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F ederal Reserve Bank o f Dallas

DALLAS, TEXAS

75222
C irc u la r No. 78-153
October 26, 1978

OPEN MARKET OPERATIONS BOOKLET AVAILABLE

TO THE CHIEF EXECUTIVE OFFICER
OF THE MEMBER BANK ADDRESSED IN THE
ELEVENTH FEDERAL RESERVE D IS T R IC T:

In an effort to educate the pu b lic about the formulation and
execution of monetary p o lic y , Paul M eek, M onetary A d v is e r in the
Federal Reserve Bank of New Y o rk 's Open M arket Operations and
T re a s u ry Issues a reas , has w ritte n the enclosed booklet, entitled
Open M a r k e t Ope ration s. T h e booklet explains the Federal Reserve's
open m arket operations in United States Governm ent securities. In
Open M a r k e t Operations, Meek has captured some of the challenge of
translating broad policy objectives into d a y -to -d a y operations, g iv in g
p a rtic u la r emphasis to monetary and c re d it aggregates as objectives
of policy.
A dditional copies of this booklet may be obtained free of
charge from the Bank and Public Information Departm ent of this Bank,
E x t. 6267.
S in ce re ly yo u rs ,
Ernest T . Baughman
President
Enclosure

Banks and others are encouraged to use the fo llo w in g incom ing WATS numbers in contacting this Bank:
1-800-492-4403 (intrastate) and 1-800-527-4970 (interstate). For calls placed locally, please use 651 plus
the extension referred to above.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Open M arket
Operations
by Paul M eek
Federal Reserve
Bank of New York

FOREWORD
F e w a re a s of e c o n o m ic s s e e m to m y s tify the
g e n e ra l p u b lic m o r e th a n F e d e ra l R e s e rv e o p e n
m a r k e t o p e ra tio n s in U n ite d S ta te s G o v e r n m e n t
s e c u ritie s . T o th o s e of us in th e F e d e ra l R e s e rv e
S y s te m , h o w e v e r, fe w a re a s a re m o r e fa s c in a tin g .
It is th r o u g h th e tr a d in g of U.S. G o v e r n m e n t s e c u ­
ritie s in the o p e n m a r k e t th a t w e try to o ffs e t
u n d u e s tre s s e s on o u r m o n e t a r y m a c h in e r y and
in flu e n c e the e c o n o m y by a ff e c tin g th e c o s t a n d
a v a ila b ility of c re d it.
Paul M e e k , M o n e ta ry A d v is e r in this B a n k ’s O p e n
M a r k e t O p e r a tio n s a n d T re a s u ry Iss u e s are a , has
s o u g h t to c a p tu r e s o m e of th e c h a lle n g e th a t w e
in th e S y s te m feel in tr a n s la tin g b ro a d p o lic y
o b je c t iv e s in to d a y -to -d a y o p e ra tio n s . H e has
p o r tra y e d o p e n m a r k e t o p e r a t io n s in th e ir c u r r e n t
s e ttin g w ith p a r t ic u la r e m p h a s is on m o n e t a r y and
c r e d it a g g r e g a te s as o b je c t iv e s of policy.
The a u th o r has b e e n a s s is te d w ith th is fo u r th
e d itio n by th e P u b lic In f o r m a t io n D e p a r tm e n t.
M a n y o th e r s w ith in the B a n k h a v e c o n tr ib u t e d
c o m m e n t s a n d s u g g e s tio n s .
W e h o p e O p e n M a r k e t O p e r a tio n s w ill s tim u la te
re a d e rs to lea rn a b o u t th e fo r m u la t io n a n d e x e c u ­
tio n o f m o n e t a r y p o lic y .
T h o m a s M. T im le n
F irs t V ic e P re s id e n t
Ju n e 1978

THE “ GO-AROUND”
T he tim e is ju s t b e fo r e noo n on th e T u e s d a y
b e fo r e T h a n k s g iv in g D ay. T h e p la c e is th e e ig h th
flo o r tr a d in g ro o m of the F e d e ra l R e s e rv e B a n k of
N e w Y o rk. T he M a n a g e r o f th e F e d e ra l R e s e rv e
S y s te m 's O p e n M a r k e t A c c o u n t has m a d e his
d e c is io n . H e te lls his s e c o n d in c o m m a n d to b u y
a b o u t $ 5 0 0 m illio n in U n ite d S ta te s T re a s u ry bills
fo r im m e d ia t e d e liv e ry.
T he d e c is io n m a d e , the o ffic e r -in - c h a rg e tu rn s to
th e te n o ff ic e r s a n d s e c u ritie s tr a d e rs w h o sit
b e fo re te le p h o n e c o n s o le s linking th e m to m o re
th a n 3 0 p r im a r y d e a le rs in U.S. G o v e r n m e n t s e c u ­
rities. “ W e ' r e g o in g in to a sk fo r o ffe rin g s o f all
bills fo r c a s h , " he says. E ach p e rs o n is q u ic k ly
a s s ig n e d tw o to fo u r d e a le rs to call.
Joan, a N e w Y ork Federal Reserve trader, presses
a b u tto n on h e r te le p h o n e c o n s o le , s o u n d in g a
b u z z e r at the c o rr e s p o n d in g c o n s o le o f a G o v e r n ­
m e n t s e c u r itie s d e a le r.
“ J a c k , ” Jo a n sa ys, “ w e a re loo k in g fo r o ffe rin g s
of all bills fo r c a s h d e liv e r y .”
J a c k replies, " I ' l l be b a c k in a m i n u t e . ” The s a le s ­
m e n o f his fir m q u ic k ly c o n t a c t c u s t o m e r s to see
if th e y w is h to m a k e o ffe rin g s . J a c k c o n s u lt s the
p a rtn e r in c h a r g e a b o u t h o w a g g re s s iv e he s h o u ld
be in o ff e rin g th e f i r m 's o w n h o ld in g s.
T en m in u te s la te r J a c k c a lls b a ck . “ Jo a n , I c a n
o ffe r yo u fo r c a s h $5 m illio n o f J a n u a ry 5 bills to

y ie ld 5 .85 p e r c e n t — $ 1 0 m illio n of J a n u a r y 26 bills
at 5 .9 0 — $ 2 0 m illio n of M a r c h 23 bills a t 6 .0 5 —
and $ 3 0 m illio n o f M a y 30 bills at 6 .1 4 .”
J o a n sa ys, " C a n I h a v e th o s e o ffe rin g s fir m fo r a
fe w m in u te s ? ”
“ S u r e .”
W ith in m in u te s th e “ g o - a r o u n d ” is c o m p le te d . The
tr a d e rs h a ve r e c o r d e d th e o ffe rin g s o b ta in e d fr o m
th e ir c a lls on s p e c ia l p r e p r in te d strip s. T he offic e r- in -c h a rg e a rr a y s th e in d iv id u a l d e a le r o ffe rin g s
on an in c lin e d b o a rd a to p a s ta n d -u p c o u n te r . A
ta lly s h o w s th a t d e a le r s h a ve o ffe re d $ 1.8 b illio n
o f b ills fo r c a s h s a le — th a t is, w it h d e liv e ry a n d
p a y m e n t th a t v e ry day.
T he o f f ic e r th e n b e g in s c irc lin g w ith a red p e n c il
th e o ffe rin g s th a t p ro v id e the b e s t— th a t is the
h ig h e s t— rate o f re tu rn fo r e a c h issue. T h e large
q u o ta tio n b o a rd fa c in g the o p e n end of the
U -sh a p e d tr a d in g d e s k te lls h im th e y ie ld s on
T r e a s u ry bills as th e y w e r e in th e m a r k e t ju s t
b e fo re the “ g o - a r o u n d ” beg a n . A n a s s o c ia te
k e e p s a ru n n in g to ta l of th e a m o u n t s bein g
b o u g h t. W h e n th e d e s ir e d a m o u n t has bee n
c irc le d , th e in d iv id u a l s trip s a re re tu rn e d to the
tra d e rs , w h o q u ic k ly te le p h o n e th e d e a le r firm s .
“ J a c k , w e ’ ll ta k e th e $5 m illio n of J a n u a ry 5 bills
at 5 .85 a n d th e $ 3 0 m illio n of M a y 30 b ills a t 6 .14
b o th fo r ca s h ; no, th a n k s , on th e o t h e r s , ” J oan
says.

F o rty -fiv e m in u te s a fte r the initial d e c is io n , the
c a lls h a v e b e e n c o m p le te d , a n d $ 5 2 3 m illio n in
T re a s u ry bills p u rc h a s e d . O n ly th e p a p e r w o r k
re m a in s . T h e tr a d e rs w r it e u p tic k e ts , w h ic h
p ro v id e th e b a s ic a u th o r ity fo r th e B a n k ’ s g o v e r n ­
m e n t b o n d d e p a r t m e n t to re c e iv e a n d p a y fo r the
s p e c if ic T re a s u ry bills b o u g h t. The b a n k s th a t
h a n d le the d e a le r s ' d e liv e r ie s — th e c le a r in g b a n k s
— w ill a u th o r iz e d e d u c tio n s o f th e s e c u r itie s fr o m
th e b o o k e n tr y list of th e ir h o ld in g s at th e F e d e ra l
R ese rve . In re tu rn , th e y w ill re c e iv e c r e d it to the
re s e rv e a c c o u n ts the b a n k s m a in ta in at the N e w
Y o rk R e s e rv e Bank.
T h e F e d e ra l R e s e rv e c r e d its to the d e a le r s ’ b a n k s
im m e d ia t e ly a d d s o v e r $ 5 0 0 m illio n to the re s e rv e s
of th e U.S. b a n k in g s y s te m .
T h e F e d e ra l R e s e r v e 's m a r k e t e n try s p a rk s
h u rrie d c o n s u lt a tio n s at d e a le r fir m s a n d m a n y
c o m m e r c ia l b a n k s th r o u g h o u t th e c o u n tr y . C o u ld
th e F e d e ra l R e s e rve h a v e b e e n try in g to p u sh
d o w n th e in te re s t rate on F e d e ra l f u n d s — in te r­
b a n k lo a n s u s u a lly m a d e fo r o n e b u s in e s s d a y —
to e n c o u r a g e a m o re ra p id g r o w th o f m o n e y and
c r e d it in th e c o u n tr y ? O r w a s it m e r e ly s u p p ly in g
r e s e rv e s to th e b a n k s to m e e t the p u b lic 's n o rm a l
d e m a n d s fo r c a s h a n d c r e d it a ro u n d T h a n k s g iv in g ?
S u c h q u e s tio n s ca n ra re ly be a n s w e r e d by a n a ly z ­
ing a s in g le F e d e ra l R e s e rv e m a r k e t o p e ra tio n .
B u t th e y u n d e r s c o r e th e k e e n in te re s t o f b a n k e rs ,
b u s in e s s m e n , a n d g o v e r n m e n t s th r o u g h o u t the

w o r ld in k n o w in g th e c u r r e n t th r u s t o f U.S. m o n e ­
ta ry p o lic y . O p e n m a r k e t o p e ra tio n s c a n s e t in
m o tio n fin a n c ia l rip p le s th a t s p re a d ra p id ly to
a f f e c t the c o s t and a v a ila b ility of c r e d it in U n ite d
S ta te s a n d fo r e ig n fin a n c ia l m a rk e ts . E v e n tu a lly ,
th e e c o n o m i c e ff e c ts of s u s ta in e d F e d e ra l
R e s e rv e a c tio n a re fe lt at h o m e a n d a b ro a d .
U n d e r th e F e d e ra l R e s e rv e A c t, th e S y s te m uses
o p e n m a r k e t p u r c h a s e s a n d s a le s of G o v e r n m e n t
and F e d e ra l a g e n c y s e c u r itie s as its m o s t fle x ib le
m e a n s of a d d in g to, o r s u b tr a c tin g fr o m , c o m m e r ­
cial b a n k re s e rv e s . A ro u tin e o b je c t iv e o f th e s e
o p e ra tio n s is to h e a d o ff th e s tr e s s e s im p o s e d on
th e m o n e t a r y m a c h in e r y by s e a s o n a l, re g io n a l, or
e r r a t ic s h ifts in m o n e y . A lo n g e r te r m o b je c t iv e is
to fo s t e r m o n e t a r y a n d c r e d it c o n d it io n s th a t will
p r o m o t e a h e a lth y e c o n o m y . T he S y s te m d e fin e s
th e s e o b je c t iv e s in te r m s of g r o w th in v a rio u s
m e a s u r e s o f th e m o n e y s to c k a n d b a n k c r e d it
o v e r a 12-m o n th p e rio d . Its u ltim a te g o a ls a re
s u s ta in a b le e c o n o m i c g ro w th , h igh e m p lo y m e n t,
re a s o n a b le p ric e s ta b ility a n d v ia b ility in th e
n a t i o n ’s in te rn a tio n a l a c c o u n ts .

COPING W ITH MONETARY STRESSES
Banks and their reserve positions
T he U n ite d S ta te s b a n k in g s y s te m , like s y s te m s in
m o s t o th e r fin a n c ia lly d e v e lo p e d c o u n tr ie s , is
c a lle d a fr a c tio n a l re s e rv e s y s te m . U n d e r F e d e ra l
a n d s ta te law s, v ir tu a lly all o f th e n e a rly 14 ,7 0 0

c o m m e r c ia l b a n k s in th e U n ite d S ta te s m u s t
m a in ta in c a s h re s e rv e s e q u a l to a s p e c ifie d f r a c ­
tion o f th e ir d e m a n d d e p o s it s — th a t is, th e c h e c k ­
ing a c c o u n t s of th e ir d e p o s ito rs . M o s t m u s t m a in ­
tain r e s e rv e s fo r s a v in g s a n d o th e r tim e d e p o s its
a s w ell.
C o m m e r c ia l b a n k s w h ic h a re m e m b e r s o f th e
F e d e ra l R e s e rv e S y s te m h old a b o u t 75 p e r c e n t of
th e b a n k in g d e p o s its in th e U.S. M e m b e r b a n k s
in c lu d e all b a n k s c h a r t e r e d by th e F e d e ra l
G o v e r n m e n t — a b o u t 4 ,7 0 0 — a n d s ta t e - c h a r t e r e d
b a n k s th a t h a ve c h o s e n m e m b e r s h ip — a b o u t
1,000. T h e y a re le g a lly re q u ire d to h old th e ir
re q u ire d re s e rv e s e ith e r as c a s h in th e ir v a u lts or
d e p o s it b a la n c e s in re s e rv e a c c o u n t s at th e ir
d is t r ic t R e s e rv e B anks.
B a n k s th a t a re not Fed m e m b e r s a re s u b je c t to
the re s e rv e r e q u ir e m e n t s o f the s ta te s th a t c h a r ­
te re d th e m . A b o u t 8 ,9 0 0 s ta t e - c h a r t e r e d ba n ks,
a c c o u n tin g fo r a b o u t 25 p e r c e n t o f all b a n k a s se ts,
a re n o n m e m b e r s . T h e y hold re q u ire d re s e rv e s in
v a u lt c a s h , d e p o s it s w ith c o r r e s p o n d e n t ba n ks,
G o v e r n m e n t s e c u ritie s , or o th e r f o r m s p e r m itt e d
by b a n k in g la w s of th e ir c h a r t e r in g s ta te s. F or
s im p lic ity , th is d is c u s s io n f o c u s e s on m e m b e r
b anks.
C o n g r e s s d e le g a te d th e r e s p o n s ib ility fo r s e ttin g
m e m b e r b a n k re s e rv e re q u ire m e n ts , w ith in b ro a d
lim its, to th e S y s t e m ’s B o a rd o f G o v e r n o r s — a
s e v e n -m e m b e r, P r e s id e n t ia l ^ a p p o in te d g ro u p . In

1977, re s e rv e re q u ire m e n ts w e r e g ra d u a te d fro m
7 p e r c e n t on the firs t $2 m illio n of d e m a n d d e p o s ­
its to 16 Vi p e r c e n t on d e p o s its in e x c e s s of $ 4 0 0
m illio n . M e m b e r b a n k s m u s t a ls o m a in ta in
re s e rv e s of 3 p e r c e n t on s a v in g s d e p o s it s and
1 to 6 p e r c e n t on o th e r tim e d e p o s its . R ese rv e
re q u ire m e n ts m u s t be m e t fo r th e w e e k e n d in g on
W e d n e s d a y , th e “ s t a t e m e n t ” w e e k , a n d a re
b a s e d on th e d e p o s its on e a c h b a n k ’s b o o k s tw o
w e e k s e a rlie r.
As p ro fit-s e e k in g e n te r p ris e s , m e m b e r b a n k s try
to k e e p th e ir re s e rv e s , w h ic h p r o d u c e no in c o m e ,
c lo s e to th e re q u ire d m in im u m . Y et, th e y a ls o
w a n t to a v o id re s e rv e d e fic ie n c ie s on w h ic h the
F e d e ra l R e s e rv e m a y levy a p e n a lty c h a rg e .
M a n a g in g a b a n k ’ s re s e rv e p o s itio n c a n be a
try in g b u s in e s s . M o s t of the fin a n c ia l t r a n s a c tio n s
of a b a n k a n d its d e p o s ito rs a f f e c t th e b a n k ’ s
re s e rv e p o sitio n . C h e c k s d ra w n by d e p o s ito rs to
p a y o u t-o f-to w n bills, fo r e x a m p le , fu n n e l b a c k
th r o u g h its d is t r ic t R e s e rv e B ank a n d a re c h a rg e d
a g a in s t th e b a n k ’s re s e rv e a c c o u n t. A b a n k a ls o
lose s r e s e rv e s w h e n it p a y s o u t v a u lt c a s h . A n d
a b a n k is likely to lose re s e rv e s w h e n m a k in g
loa n s o r b u y in g s e c u ritie s . E a c h d a y a b a n k 's
re s e rv e p o s itio n re fle c ts the net re s u lt o f re s e rv e s
lost t h r o u g h s u c h tr a n s a c tio n s , on th e o n e hand,
a n d re s e rv e s b ro u g h t in, on th e o th e r, by c h e c k
and c u r r e n c y d e p o s its , ta x c r e d its to th e T re a s u ry
a c c o u n ts the bank h o ld s ,a n d its sales of securities.

