Full text of Review (Federal Reserve Bank of St. Louis) : December 1978

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The Economic Consequences
of Wage-Price Guidelines ...........................

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Contracts and Implied Forward Rates

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21

The Economic Consequences of
Wage-Price Guidelines
MICHAEL E. TREBING
OLUNTARY wage and price guidelines have
now been adopted as a major element in the Govern­
ment’s anti-inflation program. The pricing behavior of
firms and wage demands of labor are considered by a
large portion of the population to be incompatible
with the social objective of reducing inflation. Re­
straint in wage and price movements is believed to be
necessary. Monetary and fiscal restraint alone appar­
ently have been judged as either not being able to
accomplish this objective or as carrying too high a
cost, in terms of lost output and employment.1
Although the guideline approach is popular with
the public, remarkably little discussion has been di­
rected toward its implications.2 In particular, the
probable efficiency and distributional consequences
of the program have received little public attention.

THE DECELERATION PLAN
W a ge and Price Arithm etic
The Administration has set explicit numerical stand­
ards for wage and price increases.3 The basic guide­
lines specify that annual increases in wage and fringe
benefits be held below 7 percent and that price in­
creases be limited to 0.5 percent less than their an­
nual rate of increase during 1976-77.4 An alternative
test for firms is to apply a “profit-test.” If a firm can­
not m eet the price standard, it is requested to limit
its pre-tax profit margin on sales to the average of
the best two of the past three years. In addition, total
profit increases must be below a 6.5 percent ceiling,
unless accounted for by volume increases.
The program requires that deceleration of prices be
achieved in each market, purportedly with individual
JThis conclusion is clearly stated in White Paper: The Presi­
dent’s Anti-Inflation Program (accompanied the President’s
announcement of the guideline program on October 24, 1978)
pp. 1-4.
2A recent public opinion poll demonstrates the popularity of
the adopted guideline policy. In a November 1978 Harris Poll
63 percent of the respondents supported the program. See
Louis Harris, “Americans Support Anti-Inflation Plan,” St.
Louis Globe-Democrat, October 20, 1978.
3In this article the word “standards” is used interchangeably
with guidelines and guideposts. For details of the program
see U.S. Council on Wage and Price Stability, Fact Book:
Wage and Price Standards issued October 31, 1978.
4Ibid. pp. 20-40. The pay standard applies not to individual
workers but to average pay increases for “groups” of workers.
Page 2



firms sharing equally in the burden of lowering in­
flation.5 The target for inflation is 6 to 6.5 percent
over the first year of the program. In order to reach
these objectives, the program’s aim is to have prices
rise at the same rate as unit labor costs, with average
wage increases of 7 percent minus 1.75 percentage
points for projected productivity growth yielding an
inflation rate of 5.25 percent. The Administration al­
lows an additional 0.5 percent for “legislatively man­
dated payroll costs” and arrives at a rate of 5.75 per­
cent.6 The Administration states: “The wage/price
standards are designed to serve as guides for the be­
havior of decision-making agents who have d iscre­
tionary p o w er ov er th e p rices an d th e w ag es that they
receive.”7 [emphasis added]
W hile the guidelines are “voluntary,” the Adminis­
tration has emphasized its intention to compel firms
to comply by manipulating both Federal procurement
policy and the Government’s broad regulatory author­
ity. The program also encourages that the force of
public exhortation be directed at those large firms
which exhibit “excessive” price increases.
The Administration has requested that Congress
pass a “real wage insurance” program. Under this
scheme, workers who m eet the pay standard will re­
ceive a tax rebate if the rate of inflation exceeds 7
percent. The purpose of the rebate is to reduce
workers’ fear of cooperation by insuring that they
will not have their purchasing power reduced if the
rate of inflation is not held to less than 7 percent.8
The price standards are directed at individual firms and apply
to an “overall average price” and not to specific products.
5See White Paper, p. 7.
6Fact Book, pp. 15-16. Even with widespread compliance, the
Administration concedes that prices will probably rise within
the range of 6 to 6.5 percent. This would represent, however,
an improvement over the first six months of 1978 when prices
rose at a 10 percent annual rate.
7Ibid. p. 16. The paragraph continues: “Thus, standards are
not directly relevant to pricing behavior in those markets in
which prices are determined by the impersonal workings of
supply and demand.” The program exempts raw materials and
auction type markets which include (1 ) prices of agricultural
and industrial raw materials, (2 ) interest rates, and ( 3 ) prices
which historically have moved in tandem with an organized
open exchange market.
8Note that a 7 percent pay increase and a 7 percent inflation
rate gives zero increase in real income before taxes — even if
productivity rises 1.75 percent. Given the progression in the
income tax structure, real income (after taxes) declines. See
Nancy Jianakopolos, “Paying More Taxes and Affording It
Less,” this Review (July 1975), pp. 9-13.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Incom es Policy and Inflation
Voluntary wage and price standards can be classi­
fied as an “incomes policy”. This generic term, loosely
defined, includes all of those actions taken by a gov­
ernment to affect the level of money incomes or
prices by actively participating in wage and price
decisionmaking.
Although more popular in European countries, a
wide range of incomes policies have been tried in the
United States in recent years.9 Included have been
relatively weak attempts to persuade or “jawbone”
specific firms and workers to hold down wage or price
increases in the spirit of social responsibility.10 Such a
program was adopted during the Kennedy Administra­
tion and carried over into the early years of the John­
son Administration. At the other extreme, incomes pol­
icies have included former President Nixon’s rigid
program of mandatory criteria for wage and price
behavior throughout the entire economy. Guidelines
represent an attempt to achieve a compromise between
the two extremes. By strengthening the persuasive
element used under the jawboning method while at­
tempting to avoid the harsh consequences of strict
wage and price controls, guidelines represent a politi­
cally tempting route.

WHAT “CAUSES” INFLATION?
T h e “Cost-Push” View
The acceptance of voluntary wage and price
standards as an alternative prescription for reducing
the general rate of inflation stems from the idea that
inflation is generated by “cost-push” factors. This
view describes how rising wages, the largest com­
ponent of business costs, continually force prices
upward. The resulting inflation is known to the pub­
lic as a wage-price spiral. A similar version of this
view concludes that inflation is the consequence of
increases in the market power of firms and labor over
the prices they charge. According to this analysis,
prices and wages are “administered” by large firms
and trade unions without regard to competitive mar­
ket forces.
9For historical surveys of incomes policy in the United States
and abroad see U.S. Congress, Congressional Budget Office,
Incomes Policies in the United States: Historical Review and
Some Issues, May 1977; Lloyd Ulman and Robert J. Flana­
gan, Wage Restraint: A Study of Incomes Policies in Western
Europe (Berkeley, California: University of California Press,
1971); Walter Galenson, ed., Incomes Policy: What Can We
Learn From Europe? (Ithaca, New York: New York State
School of Industrial and Labor Relations, Cornell University,
1973); and Craufurd D. Goodwin, ed., Exhortation and Con­
trols: The Search for Wage-Price Policy, 1945-1971 (Wash­
ington, D.C.: The Brookings Institution, 1975).
10These efforts are sometimes referred to as “moral suasion.”



DECEMBER

1978

The cost-push view has great popular appeal since
it depicts the inflation process as a struggle for in­
come shares between capitalists and workers. How­
ever, economic theory reveals that many implications
of this view of inflation are illogical or, at best, ques­
tionable.11 It is argued that monopoly power exists in
the market place and that firms have the ability to
push prices above competitive levels and raise the
average price level. But this analysis ignores the ques­
tion of why the monopolies had been charging less
than the high monopoly price.
The theory of monopoly pricing predicts that firms
which have protection from the entry of competitors
into their markets are able to receive prices above
those of competitive markets. Once the monopoly
price has been achieved, however, further increases
are limited to the opportunities provided by the mar­
ket. If monopoly power is now causing prices to rise,
either monopoly power is increasing or monopolists
had been behaving irrationally and have just discov­
ered their market advantage. There is little evidence to
support either alternative.12
Undeniably, many economic groups exhibit enough
market power to influence the level of certain prices
and wages. These monopoly prices are higher than
they would be if the specific market were competi­
tive. But, except for a slight rise due to the resource
misallocation, the overall level of prices and wages
will remain substantially unchanged.13 For example,
if wages in a particular industry are pushed up above
competitive levels less employment will result. Labor
will then be released for use in other sectors where a
downward pressure on wages will result until a new
equilibrium is reached. More importantly, however,
this analysis is u n ab le to explain p ersistent in creases

in prices, month after month, year after year.

