANK OF PHILADELPHIA End of Y e a r (000's omitted in d ollar figures) 1958 1957 1956 $1,037,847 60,195 $1,182,730 60,901 $1,051,274 63,053 $1,098,042 47,991 16,950 $1,243,631 38,556 15,057 $1,1 14,327 35,132 13,116 6,720 7,975 439 1,478,817 ASSETS Gold certificate reserves: Gold certificates............................................. Redemption fund—Fed. Res. notes................ Total gold certificate reserves.................. Fed. Res. notes of other Fed. Res. B a n k s......... O ther c a s h ........................................................... Loans and securities: Discounts and a d v a n c e s ............................... United States Governm ent securities........... 1,509,042 5,490 173 1,384,545 Total loans and securities......................... Due from foreign b a n k s.................................... Uncollected item s............................................... Bank p re m is e s .................................................... A ll other assets.................................................... $1,515,762 1 332,939 4,245 8,181 $1,390,208 1 345,425 4,513 12,740 $1,487,231 2 405,812 4,781 14,885 Total assets................................................. $3,024,1 1 1 $3,050,131 $3,075,286 Federal Reserve notes........................................ Deposits: M em ber bank reserve accounts.................... United States G o vern m en t........................... Foreign ........................................................... O ther deposits............................................... $1,751,391 $1,738,756 $1,756,490 863,417 22,996 16,215 4,013 874,740 30,221 23,870 12,955 859,677 27,841 21,312 16,865 Total deposits............................................. Deferred a v a ila b ility item s............................... A ll other lia b ilitie s ............................................. $ LIABILITIES Total lia b ilitie s ........................................... CAPITAL 906,641 275,287 1,253 $2,934,572 $ 941,786 279,334 623 $ 925,695 306,868 800 $2,960,499 $2,989,853 $ $ ACCOUNTS C ap ital paid in .................................................... $ 21,894 Surplus—Section 7 ............................................... 59,607* Surplus—Section 1 3 b ........................................... ............................... Reserves for contingencies 8,038 Total liabilities and capital accounts. . . Ratio of gold certificate reserves to deposit and Federal Reserve note liabilities c o m b in e d ........................................................ Commitments to m ake industrial ad vances. . . $3,024,1 1 1 4 1 .3 % — 21,192 55,923 4,489 8,028 20,629 52,301 4,489 8,014 $3,050,131 $3,075,286 4 6 .4 % $26 4 1 .5 % $15 * Includes $291,000 transferred from Surplus— Section 13b in connection with repayment of $4,198,000 advances previously received from U. S. Treasury under Section 13b of the Federal Reserve Act. 32 FEDERAL RESERVE BANK OF PHILADELPHIA (000's omitted) 1958 1957 1956 Earnings from: U. S. Governm ent securities........................... $42,317 $43,036 $34,351 O ther sources................................................. 341 2,172 1,940 Total current e a rn in g s............................... $42,658 $45,208 $36,291 O perating ex p en ses*.................................... $ 6,810 $ 6,494 $ 6,294 Cost of Federal Reserve currency................ 210 211 293 ................................................. 408 528 383 Total net expenses.................................... $ 7,428 $ 7,233 $ 6,970 Current net e a rn in g s........................................... $35,230 $37,975 $29,321 $ $ $ Net expenses: Assessment for expenses of Board of Governors Additions to current net earnings: Profits on sales of U. S. Governm ent securities (n e t)............................................. 10 10 16 Reimbursement for fiscal agency expenses incurred in prior y e a r s .............. 113 — — $ 10 $ 123 $ 17 $ 10 $ 14 $ 16 619 $ 17 $ -496 $ $35,229 $37,479 $29,321 30,541 32,594 25,296 .......................................................... 1,294 1,263 1,215 Transferred to Surplus (Section 7 ).................... $ 3,393 $ 3,622 $ 2,811 Total ad d itio n s........................................... Deductions from current net earnings: Reserves for contingencies........................... Retirement System (adjustment for 604 1 Total deductions........................................ $ Net additions or deductions (— ) ...................... $ 11 -1 1 $ Net earnings before payments to U. S. Treasury .......................................................... Paid to U. S. Treasury (interest on Federal Reserve notes)................................................. Dividends After deducting reimbursable or recoverable expenses. VOLUME OF OPERATION S FEDERAL RESERVE BANK OF PHILADELPHIA Num ber of pieces (000's omitted) Collections: O rd in a ry ch eck s*........................................... Governm ent checks (paper and c a rd )......... Postal money orders (c a rd )........................... Non-cash item s............................................... Clearing operations in connection with direct sendings and w ire and group clearings p la n s * * ........................................... Transfers of fu n d s............................................... Currency counted............................................... Coins counted...................................................... Discounts and advances to member banks. . . Depositary receipts for withheld ta x e s........... Postal receipts (rem ittances)............................. Fiscal agency activities: M arketable securities delivered or redeem ed ................................................. Savings bond transactions— (Federal Reserve Bank and agents) Issues (including re-issues)....................... Redemptions ............................................. Coupons redeem ed (Governm ent and ag encies)......................... D ollar amounts (000,000's omitted) Collections: O rd in ary checks............................................. G overnm ent checks (paper and c a rd )......... Postal money orders (ca rd )........................... Non-cash item s............................................... Clearing operations in connection with direct sendings and w ire and group clearings plans* * ........................................... Transfers of fu n d s............................................. Currency counted............................................... Coins counted...................................................... Discounts and advances to member banks. . . Depositary receipts for w ithheld ta x e s........... Postal receipts (rem ittances)............................. Fiscal agency activities: M ark etab le securities delivered or redeem ed ................................................. Savings bond transactions— (Federal Reserve Bank and agents) Issues (including re-issues)....................... Redemptions ............................................. Coupons redeem ed (Governm ent and ag encies)......................... * Checks handled in sealed packages counted as units. ** Debit and credit items. # Revised. 1958 1957 1956 168,000 26,400 19,700 800 162,800 46,600 21,900 1,000 163,100 44,200 23,600 1,000 792 119 303,100 511,500 1 492 347 864 115 314,600 425,000 2 486# 423 940 106 304,900 395,900 3 463 462 334 345 213 7,930 6,223 8,944 7,461 7,909 6,548 941 906 789 $61,100 4,890 306 140 $63,206 5,876 337 156 $60,927 6,970 346 190 31,004 58,972 2,072 52 1,559 1,806 825 31,194 49,315 2,120 45 1 1,903 1,799 870 30,793 49,524 2,049 44 11,731 1,619 819 10,832 10,798 8,035 413 462 444 620 467 521 112 101 93 Additional copies of this issue are available upon request to the Department of Research, Federal Reserve Bank of Philadelphia, Philadelphia 1, Pa.