A m e m b e r b a n k c a n e m p lo y s e v e ra l lines of
d e fe n s e if r e s e rv e s a re lost to o th e r b a n k s
th ro u g h the d a ily e b b a n d flo w o f tr a n s a c tio n s . It
m a y s e e k to b o r r o w re s e rv e s fo r o n e o r m o r e
d a y s fr o m o th e r b a n k s in the F e d e ra l fu n d s
m a rk e t. A b a n k c a n a ls o sell s h o rt-te r m G o v e r n ­
m e n t s e c u r itie s o r o th e r “ l iq u id ” — re a d ily m a r k e t ­
a b le — a s s e ts . S u c h s a le s e ff e c tiv e ly pull re s e rv e s
fr o m th e b a n k on w h ic h th e b u y e r ’ s c h e c k w a s
d ra w n . O r th e b a n k c o u ld bid fo r larg e d e p o s its ,
issuin g n e g o tia b le c e r t if ic a t e s o f d e p o s it (CDs) as
e v id e n c e o f its p r o m is e to re p a y w ith in te re s t in
30 d a y s o r lon g e r.
M e m b e r b a n k s h a v e a final d e fe n s e a g a in s t
u n fo r e s e e n re s e rv e lo s se s in th e ir p riv ile g e of
b o r r o w in g fr o m th e ir re g io n a l R e s e rv e Bank.
U s u a lly , th e y b o r r o w o n ly fo r s h o rt p e rio d s , on
th e ir o w n n o te s s e c u r e d by G o v e r n m e n t s e c u r i ­
ties o r o th e r a c c e p ta b le c o lla te r a l. T h e in te re s t
rate a m e m b e r b a n k p a y s on s u c h b o rro w in g is
th e R e s e rv e B a n k ’ s d is c o u n t rate.

The Federal Reserve steps in
O p e n m a r k e t o p e ra tio n s e n a b le th e F e d e ra l
R e s e rv e S y s te m to a f f e c t th e re s e rv e s of the
b a n k in g s y s te m a n d to re g u la te th e p re s s u re on
th e b a n k s to ta k e a c tio n . In d ivid u a l b a n k s c a n
m e e t th e ir re s e rv e re q u ire m e n ts by d ra w in g
re s e rv e s fr o m o th e r b a n ks. But, in the s h o rt run,
b a n k s as a g r o u p c a n o n ly p a ss a ro u n d the
re s e rv e s a v a ila b le — o r b o r r o w n e w re s e rv e s at

th e F e d e ra l R e s e rv e d is c o u n t w in d o w . O p e n
m a r k e t o p e ra tio n s a llo w the F e d e ra l R e s e rv e to
c h a n g e th e v o lu m e o f re s e rv e s a v a ila b le to
m e m b e r b a n k s b e fo r e th e y b o rro w fr o m th e
F e d e ra l R e s e r v e — th a t is, to m a n a g e n o n b o r ­
rowed reserves. In this w ay, the Fed ca n o ff s e t the
re se rv e s w in g s c a u s e d b y the p u b lic 's c h a n g in g
d e m a n d fo r c a s h a n d o th e r fa c to rs . By m a n a g in g
n o n b o rro w e d re s e rv e s , the Fed c a n a d ju s t the
p re s s u re on th e b a n k s to b o r r o w fr o m th e 12
re g io n a l F e d e ra l R e s e rv e B a n k s to c o v e r th e ir
re se rv e re q u ire m e n ts . By a d d in g m o re re s e rv e s
than th e b a n k s re q u ire , it c a n s tim u la te th e ir
e x p a n s io n of m o n e y a n d b a n k cre d it. A lt e r n a tiv e ­
ly, it ca n re s tra in th a t e x p a n s io n by h o ld in g b a c k
in s u p p ly in g re s e rve s.

An elastic currency
T h ro u g h o p e n m a r k e t p u rc h a s e s , the S y s te m c a n
re p la c e the re s e rv e s lost w h e n b a n k c u s to m e r s
d ra w c a s h fr o m th e ir b a n k s a ro u n d h o lid a y s like
T h a n k s g iv in g o r th e F o u rth of July. W h e n c o in a n d
c u r r e n c y a re re d e p o s ite d in th e b a n k s by
m e r c h a n t s a fte r th e h o lid a ys, o p e n m a r k e t s a le s
c a n c o m p e n s a t e fo r th e b u ild u p in v a u lt c a s h .
The e c o n o m y 's b ig g e s t a n n u a l nee d fo r c u r r e n c y
a nd c o in a ris e s as th e h o lid a y s h o p p in g s e a s o n
b u ild s to its c lim a x b e tw e e n the firs t o f N o v e m b e r
a nd C h ris tm a s . C o m m e r c ia l b a n k s s u p p ly c u s ­
to m e r s w ith p o c k e t m o n e y by o b ta in in g c u r r e n c y
fr o m the d is t r ic t R e s e rv e B a n k — d r a w in g d o w n

th e ir o w n re s e rv e a c c o u n ts (C h a rt I). If th e F e d e ra l
R e s e rv e d id n 't o ffs e t s u c h re c u rr e n t d ra in s on
b a n k re s e rve s, b a n k s w it h o u t e x c e s s re s e rv e s
w o u ld try to re b u ild th e ir re s e rv e p o s itio n s by b u y ­
ing fu n d s fr o m o th e r b a n k s (b id d in g up th e F e d e ra l
fu n d s rate), b y se lling s e c u ritie s , or by c a llin g
s h o rt-te r m loans.
S u c h a c tio n s w o u ld put s tro n g u p w a r d p r e s s u re
on in te re s t ra te s a n d c o u ld lead to s e rio u s m a r k e t
d is tu rb a n c e s . In deed, b e fo r e th e S y s te m w a s
e s ta b lis h e d , fin a n c ia l s tr a in s of this ty p e b e c a m e
s o s e v e re on a fe w o c c a s io n s th a t th e y to u c h e d
o ff fin a n c ia l p a n ic s th a t re d u c e d e c o n o m i c a c t iv ­
ity. A p a n ic in 1907 se t o ff th e s e a rc h fo r a m e t h ­
od of a s s u rin g th a t c u r r e n c y e x p a n d e d a n d c o n ­
tr a c te d w ith the n e e d s o f th e e c o n o m y . T his
s e a rc h led to th e p a s s a g e of the F e d e ra l R e s e rv e
A c t in 1913.
T h e m o v e m e n t of c u r r e n c y in to c ir c u la t io n a ro u n d
h o lid a y s is r e a s o n a b ly p re d ic ta b le . B ut a n o th e r
f a c t o r a ff e c tin g b a n k re s e rv e p o s it io n s — k n o w n as
F e d e ra l R e s e rv e flo a t— is ra th e r e rr a tic . Flo a t
a ris e s m a in ly in the c h e c k c o lle c tio n p ro c e s s . A
m e m b e r b a n k s e n d s c h e c k s fo r c o lle c tio n to its
R e s e rv e Bank. T he R e s e rv e B a n k c r e d its th e
m e m b e r ’s re s e rv e a c c o u n t w ith in a m a x im u m of
tw o b u s in e s s da ys, e v e n th o u g h th re e o r m o re
d a y s a re o fte n n e e d e d to c o lle c t fu n d s fr o m the
b a n k s on w h ic h th e y a re d ra w n . As a re su lt, the
R e s e rv e B a n k s c u s t o m a r il y s h o w on th e ir b o o k s

m o re d o lla rs d u e fr o m m e m b e r b a n k s on w h ic h
c h e c k s h a v e b e e n d ra w n , th a n d o lla rs d u e to
m e m b e r b a n k s w h ic h h ave d e p o s ite d c h e c k s fo r
c o lle c tio n .
On a ty p ic a l d a y in 1977, fo r e x a m p le , d u e fro m
ite m s in p r o c e s s o f c o lle c tio n to ta le d $ 8 ,1 4 7 m il­
lion w h ile d e fe r r e d a v a ila b ilit y — d u e to — c a s h
ite m s to ta le d o n ly $ 5 ,3 8 5 m illio n . T h e a m o u n t by
w h ic h th e d u e fr o m ite m s e x c e e d e d the d u e to
ite m s — $ 2 ,7 6 2 m illio n th a t d a y — is c a lle d F e d e ra l
R e s e rv e float. In e ffe c t, s o m e m e m b e r b a n k s had
be e n c r e d ite d b e fo r e o th e r s w e r e c h a rg e d .
C re d its c a n a ls o a ris e w it h o u t o ffs e ttin g d e b its in
th e ro u tin e p ro c e s s in g of t r a n s fe r s of fu n d s and
s e c u r itie s o v e r th e F e d ’s w ire n e tw o rk .
F lo a t c a n v a ry w id e ly w it h in a w e e k o r m o n th , as
w e ll as o v e r th e ye a r. In 1977, flo a t ra n g e d fro m
$ 2.2 b illio n to a b o u t $ 6.2 billio n . B ad w e a th e r,
tr a n s p o rta tio n tie-ups, o r a n y th in g a ff e c tin g c h e c k
d e liv e rie s o r th e s p e e d of p r o c e s s in g c a n c a u s e
larg e d a ily c h a n g e s in flo a t. F lo a t rises n e a r the
m id d le of e a c h m o n th as p e o p le a n d b u s in e s s e s
p a y th e ir m o n th ly bills (C h a rt II). T h is b u lg e te n d s
to p ro v id e th e b a n k in g s y s te m w ith s u b s ta n tia l
a d d itio n a l re s e rv e s fo r a b rie f p e rio d until flo a t
s u b s id e s w ith c h e c k v o lu m e to w a rd th e e n d of the
m o n th .
D u rin g the C h r is tm a s s e a s o n , the v o lu m e of
c h e c k s w r it te n rises s h a rp ly a n d c h e c k d e liv e rie s
a re d e la y e d as C h r is t m a s c a r d s a n d p a c k a g e s

Chart II

+ 2000

The Effect of Changes
in Float on
Bank Reserves*

+ 1800

+ 1600

•Cumulative changes i daily
n
averages July through December

+ 1400

+ 120 0

+10
00
+

800

I—

+

600

—

+

400

+ 200

0
-

flo o d the m a ils , s u p e rim p o s in g a s tro n g s e a s o n a l
rise on th e m o n t h ly p a tte rn . To p re v e n t th e larg e
s w in g s in flo a t fr o m a lt e r n a t e ly in c r e a s in g and
d e c r e a s in g the to ta l s u p p ly of re s e rv e s a v a ila b le
to the b a n k in g s y s te m , th e F e d e ra l R e s e rv e m u s t
e n g a g e in o ffs e ttin g o p e n m a r k e t o p e ra tio n s .

by th e ir e a rn in g s on the T r e a s u r y ’s b a la n c e s .
S h a rp ly h ig h e r s h o rt-te r m in te re s t rates in 1973
a n d 1974, h o w e v e r, b o o s te d b a n k e a rn in g s on
th e s e fu n d s so m u c h th a t it b e c a m e c le a r th a t
th e y e x c e e d e d s u b s ta n tia lly th e v a lu e of s e rv ic e s
r e n d e re d th e T re a s u ry .

Other reserve factors

To c o r r e c t th is im b a la n c e , the T re a s u ry s h ifte d
fu n d s to its F e d e ra l R e s e rv e b a la n c e s fr o m c o m ­
m e r c ia l ba n ks, d ra in in g re s e rv e s f r o m th e b a n k s
and n e c e s s ita tin g S y s te m p u r c h a s e s o f s e c u ritie s .
T he in te re s t th e F e d e ra l R e s e rv e e a rn e d on
th e s e h o ld in g s in c r e a s e d th e S y s t e m ’ s re g u la r
p a y m e n t s o f its n e t e a rn in g s to th e T re a s u ry .
Thus, th e T re a s u ry o b ta in e d in d ire c tly a re tu rn on
its fu n d s th a t it c o u ld n o t o b ta in fr o m c o m m e r c ia l
b a n k s d ire c tly .

C h a n g e s in the d e p o s its m a in ta in e d a t the F e d e ra l
R e s e rv e b y the T re a s u ry , fo r e ig n c e n tr a l b a n ks,
a n d in te rn a tio n a l in s titu tio n s a ls o a ff e c t b a n k
re se rv e s . W h e n s u c h d e p o s its rise, re s e rv e s are
tr a n s fe r r e d fr o m m e m b e r b a n k s to th e s e a c c o u n ts .
W h e n the b a la n c e s a re d ra w n d o w n to m a k e p a y ­
m e n ts , m e m b e r b a n k re s e rv e a c c o u n ts in c re a s e .
In e a rly 1978, s w in g s in th e T r e a s u r y 's b a la n c e at
th e F e d e ra l R e s e rv e B a n k s w e r e a m a jo r s o u rc e
o f v a ria b ility in b a n k re se rv e s . U ntil a fe w y e a rs
e a rlie r, th e T re a s u ry had s o u g h t to m a in ta in a
re a s o n a b ly s ta b le w o r k in g b a la n c e a t th e F e d e ra l
R ese rve . It u sed its " t a x a n d l o a n ” a c c o u n ts at
c o m m e r c ia l b a n k s as a b u ffe r, a c c u m u la t in g tax
a n d o th e r p a y m e n t s th e re , a n d tr a n s fe r r in g fu n d s
to th e R e s e rv e B a n k s a t a rate th a t a b o u t o ffs e t
th e c h e c k s d ra w n on its R es e rve B a n k b a la n c e .
M o re re c e n tly , th e T re a s u ry has b e e n k e e p in g the
bulk o f its b a la n c e s at th e R e s e rv e Banks.
T h e T re a s u ry its e lf c o u ld n o t le g a lly in ve st fu n d s,
b u t c o m m e r c ia l b a n k s h o ld in g th e s e a c c o u n ts
c o u ld a n d did. B a n k s p ro v id e d th e T re a s u ry w ith
s e r v ic e s w it h o u t c h a r g e a n d w e r e c o m p e n s a t e d

T h is c h a n g e in th e T r e a s u r y ’s m a n a g e m e n t of its
c a s h p o s itio n led to v e ry larg e s h o rt-te r m s w in g s
in th e T r e a s u r y ’ s F e d e ra l R e s e rv e b a la n c e , s in c e
ta x a n d loan a c c o u n ts a t c o m m e r c ia l b a n k s no
lo n g e r p r o v id e d a b u ffe r. In 1970, the a v e ra g e
w e e k ly c h a n g e in T re a s u ry d e p o s its at th e F e d e ra l
R e s e rv e w a s $ 1 2 4 m illio n . In 1977, the c h a n g e
a v e ra g e d $2 billion. To o ffs e t th e im p a c t on
re s e rv e s o f th e s e a b ru p t c h a n g e s , th e S y s te m had
to s u p p ly re s e rv e s te m p o r a r ily th r o u g h m a tc h e d
p u rc h a s e -a n d - s a le c o n tr a c ts , c a lle d r e p u rc h a s e
a g re e m e n ts . M a t c h e d s a le - p u rc h a s e c o n t r a c t s
w e r e u s e d w h e n th e S y s te m had to a b s o rb
re s e rv e s te m p o ra rily . N e w le g is la tio n w ill p e rm it

200

the T re a s u ry to re c e iv e an in te re s t re tu rn d ir e c tly
on its tax a n d loan b a la n c e s at fin a n c ia l in s titu ­
tions. S oon th e T re a s u ry c a n a g a in use th e se
b a la n c e s to in s u la te the re s e rv e s o f th e b a n k in g
s y s te m f r o m th e im p a c t of its v o la tile c a s h p o sitio n .
The S y s te m 's ta s k of s m o o th in g re s e rv e p re s ­
su re s a ris in g fr o m flu c tu a t io n s in th e s e and o th e r
fa c t o r s is n e v e r e n d in g . A s p re s s u re s shift, the
o p e n m a r k e t d e s k m u s t o fte n be p re p a re d to
c h a n g e fr o m s u p p ly in g to a b s o rb in g re s e rv e s ,
o fte n w ith in th e s a m e w e e k. W ith in m o s t m o n th s ,
th e re a re p r e d ic ta b le s h ifts in th e n eed to s u p p ly
a n d a b s o rb re s e rv e s . In th e last s e v e ra l m o n th s of
th e y e a r, a s w e h ave see n , re s e rv e s m u s t be s u p ­
p lied s e a s o n a lly , o n ly to be w it h d r a w n fr o m the
b a n k s e a rly in th e n e w year.

The Federal Reserve, the banks,
and deposit growth
The o p e n m a r k e t d e s k m u s t d e a l w ith m o r e than
th e p re s s u r e s g e n e ra te d by c u r r e n c y flo w s, F e d ­
eral R e s e rv e flo a t a n d o th e r fa c t o r s a ffe c tin g b ank
re s e rv e s . It m u s t a ls o c o p e w ith th e s w in g s in
re q u ire d re s e rv e s th a t s te m fr o m s h o rt-ru n
c h a n g e s in b a n k d e p o s its . T he tr a d in g d e s k m u s t
s e e h o w b a n k d e p o s its a re tr a c k in g in re la tio n to
s e a s o n a l p a tt e r n s to ju d g e w h e t h e r th e lo n g e r run
g r o w th in the m o n e y s to c k a n d b a n k c r e d it is
u n fo ld in g as th e F e d e ra l R e s e rv e d e s ire s .
The m a in s e a s o n a l m o v e m e n t s in d e m a n d s fo r

5

Federal Reserve Bank of New York
Assets
Liabilities

The Dealers’ Clearing Banks
Assets

Liabilities

1. T re a s u ry bills

2. R e s e rv e a c c o u n ts
of th e d e a le r s '
c le a r in g b a n k s

3. R e s e rv e a c c o u n t
a t F e d e ra l
R e s e rv e

4. D e m a n d d e p o s it
a c c o u n t s of
d e a le rs

+ $ 5 2 3 ,0 0 0 ,0 0 0

+ $ 5 2 3 ,0 0 0 ,0 0 0

+ $ 5 2 3 ,0 0 0 ,0 0 0

+ $ 5 2 3 ,0 0 0 ,0 0 0

1. F e d e ra l
R e s e rv e b u y s
T re a s u ry
bills a n d . . .

2. C le a rin g b a n k s
tr a n s fe r T re a s u ry
bills by w ire ,
re c e iv in g c r e d it
to th e ir
re s e rv e a c c o u n ts .

3. C le a rin g b a n k s '
re s e rv e a c c o u n ts
in c r e a s e a n d . . .

The Accounting Trace of a Federal
Reserve Purchase of Treasury Bills
from Nonbank Dealers

4. C le a rin g b a n k s
c r e d it d e m a n d
d e p o s it a c c o u n ts
o f d e a le rs
s e llin g the
T re a s u ry bills.