A M onetary View
An alternative theory is that inflation is a monetary
phenomenon. This view holds that changes in money
1'See George J. Stigler, The Organization of Industry (Home­
wood, Illinois: Richard D. Irwin, Inc., 1968), pp. 244-45
and Milton Friedman, “What Price Guideposts?”, Guidelines:
Informal Controls and the Market Place, ed., George P. Shultz
and Robert Z. Aliber (Chicago: University of Chicago Press,
1966), pp. 17-39.
l2For a survey of the evidence regarding the relationship be­
tween market concentration and price changes see Steven
Lustgarten, Industrial Concentration and Inflation (Wash­
ington, D.C.: American Enterprise Institute for Public Policy
Research, 1975).
13One purpose of a union monopoly, for example, might be to
gain real wage benefits for its rank and file. To accomplish
this objective the union has several alternatives available to
it. It may try to reduce the supply of labor through restric­
tive licensing practices or by not allowing non-union workers
Page 3

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

growth exert a strong influence on total spending in
the economy. W hen people find that they are holding
cash balances which are greater than desired, they
spend the excess money on real and financial assets
and bid up their prices.
The monetary view does not deny the existence of a
wage-price spiral, but interprets the cost-push analysis
as a confusion of the cause and effect relationships of
the inflation process. According to the monetary view,
the observed patterns of wage and price adjustments
are normal responses to excessive money growth. For
inflation to persist, the higher prices, no m atter w h ere
th ey originate, must be validated by increases in the
money supply. W ith money growth held constant,
price increases can be maintained only through re­
duced production and employment. For such a sit­
uation to persist, businesses would have to willingly
accept lower profits and labor would voluntarily re­
main unemployed and refuse to accept employment
at lower wages. The empirical evidence does not
support such irrational behavior.14 Only when mone­
tary authorities actively ensure that the spiral is fully
augmented through increases in the money supply,
will inflation result.

WILL VOLUNTARISM SUCCEED?
The underlying requirement for a successful guide­
line policy is that firms and wage-earners restrain
themselves from acting economically as individuals.
In a market economy the motive of individual selfinterest is crucial. Consumer preferences are revealed
through the market by nonrestricted opportunities
and/or purchases of goods and services at their mar­
ket price. These prices reflect not only the costs of
production, but also the nature of demand for the
good in question. The free movement of prices and
the consequent incentives and disincentives that are
created assure that resources in the economy will
move toward satisfying these individual demands.

DECEMBER

1978

with the social motives and wealth is transferred to
those who stand apart from the program.
The Kennedy Administration guideposts of 1962-67
represent a prime example of these conflicts. This
voluntary program established upper wage limits
which were equal to overall productivity gains for the
economy.18 The problem which resulted in the demise
of the productivity rule was that the guideline prin­
ciples did not take into account the fundamental
pressure created by accelerated money growth.
When the productivity guidelines were initially
adopted, the trend of productivity growth was sub­
stantially above the rise in consumer prices. Wages
based on the productivity rule thus provided for
growth in real wages (money wages adjusted for
price changes). As money growth accelerated and
inflationary pressures intensified in 1965 and 1966,
the wage standard became viewed as unfair. Labor,
discovering that the purchasing power of their wages
was falling, found the argument for holding down
wages unacceptable. As key settlements began to ex­
ceed the guideposts, the program was abandoned.
The degree of compliance with price guidelines
will be associated with the severity of the penalties
against those who choose to ignore them. If the con­
trols are truly voluntary and involve no costs for
violation, there is little chance that they will succeed
since gains from noncompliance can be realized with­
out costs. If economic sanctions are used against vio­
lators, however, each firm will weigh the expected
costs and benefits involved. If the expected costs of
noncompliance are less than the benefits, the firm
will choose to ignore the guidelines.16 Avoidance
can also take the form of “black-market” transactions
above the controlled price or product quality changes.

An appeal for individual restraint conflicts with a
very basic economic observation about human be­
havior — consumers naturally strive to maximize their
individual well-being. Econom ic self-interest is the
major motivating factor behind economic activity.
Guidelines, on the other hand, represent rules that
substitute “social responsibility” for self-interest.
The conflict between the two views is glaring. E co­
nomic incentives argue against in dividu al compliance

Though the burden of the program is intended
to be equally shared, this will not be the case. Gov­
ernment penalties through procurement policy will
not affect private decisions in a uniform fashion.
Some firms are dependent upon either government
purchases of their output or are directly influenced
by government policies. Other firms, however, may be
outside the range of government sanction. Holding
down the price of particular goods by penalties ben­
efits the purchasers of these goods and the sellers of
unaffected competitive goods. The losers are the
sellers of the controlled goods, those prospective
buyers of the controlled goods who can no longer

to obtain jobs. Secondly, the union might seek a higher
wage through collective bargaining and thus accept the un­
employment forthcoming at this higher wage.
14See Denis S. Kamosky, “The Effect of Market Expectations on
Employment, Wages and Prices,” Working Paper # 1 7 , Fed­
eral Reserve Bank of St. Louis.

15The Council of Economic Advisers, Economic Report of the
President (Washington, D.C.: United States Government
Printing Office, 1962), pp. 185-90.
16The same type of “cost-benefit analysis” will occur when
labor contemplates compliance with wage guidelines and
the rebate scheme which supplement them.


Page 4


DECEMBER

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

1978

Toble II

Table I

Productivity C h a n g e s for Selected Industries, 1 9 7 1 -7 6
(Annual Rates of Change)

W a g e s, Prices and Em ploym ent by
Industry (1 9 7 1 - 7 7 )
(Annual Rates of Change)

Output per
Employee-hour1
Hosiery
Synthetic Fibers
Wet Corn Milling
Aluminum Rolling & Drawing
Pharmaceutical Preparations
Paper, Paperboard, & Pulp Mills
Petroleum Refining
Steel
Concrete Products
Primary Aluminum
Hydraulic Cement
Copper Rolling & Drawing
Coal Mining

11.1%
7.4
7.2*
5.5
4.3
2.5
2.1
1.8
0.8*
—
1.4
—
1.5
—
1.7
—
4.3

*1971-75
xThe output per employee-hour figure is computed by dividing an
output index by an index of aggregate employee-hours for produc­
tion workers.
Sou rce: U .S. Department of Labor, P roductivity In d ex es F o r S elected
In dustries, 1977 edition, p. 5.

obtain them, and the purchasers of the competitive
goods. The losses exceed the gains because of the
misallocation of resources.
The proposed “real wage insurance” plan which
would supplement the guidelines, if enacted, serves to
shift the burden of compliance among economic
groups. If certain workers are guaranteed a constant
real wage, the forthcoming rebates could reduce real
incomes to the rest of the nation provided there is an
increase in the federal deficit. To the extent that these
larger deficits are “monetized”, inflationary pressures
will be supplemented, thereby reducing the wealth of
all holders of money and monetary instruments.17
The real-wage insurance program is said to be
capable of breaking inflationary psychology and be
able to bring about more rapidly the achievement of
price stability. Lower expectations of inflation in the
future, according to this view, would translate into
lower demands for wage increases and eventually
lower prices. This viewpoint, however, confuses how
inflation expectations develop. Expectations p e r se do
not cause inflation. Curbing expectations will require
controlling of the underlying force which causes them
to prevail. If price controls only delay the upward
thrust of prices caused by expansive money growth,
expectations of future inflation will not be reduced.
If inflation expectations are not reduced by slower
monetary growth, the longer-run objective of reaching
price stability will be abandoned. F or example, since
17For an analysis of the administrative problem with the “realwage insurance” program, see Gardner Ackley, “Okun’s New
Tax-Based Incomes Policy Proposal,” Economic Outlook USA
(Winter 1978), pp. 8-9.



Prices1
Manufacturing
Construction
Services
Trade
Finance
Communications
Transportation
Utilities
Mining
Agriculture

6 .0 %
8.2
7.3
6.5
4.9
3.4
5.9
8.9
18.2
9.5

Employment2

Wages'

1.0%
1.1
3.8
3.1
2.8
0.9
0.8
1.1
5.1
2.7

7 .7 %
5.7
7.7
6.4
6.6
9.9
7.7
7.8
9.6
6.5

1Changes in implicit GNP price deflator by industry.
2Full-time and part-tim e employees.
3Labor compensation per full-time equivalent employee.
Source: Su rvey o f C urrent B usiness.

market pressures will eventually push prices upward,
reaching the objectives of wage stabilization in the
future will be made more difficult. Following a period
of controls, a stable wage structure is far more likely
to allow a resumption of moderate rates of wage in­
crease than a structure in which distortions, perpet­
uated by public policies, require rapid readjustment
at the bargaining table. Experience with this type of
“wage-price explosion” is well documented from
European experience with control programs.18

MARKET DISTORTIONS AND CONTROLS
Most economists agree that, for the sake of effi­
ciency, relative wages and prices should remain flex­
ible. Relations among the wages of workers of differ­
ent skills and of workers in different localities,
industries or even firms should be allowed to vary
according to changes in demand and supply. For
example, firms which are growing have an incentive
to hire scarce resources (labor and capital) away
from other firms. Consequently, if upper limits are
imposed upon the payments that can be offered to
attract scarce inputs, the firms will not be able to
meet the demand for their output. Relative prices,
therefore, should be allowed to move in order to allo­
cate resources into their most productive uses.
The dynamic character of the U.S. economy is evi­
dent from Tables I and II. The tables display that
changes in employment and prices have varied across
industries. Some industries have experienced rapid
productivity growth; others have not. Employment
growth has varied from industry to industry and gen­
erally reflects underlying demand conditions. The
application of a single price and wage standard to
all situations ignores this ongoing adjustment process
18Ulman and Flanagan, Wage Restraint, p. 223.
Page 5

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

and confuses movements in relative prices (shifts of
resources between economic groups) and the general
level of prices. To minimize efficiency losses, it would
be necessary to keep a watchful eye on individual
wage and price relationships and make exceptions
based on individual market situations. A tradeoff is
therefore faced by the policymaker. The more strin­
gent the guideline (less exceptions) the greater the
efficiency losses. On the other hand, “weak” guide­
lines are not likely to gain the acceptance of the popu­
lace who judge the probable success of the guidelines
by the strictness of the program. The program is
therefore unlikely to reduce inflation expectations.
Implicit in the decision of who should be covered
by guidelines are important judgments regarding the
distribution of income among industries and be­
tween the factors of production. In other words, con­
trol programs politicize questions of income distribu­
tion. In a market economy, relative prices are signals
that allocate society’s resources into their most pro­
ductive uses. Reflecting changing market conditions,
these relative prices are always in motion and are
independent of political criteria for distributing in­
come between economic groups. Any guideline based
on a simple percentage price increase for all individ­
ual firms, however, is implicitly centered on an ac­
ceptance of wage and price relationships (at the time
of policy implementation) as stable ones and assumes
that the relationships will remain fixed throughout
the period of the guidelines.
D irect government controls, therefore, offer little
inducement for the efficient development and use of
resources, and contain no automatic mechanism for
resource adjustments and the alleviation of shortages
or excesses in production. Rather than being an aid
to growth and vitality, they lead to retardation of
economic resiliency and replace market forces by
political ones.
The U.S. experience with control programs dem­
onstrates these market misallocations. Price controls
during World W ar II resulted in the substitution of
low-quality goods for higher quality goods and black
markets were commonplace as individuals developed
lack of respect for the law. In later years, subsidies
to producers became an increasing part of the con­
trol program as fixed prices were insufficient to provide
the necessary incentives for production. Recent vol­
untary programs were also unable to avoid selective
scarcities. For example, the Kennedy guideposts were
blamed for shortfalls in supply of aluminum and sul­
fur and potential users were forced into using costly
substitutes. Similarly, under the Nixon Administration
controls, shortages developed for zinc, lead, steel, fer
Page 6


DECEMBER

1978

Table III

The 1 9 6 2 -6 6 G uid epo sts Period
Annual Percentage Changes
M l1
1962
1963
1964
1965
1966

W PI2

CPI3

2 .2 %
2.9
4.0
4.3
4.7

0 .3 %
-0 .3
0.2
2.0
3.3

1 .1 %
1.2
1.3
1.7
2.9

1Demand deposits plus currency and coin held by the nonbank public.
2Wholesale Price Index.
3Consumer Price Index.
Source: Departm ent of Commerce.

tilizer, petrochemical products and a long list of other
products.

THE ROLE OF MONETARY ACTIONS
The program is further complicated by the timing
of monetary action. In order to validate decelerating
inflationary pressures, it will be necessary to supple­
ment the program by tighter monetary action — re­
ducing growth in the money supply. But a problem
exists in the timing of monetary actions and the con­
trol policy. Relations observed in the past indicate
that previous changes in the money supply have ef­
fects on current variables — the pattern of aggregate
spending is determined by past monetary actions.19
A perfectly timed effort by monetary and price con­
trol authorities will be difficult to achieve.
The apparent failure of the Kennedy and Nixon
control programs to reduce inflation can be inter­
preted in a monetary framework. A monetary explana­
tion for th e failure of th e 1 9 6 2 guideposts is evident
in Table III. W hen the guidelines were adopted,
consumer prices were rising at a moderate 0.7 percent
rate. (The average change in the W holesale Price In ­
dex between 1958 and 1964 was near zero.) Through­
out the life of the guideposts (1962-66), however,
money growth increased steadily each year. The
money stock grew 1 percent per year from 1959 to
1961, but increased steadily each year of the pro­
gram.20 Correspondingly, prices and wages moved
upward reacting to the more rapid growth of spending.
W hen the program was abandoned in 1966, consumer
prices were rising at the rate of 3 percent.
During the Nixon price control period (1971-74),
money growth data reveals that the controls camou­
19One study which provides a more detailed statement of the
theory and evidence supporting these conclusions is Leonall
C. Andersen and Keith M. Carlson, “A Monetarist Model for
Economic Stabilization,” this Review (April 1970), pp. 7-25.
20Empirical support for the money-price relationship for the
period 1955 to 1971 is presented by Denis S. Karnosky’s,
“The Link Between Money and Prices — 1971-76,” this
Review (June 1976), pp. 17-23.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

flage a period of overly ex­
pansive monetary policy
during the 1970’s. Although
non-monetary factors (the
oil embargo and the shock
of controls) temporarily in­
fluenced the money-price
relationship, the growth of
the price level by 1975 par­
alleled that rate predicted
by the trend growth of
money.21

1978

Trends and Fluctuations of Money, Prices, Output, and Unemployment

Movements in the rate of
inflation have been closely
associated with movements
in the trend growth of the
money stock. The accom­
panying chart shows that
both U.S. control periods since World W ar II have
been marked by money growth above its long-run
trend. Correspondingly, in both cases rates of change
in prices eventually moved upward reflecting this
long-run trend.
W ithout curtailing aggregate spending, individual
demands will be simply shifted among controlled and
uncontrolled goods.22 Holding prices below their mar­
ket clearing levels will increase the quantity de­
manded of controlled goods. If total spending is not
reduced through monetary or fiscal actions, those who
are unlucky and do not receive the goods that would
have been supplied without controls, will shift their
spending to other products which represent, in most
cases, close substitutes. The increased demand in un­
controlled markets will put upward pressure on these
prices.

CONCLUSION
“Voluntary” wage and price guidelines have recently
been adopted as an accompanying policy alongside
the more traditional economic stabilization tools of
monetary and fiscal policy. By establishing rules for
pricing behavior, the Administration hopes to dampen
a wage-price spiral that appears to be self-sustaining.
21Ibid.
22The word “controlled” refers equally to those “voluntary” re­
sponses that are reactions to government sanctions.




DECEMBER

According to the monetary view of inflation, the
logical foundation of the control program confuses the
results and causes of inflation. According to this view,
inflation results when money growth persistently ex­
ceeds growth in the amount of money demanded. The
observed wage and price adjustment (the so-called
wage-price spiral) are but parts of the general re­
sponse in the economy to excessive money growth.
Inflation expectations, which are generated by exces­
sive money growth, will be reduced only when the
growth rate of money is slowed.
Any short-term benefits received from strict com­
pliance with the guidelines will be costly. The uncon­
strained market system provides an efficient signaling
system for moving resources between alternative uses.
Any control framework will probably conflict with
these price signals and will cause distortions which
reduce the resiliency of the market system to changing
market conditions. The emergence of black-markets
and disguised price increases through reduced product
quality are two examples of devices that have arisen
in response to previous programs and may arise in the
current program to circumvent the controls.
Past incomes policies in the U.S. have been unable
to reduce inflationary pressure because monetary ac­
tions remained expansive. If monetary actions remain
expansive throughout the current program, acceler­
ated inflation appears inevitable. The fundamental
forces of supply and demand cannot be repealed
through any type of control program.