TRACKING A FEDERAL RESERVE
PURCHASE OF TREASURY BILLS FROM
NO N B A N K DEALERS
F e d e ra l R e s e rv e p u rc h a s e s of s e c u r itie s s u p p ly
re s e rv e s to th e b a n k in g s y s te m ; s a le s w it h d r a w
re se rv e s . W h e n th e M a n a g e r p u r c h a s e d $ 5 2 3
m illio n o f T re a s u ry bills on th e T u e s d a y b e fo r e
T h a n k s g iv in g , he p a id the s e c u r itie s d e a le r s by
c re d itin g th e re s e rv e a c c o u n ts o f th e b a n k s
h a n d lin g th e d e a le r s ' p a p e r w o rk , an a c tio n
th a t c r e a t e d re s e rv e s th a t d id n 't e x is t b e fo re .
H a d he so ld T re a s u ry bills in s te a d , he w o u ld
h ave r e d u c e d the S y s te m 's o p e n m a r k e t
a c c o u n t h o ld in g s a n d e x tin g u is h e d b ank
re s e rv e s . T h e F e d e ra l R e s e rv e d e riv e s this
p o w e r to c r e a t e o r e x tin g u is h b a n k re s e rv e s
fr o m C o n g re s s , w h ic h has the C o n s titu tio n a l
p o w e r to " c o i n m o n e y (and) re g u la te th e v a lu e
t h e r e o f ” (A rtic le I, S e c tio n 8 ).
A s s u m e th e M a n a g e r p u rc h a s e d th e T re a s u ry
bills fr o m n o n b a n k d e a le rs . T h e d e a le r s ’ N e w
Y o rk c le a r in g b a n k s re c e iv e c r e d it to th e ir
re s e rv e a c c o u n t s a n d th e y, in turn, c r e d it the
d e a le r s ' d e p o s it a c c o u n ts . (W h e n bills a re
b o u g h t f r o m a b a n k a c tin g as a d e a le r, th e
d e a le r b a n k s im p ly r e c e iv e s a c r e d it to its
re s e rv e a c c o u n t. ) T h e im m e d ia te e ff e c t o f the
d a y ’ s o p e n m a r k e t p u r c h a s e s is a $ 5 2 3 m illio n

rise in F e d e ra l R e s e rv e a s s e ts (T re a s u ry bill
h o ld in g s ) a n d in F e d e ra l R e s e rv e lia b ilitie s
( m e m b e r b a n k d e p o s its). M e m b e r b a n k re s e rv e
b a la n c e s rise $ 5 2 3 m illio n w h ile d e p o s it
lia b ilitie s to c u s to m e r s rise by a s im ila r a m o u n t.
W h e n n o n b a n k d e a le r s b u y T re a s u ry s e c u r itie s
fr o m th e Fed, th e y u s u a lly a rr a n g e fo r th e ir
c le a r in g b a n k s to p a y th r o u g h a c h a r g e to e a c h
c le a r in g b a n k ’s re s e rv e a c c o u n t. T he R ese rv e
B a n k d e liv e rs the s e c u r itie s th ro u g h the
G o v e r n m e n t s e c u r itie s c le a r in g a r r a n g e m e n t.
( D e a le r b a n k s pay fo r S y s te m p u rc h a s e s by
a u th o r iz in g d ir e c t d e d u c tio n s f r o m th e ir re s e rv e
a c c o u n ts .)
W h e n th e S y s te m a d d s to b a n k re s e rv e s
th ro u g h o p e n m a r k e t p u rc h a s e s , th e a d d itio n a l
re s e rv e s d o n ’t all r e m a in in the N e w Y o rk C ity
b a n k s th a t h a n d le s e c u r itie s fo r th e n o n b a n k
d e a le rs . T o b u y and h old G o v e r n m e n t
s e c u ritie s , th e s e d e a le r s n o rm a lly b o r r o w
m o n e y fr o m all a ro u n d th e c o u n t r y — fr o m
in s u r a n c e c o m p a n ie s , c o r p o r a t e tr e a s u re rs ,
ba n ks, s ta te a n d lo ca l g o v e r n m e n t s a n d o th e rs.
In fa c t, th e y b o r r o w 95 c e n ts or m o r e of e v e ry
d o lla r u s e d to buy s e c u ritie s , p le d g in g the
s e c u r itie s b o u g h t as c o lla te r a l.
W h e n th e F e d e ra l R e s e rv e b o u g h t s e c u ritie s

fr o m d e a le r s on th a t T u e s d a y b e fo r e T h a n k s ­
givin g , n o n b a n k d e a le r s had to re p a y th e ir
b o r r o w in g s a n d re d e e m the s e c u r itie s b e fo r e
th e y c o u ld d e liv e r th e m to th e S y s te m A c c o u n t.
In e ffe c t, th e y re p a id th e loa n s th a t d a y w ith
the p r o c e e d s of th e s a le to th e S y s te m .
A larg e p a rt of th e in c r e a s e in re s e rv e s w a s
t r a n s fe r r e d th e s a m e d a y fr o m the d e a le r s '
c h e c k in g a c c o u n ts o v e r th e F e d e ra l R e s e r v e ’ s
w ir e n e tw o rk to the re s e rv e a c c o u n t s o f b a n k s
in o th e r c itie s . P e rh a p s $ 1 0 m illio n w a s w ir e d
to H a r tf o r d by a d e a le r to p a y o ff an in s u r a n c e
c o m p a n y loan, $6 m illio n to C h ic a g o to re p a y a
m a n u f a c tu r e r , $ 2 5 m illio n to a S an F r a n c is c o
b a n k to re d e e m s e c u r itie s h eld by it, a n d so on.
Th u s, an a d d itio n to b a n k r e s e rv e s s p re a d s
q u ic k ly a c r o s s the c o u n try . A n d b a n k s g a in in g
re s e rv e s m a y re d is trib u te p a rt of th e m
t e m p o r a r ily by le n d in g th e m in th e F e d e ra l
fu n d s m a rk e t.

b a n k c r e d it a n d d e p o s it s a re c le a r to th e F e d e ra l
R e s e rv e a n d c o m m e r c ia l b a n k e rs alike. A s a rule,
th e re is a p ro n o u n c e d u p s w in g in b a n k loa n s to
b u s in e s s in th e last fo u r m o n th s of e a c h ye a r,
p a rtly b e c a u s e a g ric u ltu ra l c r o p s a re m o v in g to
m a rk e t, b u t c h ie f ly b e c a u s e retail b u s in e s s e s a re
b o r r o w in g to s to c k up fo r th e fall s e a s o n a n d the
C h r is t m a s rush. T h e T re a s u ry is a ls o a m a jo r b o r­
ro w e r in th is s e a s o n b e c a u s e ta x re c e ip ts t y p ic a l­
ly fall s h o rt o f e x p e n d it u r e s in th e last h a lf o f the
c a le n d a r y e a r.
The e x p a n s io n of c r e d it d e m a n d s a n d b u s in e s s
a c tiv it y in th e fall is ty p ic a lly a c c o m p a n ie d by a
rise in e m p l o y m e n t a n d in c o m e s , on th e o n e
hand, a n d a rise in w o r k in g b a la n c e s a n d s a v in g s
d e p o s its a t c o m m e r c ia l b a n ks, on th e o th e r. R is­
ing d e p o s its lead to an in c r e a s e in th e re q u ire d
re s e rv e s th a t th e b a n k s m u s t h old (C h a rt III). In
p re -F e d e ra l R e s e rv e da ys, b a n k s o fte n had to sell
liq uid a s s e ts in larg e v o lu m e to m a k e ro o m fo r th e
s e a s o n a l in c r e a s e in loa n s a n d re s e rv e re q u ir e ­
m e n ts . T o d a y , th e F e d e ra l R e s e rv e s u p p lie s th e
b a n k in g s y s te m w it h a d d itio n a l re s e rv e s in s te p
w ith th e s e a s o n a l d e m a n d fo r c r e d it a n d d e p o s its .
T h e re is no n e e d fo r f o r c e d s a le s o f s e c u r itie s or
o th e r a s s e ts , w h i c h w o u ld ra ise in te re s t rates.
The a c tu a l b e h a v io r o f b a n k c r e d it and d e p o s its
e a c h y e a r r e fle c ts th e in te ra c tio n of b a n ks, th e ir
c u s to m e r s , a n d the F e d e ra l R e s e rv e . B a n k d e c i­
s io n s a re i n f lu e n c e d b y p re s e n t a n d p r o s p e c t iv e

c u s t o m e r d e m a n d s , the e c o n o m ic o u tlo o k , and
b a n k e r s ’ p e rc e p t io n s of h o w re a d ily th e F e d e ra l
R e s e rv e m a y a c c o m m o d a t e n a tio n w id e d e m a n d s
fo r m o n e y and c re d it. M o s t larg e b a n k s p r o je c t
b o th the loan d e m a n d th e y a re likely to f a c e and
the d e m a n d and s a v in g s d e p o s its th e y a re likely
to a tt r a c t . M a n y a ls o e s tim a t e w h e t h e r th e T r e a ­
s u r y ’s p r o je c te d b u d g e t c a lls fo r g re a t e r than
s e a s o n a l b o r r o w in g in th e m o n th s a h e a d . B a n k e rs
m u s t j u d g e w h e t h e r all th e c r e d it d e m a n d s th e y
f o r e s e e c a n be a c c o m m o d a t e d w ith in th e ra te s of
g ro w th in th e m o n e y s to c k a n d b a n k c r e d it b e in g
s o u g h t b y th e F e d e ra l R e s e rv e S y s te m . In te re s t
ra te s w ill be e x p e c te d to rise if m o n e y a n d c r e d it
d e m a n d s a re e x c e s s iv e — or fall if th e y a re b e lo w
th e F e d ’s g ro w th o b je c tiv e .

F e d e ra l R e s e rv e to hold b a c k on s u p p ly in g n o n ­
b o rro w e d re s e rv e s th r o u g h o p e n m a r k e t o p e r a ­
tio n s in o rd e r to s lo w d e p o s it a n d b a n k c re d it
g ro w th . S in c e in te re s t ra te s w o u ld rise in th a t
c a s e , the b a n k m ig h t c h o o s e a lo n g e r te r m m e a n s
o f a d ju s tm e n t. It m ig h t sell C D s o r T re a s u ry s e c u ­
rities a t c u r r e n t in te re s t ra te s ra th e r th a n t e m p o ­
rize by b o rr o w in g in th e F e d e ra l fu n d s m a r k e t
or fr o m its R e s e rv e Bank. C o n v e rs e ly , if d e p o s it
g r o w th w e r e to o u tp a c e the rise in loa n s and
s e c u ritie s , th e b a n k w o u ld be likely to b u y a d d i­
tio n a l s e c u ritie s , w h ile s te p p in g up its e ffo rts to
g e n e ra te loans. E x p e c ta tio n s o f an e x p a n s iv e
F e d e ra l R e s e rv e p o lic y w o u ld s p e e d up s u c h
a c tio n s .

A g a in s t th is b a c k g ro u n d , b a n k e rs w ill a c t on th e ir
in d iv id u a l re a d in g s o f in c o m in g e v id e n c e . If its
h o ld in g s o f loa n s a n d s e c u r itie s w e r e risin g fa s te r
th a n its d e m a n d a n d s a v in g s d e p o s its , a b a n k
w o u ld lose re s e rv e s to o th e r b a n k s a n d fall s h o rt
of m e e t in g its rising re s e rv e r e q u ire m e n ts . It m u s t
d e c id e w h e t h e r to a d ju s t by r e d u c in g its a s s e ts ,
a d d in g to its lia b ilitie s , or s o m e c o m b in a tio n o f th e
tw o.

The F e d e ra l R e s e rv e fo r its p a rt fo llo w s c lo s e ly
th e m a n n e r in w h ic h th e m o n e y s to c k a n d b a n k
c r e d it re s p o n d to the a c tio n s o f b a n k s and th e ir
c u s to m e r s . P a rtic u la r a tte n tio n is p a id in o p e r a ­
tio n s to the g r o w th o f m o n e y , in b o th its M, d e fin i­
t io n — co in , c u r r e n c y , a n d p riv a te d e m a n d
d e p o s its at c o m m e r c ia l b a n k s — and its M 2 d e fin i­
t io n — M, p lu s tim e a n d s a v in g s d e p o s it s o th e r
th a n larg e n e g o tia b le c e r t if ic a t e s of d e p o s it at
m a jo r b a n k s . T he F e d e ra l O p e n M a r k e t C o m m it ­
te e (F O M C — s e e p a g e s 13-15), a k e y S y s te m p o lic y ­
m a k in g bod y, g iv e s the S y s te m A c c o u n t M a n a g e r
a s e t of w e e k ly a n d m o n th ly tr a c k in g p a th s th a t
tie in w ith th e d e s ir e d lo n g e r te r m g r o w th of the
tw o m o n e t a r y a g g re g a te s , M, a n d M 2.

T he b a n k 's c u r r e n t e x p e c ta t io n s o f loan d e m a n d
an d Fed p o lic y w ill a f f e c t its c h o ic e a m o n g
d if fe r e n t c o u r s e s o f a c tio n . If the b a n k s e e s a
d e v e lo p in g n a tio n a l p a tte rn o f s tr o n g loan d e m a n d
an d ra p id ly g r o w in g d e p o s its , it m a y e x p e c t the

S u p p o s e th e tw o a g g re g a te s a p p e a r to be e x p a n d ­
ing m o re ra p id ly th a n d e s ire d . The M a n a g e r is
then s u p p o s e d to s u p p ly f e w e r n o n b o rro w e d
re s e rv e s in re la tio n to the la rg e r b a n k d e m a n d fo r
re s e rv e s th a t ty p ic a lly a c c o m p a n ie s a rise in M,
a nd M 2. In th a t ca s e , b a n k s w ill be s h o rt of
rese rve s, w ill bid up the rate on F e d e ra l fu n d s ,
a nd w ill be f o r c e d to b o r r o w m o r e at the F e d e ra l
R es e rv e d is c o u n t w in d o w . In tim e , th e rise in
in te re s t ra te s a n d th e p o rtfo lio a d ju s t m e n t s s e t in
m o tio n a m o n g ba n ks, b u s in e s s e s , and c o n s u m e r s
s h o u ld w o r k to s lo w th e g ro w th rate of d e p o s its
a n d re q u ire d res e rv e s .
C o n v e rs e ly , s u p p o s e d e p o s its and b a n k c r e d it fall
s h o rt of th e F e d e ra l R e s e r v e ’ s d e s ire s . T h e M a n ­
a g e r w o u ld th e n be o b lig a te d to p u rc h a s e large
a m o u n ts o f G o v e r n m e n t s e c u ritie s in o rd e r to
p ro v id e n o n b o r r o w e d re s e rv e s m o re fre e ly. T his
a c tio n w o u ld p ush d o w n the F e d e ra l fu n d s rate,
and be in te n d e d to s p u r g ro w th in b a n k in v e s t­
m e n ts a n d d e p o s its o v e r the m o n th s ahe a d .
T he F e d e ra l R e s e rv e m u s t c lo s e ly m o n ito r
p r o g re s s to w a r d its lo n g e r te r m o b je c tiv e s w h ile it
c o p e s w it h the s h o rt-ru n s tre s s e s c a u s e d b y s e a ­
s onal and ra n d o m fo r c e s . A lth o u g h th e S y s te m
g u a rd s a g a in s t s e a s o n a l s tra in s by a n tic ip a t in g
re s e rv e n e e d s a n d c h a n g e s , no tw o y e a rs a re
alike. F le x ib ility re m a in s th e key to e ffe c tiv e
a c tio n .

PROM OTING A HEALTHY ECONOM Y
Monetary goals
T he F e d e ra l R e s e r v e ’ s m o s t im p o rta n t ta s k is to
im p le m e n t a m o n e t a r y p o lic y th a t m o v e s the
natio n to w a rd its e c o n o m ic o b je c t iv e s of s u s ta in ­
a b le e c o n o m ic g ro w th , high e m p lo y m e n t, r e a s o n ­
a b le p ric e s ta b ility a n d a s u s ta in a b le p a tte rn of
in te rn a tio n a l tr a n s a c tio n s . R es e rve r e q u ire m e n t
and d is c o u n t rate c h a n g e s a re im p o r ta n t to ols,
but o p e n m a r k e t o p e ra tio n s a re the p r im a r y v e h i­
cle fo r c a r r y in g o u t m o n e t a r y p o licy .
M o n e ta ry p o lic y , in c o n c e r t w ith o th e r g o v e r n m e n ­
tal p o lic ie s , s e e k s to e n c o u r a g e re la tiv e ly full use
of th e e c o n o m y ’s p r o d u c t iv e re s o u rc e s . It m u s t
a ls o ke e p d e m a n d fo r g o o d s and s e rv ic e s in b a l­
a n c e w ith th e e c o n o m y 's a b ility to use land, labor,
c a p ita l a n d te c h n o lo g y w it h o u t in fla tio n . A c h ie v in g
this b a la n c e is im p o r ta n t not o n ly fo r d o m e s t ic
p ro g re s s b u t a ls o fo r m a in ta in in g the c o u n t r y ’ s
c o m p e t it iv e p o s itio n in th e w o r ld e c o n o m y .

More money and bank credit or less?
T im e ly a c tio n to s p e e d up o r s lo w d o w n the
g r o w th of the n a tio n 's m o n e y s u p p ly a n d b a n k
c r e d it a ff e c ts le n d e rs a n d b o r r o w e r s and, th ro u g h
th e ir a c tio n s , a ff e c ts to ta l s p e n d in g and e c o n o m ic
a c tiv ity . W h e n it fo r e s e e s fa llin g p ro d u c tio n and
rising u n e m p lo y m e n t (re c e s s io n ), the F e d e ra l
R e s e rv e c a n p ro v id e m o r e n o n b o rro w e d re s e rv e s
to c o m m e r c ia l b a n k s a n d c o n tr ib u t e to a d e c lin e
in in te re s t rates. P ro v id e d b o r r o w e r s a re s e e k in g

MONETARY POLICY:
HISTORICAL PERSPECTIVE
The s h iftin g c h a lle n g e c o n fr o n tin g m o n e ta ry
p o lic y and th e v a ry in g im p o r ta n c e of its role
a re illu s tra te d in th e h is to ry o f th e p a s t h alf
c e n tu ry .