Page 7

Is Inflation All Due to Money?
ALBERT E. BURGER

IN F L A T IO N is an all-pervasive problem which af­
fects everyone’s decisions. Individuals must consider
the outlook for prices when planning budgets or wage
demands, when deciding whether to buy a house or
in what form to hold savings, as well as a multitude
of other economic decisions. Also, business is increas­
ingly concerned about the outlook for inflation, espe­
cially as it relates to planning and capital investment.1
It is not surprising, therefore, that persistent inflation
has led to increased public demands that something
be done to correct the problem.
The current Administration has responded to these
demands by announcing an anti-inflation program
which includes, among other aspects, a promise to
intervene in individual price and wage decisions in
an attempt to reduce inflationary pressures. But such
an approach, at best, has only a very limited chance
for success because it fails to distinguish between two
key characteristics of the inflation process. First, there
are increases (or decreases) in prices which result from
nonmonetary factors that cover a gamut of influences
such as the effects of weather on agriculture and
actions of foreign oil producers. The basic character­
istic of all these nonmonetary factors is that they
have a transitory influence on inflation. They have
their impact on the level of prices in selected periods,
but their influence is either reversed in following
periods or ceases to be a cause of period-after-period
changes in prices in the same direction. It is the sec­
ond aspect of inflation, the trend or persistent yearafter-year increase of prices, that is really “public
enemy number one.” This is the aspect of inflation
to which corrective economic policy must be directed.
Otherwise, all other economic programs to stop infla­
tion will end in frustration.

Contrasting Explanations of Inflation
The rate of change of prices can show considerable
short-term fluctuation. For example, the implicit price
deflator for gross national product rose at a 5 percent
1John A. Tatom and James E. Turley, "Inflation and Taxes:
Disincentives for Capital Formation,” this Review (January

1978), pp. 2-8.


Page 8


rate in the third and fourth quarters of 1977, accele­
rated to about a 7 percent rate in the first quarter of
1978, rose further to an 11 percent rate in the second
quarter, only to recede back to a 7 percent rate in the
third quarter of 1978.
In addition to this variation in the general price
index, there are also frequent fluctuations in the prices
of individual items included in the general price in­
dexes. Since pronounced swings in the prices of spe­
cific goods or services sometimes coincide with fluc­
tuations in the general index of prices, specific items
are frequently cited as the cause of the current infla­
tion. Also, because the magnitude and timing of price
changes vary from item to item, the blame for in­
flation is often transferred, from period-to-period,
from one item to another. Consequently, a number
of explanations of the inflation process have been
offered, involving at various times the behavior of
such diverse items as steel prices, exchange rate move­
ments, union wage demands, agricultural conditions,
changes in minimum wages and even the behavior of
the periodically elusive anchovy. Such an analysis
provides an ever-changing array of inflation villains.
The blame for inflation is shifted from Arabs to coffee
producers to beef producers to steel producers to
specific union leaders to large banks and so on.
Concentration on such short-term oscillations in the
various elements of price indexes clouds the issue of
the fundamental force behind the persistent increase
in the general level of prices. The problem of inflation
is much more than an unfortunate sequence of in­
creases in the prices of particular items. Focusing
attention on movements in the price of particular items
or each wiggle in the general price indexes gives only
a description of where and when the general infla­
tionary pressures fall in the economy. The important
issue is why prices, on average, continue to rise over
an extended period of time.
An explan ation of the fundamental source of a con­
tinued pressure on prices requires a broader, longerrun perspective that incorporates monetary develop­
ments. W hen the money stock grows too rapidly
relative to the rate of increase of goods and services,

DECEMBER

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

individuals find themselves holding more money than
they demand, given existing income, prices, and yields
(including interest rates) on other assets. In the proc­
ess by which they attempt to pull their holdings of
money in line with the quantity demanded, inflation
results. To put the matter more simply, when “too
much money is chasing too few goods” there will be
persisten t increases in prices. Consequently, analysis
of persistent increases in the general level of prices
requires consideration of the growth of the money
stock. Such a monetary view contends that although
prices can periodically rise or fall sharply due to
nonmonetary factors, inflation continues only if these
nonmonetary factors recur in succeeding periods, or
if there is a continued excessive expansion of money.

1978

Table I

M onetary G ro w th as an

Indicator of Inflation

(1)

Period

(2)

Growth Rate
of Money

Growth Rate
of Prices

Period

{ i >- (2 :

2.3 %

1953

1.5%

0.8

2.7

1954

1.4

1.3

1949-54

3.2

1955

2.2

1.0

1950-55

3.3

1956

3.1

0.2

1951-56

2.7

1957

3.4

- 0 .7

1952-57

1.8

1958

1.6

0.2

1953-58

1.5

1959

2.2

- 0 .7

1954-59

2.0

1960

1.7

0.3

1955-60

1.3

1961

0.9

0.4

1956-61

The emphasis which is placed on the role of mone­
tary actions in the fight against inflation depends very
much on which of these two aspects of price changes
is the center of attention. Concentration on movements
in individual prices or short-term movements in the
general price indexes typically leads to assignment
of a limited role to monetary actions, a focus of at­
tention on nonmonetary factors, and the recommen­
dation of some form of direct controls on the prices
of specific items. In contrast, consideration of why
prices continue to increase period after period, pin­
points the rate of monetary expansion as the prime
factor in the fight against inflation.

1947-52
1948-53

1.5

1962

1.8

-0 .3

1957-62

1.8

1963

1.5

0.3

1958-63

2.2

1964

1.6

0.6

1959-64

2.2

1965

2.2

0.0

1960-65

3.1

1966

3.3

-0 .2

1961-66

3.6

1967

2.9

0.7

1962-67

4.0

1968

4.5

-0 .5

1963-68

4.8

1969

5.0

-0 .2

1964-69

5.2

1970

5.4

-0 .2

1965-70

5.1

1971

5.1

0.0

1966-71

5.5

1972

4.1

1.4

1967-72

6.1

1973

5.8

0.3

To illustrate the difference between inflation caused
by monetary factors and short-term movements in
price indexes caused by nonmonetary factors, consider
the following simple monetary guide to inflation:2
The rate of change of prices over the next year is
equal to the average rate of growth of the money
stock over the previous five years.

The results of using this shorthand representation
of the driving force behind the inflation process and
its long-run character are presented in Table I.8 The
information in this table shows that, over the period
1953-71, past or trend growth rates of money were
a reasonably good guide to the year-to-year behavior
of prices. During this nineteen-year period, the
2For other examples of the use of monetary guides to inflation,
see Richard T. Selden, “Inflation: Are We Winning the
Fight?,” Morgan Guaranty Survey (October 1977), pp. 7-13,
and Allan Meltzer, “It Takes Long-Range Planning to Lick
Inflation,” Fortune (December 1977), pp. 96-106.
3Annual data are calculated as to the average of the four
quarters of data in a given year. For example, the growth
rate of prices from 1976 to 1977 on an annual basis is com­
puted by comparing the average of the four quarters in 1977
to the average of the four quarters in 1976.



6.2

1974

9.7

-3 .5

6.1

1975

9.6

-3 .5

1970-75

M oney and Inflation

1968-73
1969-74

6.2

1976

5.2

1.0

1971-76

6.0

19 77

5.9

0.1

average difference between actual yearly inflation
and that indicated by the past rate of monetary ex­
pansion was only 0.2 percentage point, and in twothirds of the years the error was 0.5 percentage point
or less. On a quarter-to-quarter basis, the rate of
change of prices oscillated around the trend rate of
inflation. However, the rate of change of prices re­
turned consistently to that dictated by the rate of
monetary expansion.
Also during this period, changes in the five-year
trend growth of money accurately indicated changes
in the year-to-year rate of inflation. As the trend
growth of money slowed in the period 1958-63, in­
flation was reduced. Over the next eight years, the
trend growth of money accelerated steadily from
less than a 2 percent rate to a 5 percent rate, and
inflation rose from less than 2 percent to 5 percent
per year.
In contrast to the 1953-71 period, the last six years
present some examples of abnormally large differences
Page 9