1930’s: Depression decade
The w o r ld w id e e c o n o m ic c o lla p s e d u rin g the
G re a t D e p r e s s io n o f th e e a rly 1 9 3 0 's s h a tte re d
b u s in e s s and c o n s u m e r c o n fid e n c e . The
F e d e ra l R e s e rv e p u m p e d re s e rv e s in to the
b a n k in g s y s te m a n d in te re s t ra te s fell to v e ry
lo w levels. B u t th e re s e rv e s p ile d up as idle
b a la n c e s . B a n k a n d b u s in e s s fa ilu re s and
e c o n o m ic u n c e r t a in t y re s tra in e d th e p riv a te
d e m a n d fo r c r e d it a n d a ls o te m p e r e d b a n k e r s ’
re a d in e s s to lend a n d invest. S te p p e d -u p U.S.
G o v e r n m e n t s p e n d in g c o n tr ib u t e d to a g ra d u a l
e c o n o m ic re c o v e r y in th e m id - 1 9 3 0 ’ s. B u t
o u tp u t re m a in e d g e n e ra lly b e lo w its 1 929
p e a k s until d e fe n s e s p e n d in g a c c e le r a te d
d r a m a t ic a lly a fte r th e 193 9 o u tb r e a k of w a r in
E u rope. O n ly th e n did th e u n e m p lo y m e n t
ra te — w h ic h w a s still o v e r 17 p e r c e n t in 1 939 —
b e g in fa llin g sh a rp ly .

1940’s: War and its aftermath
T h e F e d e ra l R e s e rv e m a d e s u re th a t b a n k s had
a d e q u a te re s e rv e s to b u y the T re a s u ry

s e c u r itie s th a t fin a n c e d the G o v e r n m e n t ’ s h u g e
w a r s p e n d in g and the re s u lta n t b u d g e t d e fic its .
By 1943, total o u tp u t (G NP) w a s 70 p e rc e n t
a b o v e th e 1 9 3 9 level in real te r m s a n d the
u n e m p lo y m e n t rate w a s b e lo w 2 p e rc e n t. P rice
c o n tro ls , ra tio n in g , a n d c o n s u m e r s a v in g
h e lp e d re s tra in the u p w a r d p re s s u re of d e m a n d
on the p ric e s of th e lim ite d s u p p lie s of
c o n s u m e r g o o d s a va ila b le .
P e a c e b ro u g h t a ra p id s h ift fr o m G o v e r n m e n t
s p e n d in g fo r w a r to b o o m in g c iv ilia n d e m a n d
fo r h o u s in g a n d c o n s u m e r g o o d s. U.S. lo a n s
an d e c o n o m i c aid h e lp e d s u s ta in E u ro p e
an d re b u ild its p ro d u c t iv e c a p a c ity . P ric e s
rose ra p id ly in 1947 a n d 1 9 4 8 as p ric e c o n ­
tro ls a n d ra tio n in g w e r e e n d e d a n d s p e n d in g
o u tr a n e x p a n d in g p ro d u c tio n . By the end
of th e d e c a d e , h o w e v e r, p r ic e s had le v e le d
o ff w h e n th e e c o n o m y s p u tte re d in to its firs t
m ild p o s tw a r re c e s s io n .

1950’s: Countering the business cycle
T he o u tb r e a k o f the K o re a n c o n f l ic t in Ju n e
1 9 5 0 b o o s te d G o v e r n m e n t s p e n d in g and
t o u c h e d o ff a w o r ld w id e b o o m in ra w m a te ria l
a n d o th e r p ric e s . In fla tio n w a s a m a jo r c o n c e r n
th r o u g h o u t th e d e c a d e , b u t u n e m p lo y m e n t and
s lu g g is h g r o w th w e r e e m e rg in g as p o lic y
issue s b e fo r e th e 1 9 5 0 ’ s w e r e over. F re e d in

1951 fr o m e a rlie r c o n s tr a in t s on its a b ility to
use m o n e t a r y p o lic y fle x ib ly, th e F e d e ra l
R e s e rv e s o u g h t to u se o p e n m a r k e t o p e ra tio n s
to m o d e r a t e s w in g s in e c o n o m ic a c tiv it y and
re s tra in th e e c o n o m ic e x c e s s e s th a t lead to
infla tio n . The G o v e r n m e n t a ls o u s e d its ta x a n d
s p e n d in g p o w e r s — fis c a l p o lic y — to c o u n te r
e c o n o m ic s w in g s. M ilita ry o u tla y s w e r e c u t
a fte r th e K o re a n w ar. A lso , d u rin g b u s in e s s
re c e s s io n s , th e F e d e ra l a u th o r itie s u n d e rto o k
to m a in ta in d e m a n d by s te p p in g up G o v e r n ­
m e n t s p e n d in g a n d s u s ta in in g p riv a te d e m a n d
th r o u g h u n e m p lo y m e n t c o m p e n s a tio n .
T ax re v e n u e s ty p ic a lly fall in re c e s s io n s w h e n
p e o p le a re out of w o r k a n d c o r p o r a t e p ro fits
a re d e c lin in g . H ig h e r G o v e r n m e n t s p e n d in g
th e n has to be fin a n c e d by T re a s u ry b o rro w in g .
D u rin g th e s e p eriods, th e F e d e ra l R es e rv e
s u p p lie d c o m m e r c ia l b a n k s w it h e n o u g h
re s e rv e s to b u y T re a s u ry s e c u r itie s h e a v ily
as w e ll a s to a d d to th e ir m o r tg a g e loans.
D u r in g th e 1 9 5 0 ’ s, p o lic y m a k e r s le a rn e d th a t
re s tra in in g e x c e s s iv e d e m a n d in b o o m tim e s
w a s im p o r ta n t fo r tw o re a s o n s . It h e lp e d k e e p
in fla tio n fr o m g e ttin g o u t of hand. A n d it also
h eld b a c k c re d it-s e n s itiv e p riv a te s p e n d in g until
s la c k tim e s , w h e n it c o u ld be re le a s e d by
m a k in g m o n e y m o r e re a d ily a va ila b le .

1960-65: Seeking balanced growth
By th e e a rly 1 9 6 0 ’ s, the s ta g e s e e m e d s e t fo r a
b ro a d ly b a s e d e c o n o m i c e x p a n s io n w it h o u t
infla tio n . T h e e c o n o m y re c o v e re d s m a r tly fr o m
the 1960-61 re c e s s io n . B ut fo r the firs t tim e in
the p o s tw a r p e rio d , e x p a n s io n p o lic ie s and
lo w e r in te re s t ra te s s e t o ff a t r a n s fe r o f fu n d s
a b ro a d a n d c a u s e d c o u n tr ie s to b u y g o ld fr o m
th e U.S. ra th e r th a n a d d to th e ir d o lla r h o ldings.
N e ith e r an e x p a n s iv e m o n e t a r y p o lic y nor
risin g F e d e ra l e x p e n d itu re s s e e m e d a b le to
p u s h th e e c o n o m y n e a re r its full p ro d u c tiv e
p o te n tia l. In 1963, the u n e m p lo y m e n t rate
a v e ra g e d 5.7 p e rc e n t, only o n e p e rc e n ta g e
p o in t b e lo w the re c e s s io n level of tw o y e a rs
e a rlie r. M o re o v e r, G o v e r n m e n t p o lic ie s had to
re b u ild c o n f i d e n c e in th e d o lla r a n d th e in te r­
n a tio n a l m o n e t a r y s y s te m a fte r th e g o ld o u tflo w
of 1960.
G ra d u a lly , a c o n s e n s u s d e v e lo p e d th a t the
n a tio n 's h ig h ly p r o g re s s iv e in c o m e tax
s tr u c tu r e w a s c h o k in g o ff p riv a te d e m a n d . Tax
c u ts in 1964 c o n tr ib u t e d to a c c e le r a te d
c o n s u m e r s p e n d in g a n d b u s in e s s in v e s tm e n t in
n e w p la n t a n d e q u ip m e n t. U n e m p lo y m e n t
d e c lin e d to 4 ’/2 p e r c e n t by m id -1 9 6 5 w h ile
r e m a r k a b ly s ta b le p r ic e s c o n tr ib u t e d to solid
g a in s in tra d e w it h o th e r n ations.

c re d it, b a n k s w ill m a k e loa n s and b u y s e c u ritie s ,
ty p ic a lly p a y in g w ith n e w ly c r e a t e d d e m a n d d e ­
posits. M, w ill te n d to rise. A s b o r r o w e r s s p e n d
th e ir n e w fu n d s , th e rise in s p e n d in g w ill g e n e ra te
n e w jo b s a n d h ig h e r in c o m e s . A n d tim e a n d s a v ­
ings d e p o s its a re likely to rise w ith i n c o m e so th a t
M 2 g r o w th w ill a lso a c c e le r a te .
W h e n th e F ed fo r e s e e s th a t m o n e t a r y d e m a n d is
likely to be e x c e s s iv e s o th a t rising p ric e s (in fla ­
tion) a re on th e h o rizo n , the F e d e ra l R e s e rv e ca n
p ro v id e f e w e r n o n b o rro w e d re s e rv e s . T h e F e d e ra l
fu n d s rate w ill rise, a n d b a n k s w ill b o r r o w m o r e
h e a v ily a t th e d is c o u n t w in d o w . A s th e c o s t of
re s e rv e s a n d m a r k e t in te re s t ra te s rise, b a n k s and
th e ir c u s t o m e r s s ta r t to a d ju s t th e ir p o r t fo lio s of
f in a n c ia l a s s e ts . U n d e r s u s ta in e d p re s s u re fr o m
the Fed, th e s e a d ju s t m e n t s tr a n s la te in t im e into
re d u c e d ra te s of d e p o s it a n d b a n k c r e d it g ro w th .
S o m e b o r r o w e r s g e t s q u e e z e d o u t o f th e c r e d it
m a r k e ts a n d m o n e t a r y d e m a n d is b ro u g h t b a c k in
line w ith th e e c o n o m y 's p ro d u c tiv e c a p a c it y .
T h e re a re no g u a r a n t e e s th a t m o n e t a r y p o lic y w ill
h ave p r e c is e ly th e d e s ir e d i m p a c t on s p e n d in g in
th e e c o n o m y . O p e n m a r k e t o p e ra tio n s h a v e a
d ir e c t e f f e c t on n o n b o r r o w e d re s e rv e s a n d s h o r t­
te r m in te re s t rates. B u t th e e ff e c ts on M, a n d M 2
m a y v a ry g re a tly , d e p e n d in g on th e a g g r e s s iv e ­
ness w it h w h ic h b a n k s lend and invest, a n d
w h e t h e r th e p u b lic h o ld s its liq uid a s s e ts as tim e
d e p o s its w it h b a n k s o r in o th e r fo rm s . In a d d itio n ,

th e e c o n o m y 's c o u r s e w ill re fle c t m o r e th a n th e
b o r r o w in g - a n d s p e n d in g d e c is io n s o f c o n s u m e r s ,
b u s in e s s e s and g o v e r n m e n t s . A ls o at w o r k will
be th e p ric in g p o lic ie s o f b u s in e s s , the w a g e
g o a ls of labor, the tax la w s o f g o v e rn m e n t,
an d e c o n o m i c c o n d it io n s a b ro a d .
T h e F e d e ra l R e s e rv e has c o n s id e r a b le c o n tro l
o v e r n o n b o rro w e d re s e rv e s , b u t it c a n 't c o n tr o l
th e u se o f th o s e re s e rv e s in the s h o rt run. The
b a n k s m a y u s e a d d itio n a l re s e rv e s to re d u c e
in d e b te d n e s s to R e s e rv e B a n k s o r o th e rs , ra th e r
th a n m a k e m o re lo a n s o r b u y m o r e s e c u ritie s .
F u r th e r m o r e , the F e d e ra l R e s e rv e c a n 't c o n tr o l
h o w th e p u b lic h o ld s its m o n e y b a la n c e s . If the
p u b lic w it h d r a w s larg e a m o u n t s of c a s h f r o m the
b a n ks , as w e h ave se e n , th e F e d e ra l R e s e rv e w ill
ha v e to p u m p in an e q u a l a m o u n t of re s e rv e s
s im p ly to a v o id p u ttin g u p w a r d p re s s u re on in te r­
e s t ra te s th a t c o u ld lead to a d e c lin e in th e m o n e y
s to c k . W h ile Fed i n f lu e n c e o v e r th e m o n e y s to c k
is lim ite d in a w e e k o r a m o n th , the Fed d o e s
h a v e a re a s o n a b le p r o s p e c t o f a c h ie v in g d e s ire d
g r o w th in m o n e y o v e r a p e rio d of m o n th s .
T h e a p p r o p r ia te g ro w th ra te fo r m o n e y d e p e n d s
on th e rate a t w h ic h th e m o n e y s to c k is u s e d — its
rate o f tu r n o v e r o r v e lo c ity . T he F e d e ra l R e s e r v e 's
s tr o n g in flu e n c e o v e r re s e rv e s and s h o rt-te r m
in te re s t ra te s a re not th e o n ly fa c t o r s a t w o r k . The
p u b lic 's d e s ir e fo r c a s h a n d in s titu tio n a l a r r a n g e ­
m e n ts fo r h a n d lin g m o n e y p a y m e n t s a re la rg e ly

o u ts id e th e F e d 's s h o rt-ru n in flu e n c e . M o n e ta ry
p o lic y m a k in g in v o lv e s c o n tin u a l re v ie w o f g o a ls
a nd the o p e ra tio n s b e in g u sed to p u rs u e th e m .

Policy in context
In th e m id -1 9 6 0 's , A m e r i c a w a s riding the c r e s t of
a le n g th y e c o n o m i c e x p a n s io n . C o n f id e n c e w a s
h igh th a t p o lic y m a k e r s c o u ld m a n a g e e c o n o m ic
g r o w th w it h o u t s u s ta in e d u n e m p lo y m e n t o r e s c a ­
latin g p ric e s . But, w ith in ten y e a rs , m o s t o f the
in d u s tria l w o r ld w a s s u ffe rin g fr o m b o th — a n d at
the s a m e tim e .

W hat went wrong?
U.S. e n tr y in to th e V ie tn a m c o n f l ic t in m id -1 9 6 5
i m p o s e d h e a v y n e w d e m a n d s on an e c o n o m y
a lr e a d y g r o w in g a b o u t as fa s t as it c o u ld w it h o u t
g e n e ra tin g infla tio n . B ut th e G o v e r n m e n t c h o s e
n ot to in c r e a s e ta x e s s ig n ific a n tly o r c u t b a c k on
n e w ly la u n c h e d s o c ia l p ro g ra m s . B u d g e t o u tla y s
ro se 50 p e r c e n t o v e r th e n e x t th r e e y e a rs w ith
m ilita r y s p e n d in g a c c o u n tin g fo r h a lf th e in c re a s e .
T he a n n u a l F e d e ra l d e fic it rose f r o m $ 1 .6 billio n
to $ 2 5 .2 billion.
M o n e t a r y p o lic y w a s f o r c e d to try to k e e p to ta l
d e m a n d f r o m o u ts trip p in g p ro d u c t iv e c a p a c ity . In
1966, th e F e d e ra l R e s e rv e s o u g h t to re s tra in b a n k
re s e rv e g r o w th in o rd e r to hold b a c k p riv a te
s p e n d in g a n d re le a s e th e g o o d s a n d s e rv ic e s
b e in g ta k e n by th e G o v e r n m e n t. By late s u m m e r ,
as th e e c o n o m y ra c e d a h e a d , th e r e s u lta n t c o m ­
p e titio n fo r fu n d s by G o v e r n m e n t, b u s in e s s a n d

Chart IV
The Flow of Funds
and Interest Rates
N ote : D a rk a re a s in
u p p e r c h a rt m a rk
b u s in e s s c y c le c o n tr a c tio n s
— T h ree m o n th T r e a s u ry bills
— T h re e m o n th E u ro d o lla r rates
• • U.S. G o v e rn m e n t long -term

■

C o m m e r c ia l ba n kin g s y s te m
□ O th e r s o u rc e s
'F r o m c re d it a n d eq u ity m a rk e ts

c o n s u m e r s d ro v e in te re s t ra te s to leve ls not s een
fo r o v e r 4 0 y e a rs . T h rift in s titu tio n s lost d e p o s its
as s a v e rs s w it c h e d to th e h ig h e r rates b e in g paid
by m a r k e t a b le s e c u r itie s a n d by c o m m e r c ia l
b a n k s on s m a ll C D s a t th a t tim e . T h e n th r ifts w e r e
f o r c e d to c u t m o r tg a g e lending, a n d h o u s in g
s ta rts p lu m m e t e d . In d u s tria l p r o d u c t io n b e g a n
d ip p in g b y th e e n d of 1966, b u t s te e p ly rising
im p o rts a n d in fla tio n s h o w e d th a t m o n e t a r y p o lic y
h a d n ’t c o m p e n s a t e d fo r the la c k of fis c a l re s tra in t.
O n c e the e c o n o m y b e g a n s lo w in g in th e fa ll of
1966, th e F e d e ra l R e s e rv e re v e rs e d p o lic y d ir e c ­
tion. O p e n m a r k e t o p e ra tio n s p u m p e d in b a n k
re s e rv e s to re v iv e h o u s in g a n d a v o id a c u m u la tiv e
d e c lin e in e c o n o m i c a c tiv ity . In te re s t ra te s fell,
b a n k c r e d it a n d th e m o n e y s u p p ly rose, a n d in
1967, th e e c o n o m y r e s u m e d its a d v a n c e .
T he A d m in is tr a tio n c a lle d fo r a b ro a d ta x in c r e a s e
to b lu n t the in fla tio n a r y th r u s t of risin g F e d e ra l
e x p e n d it u r e s and to re s to re b a la n c e d e c o n o m ic
g ro w th . C o n g r e s s io n a l d is c u s s io n o f th e tax p ro ­
p o sa l, h o w e v e r , d r a g g e d on w h ile a n o th e r b o o m
g a th e r e d s te a m . U n e m p lo y m e n t d r o p p e d to 3 1
/2
p e rc e n t, w a g e s a n d p ric e s c o n tin u e d g o in g up,
and th e fo r e ig n tr a d e b a la n c e w o r s e n e d . To m a k e
m a t te r s w o r s e , th e in te rn a tio n a l m o n e t a r y s y s te m
e x p e r ie n c e d a s e v e re c ris is , s p a rk e d b y the d e v a l­
u a tio n of s te rlin g in th e a u tu m n o f 1967.
T h e F e d e ra l R e s e rv e o n c e m o r e m o v e d a g a in s t
e x c e s s d e m a n d , a n d in te re s t ra te s ro se (C h a rt IV).

By 1968, p a s s a g e of a ta x in c r e a s e , c o u p le d w ith
a F e d e ra l s p e n d in g c ut, te m p o r a r ily re lie v e d fe a rs
of infla tio n a t h o m e a n d stille d ta lk th a t th e d o lla r
m ig h t h a v e to be d e v a lu e d .