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

between changes in the price index and the inflation
indicated by past growth rates of money. In particu­
lar, 1972 and 1974-75 stand out as glaring exceptions
to the previous performance of the monetary guide
to inflation. To understand the behavior of inflation
since 1971, and how this experience fits into the
general monetary explanation of inflation, it is crucial
that one clearly understand the effect of nonmonetary
factors on the behavior of prices. Specifically, it is
very important to realize that, although the level of
prices can change, sometimes even for a prolonged
period, the rate of change of prices cannot continue
to substantially deviate from the rate of monetary
expansion.4
W hat special nonmonetary factors in 1972 and
1974-75 operated to cause such large deviations of
actual changes in prices from those indicated by
past growth rates of money?5 First, 1972 was a year
of price controls. By law, reported prices were not
allowed to fully reflect market pressures, especially
those pushing prices upward. Under such circum­
stances, the reported change in prices would be
expected to be considerably less than inflation in­
dicated by a monetary guide. From the perspective
of a monetary interpretation of inflation, the gap in
1972 between price changes consistent with past
money growth (about 5.5 percent) and those re­
ported during wage and price controls (about 4
percent) indicates (1 ) an upsurge of prices when
price controls were removed, and (2) an incentive
for transactions to take place at prices above posted
prices.
Other major differences between reported changes
in prices and those indicated by past monetary expan­
sion occur in the more recent period of 1974-75. Over
this period, the level of prices was sharply and un­
expectedly raised by the now well-known pricing
actions of the major oil-producing nations and the
nonmonetary effects of weather on agriculture. The
actions of the Organization of Petroleum Exporting
Countries (O P E C ) resulted in a substantial, unex­
pected rise in the price of energy. Since energy is a
basic input into most production processes, these
4Even here, however, monetary factors still play a role, although
indirectly. Autonomous events can have an effect on the de­
mand for money, which, if not matched by a one-time change
in the money supply, result in a one-time increase in the
level of prices. In such instances, prices rise not because of an
excessive increase in the money supply but because of exces­
sive money balances created by a decrease in money demand.
5For a more complete technical discussion of the effects of
special developments in 1972-74, see Denis S. Kamosky, “The
Link Between Money and Prices— 1971-76,” this Review
(June 1976), pp. 17-23.
Digitized for Page 10
FRASER


DECEMBER

1978

Table II

G ro w th Rates o f Selected
Com ponents o f Consum er Prices

Period
11/71 _

IV /72

Food
Prices
3 .9 %

Energy
Prices
3 .7 %

All Items Monetary
less Food
Rate of
and Energy Inflation
3.1 %

6 .0 %

IV /72 — 1/74

19.6

22.3

4.6

6.0

1/74 — 111/75

8.8

13.9

9.7

6.0

111/75 — 11/78

6.2

6.9

6.6

6.0

O PEC actions had a widespread, and unexpected up­
ward effect on costs of production. There was a de­
crease in the effective productive capacity of the
economy. W ith aggregate demand affected to only a
minor extent and real output reduced, the lev el of
prices rose sharply.6 Consequently, the rate of change
of prices, computed over the period when these sharp
upward adjustments in the level of prices took place,
would be expected to be substantially, but tempo­
rarily, higher than that indicated by past monetary
expansion. As their effect was absorbed in the econ­
omy, however, the rate o f ch an g e of prices fell back
to that dictated by the trend rate of money growth.
Although in 1976-77 inflation returned to the rate
dictated by monetary expansion, the lev el of prices
remained about 4 percent higher, reflecting the effect
of the O PEC actions.
Table II shows the movement of prices of selected
groups of items during the period from mid-1971 to
mid-1978. As show n in the table, price increases of
all items other than food and energy were held to
about a 3-4 percent rate while general price controls
were in effect (August 1971 through April 1974).
After controls were removed from most items, prices
accelerated to about a 10 percent rate, as shown in
the period 1/74 — III/75. Table II also clearly shows
that the sharp surge in prices from late 1973 into
late 1975 was initially led by the sharp rise in agri­
cultural and energy prices7 and then was reinforced
by the adjustment of prices of all other items re­
sulting from the removal of price controls in early
1974. None of these components of consumer prices
6For a technical discussion of the effect of the rise in energy
prices, see Kamosky, “The Link Between Money and Prices
— 1971-76,” pp. 17-23; Robert H. Rasche and John A. Tatom,
“The Effects of the New Energy Regime and Economic Ca­
pacity, Production, and Prices,” this Review (May 1977), pp.
2-12; and “Energy Resources and Potential GNP,” this Re­
view (June 1977), pp. 10-24.
7Price controls on agricultural products were removed in Sep­
tember 1973. The initial OPEC rise in oil prices came in late
1973.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

(food, energy, all other) continued the sustained
double digit rate of increase. Since 1975 the average
rate of increase of all these prices has fallen back into
line with the sustainable rate indicated by the past
rates of monetary expansion.

Implications for M onetary Actions
The above discussion has important implications
for assessing the effects of past, current, and pros­
pective monetary actions in the battle against in­
flation. The experience of the last six years makes
it clear that it can be just as misleading to ascribe
each and every reported increase in prices entirely
to monetary factors as it is to ignore the effect of
money on inflation. Consequently, failure to separate
the monetary (trend) and nonmonetary (transitory)
aspects of inflation can lead to confused demands on
policymakers.
To illustrate the importance of this distinction,
consider economic developments over the last six
years. During the three-year period ended in the
second quarter of 1971, the persistent rate of infla­
tion was very much in line with the rate indicated
by a monetary guide to inflation. Over the next six
quarters, however, prices rose at about a 4 per­
cent rate. Could this fall in inflation be attributed
to monetary actions? The answer is no, the fall in
rep o rted inflation was strictly due to nonmonetary
factors, that is, price controls that went into effect
in August 1971.
From early 1973 through early 1975 prices rose
very rapidly. From a 4 percent rate, inflation ac­
celerated to about an 8 percent rate in the year
ended first quarter 1974. Then, over the next four
quarters inflation took another sharp leap upward,
averaging 11.6 percent. If one attributes all of these
increases in prices during this period to the cumu­
lative effect of past monetary actions, then it appears
that the Federal Reserve had let things get seriously
out of hand. On the other hand, if the short-run in­
fluences of nonmonetary developments on prices are
taken into consideration, quite a different conclusion
emerges. Careful analysis of the effects on prices of
weather, O PEC actions, and the removal of price
controls would indicate a sharp rise in the level of
prices beginning in late 1973 that was not the result
of past monetary actions. The basic rate of inflation,
the one determined by the cumulative effect of
past monetary actions, remained at about 6 percent.
Early in 1975, inflation dropped sharply, and aver­
aged 6.5 percent over the remainder of the year.



DECEMBER

1978

Then inflation eased further to a 4.4 percent rate
over the first three quarters of 1976. W as this sub­
stantial slowing in inflation the result of monetary
policy actions? Again the answer is no. The slowing
in the rate of change of prices from the double-digit
pace of 1974 reflected only that the O PEC actions
of late 1973 were not repeated in the following years,
the general adjustment of other prices to the removal
of price controls had been completed, and favorable
agricultural conditions resulted in a sharp drop in the
rate of increase of food prices. Did the basic infla­
tion slow to a sustained 4.5 percent rate by late 1976?
Again the answer is no. From late 1976 to the end
of 1977 inflation returned to a 6 percent rate, the
same as that indicated by the trend growth of money.
W hat was the effect of monetary actions, as mea­
sured by the growth of the money stock, on inflation
over the six-year period 1972-77? In particular, what
was the effect of allowing M l to grow at about an 8
percent rate from late 1971 to early 1973, then cut­
ting M l growth to 6 percent for a year, further
slashing it to 4 percent for a year, and then progres­
sively reaccelerating M l growth, first to 5 percent
for six quarters, and then to almost 8 percent over
the two-year period ended in the third quarter of
1978? Did these gyrations in money growth substan­
tially change the basic rate of inflation? Using the
past growth pattern of M l as a guide to inflation,
then again the answer is no. Money had grown at a
6 percent rate over the five years (20 quarters)
ended in the fourth quarter of 1971, remained at 6
percent in the 20 quarters ended in early 1975 and
by the end of the fourth quarter of 1977 the twentyquarter growth rate of M l was still essentially 6
percent.