Inflation gathers momentum
T he in fla tio n a r y m o m e n t u m b u ilt up in th re e y e a rs
p ro v e d d if f i c u lt to c h e c k . In c r e a s e d m o n e t a r y
s tim u lu s on the h e e ls of th e 1 9 6 8 ta x in c r e a s e
p ro v e d to be a m is ta k e , w h ic h a d d e d to u p w a r d
p re s s u re s on p ric e s . D u rin g 1969, m o n e t a r y p o l­
icy s h ifte d p r o g r e s s iv e ly to w a r d re s tra in t. In te re s t
ra te s m o v e d to still h ig h e r levels, re fle c tin g b o th a
s lo w in g in m o n e y s u p p ly a n d b a n k c r e d it g ro w th ,
a n d an " i n f la t io n p r e m i u m ” le n d e rs n e e d e d to
p r o t e c t a g a in s t the lo w e r p u r c h a s in g p o w e r
e x p e c te d w h e n fu n d s w e r e repaid.

u n d e r e s t im a t e d th e s tr e n g th of in fla tio n a r y
d e m a n d s b u ild in g up in th e w o r ld e c o n o m y .
F is ca l p o lic y a ls o re m a in e d s tr o n g ly s tim u la tiv e .
F e d e ra l G o v e r n m e n t o u tla y s e x c e e d e d tax
re c e ip ts b y $ 3 8 b illio n in fis c a l 197 2 and 1973,
w h e n th e e c o n o m y w a s a lre a d y m o v in g a h e a d .
M o n e t a r y p o lic y s h ifte d in c r e a s in g ly to w a rd
r e s tra in t in 1 9 7 3 a n d 1974. S u rg in g c r e d it
d e m a n d s , fe e d in g w h a t w a s n o w an in fla tio n a ry
b o o m , p u s h e d in te re s t ra te s h ig h e r and higher.
The p rim e le n d in g rate o f c o m m e r c ia l b a n k s
re a c h e d 12 p e r c e n t in th e s u m m e r o f 1974.

T h e F e d e ra l R e s e r v e 's b ra k in g a c tio n to o k hold in
1 970 a n d in d u s tria l p r o d u c t io n s lip p e d th r o u g h o u t
th e y e a r (C h a rt V). A s u n e m p lo y m e n t rose
t o w a rd 6 p e rc e n t, th e F e d e ra l R e s e rv e s h ifte d
o n c e a g a in to a p o lic y o f m o n e t a r y s tim u la tio n .
P rice s , h o w e v e r, c o n tin u e d to rise as la b o r w o n
w a g e s e tt le m e n ts th a t m o r e th a n m a d e up fo r
p a s t in c r e a s e s in living c o s ts . T h e re c o v e r y
re m a in e d s lu g g is h th r o u g h m id-1971 b u t p ric e
in fla tio n p e rs is te d .

C o n s u m e r s r e a c te d to s o a rin g in te re s t ra te s a n d a
12 p e r c e n t rise in p r ic e s in 1 974 b y re d u c in g th e ir
s p e n d in g a n d a d d in g to s a vin g s. T h e s h a rp rise in
oil p ric e s o f N o v e m b e r 1973 a ls o c u t into c o n ­
s u m e r s ' a b ility to s p e n d on o th e r p ro d u c ts . F a lte r­
ing c o n s u m e r d e m a n d b e g a n to p r o d u c e b a c k lo g s
of u n s o ld m e r c h a n d is e a n d u n u s e d ra w m a te ria ls .
B u s in e s s e s s h a rp ly re d u c e d c u r r e n t o u tp u t to
w o r k o ff th e s e s w o lle n in v e n to rie s , p ro d u c in g
the w o r s t re c e s s io n of th e p o s t-W W II p e rio d
(C h a rt V). By s p rin g 1975, th e u n e m p lo y m e n t
rate had s o a re d to 9 p e rc e n t. A b ro a d , the
m a la is e o f h igh u n e m p lo y m e n t and rising p ric e s
w a s s p re a d in g to m o s t in d u s tria l c o u n tr ie s , le a d ­
ing in s o m e to s o c ia l u n re s t and p o litic a l tu rm o il.

In 1 9 7 0 a n d 1971, th e F e d e ra l R e s e rv e p u rs u e d
an e x p a n s iv e p o lic y to p r o m o t e r e c o v e ry , a n d it
c o n tin u e d to fo s t e r e x p a n s io n in 197 2 a n d 1973. It

T he in fla tio n o f 197 4 g e n e ra te d b ro a d p u b lic
s u p p o rt fo r p o lic ie s o f e c o n o m i c re s tra in t. P e o p le
a p p e a re d c h a s te n e d b y in fla tio n 's in ro a d s on real

Chart V
Industrial Production,
Money Supply
and Time Deposits
N ote : D a rk a re a s in
u p p e r c h a r t m a rk
b u s in e s s c y c le c o n tra c tio n s
- - I n d u s t r i a l p r o d u c tio n (1967 = 100)

■
□

1111. 1
THE IN TER N A TIO N A L CO NNECTION
T he ru m b lin g s of in te rn a tio n a l fin a n c ia l c ris is
b e g a n e x e rtin g a p e rv a s iv e in flu e n c e on the
U.S. e c o n o m y in th e e a rly 1 9 7 0 ’ s.
T he in te rn a tio n a l m o n e ta ry s y s te m th a t
d e v e lo p e d a fte r W o rld W a r II re lie d on U.S.
d o lla rs as th e m a in s o u r c e of w o r ld liquidity.
F o re ig n g o v e r n m e n t s b u ilt up d o lla r h o ld in g s in
the 19 5 0 ’ s a n d 19 6 0 ’s. P r o te c te d by th is b u ffe r,
c o u n tr ie s d is m a n tle d tra d e b a rrie rs and
c o m m e r c e flo u ris h e d . B ut an im p o r ta n t w e a k ­
ness b e c a m e in c r e a s in g ly v is ib le in th e 1 9 6 0 ’ s.
A key s u p p o r t w a s th e U n ite d S ta te s p le d g e to
re d e e m d o lla rs h eld b y fo r e ig n c e n tr a l b a n k s
a n d g o v e r n m e n t s in g o ld at a fix e d p ric e o f $35
an o u n c e . F ro m th e e n d of W W II, w h e n the
U.S. g o ld s to c k s to o d at $25 billion, to 1969,
the U.S. p a id o u t $ 1 3 billio n of gold. T he $12
billio n r e m a in in g w a s no m a tc h fo r th e $ 1 6
billio n of d o lla r re s e rv e s in c e n tra l b a n k s a n d
th e $ 2 8 b illio n in p riv a te h a n d s a b ro a d . A s e a rly
as 1960, risin g d o lla r b a la n c e s b e g a n u n d e r ­
m in in g fa ith in th e U.S. p ledge. In th e late
1 9 6 0 's , in fla tio n w e a k e n e d this c o u n t r y ’ s
c o m p e t it iv e p o s itio n , fu r th e r e ro d in g c o n fid e n c e .
T he F e d e ra l R e s e rv e p u m p e d re s e rv e s into
b a n k s to s tim u la te the e c o n o m y in 1970. A s
U.S. in te re s t ra te s d e c lin e d , p riv a te fu n d s

III

in v e s te d h ere re tu rn e d to o v e rs e a s m a rk e ts .
U.S. b a n k s a ls o e x p a n d e d le n d in g a b ro a d .
C e n tra l b a n k s o ffe re d th e ir c u r r e n c ie s fo r
d o lla rs to k e e p th e ir e x c h a n g e ra te s fr o m rising
a g a in s t th e d o lla r. O ffic ia l fo r e ig n d o lla r
h o ld in g s rose by $8 b illio n d u rin g 1970, e v e n
th o u g h U.S. c u r r e n t c o m m e r c ia l tr a n s a c tio n s
w ith o th e r s w e r e a lm o s t b a la n c e d .
A s the U.S. e c o n o m y r e c o v e re d in 1971,
d e m a n d s fo r g o o d s rose rapidly, b o o s tin g
im p o rts a n d e x p a n d in g fo r e ig n d o lla r h o ld in g s.
A t th e s a m e tim e , A m e r ic a n b u s in e s s e s b e g a n
s h iftin g fu n d s to fo r e ig n o p e ra tio n s , h e d g in g
a g a in s t a p o s s ib le d o lla r d e v a lu a tio n th a t w o u ld
b o o s t th e d o lla r c o s t o f fo r e ig n c u r r e n c ie s .
F o re ig n c e n tr a l b ank d o lla r p u rc h a s e s rose
sh a rp ly , a n d s e v e ra l b a n k s b e g a n p r o t e c tiv e ly
te n d e r in g h o ld in g s fo r gold . L a rg e ly as a result,
in A u g u s t 1971, the U.S. s to p p e d s e llin g gold .
In te rn a tio n a l m o n e y m a r k e ts e n te re d a p e rio d
of g re a t u n c e r t a in t y a n d w id e ly flu c tu a t in g
fo r e ig n e x c h a n g e rates. T he S m ith s o n ia n
a g r e e m e n t in D e c e m b e r 1971 a llo w e d a 10
p e r c e n t d o lla r d e v a lu a tio n a g a in s t gold . But
a fte r fu r th e r tu r b u le n c e th e d o lla r b e g a n
floating against oth e r c u rre n c ie s in M a rc h 1973.
C e n tra l b a n k s w e r e u n c e rta in a b o u t h o w to
o p e ra te in the n e w e n v ir o n m e n t. If th e y d id n 't

C h a n g e in m o n e y s u p p ly (M,)
C h a n g e in m o n e y sup ply plus
tim e d e p o s its (M 2)

I

b u y d o lla rs w it h th e ir o w n c u r r e n c y w h e n the
d o lla r w a s w e a k , the d o ll a r ’s d e c lin in g v a lu e
w o u ld a d v e rs e ly a f f e c t th e ir c o m p e t it iv e
p o s itio n s . H o w e v e r, b u y in g d o lla rs w o u ld add
re s e rv e s to d o m e s t ic b a n k in g s y s te m s and risk
o v e r s t im u la tin g th e ir e c o n o m ie s .
In the end, c e n tr a l b a n k s m a in ly c o n tin u e d
b u y in g d o lla rs . T he a n n u a l g r o w th of w o r ld
re s e rv e s , w h ic h a v e ra g e d 2.7 p e r c e n t fr o m
1 9 5 0 to 1969, a v e ra g e d a lm o s t 30 p e r c e n t
a n n u a lly in 197 0 a n d 1971 a n d 17 p e r c e n t fr o m
197 2 to 1 9 7 4 .* N ot s u rp ris in g ly , th is e x c e s s iv e
g r o w th w a s fo llo w e d , w ith a lag, b y rapid
g r o w th in th e m o n e y s u p p lie s of m a n y
c o u n tr ie s , m a r k e d ly h ig h e r p ric e s fo r in te r­
n a tio n a lly tr a d e d g o o d s , a n d a la g g e d e ff e c t on
c o n s u m e r p r ic e s in n e a rly e v e ry c o u n try .
W o rld c o n s u m e r p ric e s , w h ic h ro s e a b o u t 4
p e r c e n t a n n u a lly on a v e ra g e fr o m 1 950 to
1969, rose 15 p e r c e n t in 1974. T h e rise in
p r ic e s re s u lte d p a rtly fr o m a d v e rs e a g r ic u lt u r a l
c o n d it io n s and p a rtly fr o m th e q u a d ru p lin g of
oil p ric e s in late 1973. B u t th a t s c r a m b le fo r
c o m m o d i t i e s c a n ’ t be s e p a ra te d f r o m th e
a c c e le r a te d g ro w th in w o r ld re s e rv e s o r the
e x p a n s iv e p o lic ie s of m a n y n a tio n s in p rio r years.
* H . R o b e r t H e lle r, " I n t e r n a t i o n a l R e s e rv e s a n d W o r ld - W id e I n fl a ti o n , "
I M F St a f f Pa per s, V o lu m e 23, pp. 61-87.

in c o m e a n d p ro fits . T h e re w a s in c r e a s in g v o te r
re s is ta n c e to n e w o r e x p a n d e d s p e n d in g
p ro g ra m s . P o lic y m a k e rs w e r e a n x io u s to tu rn the
e c o n o m y a r o u n d w it h o u t m o n e t a r y a n d fis c a l
o v e r s t im u la tio n th a t m ig h t p e rp e tu a te d o u b le d ig it
inflation.
L a te in th e s u m m e r o f 1974, th e F e d e ra l R e s e rv e
b e g a n s h iftin g fr o m re s tra in t to m o d e r a t e ease.
O p e n m a r k e t o p e ra tio n s s u p p lie d re s e rv e s to
th e b a n k in g s y s te m to s p u r m o n e t a r y g ro w th .
C o n tin u e d s tr o n g F e d e ra l s p e n d in g h e lp e d s u s ta in
c o n s u m e r in c o m e and s p e n d in g . B ut c o n s id e r a b le
p u b lic u n e a s e w a s e v id e n t o v e r th e $ 1 1 2 billio n
F e d e ra l d e f i c it in fis c a l 197 5 a n d 1 976 c o m b in e d .
The e c o n o m y tu r n e d a ro u n d ra p id ly in e a rly 1975
a fte r b u s in e s s in v e n to rie s had b e e n w o r k e d d o w n .
B u t th e r e c o v e r y s t r e tc h e d o u t w ith b u s in e s s m e n
s p e n d in g c a u tio u s ly . W h ile e m p lo y m e n t rose
s tro n g ly , u n u s u a lly ra p id g r o w th in th e la b o r f o r c e
k e p t the u n e m p lo y m e n t rate fr o m fa llin g m u c h
b e lo w 7 p e r c e n t d u rin g th e firs t tw o a n d h a lf y e a rs
of th e re c o v e ry . In fla tio n re tre a te d to an a n n u a l
ra n g e of 5 to 6 p e rc e n t, b u t no lo w e r, as la b o r
b a rg a in e d to p r o t e c t real w a g e s and b u s in e s s m e n
s o u g h t to re s to re p ro fit m a r g in s to p re -in fla tio n
levels. Still, th e s o lid ity of the e c o n o m i c a d v a n c e
ra is e d h o p e s th a t w it h g o o d m a n a g e m e n t it c o u ld
c o n tin u e w it h o u t p r ic e s s p ira lin g u p w a r d again.
A b ro a d , th e e c o n o m i c re c o v e r y in o th e r in d u s tria l
c o u n tr ie s la g g e d b e h in d th a t in th e U.S. w h ile

g ro w th in th e d e v e lo p in g and oil p ro d u c in g c o u n ­
trie s c o n tin u e d . N e a rly e v e r y w h e r e th e r e w a s
re c o g n itio n th a t infla tio n had to be k e p t u n d e r
c o n tr o l if th e w o r ld e c o n o m y w e r e to a c h ie v e s u s ­
ta in e d g ro w th .
The e c o n o m i c e x p e r ie n c e s o f th e p a s t d o z e n
y e a rs h a v e b ro u g h t h o m e tw o p a in fu l lessons.
First, e x c e s s iv e m o n e t a r y g r o w th s p ills o v e r in to
h ig h e r p ric e s . Oil a n d a g r ic u ltu ra l p ric e in c r e a s e s
a lo n e c a n n o t e x p la in the re c e n t in fla tio n . S e c o n d ,
re s tra in in g m o n e t a r y g ro w th is d if fic u lt w h e n F e d ­
eral s p e n d in g c o n s is t e n tly o u ts trip s tax re c e ip ts
by s iz a b le m a rg in s .
The F e d e ra l R e s e rv e has f o c u s e d in c r e a s in g ly in
th e 1 9 7 0 's on s e ttin g fo rth g r o w th rates in s e v e ra l
m o n e t a r y m e a s u re s as its ju d g m e n t o f w h a t is
a p p r o p r ia te fo r th e n a tio n a l e c o n o m y . A n d it has
b e g u n lo w e rin g th e s e g ro w th ra te s to s h o w its
d e s ire to r e d u c e th e in fla tio n rate. H o w to m o v e
b a c k to w a r d fu lle r use o f a v a ila b le m a n p o w e r
w it h o u t s e ttin g o ff a n o th e r in fla tio n a r y b u rs t is a
p ro b le m lik e ly to b e d e v il p o lic y m a k e r s fo r s o m e
ye a rs . T h e v a lid ity o f th e S y s t e m ’s a p p r o a c h —
a n d the re so lv e of m o n e t a r y and fis c a l p o li c y ­
m a k e r s — re m a in s to be te s te d w h e n e v e r a s tro n g
s u rg e in e c o n o m i c a c tiv ity a g a in c a lls fo r re s tra in t.

FORM ING MONETARY POLICY
The B o a rd of G o v e r n o rs of the F e d e ra l R e s e rv e
S y s te m a n d th e 12 R e s e rv e B a n k s s h a re in

the f o r m u la t io n of th e n a t i o n ’s m o n e t a r y p o licy.
T he B o a rd s e ts re s e rv e re q u ire m e n ts , th a t is, the
p ro p o rtio n of d e p o s its m e m b e r b a n k s m u s t hold
as re s e rv e s . D ir e c t o r s of th e R e s e rv e B a n k s in iti­
a te c h a n g e s in the d is c o u n t rate, s u b je c t to
re v ie w a n d d e te r m in a t io n by th e B o a rd of G o v e r­
nors. T he R e s e rv e B a n k s a d m in is t e r le n d in g o p e r ­
a tio n s — th a t is, pa ss on m e m b e r b a n k a p p lic a ­
tio n s fo r loans, w h ic h u s u a lly c a n n o t e x c e e d 15
days.
T he F e d e ra l O p e n M a r k e t C o m m itt e e , c o m p o s e d
o f s e v e n B o a rd m e m b e r s and fiv e o f th e 12
R e s e rv e B a n k p re s id e n ts , d ir e c ts o p e n m a rk e t
o p e ra tio n s . T he F e d e ra l O p e n M a r k e t C o m m itte e ,
o r F O M C as it is kn o w n , m e e ts o n c e e a c h m o n th
in W a s h in g to n . F O M C m e e tin g s p ro v id e th e fo c a l
p o in t fo r F e d e ra l R e s e rv e a s s e s s m e n t o f the
e c o n o m y ’s p e r f o r m a n c e a n d d e c is io n s on w h a t
o p e n m a r k e t p o lic y s h o u ld be. T h e re is o fte n d is ­
c u s s io n a s w ell of th e u s e of re s e rv e re q u ire ­
m e n ts a n d th e d is c o u n t rate, a lth o u g h th e F O M C
has no re s p o n s ib ility fo r th e s e tools.

The FOM C organization
The F O M C d e v e lo p e d fr o m an in fo rm a l in v e s t­
m e n t c o m m it t e e set up b y the R e s e rv e B a n k s in
th e e a rly 1 9 2 0 's a n d w a s g iv e n its p re s e n t legal
s tr u c tu r e and p o w e r s in 1935. T he P re s id e n t of
the F e d e ra l R e s e rv e B a n k of N e w Y o rk by law
s e rv e s a s a c o n tin u in g m e m b e r o f th e F O M C
w h ile th e p re s id e n ts o f fo u r o f th e 11 o th e r

R ese rve B a n k s s e rv e o n e -y e a r te r m s in ro ta tio n .
T ra d itio n a lly , the F O M C has s e le c te d as its C h a ir ­
m a n , th e C h a ir m a n o f th e B o a rd of G o v e r n o rs ,
a nd as its V ic e C h a irm a n , the P re s id e n t o f th e
F e d e ra l R e s e rv e B a n k of N e w Y o rk. In p ra c tic e ,
e a c h R e s e rv e B a n k p re s id e n t, or a lte rn a te , a tte n d s
e v e ry m e e tin g of th e C o m m itt e e a n d p a r t ic ip a te s
fu lly in its d is c u s s io n s , e v e n if he is not c u r r e n t ly
a vo tin g m e m b e r o f th e FOM C.
U n d e r th e F O M C ’ s d ir e c tio n , th e F e d e ra l R e s e rv e
B an k of N e w Y o rk b u y s a n d sells s e c u r itie s fo r
the a c c o u n t o f all R e s e rv e B anks. The 12
R e s e rv e B a n k s p a r t ic ip a te in the S y s te m O p e n
M a r k e t A c c o u n t, w h ic h held $ 1 0 2 b illio n in G o v ­
e r n m e n t a n d F e d e ra l a g e n c y s e c u r itie s in e a rly
1978. A n n u a lly , th e F O M C c u s to m a r ily a p p o in ts a
s e n io r o f f ic e r o f th e N e w Y o rk R ese rv e B a n k as
the M a n a g e r o f the S y s te m O p e n M a r k e t A c c o u n t.
The M a n a g e r o f th e A c c o u n t, c u r r e n t ly an e x ­
e c u tiv e v ic e p re s id e n t o f th e N e w Y o rk Bank,
o v e rs e e s S y s te m o p e ra tio n s in b o th th e d o m e s t ic
s e c u ritie s a n d fo re ig n e x c h a n g e m a rk e ts . H e and
the D e p u ty M a n a g e r of the O p e n M a r k e t A c c o u n t,
a s e n io r v ic e p re s id e n t, a tte n d e a c h m e e tin g of
the F O M C , re p o rt on o p e n m a r k e t o p e ra tio n s , and
re c e iv e in s tru c tio n s . U n d e r th e d ir e c t s u p e rv is io n
of the D e p u ty M a n a g e r, the s e c u r itie s d e p a r t m e n t
c a r r ie s o u t S y s te m o p e ra tio n s . It a ls o e x e c u te s
s e c u ritie s tr a n s a c tio n s on b e h a lf of the U n ite d
S ta te s T re a s u ry , fo r e ig n c e n tra l b a n k s a n d o ffic ia l
in stitu tio n s , a n d in te rn a tio n a l o rg a n iz a tio n s .

B e tw e e n m e e tin g s o f the F O M C , m e m b e r s o f th e
C o m m itt e e as w e ll a s n o n v o tin g R e s e rv e B ank
p r e s id e n ts e v a lu a te b u s in e s s , c re d it, a n d in t e r n a ­
tional d e v e lo p m e n ts , fo llo w th e im p a c t o f ope n
m a r k e t o p e ra tio n s , and d e v e lo p th e ir v ie w s on the
fu tu re c o u r s e o f m o n e t a r y p o lic y . E c o n o m is ts in
th e r e s e a rc h d e p a r t m e n ts o f th e B o a rd a n d the
F e d e ra l R e s e rv e B a n k s p ro v id e a s tr e a m of
re p o rts on b u s in e s s and fin a n c ia l tr e n d s to th e ir
p rin c ip a ls . The F e d e ra l R e s e rv e B a n k of N e w
Y o rk re p o rts d a ily a n d w e e k ly on F e d e ra l R e s e rv e
o p e ra tio n s a n d on th e m o n e y , G o v e r n m e n t s e c u r i­
ties, a n d fo r e ig n e x c h a n g e m a rk e ts . R e s e rv e B ank
p r e s id e n ts a ls o g ain in s ig h ts in to b u s in e s s tre n d s
fr o m m e e tin g s of e a c h B a n k 's b o a rd of d ir e c to rs ,
w h ic h is c o m p o s e d of n in e m e m b e r s d ra w n fro m
b a n kin g , b u s in e s s , a g r ic u lt u r e a n d o th e r s e c to r s
of s o c ie ty . B e fo re e a c h m e e tin g of th e F O M C ,
e a c h p r e s id e n t and B o a rd m e m b e r c u s to m a r ily
m e e ts w ith s ta ff a id e s to re v ie w th e s ta te o f the
e c o n o m y a n d to d is c u s s th e m o s t a p p ro p ria te
c o u rs e fo r m o n e t a r y p o lic y to fo llo w .

The FOM C meeting
By the tim e th e m e m b e r s o f th e C o m m itt e e a s s e m ­
ble in W a s h in g to n , th e y a re w e ll p re p a re d to d e lib ­
era te . E a ch has in h a n d re p o rts fr o m th e B o a r d ’s
s ta ff on p a s t a n d p r o s p e c t iv e e c o n o m ic a n d fin a n ­
cial d e v e lo p m e n ts , b o th d o m e s t ic and in t e rn a tio n ­
al. A lso , e a c h has s tu d ie d d r a f ts of a lte rn a tiv e
p o lic y d ir e c tiv e s , w h ic h m ig h t be u sed to g o v e rn

o p e n m a r k e t o p e ra tio n s until the C o m m it t e e n ext
m e e ts . E a ch a lte rn a tiv e p re p a re d b y th e B o a r d ’ s
s ta ff in c lu d e s a n n u a l g r o w th o f th e m o n e ta ry
a g g r e g a t e s b e lie v e d c o n s is t e n t w it h F O M C e c o ­
n o m ic o b je c tiv e s . It a lso in c lu d e s ra n g e s fo r M,,
M 2, a n d the F e d e ra l fu n d s rate o v e r th e n e a r te rm .
A t th e m e e tin g , the C o m m it t e e firs t h e a rs re p o rts
on th e fo r e ig n e x c h a n g e m a r k e t a n d ta k e s a c tio n
as n e c e s s a r y in c o n n e c tio n w ith its fo re ig n
e x c h a n g e o p e ra tio n s . T h e C o m m itt e e th e n c o n s id ­
e rs th e o u tlo o k fo r the d o m e s t ic e c o n o m y .
O n c e a q u a rte r, s e n io r m e m b e r s of th e B o a r d ’ s
s ta ff p re s e n t d e ta ile d p r o je c tio n s of th e likely
b e h a v io r o f th e e c o n o m y o v e r th e n e x t y e a r o r so,
a s s u m in g a c o n tin u a tio n o f g r o w th in th e m o n e ­
ta ry a g g r e g a t e s a t th e rate a d o p te d in th e p re v i­
ous q u a rte r. T h e s ta ff is a ls o p re p a re d to g iv e its
v ie w s on th e im p a c t th a t h ig h e r o r lo w e r m o n e t a r y
g r o w th ra te s w o u ld h a ve on e c o n o m i c g ro w th ,
e m p lo y m e n t and p ric e s . A ft e r a full d is c u s s io n
a m o n g F O M C m e m b e r s a n d o th e r a tte n d in g p re s i­
d e n ts, th e F O M C a d o p ts ra n g e s o f d e s ir e d g ro w th
fo r v a rio u s m o n e ta ry m e a s u r e s o v e r th e y e a r
b e g in n in g in the q u a r t e r ju s t past. In J u ly 1977, fo r
e x a m p le , the C o m m itt e e s e t ra n g e s of 4 to 6 V2
p e r c e n t g ro w th fo r M, in the y e a r e n d in g in the
s e c o n d q u a r t e r o f 1 978 a n d 7 to 9 V2 p e r c e n t fo r
M 2. (The C h a irm a n of th e F O M C d is c u s s e s th e s e
ra n g e s a n d th e e c o n o m i c o u tlo o k w it h th e b a n k in g
c o m m it t e e s of the C o n g r e s s in th e q u a r t e r ly

m e e tin g s th e y e m p lo y fo r o v e rs ig h t of m o n e t a r y
p o licy.)
At e a c h m o n th ly m e e tin g , th e B o a r d 's s ta ff re p o rts
on e c o n o m i c and fin a n c ia l d e v e lo p m e n ts and
th e ir e f f e c t on the lo n g -te rm o u tlo o k . T h e p r in c i­
pals th e n d is c u s s th e situ a tio n . T h e re a fte r, a tt e n ­
tio n s h ifts to the p r a c t ic a l p ro b le m s o f a c h ie v in g
th e g r o w th in m o n e y s o u g h t by the C o m m itte e .
T he D e p u ty M a n a g e r of th e S y s te m O p e n M a r k e t
A c c o u n t re p o rts on d o m e s t ic o p e n m a r k e t o p e r a ­
tio n s a n d d e v e lo p m e n ts in the fin a n c ia l m a r k e ts
s in c e th e last m e e tin g . A s e n io r B o a rd s ta ff m e m ­
b e r c o m m e n t s on th e m o n e t a r y re la tio n s h ip s
a s s o c ia t e d w it h th e a lte rn a tiv e d ir e c tiv e s g iv e n
the C o m m itt e e .
E ach o f th e p r in c ip a ls a tte n d in g g iv e s his v ie w s
on th e p ro p o s e d a lte rn a tiv e d ir e c tiv e s and on the
m a n n e r in w h ic h o p e n m a r k e t o p e ra tio n s o u g h t to
be c a r r ie d out. The C h a ir m a n s e ts fo r th the m a in
th r u s t of the d is c u s s io n a n d p u ts b e fo r e th e m e e t­
ing fo r final d is c u s s io n and v o te th e d ir e c tiv e th a t
b e s t e m b o d ie s th e C o m m i t t e e 's inte n t. The
F O M C 's d ir e c tiv e p r o v id e s the M a n a g e r of the
S y s te m A c c o u n t w it h th e b ro a d o b je c t iv e s of o p e n
m a r k e t o p e ra tio n s . In a d d itio n , it ty p ic a lly e s ta b ­
lis h e s th e initial o b je c t iv e fo r th e F e d e ra l fu n d s rate
a n d th e ra n g e w ith in w h ic h it is to v a ry b e tw e e n
m e e tin g s . F o r e x a m p le , if M, and M 2 g r o w th tu rn
o u t to be s tr o n g re la tiv e to th e ir ra n g e s fo r a tw om o n th p e rio d , th e M a n a g e r is in s tru c te d to hold

b a c k in p ro v id in g re s e rv e s so th a t th e F e d e ra l
fu n d s rate rises w it h in its range. T he in c r e a s e in
the F e d e ra l fu n d s rate is e x p e c te d to w o r k to
c h o k e o ff an u n d e s ir e d g ro w th in d e p o s it s .1

M AN A G IN G THE ACCOUNT
A fte r e a c h F O M C m e e tin g th e M a n a g e r o f the
S y s te m O p e n M a r k e t A c c o u n t re tu rn s to N e w
Y o rk w ith th e re s p o n s ib ility fo r m a n a g in g o p e r a ­
tio n s until th e n e xt m e e tin g . In c a rr y in g o u t the
F O M C ’s in s tru c tio n s , he p re s id e s o v e r an e la b o ­
rate m e c h a n is m fo r a s s e s s in g the p r e s s u re s on
b a n k re s e rv e s a n d the fin a n c ia l m a rk e ts .
T he M a n a g e r loo ks to the F e d e ra l fu n d s m a r k e t to
g a u g e th e g e n e ra l a v a ila b ility of n o n b o rro w e d
re s e rv e s in th e b a n k in g s y s te m in re la tio n to
m e m b e r b a n k re s e rv e re q u ire m e n ts . T h e F e d e ra l
fu n d s rate ty p ic a lly c o m e s u n d e r u p w a r d p re s s u re
w h e n e v e r n o n b o r r o w e d re s e rv e s fall s ig n ific a n tly
s h o rt of re q u ire m e n ts , s in c e s o m e m e m b e r b a n k s
w ill bid up the rate ra th e r th a n b o r r o w a t the
F e d e ra l R e s e rv e d is c o u n t w in d o w . T he rate
t y p ic a lly fa lls w h e n re s e rv e s e x c e e d re q u ir e m e n t s
by s iz a b le a m o u n ts . T he M a n a g e r fin d s a n o th e r
c lu e in th e d a ily c o n v e r s a t io n s s ta f f m e m b e r s
'S ee A lan R. H o lm e s, P eter D. S te rn lig h t, Jo h n S. Hill, an d
C h ris to p h e r J. M c C u rd y, " T h e Im p le m e n ta tio n of M o n e ta ry
P olicy in 1 9 7 6 ," F e d e ra l R e se rve B ank of N e w Y ork, Q u a r te r l y
Review, S pring 1977, pp. 37-49.

h ave w ith n o n b a n k d e a le r s in G o v e r n m e n t s e c u r i­
tie s c o n c e r n in g th e ir s u c c e s s in fin a n c in g h o ld ­
ings w ith s h o rt-te r m loans. T h e s e in d ic a to r s help
the M a n a g e r ju d g e th e e x te n t to w h i c h m e m b e r
b a n k s a re lik e ly to b o r r o w fr o m R e s e rv e B a n ks
a nd w h e t h e r p re s s u re s s e e m likely to be g re a te r,
or less, th a n inte n d e d .
The M a n a g e r w a t c h e s d e v e lo p m e n ts in the
m a r k e t fo r T re a s u ry bills, c o m m e r c ia l paper,
b a n k e r s ’ a c c e p ta n c e s , a n d C D s w h e r e in v e s to rs
m a y be e x c h a n g in g c a s h fo r s e c u r itie s o r s e c u r i­
ties fo r c a s h . T h e m a r k e t fo r lo n g e r te r m s e c u r i­
ties is a ls o o f in te re s t b e c a u s e th e s m o o th flo w of
c a p ita l into in v e s t m e n t uses is e s s e n tia l to the
e c o n o m y ’s g ro w th . T h e o rd e rly sa le o f s e c u ritie s
fr o m c o r p o r a t io n s a n d g o v e rn m e n ta l u n its to
i n v e s to rs d e p e n d s on th e re lia b le a v a ila b ility of
s h o rt-te r m c r e d it to in v e s t m e n t b a n k e rs and o th e r
s e c u r itie s d e a le r s on r e a s o n a b ly s ta b le te rm s .
Like th e G o v e r n m e n t s e c u r itie s d e a le rs , th e y
d e p e n d on b o r r o w e d m o n e y to fin a n c e th e ir in v e n ­
to rie s of s a la b le s e c u ritie s .
T he M a n a g e r m u s t a lw a y s be a le r t to the in t e r a c ­
tion b e tw e e n th e s h o rt- a n d lo n g -te rm c r e d it m a r ­
k ets s in c e th e e ff e c ts of m o n e t a r y p o lic y ty p ic a lly
fa n o u t f r o m th e s h o rt-te r m m a r k e t to the lo n g ­
te r m m a r k e t. H e a ls o k e e p s in fo rm e d a b o u t the
e x te n t to w h i c h c r e d it is b e in g u se d in the m a r k e t
fo r c o r p o r a t e s to c k s , an a c tiv it y s u b je c t to the
F e d e ra l R e s e rv e B o a r d ’ s m a r g in re g u la tio n s .

Da ily average tu rno ve r, 1977

Chart VI
Profile and Selected
Money and Capital
Market Instruments
‘ N ot g u a ra n te e d by
the U.S. G o v e rn m e n t

THE EN VIR O N M EN T
The m o n e y m a r k e t is th e n a tu ra l p o in t of
c o n t a c t b e tw e e n th e F e d e ra l R e s e rv e a n d the
e c o n o m y ’ s fin a n c ia l s e c to rs . A n a tio n a l m a r k e t
fo r m o n e y a n d m o n e y s u b s titu te s , s u c h as
T r e a s u ry bills and o th e r s h o rt-te rm o b lig a tio n s ,
p r o v id e s o u r c o m p le x e c o n o m y w ith a m e a n s
of e c o n o m iz in g its use of m o n e y (C h a rts VI & VII)
Thousands of businesses, financial co rp o ra tio n s
a n d g o v e r n m e n t a l u n its m in im iz e th e ir c a s h
b a la n c e s by re ly in g on th e s e s h o rt-te rm ,
in te re s t-e a rn in g a sse ts, w h ic h c a n re a d ily be
c o n v e r t e d in to c a s h w ith little risk of loss.
C o rp o ra tio n s , fo r e x a m p le , fin d T re a s u ry bills
an a tt r a c t iv e in v e s tm e n t fo r fu n d s not
im m e d ia t e ly re q u ire d fo r tax p a v m e n ts ,
d iv id e n d s or o th e r uses. In p a rt b e c a u s e of this,
the T re a s u ry c a n u s u a lly sell s h o rt-te r m o b lig a ­
tio n s a t a lo w e r in te re s t c o s t than a lo n g e r te r m
issue w o u ld require. B anks, fin a n c e c o m p a n ie s ,
a n d o th e r b u s in e s s e s a ls o fin d the m a r k e t a
c o n v e n ie n t p l a c e t o b o rro w .
C o m m e r c ia l b a n k s a re the h e a rt of th e m o n e y
m a rk e t. The b a la n c e s on th e ir b o o k s a n d the
b o o k s of R e s e rv e B a n ks a re its lifeb lo o d . B a n ks
tu rn to the m o n e y m a r k e t to b o r r o w o r lend
fu n d s o v e rn ig h t (p u rc h a s e o r sell F e d e ra l
funds). T h e y use it w h e n th e y b u y T re a s u ry bills