Conclusions
In analyzing the inflationary process, one must be
careful to avoid shortsightedness. In particular, shortrun gyrations in prices must be distinguished from
persistent changes in prices. Monetary policy cannot
prevent the quarter-to-quarter fluctuations in the price
level that naturally result from the dynamics of eco­
nomic activity. However, concentrating on only these
short-run fluctuations in the level of prices can result
in falsely blaming nonmonetary factors for a persistent
rise in prices. The analysis of inflation then tends to
bounce, month-to-month, quarter-to-quarter from one
item or sector of the economy to another. Such an
approach diverts attention from the role of monetary
actions, results in failure to permanently reduce in­
flation and ultimately means that inflation will return
Page 11

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

to plague the economy. The monetary actions of the
government must be given a key position in any
program to permanently reduce persistent inflation.
Over the first half of 1978, prices rose at about a 9
percent rate. Should inflation be expected to continue
at this rate? The monetary guide presented in this
paper, indicates a persistent inflation of about 6.2
percent for the period 111/78 — 111/79. Some econo­
mists would contend that individuals now adapt their
expectations of inflation more rapidly than previously,
hence, a five-year trend rate of growth for M l is too
long. If the period for calculating the trend rate of
money is shortened to four years, the inflation indi­
cated for 111/78 — 111/79 rises to 6.4 percent. Short­
ening the period further to three years, raises the
basic inflation rate to 6.8 percent for the next year.
Consequently, the lasting rate of inflation indicated
by past monetary developments falls in a fairly nar­
row range of 6.2-7 percent, nowhere near a 9 per­
cent rate.
However, just because a rough monetary guide to
inflation, such as the one presented in this article,
does not indicate that past monetary actions have
yet cumulated into a 9 percent persistent inflation
should not be taken as a cause for rejoicing. A per­
sistent inflation of 6.5-7 percent is still at least three

Page 12



DECEMBER

1978

times as fast as any lasting inflation the U.S. economy
experienced from the end of World W ar II through
1965. Furthermore, historical evidence indicates that
the development of such a persistent inflation is a
rather sluggish process that does not adjust immedi­
ately to accelerations or decelerations of the growth
of money.8
Currently, the trend rate of money growth is being
held down by the 5 percent growth rate that pre­
vailed from the third quarter of 1973 to the third
quarter of 1976. In sharp contrast, over the last two
years (111/76 — 111/78), the average rate of monetary
expansion accelerated to 8 percent. As the effect of
the 5 percent growth wears off, if money continues
to grow at an 8 percent or faster rate, inflation will
rise sharply to a persistent, year-after-year, 8-9 percent
rate.
R
For example, growth of money (M l) accelerated to about a
7 percent annual rate in 1968, after rising at an average rate
of about 4 percent over the previous five years. Inflation did
not rise to 7 percent in 1968, instead it was 4.5 percent, about
in line with the 4 percent average growth of Ml over the
previous five years. However, as the money stock continued
to grow rapidly by past standards — at a 6 percent rate in
1969 — the five year average growth of M l rose to 5.2 per­
cent by the end of 1969 and the rate of inflation moved up to
5.4 percent in 1970. This increase in inflation took place even
though the growth of Ml subsequently decreased to about a
4 percent rate in 1970.

Are the Preliminary Week-to-Week
Fluctuations in Ml Biased?
COURTENAY C. STONE and JEFFREY B. C. OLSON

F h E preliminary seasonally adjusted
estimate for weekly M l — the money
stock consisting of currency in the hands
of the public and net private demand
deposits — released each Thursday after­
noon by the Federal Reserve has become
one of the most eagerly awaited, widely
publicized, and closely watched of all
economic statistics. Changes in stock
prices, movements in interest rates, vari­
ations in the volume of trading on finan­
cial markets — even fluctuations in the
foreign-exchange value of the U.S. dol­
lar — are frequently cited as conse­
quences of the public’s reactions to the
week-to-week changes reported for the
money stock. The impact attributable to
the publication of these weekly money
numbers has been described, with only
slight hyperbole, by one economist as
follows:

Table I

M eans and S tan d ard D eviations for
Prelim inary S e a so n a lly A djusted Short-Run
M l G ro w th R ates: 1 9 7 1 -7 7
One-Week
Growth Rates
Period

Standard
Deviation

Mean

Two-Month
Growth Rates

Standard
Deviation

Mean

Standard
Deviation
5 .5 %

1971

6 .4 %

2 5 .2 %

6 .1 %

6 .5 %

6 .3 %

1972

7.5

24.1

8.0

4.9

7.5

3.2

1973

8.7

35.7

5.6

5.1

5.4

4.1

1974

5.2

29.8

4.9

4.5

5.1

3.0

1975

4.6

25.8

4.7

7.7

4.7

5.4

1976

5.0

26.9

5.6

5.2

5.2

3.3

1977

7.2

29.9

7.2

6.6

7.3

3.8

Sources: The preliminary Ml data series used for computing the one-week growth rates
were obtained from the initial estimates published in the Federal Reserve Statis­
tical Release H.6. The one- and two-month growth rates are from Alfred Broaddus and Timothy Q. Cook, “Some Factors Affecting Short-Run Growth Rates of
the Money Supply,” Federal Reserve Bank of Richmond E con om ic R evieiv
(November/December 1977), p. 4.

E ach Thursday has become a Day of Judgement
of anticipatory trembling over the latest Fed report
on money supplies. E ach set of weekly statistics is
combed as heralding a new wave of the business
cycle, a new round of inflation, a new course of stock
prices, and a new state of the economy ahead. Civili­
zation itself appears to hang in the balance.1

The attention devoted to these numbers recently
motivated the Chairman of the Board of Governors of
the Federal Reserve System to wish that “we could
get away from the habit in this country of looking at
those [money supply] figures every Thursday and
assuming that the world is going up or down based on
a weekly figure.”2
The growing popularity of this “habit” is puzzling
to many economists for a variety of reasons. First, and
perhaps most important, week-to-week fluctuations in
M l are irrelevant for assessing the impact of money
'Sidney Weintraub, “Wall Street’s Mindless Affair with Tight
Money,” Challenge (January/February 1978), p. 35.
2G. William Miller, “Hearings,” Second Meeting on the Con­
duct of Monetary Policy, U.S. Congress, Senate, Committee
on Banking, Housing and Urban Affairs, 95th Cong., 2nd
sess., April 25, 1978, p. 153.



Mean

One-Month
Growth Rates

growth on employment, output and prices. Only the
longer-run variations in M l growth — over periods
of several quarters or more — are generally consid­
ered to have significant effects on aggregate economic
behavior. One-week growth in the money stock per se
simply does not matter unless it can be used as a
guide to the longer-term money stock movements.
Second, as the period decreases over which the
money stock growth rates are calculated, the greater
is the influence of purely random events on the indi­
vidual growth rates — and the greater is the likeli­
hood of obtaining misleading results when using these
growth rates to estimate the longer-run M l fluctua­
tions. An illustration of this problem appears in Table
I which shows the means and standard deviations for
annualized short-run growth rates of preliminary sea­
sonally adjusted M l for the 1971-77 period. Compar­
ison of the standard deviations, year by year, across
the alternative short-run M l growth rates indicates
that the one-week growth rates are more volatile than
the one-month growth rates, which, in turn, display
greater variation than the two-month growth rates.
This greater variation around the mean growth rate
Page 13

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

demonstrates how the impact of random events, which
tends to “wash out” over longer periods, can mislead
those who want to use the short-run growth rates
to estimate the longer-term growth in M l. For ex­
ample, the preliminary rate of money growth for 1977
was about 7.2 percent regardless of which short-run
money growth estimates are used. Yet, one-third of
the week-to-week M l growth rates during that year
were either less than -2 2 .7 percent or greater than
37.1 percent. This wider variation in the one-week
growth rates makes it difficult to decipher the under­
lying longer-run trend growth in M l using the weekly
money data.

DECEMBER

1978

Table II

M eans and Stan d ard D eviations for
Fin ally Revised S e a so n a lly Adjusted O n e -W e e k
M l G row th R ates: 1971- 77
One-Week Growth Rates

The purpose of this article is to describe the nature
of the bias that exists in using the preliminary money
stock fluctuations to estimate the actual money stock
movement on a week-to-week basis. As such, it in­
vestigates the extent to which the preliminary money
stock estimates released each Thursday provide re­
liable information about the actual w eek ly growth in
M l.
This article demonstrates that the most widely
cited of the money estimates, those for preliminary
seasonally adjusted M l, are generally unreliable guides
to the actual weekly growth in the money stock.
Therefore, whatever explains the popular mystique as­
sociated with the Thursday release of the weekly
money estimate, it does not appear to be due to its
Page 14



Mean

Standard
Deviation

1971

6 .2 %

7 .4 %

1972

9.0

6.1

1973

5.6

9.1

1974

4.2

6.7

1975

4.5

11.5

1976

Finally, preliminary estimates of the money stock
are subject to substantial revisions over an extended
period of time after their initial public release. Com­
parison of the means and standard deviations for the
finally revised one-week growth rates of seasonally
adjusted M l for 1971-77, shown in Table II, with the
equivalent statistics for the preliminary one-week
growth rates in Table I provides an initial indication
of the impact of the money stock revision process.
The average one-week M l growth rates were revised
upward for three of the seven years; four of the seven
mean M l growth rates declined as a consequence of
these revisions. Moreover, the volatility displayed by
the one-week growth rates was substantially reduced
as a result of the revisions. Because of the sizable ef­
fect of the revision process on the initially published
growth rates for seasonally adjusted M l, the prelim­
inary one-week growth rates for M l may provide un­
reliable estimates of the actual movement in the
money stock ev en on a w e e k -b y -w e e k basis. If the
preliminary weekly money growth rates are biased,
using them to estimate the longer-run growth in the
money stock is even more troublesome.

Period

6.1

11.0

1977

7.5

9.3

Sou rce: The finally revised M l series incorporates all revisions up
to, and including, those appearing in the September 21,
1978 Federal Reserve Statistical Release H.6.

usefulness in providing accurate information about
the actual week-to-week growth in seasonally adjusted
money.

Revising the Prelim inary M oney Stock
Estimates
Although many economic data series remain vir­
tually unchanged once they are collected and pub­
lished, the money stock series are not among these.
Exhibit I reproduces the first page of the Federal
Beserve Statistical Belease H.6 — the initial public
source of the preliminary weekly money stock esti­
m ates —■for T h u rsd ay , N o v em b er 2, 1978 to show one
example of h o w the revision process affects the weekly
M l numbers.
There are several points to consider in Exhibit I.
First, although the H.6 release is dated November 2,
the most recent weekly money stock figures shown
are those for the week ending on Wednesday, October
25; the weekly money stock is reported with a lag of
eight days. Second, the H.6 release contains estimates
for five different definitions of the money stock, M l
through M5.3 Because M l is the most commonly cited
money stock in the reports linking weekly money fluc­
tuations to financial market activity, only M l will be
discussed in this article. Third, although financial ana­
lysts concentrate primarily on the behavior of the sea­
sonally adjusted money stock, the H.6 release includes
estimates for both seasonally adjusted (SA) and not
seasonally adjusted (NSA) weekly M l. Both are stud3Beginning with the November 16, 1978 H.6 release, an addi­
tional money stock measure, M 1+ , is now being published.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

DECEMBER

1978

Exhibit I

A REPR O D U CTIO N O F THE FEDERAL RESERVE STATISTICAL RELEASE H .6
MONEY STOCK MEASURES
In Billions of Dollars
Mi

m2
M i Plus
Time De­
posits at
Com­
mercial
Banks
Currency
Other
Plus
Than
Demand
Large
Deposits'
CD's2

Date

M3

M4

Ms

For Immediate Release
Nov. 2, 1978
Ml

M2

M3

M4

M5

M2 Plus
Deposits
at
Nonbank
Thrift
Institu­
tions3

M2 Plus
Large
Nego­
tiable
CD's 4

M3 Plus
Large
Nego­
tiable
CD's5

m T p I us

M2 Plus
Deposits
at
Nonbank
Thrift
Institu­
tions3

M2 Plus
Large
Nego­
tiable
CDs*

M 3 Plus
Large
Nego­
tiable
CD's5

Time De­
posits at
Com­
mercial
Banks
Currency
Other
Plus
Than
Large
Demand
Deposits'
CD's2

Seasonally Adjusted

Not Seasonally Adjusted

1977 — SEPT.

333.0

795.1

1344.9

858.9

1408.7

331.1

791.3

1339.7

856.7

1405.1

OCT.

335.9

801.4

1357.9

867.8

1424.3

335.2

798.7

1353.0

867.1

1421.3

NOV.

336.2

805.4

1367.1

876.3

1438.0

338.4

802.8

1360.1

874.4

1431.7

DEC.

338.5

809.5

1376.1

883.5

1450.1

348.2

814.9

1377.5

890.9

1453.4
1465.4

341.7

815.9

1386.6

892.2

1462.9

347.5

820.6

1389.0

897.0

FEB.

341.8

819.1

1393.1

898.5

1472.5

335.9

813.9

1386.0

890.8

1462.9

MAR.

342.9

822.6

1400.3

904.7

1482.3

338.2

821.1

1400.2

901.4

1480.5

APR.

348.5

830.3

141 1.4

913.7

1494.9

350.9

836.6

1421.2

917.9

1502.6

MAY

350.6

835.2

1419.9

922.2

1506.9

345.3

833.6

1420.3

918.2

1505.0

JUNE

352.8

840.6

1429.8

927.3

1516.5

351.7

842.0

1435.2

928.3

1521.5

JULY

354.2

846.2

1440.9

933.6

1528.3

356.0

848.7

1447.9

936.0

1535.2

AUG.

356.7

853.5

1455.1

939.8

1541.4

354.2

850.8

1452.9

938.8

1541.0

SEPT.

360.9

r 862.4

r 1472.0

r 950.5

r 1560.1

358.8

r 858.4

r 1466.4

r 948.7

r 1556.7

1978 — JAN .

WEEK ENDING:
1978 — AUG. 30
SEPT.

6

355.5

854.3

940.9

350.0

848.0

936.8

361.4

861.3

948.8

360.3

859.4

948.7

13

360.5

861.7

950.3

362.4

861.9

952.1

20

361.1

862.6

951.8

360.3

858.8

949.5

27

361.8

864.1

95 1.7

353.0

852.6

943.3
953.1

4

360.2

864.5

951.4

360.5

862.5

11

r 364.3

869.4

955.8

r 364.9

868.6

958.4

18 P

r 364.3

r 869.3

r 956.3

r 364.8

r 868.0

r 957.7

25 P

OCT.

358.9

865.7

954.3

356.1

860.2

951.0

inclu d es (1) demand deposits at all commercial banks other than those due to domestic commercial banks and the U.S. Government, less cash
items in the process of collection and F .R . F lo a t; (2) foreign demand balances a t F.R , B a n k s; and (3 ) currency outside the treasury, F.R .
Banks and vaults of all commercial banks.
2Includes, in addition to currency and demand deposits, savings deposits, time deposits open account, and time certificates of deposits other
than negotiable time certificates of deposit issued in denominations o f $100,000 or more by large weekly reporting commercial banks.
3Includes M2 , plus the average of the beginning and end of month deposits of mutual savings bank, savings and loan shares, and credit union
shares.
4Includes M2, plus negotiable time certificates of deposit issued in denominations of $100,000 or more.
includ es M3, plus negotiable time certificates of deposit issued in denominations of $100,000 or more.
P — Prelim inary ; R — Revised

ied in this article. Fourth, the two most recent weeks’
numbers are clearly designated as preliminary (as
indicated by the “P” following their dates) to show that
they are still being checked for processing errors.
Finally, the previous two weeks’ M l numbers have



been revised to correct an error detected since the
previous H.6 release was published.
Although processing errors in the estimation of M l
occur irregularly, there are two standard revisions
Page 15

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

that regularly affect the initially reported M l numbers
— benchmark revisions and changes in the seasonal
adjustment factors.4 Benchmark revisions in the money
stock occur because, unlike the member bank data on
vault cash and demand deposits which are available to
the Federal Reserve each week, data for the majority
of nonmember banks are reported to the Federal R e­
serve infrequently and then only for a one-week pe­
riod.5 Because weekly data for the periods between
the nonmember banks’ reporting dates must be esti­
mated to obtain the preliminary weekly money figures,
the money stock numbers are “subsequently revised
as more information becomes available, in order to
‘benchmark’ the estimated weekly data to the few
weeks of actual nonmember bank data.”6 As a conse­
quence of the correction of processing errors and in­
corporation of the benchmark changes, the prelimi­
nary not seasonally adjusted M l estimates are revised
into final estimates of the NSA money stock over a
period of months after their initial publication. These
“final” NSA M l estimates are subject to yet further
revision over a period of years whenever previously
undetected processing errors are discovered or defini­
tional changes occur.7
The seasonally adjusted money stock is obtained by
separately adjusting the currency and demand deposit
components of NSA M l to take account of sea­
sonal patterns in money holdings.8 Therefore, in addi­
tion to being subject to benchmark revisions and
correction of processing errors (which change the
underlying NSA money stock components), the pre­
liminary SA money stock is also subject to revision if
the initial seasonal factors used to obtain the season­
ally adjusted M l series are found subsequently to be
inaccurate. The process of “firming up” the seasonal
factors takes at least four years after the initial SA
money stock numbers are publicly released.
4In this article, the term “processing errors” is used to indicate
all revisions except benchmark revisions and changes due to
reestimation of seasonal factors.
5Currently, FDIC-insured nonmember bank data are reported
four times each year while data for noninsured nonmember
banks are reported twice each year. For detailed explanations
of the benchmark revision process, see Darwin Beck and Jo­
seph Sedransk, “Revision of the Money Stock Measures and
Member Bank Reserves and Deposits,” Federal Reserve Bulle­
tin (February 1974), pp. 81-89, and Richard W. Lang,
“Benchmark Revisions of the Money Stock and Ranges of
Money Stock Growth,” this Review (June 1978), pp. 11-19.
®Lang, “Benchmark Revisions,” p. 11.
7Recently, for example, the money stock was revised back
to mid-1975 to correct a bias discovered in the cash items
adjustment. See the September 21, 1978 Federal Reserve
Statistical Release H.6.
8For extended treatment of the seasonal adjustment of the
money stock, see Thomas A. Lawler, “Seasonal Adjustment of
the Money Stock: Problems and Policy Implications,” Federal
Page 16