and b a n k e r s ’ a c c e p t a n c e s a s th e y s tru g g le to
ke e p fu lly inve ste d . T h e y u s e it d iffe r e n tly w h e n
th e y sell th e ir o w n C D s or o th e r a s s e ts to m e e t
n e w a n d p r e s s in g c u s to m e r c r e d it d e m a n d s .
The large m o n e y m a r k e t b a n k s a re as
im p o rta n t to the m o n e y m a r k e t as it is to th e m .
T h e y s u p p ly m u c h of the c r e d it th a t e n a b le s
n o n b a n k d e a le r s in m o n e y m a r k e t p a p e r to buy
a n d hold an in v e n to ry. W h e n c o r p o r a t io n s and
o th e r s w h o lend to d e a le r s c u t b a c k on lending,
th e m o n e y m a r k e t b a n k s fill th e c r e d it gap.
T h e s e b a n k s ’ re s e rv e p o s itio n s a n d th e m o n e y
m a r k e t a re likely to b e a r the b ru n t of fin a n c ia l
p re s s u re s e ls e w h e re in th e e c o n o m y .
O p e n m a r k e t o p e ra tio n s c e n te r in th e G o v e r n ­
m e n t a n d F e d e ra l a g e n c y s e c u r itie s m a rke t.
A b o u t $ 4 2 0 billio n of m a r k e t a b le bills, notes,
a n d b o n d s of the U.S. G o v e r n m e n t a re the
s to c k - in -tra d e of this m a rk e t. T h e y ra n g e in
m a t u r it y fr o m T r e a s u ry bills fa llin g d u e e v e ry
T h u rs d a y to th e b o n d s m a tu rin g in 2007. The
re m a in in g $ 2 3 0 billio n o r s o of the n a tio n a l d e b t
c o n s is t s o f n o n m a r k e t a b le issues, s u c h as
s a v in g s b o n d s a n d s p e c ia l s e c u ritie s is su e d to
g o v e r n m e n t a l tr u s t fu n d s a n d fo re ig n o ffic ia l
a c c o u n ts .
T he v o lu m e of tr a n s a c tio n s in th is " o v e r - t h e -

te le p h o n e m a r k e t ” is huge. In 1977, v o lu m e
a v e ra g e d a b o u t $11 b illio n d a ily at fa c e value,
a b o u t 18 tim e s the d a ily d o lla r v o lu m e of
tr a d in g on the N e w Y o rk S to c k E xc h a n g e .
G o v e r n m e n t s e c u r itie s tr a d in g is h e a v ie s t in
th e $ 1 5 5 b illio n of T re a s u ry b ills th a t m a tu re
w ith in o n e ye a r, b u t tr a d in g is a ls o v e ry a c tiv e
in n o te s and in a g e n c y s e c u ritie s .
P rim a ry d e a le rs in g o v e r n m e n t a n d a g e n c y
s e c u ritie s a re p re p a re d to b u y th e s e s e c u r itie s
fr o m c u s to m e r s fo r in v e n to ry a n d sell fr o m their
o w n h o ld in g s . As n o te d e a rlie r, n o n b a n k d e a le rs
p le d g e th e s e h o ld in g s as c o lla te r a l fo r loans.
N a tu ra lly , th e y try to b o r r o w a t a lo w e r rate
th a n th a t e a rn e d on th e ir h o ld in g s. D e a le rs a ls o
d e riv e in c o m e fr o m the s p re a d b e tw e e n p u r­
c h a s e a n d s a le p ric e s . S p re a d s b e tw e e n bid
a n d a s k e d p ric e s ty p ic a lly a m o u n t to $ 5 0 fo r $1
m illio n of T r e a s u ry bills m a tu rin g in th re e
m o n th s a n d m o re fo r lo n g e r m a tu ritie s . D e a le rs
a ls o h a v e tra d in g p ro fits o r losses, w h ic h re fle c t
th e ir a b ility to a n tic ip a t e m a r k e t tre n d s s u ffi­
c ie n tly to b u y lo w a n d sell high. C o m p e titio n
is k e e n a m o n g the th re e d o z e n d e a le r s in this
m a rk e t. S e v e ra l h u n d re d o f th e ir b a n k and
o th e r c u s to m e r s a re a c tiv e tra d e rs , but th e y do
not d e a l on e ith e r side of the m a r k e t in re­
s p o n s e to o th e rs a s d e a le r s do.

Debt o u ts ta n d in g , De cem be r 1977

C h art VII
Profile and Selected
Money and Capital
Market Instruments
' N o t g u a ra n te e d by
the U.S G o v e rn m e n t

Tools of the trade
The N e w Y o rk F e d ’ s tr a d in g d e s k on th e e ig h th
flo o r c lo s e ly fo llo w s d e v e lo p m e n ts in e a c h o f the
in t e rre la te d m o n e y a n d c a p ita l m a rk e ts . T w o or
th re e F e d e ra l R e s e rv e tr a d e rs c o n tin u o u s ly c h e c k
p ric e s a n d d e a le r s ’ o p in io n s of m a r k e t tre n d s.
O t h e rs m a y e x e c u te b u y a n d sell o rd e rs fo r f o r ­
e ig n a c c o u n ts . C o n s ta n t m o n ito rin g a s s u re s th a t
the q u o ta tio n s r e c e iv e d a re re p re s e n ta tiv e of th e
tr a d in g g o in g on in the m a rk e t.

tr a n s a c tio n in v o lv e s d e liv e ry a n d p a y m e n t on the
fo llo w in g b u s in e s s day.

T h e B a n k 's r e s e a rc h d e p a r t m e n t g iv e s the M a n ­
a g e r d a ily re p o rts on the re s e rv e p o s itio n s of
larg e m e m b e r b a n k s in N e w Y o rk City, in o th e r
fin a n c ia l c e n te r s a n d in the c o u n tr y a t large.
O th e r re p o rts re c o rd the s e c u r itie s h o ld in g s and
tr a n s a c tio n s o f G o v e r n m e n t s e c u r itie s d e a le rs . A
s p e c ia l s ta f f p re p a re s d a ily s ta t e m e n t s of the p ast
a n d p ro je c te d b e h a v io r o f all fa c to rs a ffe c tin g
m e m b e r b a n k re s e r v e s — in c lu d in g c u r r e n c y in
c ir c u la t io n , float, a n d T re a s u ry o p e ra tio n s .

The F e d e ra l R e s e rv e a ls o s u p p lie s re s e rv e s by
m a k in g re p u r c h a s e a g r e e m e n t s w ith d e a le r s in
U n ite d S ta te s G o v e r n m e n t a n d F e d e ra l a g e n c y
s e c u r itie s o r in b a n k e rs ' a c c e p ta n c e s . In a r e p u r­
c h a s e a g r e e m e n t, th e R e s e rve B a n k p u rc h a s e s
s e c u r itie s fr o m a d e a le r, w h o a g re e s to r e p u r­
c h a s e the s a m e s e c u r itie s at th e o rig in a l p ric e
plus in te re s t a t a c o m p e t it iv e ly d e te r m in e d rate
w ith in an a g re e d p e rio d of up to 15 days. R e p u r­
c h a s e a g r e e m e n t s a re m a d e o n ly at th e F e d 's
initia tive . T he c o n t r a c t s m a y e ith e r b ind the
p a rtie s fo r a s p e c ifie d tim e o r a llo w e ith e r to
te r m in a t e the a g r e e m e n t b e fo r e m a tu rity . In a
r e p u rc h a s e a g r e e m e n t, the Fed p a y s o u t m o n e y,
and s u p p lie s re s e rv e s , on the d a y of the p u rc h a s e .
W h e n the d e a le r r e p u rc h a s e s th e s e c u ritie s , his
p a y m e n ts a re c h a r g e d to his b a n k 's re s e rv e
a c c o u n t, w it h d r a w in g re s e rv e s fr o m the S ys te m .

W h e n th e M a n a g e r re a c h e s a d e c is io n on w h a t is
to be d o n e on a g iv e n day, he has s e v e ra l m e a n s
of s u p p ly in g o r a b s o rb in g re s e rve s. H e m a y m a k e
an o u tr ig h t p u r c h a s e o r sa le d ir e c tly th r o u g h the
’g o - a r o u n d " of th e m a r k e t d e s c r ib e d in th e o p e n ­
ing p a g e s . On in fre q u e n t o c c a s io n s , he m a y a c ­
c e p t c o m p e t it iv e ly p r ic e d b id s for, o r o ffe rin g s of,
s e c u r itie s m a d e by d e a le rs on th e ir in itia tiv e . A
‘ c a s h ” d e liv e ry t r a n s a c tio n in v o lv e s d e liv e ry and
p a y m e n t the s a m e day. A " r e g u l a r " d e liv e ry

S im ila rly , th e F e d e ra l R e s e rv e c a n a b s o rb
re s e rv e s te m p o r a r ily th ro u g h m a t c h e d salep u rc h a s e tr a n s a c tio n s . T h e s e tr a n s a c tio n s inv o lv e
se llin g T re a s u ry bills fo r c a s h , a n d s im u lt a n e o u s ly
p u r c h a s in g the s a m e issue of bills fo r re d e liv e ry
o n e or m o re d a y s la te r at c o m p e t it iv e rates. B oth
this te c h n iq u e a n d the r e p u rc h a s e a g r e e m e n t
e n a b le th e A c c o u n t M a n a g e r to a ff e c t r e s e rv e s in
large v o lu m e w ith little, if any, im p a c t on T re a s u ry
bill rates.

The F e d e ra l R ese rv e h a s a s p e c ia l o p p o rtu n ity
e a c h w e e k to w it h d r a w re s e rv e s by a llo w in g s o m e
p o rtio n of its h o ld in g s of m a tu rin g T re a s u ry bills to
run o ff a t m a tu rity . (As a m a tte r of p r a c t ic e , the
S y s te m d o e s n 't bid fo r m o re bills at th e w e e k ly
a u c tio n than it ho ld s of m a tu rin g bills.) E a ch M o n ­
day, the T re a s u ry o ffe rs to sell at a u c tio n a s p e c i­
fied a m o u n t of th re e - a n d s ix -m o n th T re a s u ry bills,
w h ic h m u s t be p aid fo r on th e fo llo w in g T h u rs d a y ;
the a m o u n t of bills o ff e r e d m a y be g re a te r, or
less, th a n th e a m o u n t m a tu rin g . T h e F e d e ra l
R e s e rv e m a y roll o v e r its h o ld in g s a t th e a v e ra g e
p ric e e s ta b lis h e d in th e c o m p e t it iv e a u c tio n .
H o w e v e r, if on M o n d a y th e M a n a g e r a lr e a d y fo r e ­
s e e s a n e e d to w it h d r a w re s e rv e s in the n ext
w e e k , he m a y s u b m it a low bid on a p a rt of the
F e d 's m a tu rin g h o ld in g s , thus in te n tio n a lly " m i s s ­
in g " th e ra n g e of a c c e p te d bids. O t h e r b u y e rs
th e n a b s o rb th e a d d itio n a l bills, c a u s in g a d ro p in
b a n k re s e rv e s on T h u rs d a y , w h e n b u y e rs p a y fo r
th e bills.

All part of a day’s work
E ach d a y p re s e n ts a n e w c h a lle n g e to the M a n ­
a g e r a n d his c o lle a g u e s . Y e t e a c h d a y has m u c h
in c o m m o n w it h e v e ry o th e r day. L e t ’ s go b a c k to
th a t T u e s d a y b e fo re T h a n k s g iv in g D a y a n d fo llo w
the d e v e lo p m e n ts w h ic h led to th e F e d 's p u r­
c h a s e of $ 5 2 3 m illio n in G o v e r n m e n t s e c u ritie s .
On th a t d ay, as on all da ys, th e M a n a g e r m u s t
b e a r in m in d the d ir e c tiv e a d o p te d a t th e last

Chart VIII
Projected Cumulative
Effect on Excess
Reserves
■
■
□
■

F O M C m e e tin g . S u p p o s e th e d ir e c tiv e c a lle d fo r
fo s te rin g g ro w th in th e m o n e y a n d c r e d it a g g r e ­
g a te s c o n d u c iv e to s u s ta in a b le e c o n o m i c e x p a n ­
sion. S u p p o s e fu r th e r th a t th e in s t r u c t io n s c a lle d
fo r k e e p in g the F e d e ra l fu n d s ra te at th e m id d le of
th e 5 Vi to 6 Vi p e r c e n t ra n g e e s ta b lis h e d .
T he M a n a g e r c o u ld se e th e m a in o u tlin e s of his
ta s k e a rly on T u e s d a y m o rn in g . H e had b e fo r e
him M o n d a y 's p r o je c tio n s of the b e h a v io r e x p e c te d
of n o n b o r r o w e d re s e rv e s o v e r th e c o m in g w e e k s
(C h a rt VIII). T u e s d a y ’ s p r o je c tio n s w o u ld be a v a il­
a b le a b it later, a t 10:45 a.m . T he p r o je c tio n s are
b a s e d u p o n the b e h a v io r of re s e rv e fa c t o r s o ve r
th e s a m e c a le n d a r p e rio d d u rin g th e p a s t s e v e ra l
y e a rs.
M o n d a y 's p r o je c tio n s in d ic a te d th a t d u rin g the
n ext w e e k the d e c lin e in flo a t a t th e m o n th -e n d
w o u ld c o m b in e w ith a s e a s o n a l rise in c u r r e n c y in
c i r c u la t io n to a b s o r b a larg e v o lu m e of n o n b o r ­
ro w e d re s e rv e s . O v e r th e w e e k s a h e a d the
M a n a g e r w o u ld h a v e to add h e a v ily to re s e rv e s
to c o m p e n s a t e fo r the c o n tin u in g o u tf lo w of
c u r r e n c y as th e s h o p p in g s e a s o n r e a c h e d its
p e a k a n d to p ro v id e fo r the s e a s o n a l rise in
re q u ire d re se rv e s .
U s e fu l a s a ro ugh y a rd s tic k , th e p r o je c tio n s c a n ­
not b e a p re c is e g u id e to o p e ra tio n s . E a c h year,
fo r all its s im ila ritie s to th e pa st, p r o d u c e s a p a t­
te rn of fin a n c ia l flo w s th a t is all its o w n . T h e M a n ­
a g e r a n d his e x p e r ie n c e d o ff ic e r s m u s t loo k to the

F e d e ra l fu n d s m a r k e t its e lf fo r s ig n a ls of the tim in g
a n d m a g n itu d e of th e re s e rv e p re s s u re s a c tu a lly
at w o r k on th is p a r t ic u la r day.

Open for business
T he tr a d in g r o o m ’s b u s in e s s d a y b e g in s a fe w
m in u te s a ft e r 9 a.m . N e w s tic k e r s a re p o u n d in g
out the o v e rn ig h t a c c u m u la t io n o f fin a n c ia l ne w s.
S e c u ritie s tr a d e rs re o rie n t th e m s e lv e s by s c a n ­
n ing y e s t e r d a y ’ s c lo s in g q u o ta tio n s on the b o a rd
fa c in g th e o p e n e n d of th e tr a d in g de sk. A c h e c k
o f a te le v is io n s c r e e n s h o w s w h e t h e r a n y
c h a n g e s a re ta k in g p la c e th a t m o rn in g .

Dealer conference
A t 9 :0 0 a.m . on th a t T u e s d a y b e fo r e T h a n k s g iv in g ,
tw o o ff ic e r s of th e s e c u r itie s d e p a r t m e n t h u rry to
a te n th flo o r c o n f e r e n c e ro o m fo r s e p a ra te m e e t­
ings w ith r e p re s e n ta tiv e s of th r e e d e a le r firm s .
Fed o ff ic e r s d ir e c t ly re s p o n s ib le fo r o p e n m a r k e t
o p e r a t io n s m e e t w ith th e d e a le r s on a ro ta tin g
b a sis e v e ry b u s in e s s day. The d e a le r s c o m m e n t
on m a r k e t d e v e lo p m e n ts as w e ll as m a t te r s of
p a r t ic u la r in te re s t to th e ir firm s . T he Fed o ff ic e r s
listen a n d a s k q u e s tio n s . T he m e e tin g s , b rie f a n d
to th e poin t, a re c o n d u c t e d in m a r k e t ja rg o n .
A t the firs t m e e tin g , a s e n io r p a rtn e r of a d e a le r
f ir m c o m m e n t s on th e m a r k e t ’s in a c tiv ity d u rin g
th e last fe w d a y s. H e s a y s he is a bit d is a p p o in te d
by th e re c e n t la c k o f d e m a n d fo r T re a s u ry n o te s
a n d bo n d s. In s u r a n c e c o m p a n ie s a n d p e n s io n
fu n d s, he b e lie v e s , a re d e la y in g b o n d p u r c h a s e s

C u r r e n c y in c irc u la tio n
R e q u ire d re se rve s
O th er
T otal o p e ra tin g fa c to rs

until the X Y Z C o r p o r a t i o n ’ s $ 2 0 0 m illio n b o n d
issue hits th e m a r k e t on W e d n e s d a y . T u rn in g
a b r u p t ly to th e T r e a s u r y 's f in a n c in g n e e d s , the
d e a le r s a y s he w o u ld a d v is e the T re a s u ry to sell a
fiv e -y e a r issue in D e c e m b e r . S u c h an o ffe rin g
w o u ld g e n e ra te g o o d b a n k in te re s t and s tim u la te
tr a d in g a c tiv it y in G o v e r n m e n t s e c u ritie s . A fte r
a n s w e r in g s e v e ra l q u e s tio n s a s k e d by th e d e s k
o ffic e r s , th e d e a le r d e p a rts at 9:15.
T w o r e p r e s e n ta tiv e s of a s e c o n d d e a le r firm e n te r
th e c o n f e r e n c e ro o m . A lth o u g h d o m e s t ic d e m a n d
has b e e n q u ie t, th e ir firm has sold iss u e s m a t u r ­
ing in tw o to fiv e y e a rs to a fo r e ig n c e n tr a l b a n k in
the la s t fe w da ys. T h e y fe e l th a t m a n y in s titu tio n a l
in v e s to rs a re s ittin g on la rg e c a s h p o s itio n s until
y i e l d s 'b e c o m e m o r e a tt r a c t iv e . O n e d e a le r says
he a ls o fe e ls th e m o n e y m a r k e t w a s a little tig h t
on th e p r e v io u s a ft e r n o o n e v e n th o u g h th e S y s te m
had p u m p e d in re s e rv e s . T o o b ta in fin a n c in g fo r
th e f i r m ’s p o s itio n , th e d e a le r had to p a y a re la ­
tiv e ly h igh in te re s t rate on re p u r c h a s e a g r e e ­
m e n ts w it h o u t-o f-to w n c o r p o ra tio n s .
T he s e c o n d f i r m ’s r e p re s e n ta tiv e s le a v e a t 9:30.
T he v ic e p r e s id e n t in c h a r g e of d e a le r o p e ra tio n s
fo r a N e w Y o rk b a n k c o v e r s m u c h th e s a m e
g ro u n d and d e p a rts a t 9:45. T h e Fed o ff ic e r s
re tu rn to th e ir o ff ic e s to p re p a re fo r th e d a ily
T re a s u ry call.

The Treasury call
S h o rtly a fte r 10:1 5 e a c h d ay, th e F is c a l A s s is ta n t

S e c r e ta r y o f th e T re a s u ry a n d th e D e p u t y A c c o u n t
M a n a g e r u s e a d ir e c t te le p h o n e line to c o m p a r e
n o te s on th e im m e d ia t e o u tlo o k fo r th e T r e a s u r y ’s
b a la n c e s h e ld at R e s e rv e B anks. T h e ir o b je c tiv e
is to c o o r d i n a t e c h a n g e s in T r e a s u r y b a la n c e s
w ith th e S y s t e m ’ s m a n a g e m e n t of b a n k res e rve s .
T h e y c o m p a r e n o te s on th e a m o u n t o f T r e a s u ry
c h e c k s th e y e x p e c t to be p re s e n te d fo r p a y m e n t
at R e s e rv e B a n k s th a t d a y a n d on the n e x t tw o
days.
T o d a y , the A s s is t a n t S e c r e ta r y te lls th e D e p u ty
M a n a g e r th a t his p r o je c tio n s of d a ily G o v e r n m e n t
re c e ip ts a n d e x p e n d it u r e s in d ic a te $ 5 0 0 m illio n
m u s t be tr a n s fe r r e d to d a y fr o m its b a la n c e s at
c o m m e r c ia l b a n k s to th e T r e a s u r y ’s R e s e rv e
B a n k b a la n c e . T he fu n d s w ill c o m e fr o m ta x and
loan a c c o u n t s at 2 7 5 larg e c o m m e r c ia l b a n k s
a c r o s s th e c o u n tr y (the C la s s C banks), a n d w ill
be in a d d itio n to c a lls p r e v io u s ly s c h e d u le d on tax
a n d loan a c c o u n t s a t o th e r c o m m e r c ia l banks.
T he F e d ’ s p r o je c tio n s in d ic a te a d ra in of $ 6 0 0 m il­
lion fr o m th e T r e a s u r y 's a c c o u n t. A ft e r d is c u s ­
sion, th e A s s is ta n t S e c r e ta r y d e c id e s to c a ll 100
p e r c e n t of the p r e v io u s n ig h t ’s T re a s u ry b a la n c e s
at th e “ C ” b a n k s — a b o u t $ 5 5 0 m illio n .
T h e c o n v e r s a t io n o ve r, the D e p u ty M a n a g e r in­
fo r m s a n o th e r o f f ic e r in th e B a n k th a t th e T re a ­
s u ry has d e c id e d to m a k e a s p e c ia l ca ll to d a y on
th e “ C ” b a n k s . By 11 a.m ., large b a n k s e v e r y ­
w h e r e w ill h a v e be e n in s tru c te d to t r a n s fe r 100

p e r c e n t o f th e T r e a s u r y ’s d e p o s its w ith th e m at
M o n d a y ’s c lo s e to th e ir d is t r ic t R e s e rv e B anks.
T h e s e t r a n s fe r s w ill d ra in m e m b e r b a n k re s e rv e s .
In th is c a s e , th e tr a n s fe r w ill o n ly o ffs e t m o s t of
the in c r e a s e in m e m b e r b ank re s e rv e s e x p e c te d
fr o m t o d a y ’s p a y m e n t of T r e a s u ry c h e c k s p r e ­
s e n te d d u rin g th e d a y to th e R e s e rv e B anks.
T h e s e c h e c k s a re o fte n d e p o s ite d w id e ly o v e r the
c o u n tr y . Big c ity b a n k s m a y fin d t h e m s e lv e s net
lo s e rs w h e n th e y tr a n s fe r T re a s u ry d e p o s its to the
R e s e rv e B a n ks. In th a t c a s e , th e s e b a n k s w o u ld
nee d to s te p up th e ir o v e rn ig h t b o rr o w in g in the
F e d e ra l fu n d s m a rk e t.

Getting the “ feel” of the market
W e ll b e fo r e 10:0 0 a.m ., th e G o v e r n m e n t s e c u r itie s
m a r k e t has u s u a lly b e c o m e a c tiv e . By th e n s e v e r ­
al tr a d e r s a ro u n d th e F e d ’s d e s k a re try in g to
learn fr o m d e a le r s w h e t h e r a n y tre n d is d e v e lo p ­
ing. O th e r tr a d e rs a re g e ttin g a r u n d o w n fr o m the
B a n k ’s fo r e ig n d e p a r t m e n t a b o u t o rd e rs to be
e x e c u te d fo r fo r e ig n a c c o u n ts . R e p o rts h ave
a rr iv e d on d e a le r p o s itio n s , a n d on re s e rv e p o s i­
tio n s a n d F e d e ra l fu n d s t r a n s a c tio n s th e day
b e fo r e at m a jo r b a n k s in N e w Y o rk a n d o th e r
c itie s. O n h a n d is a re p o rt g iv in g th e d is trib u tio n
of re s e rv e s a m o n g m o n e y m a r k e t b a n ks, o th e r
re s e rv e c ity b a n k s , a n d c o u n tr y ba n ks.
S h o rtly a fte r 10 o ’c lo c k , tw o c le r k s u p d a te the
q u o ta tio n b o a rd w ith th e la te s t " r u n s ” of p ric e s

and yields obta ined by te lephone fro m dealers. The
F e d 's tr a d e r s a lr e a d y k n o w fr o m th e ir c o n v e r s a ­
tio n s w it h d e a le r s w h a t th e b o a rd s h o w s : p ric e s
a re ste a d y . T h e y a ls o k n o w th a t th e re has b een
little tr a d in g e x c e p t a m o n g d e a le r s w h o a re te s t­
ing e a c h o t h e r ’ s m a r k e ts by “ h ittin g a b id ” — th a t
is, se llin g s e c u r itie s at th e p r ic e bid by a n o th e r
de a le r. F ed fu n d s a re q u o te d 5 7/8 p e r c e n t b i d , 6
p e rc e n t o ffe re d , w h ic h is a s h a d e h ig h e r than
y e s t e r d a y ’s a v e ra g e ra te o f 5V* p e r c e n t a n d w ell
a b o v e th e F e d ’ s 5 1 p e r c e n t d is c o u n t rate.
/2
O n e s ta ff m e m b e r c a lls th e n o n b a n k d e a le r s to
fin d o u t h o w m u c h n e w m o n e y w ill be n e e d e d to
re p la c e loa n s m a tu rin g to d a y or to fin a n c e s e c u r i­
ties b e in g d e liv e re d to d a y. A fe w m in u te s b e fo re
11 a.m ., his ta b u la tio n s h o w s th a t th e d e a le rs
ne e d lo a n s o f a b o u t $ 4 .5 b illio n to fin a n c e th e ir
p re s e n t s e c u ritie s h o ld in g s. M o n e y w a s a v a ila b le
a t th e c lo s e y e s te r d a y a t 5 3 p e rc e n t, but s e v e ra l
A
d e a le r s th in k m o n e y m a y be m o re e x p e n s iv e and
h a rd e r to g e t today.
T h e d e s k o ffic e r , w h o has ju s t b e e n jo in e d by
th e D e p u ty A c c o u n t M a n a g e r and a n o th e r o ffic e r,
s u m m a r iz e s d e v e lo p m e n ts fo r th e m . T o g e th e r,
th e y re v ie w th e n e w e s t p ro je c tio n of fa c t o r s
a ff e c tin g b a n k re s e rv e s o v e r the n ext six w e e k s ,
a re s e a rc h re p o rt r e c e iv e d o n ly m o m e n t s b e fo re .
T he p r o je c tio n in d ic a te s th a t flo a t on M o n d a y
w a s $ 5 0 0 m illio n less th a n e x p e c te d . R evise d
p r o je c tio n s s u g g e s t th e Fed m u s t in je c t m o re

re s e rv e s in the c u r r e n t w e e k to h old th e Fed
fu n d s rate a ro u n d
p e rc e n t. T h e o ff ic e r s b e g in
to f o r m u la t e th e d a y 's p lan of a c tio n ; th e D e p u ty
M a n a g e r c h e c k s w it h the M a n a g e r b y p h o n e
a n d w r it e s o u t th e d a y 's p ro g ra m . A la s t-m in u te
c o n t a c t w ith th e tr a d e rs in d ic a te s th a t b a n k s a n d
o th e r s a re b e g in n in g to sell T re a s u ry b ills to
d e a le r s in g re a te r v o lu m e than b u y e rs a re ta k in g
f r o m th e m . D e a le rs a re ra isin g the ra te s th e y a re
b id d in g fo r T re a s u ry bills, th a t is, p r ic e s a re
b e g in n in g to d e c lin e .
M e a n w h ile , a s ta ff ca ll is m a d e to the B o a rd of
G o v e r n o rs in W a s h in g to n a n d to th e o ff ic e of one
of th e R ese rv e B a n k p re s id e n ts c u r r e n t ly on the
F O M C . The N e w Y o rk s ta ff p r o v id e s in f o rm a tio n
on th e full ra n g e o f d a ta a v a ila b le on b a n k
re s e rv e s and th e m o n e y a n d G o v e r n m e n t s e c u r i­
tie s m a rk e ts . Thus, th e R e s e rv e B a n k P re s id e n t
w ill h a v e b e fo r e h im th e d a ta on w h ic h th e d e s k 's
plan o f a c tio n is b a s e d . T he o ff ic e r s h u rry to an
a d jo in in g o ff ic e to p a r t ic ip a te in th e k e y te le p h o n e
c o n v e r s a t io n th a t fo r m a liz e s the d a y ’s s t r a te g y —
th e 11:1 5 c o n fe r e n c e call.

The conference call
“ W a s h in g to n a n d San F r a n c is c o a re s ta n d in g
by," a n n o u n c e s th e te le p h o n e o p e ra to r, c o m p l e t ­
ing th e th r e e -w a y te le p h o n e h o o k u p th a t e n a b le s
th e A c c o u n t M a n a g e r to re v ie w d e v e lo p m e n ts
w it h th e s ta ff o f th e B o a rd a n d th e R e s e rv e B ank
2 0 p r e s id e n t on th e call. S ittin g in on th e c o n v e r s a ­

tio n a t th e N e w Y o rk e n d to d a y a re the P re s id e n t
of th e Bank, th e M a n a g e r a n d D e p u ty M a n a g e r of
th e S y s te m A c c o u n t, a n d th e o ff ic e r s o f th e s e c u ­
rities d e p a rtm e n t. S e a te d d ir e c tly b e h in d a te le ­
p h o n e m ic r o p h o n e , o n e o f th e o ff ic e r s s p e a ks:
“ C o n d itio n s h a v e c h a n g e d s o m e w h a t s in c e w e
s p o k e y e s te rd a y . T h e G o v e r n m e n t s e c u r itie s m a r ­
ket o p e n e d th is m o r n in g w ith v e ry fe w c h a n g e s in
p ric e s and rates, a n d w ith little a c tiv ity . B ut T r e a ­
s u ry bill rates n o w se e m to be rising. T h e re are
s o m e in d ic a tio n s th a t lo n g -te rm in v e s to rs a re
h o ld in g o ff to s e e h o w th e m a r k e t w ill ta k e the
$ 2 0 0 m illio n b o n d issue o f th e X Y Z C o rp o ra tio n
t o m o r r o w . Fed fu n d s o p e n e d a t 5 7/8 p e r c e n t bid,
1/8 p e r c e n t a g e p o in t a b o v e y e s te r d a y 's c lo s in g
rate, a n d fu n d s a re w e ll bid at th a t rate. D e a le r
fin a n c in g n e e d s th is m o r n in g o p e n e d at a b o u t
$ 4.5 billion. The b a n k s h ave ra is e d th e ir ca ll loan
ra te s on d e a le r lo a n s fr o m 6 to 6 Vi p e r c e n t .
“ Y e s te rd a y , w e h a d a s h o rtfa ll in re s e rv e s th a t
m o r e th a n o ff s e t w h a t w e put in. W e loo k fo r a
s h a rp d e c lin e in re s e rv e s to d a y a n d to m o r r o w as
c u r r e n c y in c i r c u la t io n in c r e a s e s a n d flo a t d ro p s .
B a n k s h e re a n d in C h ic a g o s e e m u n d e r s p e c ia l
p re s s u re a n d h ave b e e n v e ry h e a v y b u y e rs of
F e d e ra l fu n d s on e a c h o f th e last th re e b u s in e s s
days. B a n k s in s e v e ra l o th e r m a jo r c itie s s h o w
re s e rv e d e fic ie n c ie s . T o d a y ’ s $ 5 5 0 m illio n call on
th e “ C ” b a n k s w ill a d d to p re s s u r e on the m o n e y
m arket b a n k s .”

T h e o ff ic e r th e n re a d s th e M a n a g e r ’s p ro p o s e d
p lan fo r the day:
“ In v ie w o f the e x p e c te d s tr in g e n c y in re s e rv e s ,
the A c c o u n t p la n s to p u r c h a s e s e c u r itie s fo r ca sh .
If th e m a r k e t c o n tin u e s to tig h te n , w e m a y b u y as
m u c h as $ 5 0 0 m illio n of T re a s u ry bills. W e ca n
use re p u r c h a s e a g r e e m e n t s to s u p p ly a d d itio n a l
re s e rv e s if n e e d e d .”
The c o n v e r s a t io n is, of c o u rs e , m o r e d e ta ile d and
la c e d w ith th e v e rb a l s h o r t c u ts fa m ila r to p e o p le
o p e ra tin g in th e m o n e y m a rk e t. P r o s p e c tiv e d e v e l­
o p m e n t s in th e n e x t c o u p le of w e e k s a re d is ­
c u s s e d . T h e B o a rd p a r t ic ip a n ts m a y re p o rt a b o u t
p o s s ib le M, a n d M 2 re v is io n s . T he San F r a n c is c o
R e s e rv e B ank p re s id e n t w ill e x p re s s his v ie w on
th e p ro p o s e d a c tio n .
The call is u s u a lly c o m p le t e d by 1 1 :30. A s ta ff
m e m b e r at th e B o a rd p r o m p t ly s u m m a r iz e s the
call in a m e m o r a n d u m s e n t to e a c h B o a rd m e m ­
b e r and a te le g ra m is s e n t to e a c h R e s e rv e B a n k
p re s id e n t.

The decision
S h o rtly b e fo r e noo n , c o n d it io n s b e g in to je ll ra p id ­
ly a n d in d ic a te a s h a rp in c r e a s e in re s e rv e p r e s ­
su re s. Fed fu n d s a re h e a v ily bid fo r at 5 15/16
p e rc e n t. N e w Y o rk C ity b a n k s a n d o th e r p a r t ic i­
p a n ts in th e fu n d s m a r k e t re p o rt th a t fu n d s are
h a rd to find. D e a le rs re p o rt little p ro g re s s in m e e t­
ing th e ir fin a n c in g n e e d s by b o r r o w in g on a

s e c u r e d b a s is f r o m th e ir o u t-o f-to w n s o u rc e s ,
even a t 5 7/8 p e rc e n t.
The M a n a g e r re v ie w s th e e v id e n c e a n d g iv e s the
final g o a h e a d : “ T h e m a r k e t has re a lly s ta r te d
tig h te n in g up. W e ’d b e tte r m o v e in rig h t a w a y in
size to p re v e n t th is fr o m g e ttin g o u t o f ha n d . L e t ’s
g o in a n d b u y a b o u t $ 5 0 0 m illio n in T r e a s u r y bills
fo r c a s h to d a y . ” A s w e h ave se e n , w it h in th irty
m in u te s th e F e d 's tr a d e rs p u r c h a s e $ 5 2 3 m illio n
in T re a s u ry bills fo r c a s h in a m a r k e t “ go-a ro u n d .”
Fed o ff ic e r s c o n tin u e to w a t c h the s itu a tio n a fte r
th e “ g o - a r o u n d ” is c o m p le te d a t a r o u n d 12:30
p.m . T he Fed fu n d s rate e a s e s b a c k to 5 7/8 p e r­
c e n t bid fo r a tim e , b u t th e n th e b ro k e rs re p o rt
th a t b id s a p p e a r to be b u ild in g w h ile th e s u p p ly
a v a ila b le r e m a in s lim ite d . G iv e n th e p e r s is te n t
tig h tn e s s , th e M a n a g e r a p p ro v e s th e d e s k
o f f i c e r ’s r e c o m m e n d a tio n th a t th e S y s te m
p u r c h a s e a b o u t $1 b illio n of T re a s u ry a n d F e d e ra l
a g e n c y s e c u r itie s u n d e r o v e rn ig h t r e p u rc h a s e
a g r e e m e n t s . P e rh a p s $ 1 0 0 m illio n o f b a n k e r s ’
a c c e p t a n c e s w ill be b o u g h t u n d e r s im ila r c o n ­
tra c ts .
By 1:00, th e a d d itio n a l in je c tio n of re s e rv e s has
b e e n m a d e , b rin g in g th e d a y ’s to ta l to o v e r $ 1.5
billion. B e tte r b a la n c e re tu rn s to th e F e d e ra l fu n d s
m a rk e t, b u t th e o ff ic e r s w ill not k n o w until the
n ext d a y w h e t h e r th e s h o rta g e o f re s e rv e s
re fle c te d a s h a r p e r- th a n -e x p e c te d d ro p in flo a t or
s o m e th in g else . A d a ily te le g r a m to th e B o a rd and

R e s e rv e B a n k s w ill s u m m a r iz e th e d a y ’ s d e v e lo p ­
m en ts.
P riv ate m a r k e t tr a d e rs w ill d e b a te w h e t h e r the
F e d 's a c tio n th a t d a y s o u g h t s im p ly to h e a d o ff
th e d e v e lo p in g s tra in in th e m a r k e t o r w h e t h e r it
had b ro a d p o lic y s ig n ific a n c e . A n a ly s ts m a y c o n ­
c lu d e th a t th e F e d e ra l R e s e r v e 's d o u b le - b a rre le d
e n tr y s u g g e s ts th a t 5 3 i p e r c e n t is still the d e s k ’s
/
o b je c tiv e . O n a n o th e r o c c a s io n , if a n a ly s ts w e r e
w o r r ie d at th e s tr e n g th in th e M, a n d M 2 d a ta p u b ­
lish e d in re c e n t w e e k s , th e y m ig h t q u ic k ly c o n ­
c lu d e th a t th e F e d e ra l fu n d s rate o b je c tiv e w a s
be in g r a is e d — w e r e th e d e s k to a p p e a r s lo w in
s u p p ly in g re s e rv e s . B u t to d a y th e re s e rv e s tra in s
th a t th r e a te n e d to b e c o m e a c u te h a ve d is a p p e a r e d .
T o m o r r o w is a n o th e r d a y . . .

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