DECEMBER

1978

The money stock revision process represents a con­
tinuously ongoing attempt to produce more accurate
money stock data. Consequently, the finally revised
money stock numbers are not necessarily “final”. They
are always subject to the possibility of additional
future revision. However, if the revision process pro­
duces more reliable money stock data by correcting
all known sources of error, the most recently revised
money stock figures can be thought of as the best
current estimates of the actual or “true” money stock.
In the following discussion, the actual, or underlying,
money stock is defined as the finally revised money
stock incorporating all revisions up to, and including,
those published in the September 21, 1978 Federal
Reserve Statistical Release H.6, which contains the
most recent benchmark revisions.

M easuring the Reliability of the Preliminary
W eekly Fluctuations in M l
Because the weekly money stock estimates undergo
a series of revisions after their initial release, questions
concerning the reliability of the preliminary fluctua­
tions in weekly M l naturally arise. How closely do the
preliminary weekly changes in M l, as derived from
the H.6 releases, conform to the actual money stock
changes after incorporating all corrections and revi­
sions? Do the growth rates computed from the ini­
tially reported M l numbers provide reliable estimates
of the actual weekly growth in the money stock?
The evidence from the 1970s suggests that the pre­
liminary money stock estimates are significantly af­
fected by the revisions that occur after they first ap­
pear in the H.6 releases. During the 1971-77 period,
over 99 percent of the preliminary weekly money
numbers were altered by subsequent revisions. The
impact of these revisions on the week-to-week fluctu­
ations in M l can be determined by comparing the
preliminary weekly change (or rate of growth) with
the final change (or rate of growth) in M l after all
revisions have been incorporated. Table I II presents
summary statistics for this comparison using the NSA
weekly money stock series for the 1971-77 period.
Table IV presents similar results for the SA money
stock. The absolute value, rather than the arithmetic
value, of the difference between the final and the pre­
liminary changes (A M ) or annual rates of growth
(%AM ) is used to focus on the magnitude of the dis­
crepancy between the initially reported weekly
changes or growth rates in the money stock and their
finally revised values.
Reserve Bank of Richmond Economic Review (November/
December 1977), pp. 19-27.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

DECEMBER

1978

Table IV

Table III

M eans a n d Stan d ard D eviations for A bsolute
Differences Between Fin a lly Revised and Initially
Reported W e e k ly S e a so n a lly Adjusted M l
Fluctuations: 1 9 7 1 -7 7

M eans a n d S tan d ard D eviations for A bsolute
Differences Between Fin ally Revised and Initially
Reported W e e k ly Not S e a so n a lly A djusted M l
Fluctuations: 1 9 7 1 -7 7
NSA M l Changes
(billions of dollars)
Final A M I
minus Preliminary A M I

SA M l Changes
(billions of dollars)
Final A m i
minus Preliminary A M I

SA M l Growth Rates
(annual percentage rates)
Final % A M 1
minus Preliminary % A M 1

Period

Mean
Absolute
Difference

Standard
Deviation

Mean
Absolute
Difference

NSA M l Growth Rales
(annual percentage rates)
Final % A M 1
minus Preliminary % A M 1

Mean
Absolute
Difference

Standard
Deviation

1971

$ .38

$ .32

8 .6 %

7 .4 %

1971

$ .74

$ .67

17.1%

15.7%

1972

.36

.30

7.5

6.3

1972

.83

.66

18.1

14.3

1973

.35

1.25

6.9

24.9

1973

1.16

1.16

23.3

23.7

1974

.40

.40

7.5

7.5

1974

1.17

.81

21.8

15.1

1975

.34

.28

6.2

5.0

1975

.95

.64

16.9

11.5

Period

Mean
Absolute
Difference

Standard
Deviation

Standard
Deviation

1976

.35

.32

5.9

5.3

1976

1.03

.79

17.6

13.5

1977

.26

.26

4.1

4.2

1977

1.28

.83

20.6

13.2

1971-77

.35

.55

6.7

10.9

1971-77

1.02

.82

19.4

15.7

Comparison of the results shown in Tables III and
IV yields two general conclusions about the effects
of the revision process on the initially published weekto-week fluctuations in M l. First, the mean absolute
differences are sufficiently large enough, given their
standard errors, to be significantly different from zero.9
Therefore, the revisions in the money stock series have
had a significant impact on the initially reported
weekly movements in M l.
Second, the money stock revisions have had a more
substantial impact on the SA money stock fluctuations
than on the NSA money stock movements. The mean
absolute difference between the final and the prelim­
inary weekly changes or rates of growth in SA M l
ranges from approximately two to five times the
equivalent difference in NSA M l, depending upon
the year of comparison.
For the 1971-77 period as a whole, the mean abso­
lute difference between the final and preliminary
week-to-week changes in SA M l was $1.02 billion;
between the final and preliminary weekly growth
rates, the mean absolute difference was 19.35 per­
cent. Thus, during this period, the final weekly change
in SA M l differed in absolute value from its prelimi­
nary estimate by slightly more than $1 billion, on
average, each week. Similarly, the final weekly growth
9Standard errors are obtained by dividing the standard devia­
tions by the square root of the number of weeks in the year.
The mean absolute differences are all significantly greater than
zero at the 5 percent level.



in SA M l varied, on average, about 19 percent each
week from the preliminary growth rate.
Over the same period, these differences for the NSA
money stock fluctuations were roughly one-third as
large. The mean absolute difference for week-to-week
changes in NSA M l was $.35 billion; for weekly
growth rates, it was 6.67 percent.
Another assessment of the reliability of the prelimi­
nary changes reported for M l can be obtained from
the estimation of the following equation:
(1 )

AMlt = a 0 + aiA M lPt

where A M lt designates the actual change in M l from
week t-1 to week t based on the most recently revised
M l data and A M lP t designates the preliminary
weekly change derived from the weekly M l numbers
initially reported for week t-1 and week t. If the pre­
liminary week-to-week changes in M l (A M 1P) pro­
vide unbiased estimates of the underlying changes in
the money stock (A M I), we would expect the esti­
mates to show that a 0 = 0 and a , = 1, or, alterna­
tively, that A M lt = A M lP t.
A similar test for growth rates can be obtained by
estimation of the equation:
(2 )

%AMlt = | o + Pi%AMlPt
3

where % A M lt designates the actual annualized per­
centage growth rate in M l from week t-1 to week t
based on the most recently revised M l data and
% A M lP t designates the preliminary annualized per­
centage growth rate derived from the weekly M l
Page 17

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

Finally, if the preliminary changes in M l are to be
useful in estimating the actual changes in the money
stock, the closer these two variables are related, the
better. The R2 statistic calculated from the estimated
relationship represents one measure of the closeness
between the preliminary and the actual fluctuations
in M l.11 Each R 2 shows, approximately, the propor­
tion of the total variation in the actual M l fluctuations
that is associated with the fluctuations in the prelimi­
nary M l series. To the extent that the initially pub­
lished M l fluctuations closely parallel the actual move­
ment in the money stock after all computational
errors have been corrected and the necessary revisions
have been incorporated, the R 2 would be expected to
have a value close to one. If the preliminary M l
fluctuations do not closely anticipate the actual
changes in M l after all necessary adjustments have
taken place, the R 2 will have a value closer to zero.
Thus, the closer the value of the R 2 is to one for the
estimated relationship, the closer these variables are
correlated.

Assessing the Reliability of the Preliminary
Not Seasonally Adjusted M l Fluctuations
Table V shows the results obtained from estimating
the above relationships between preliminary and final
weekly NSA M l fluctuations over the period 1971-77.
W hat do these tell us about the reliability of the pre­
liminary changes reported for weekly NSA M l? First,
the preliminary weekly changes and rates of growth
in the initially reported NSA M l appear to provide
reasonably reliable estimates of the actual weekly
changes occurring in the NSA money stock — despite
the existence of various processing errors and bench­
mark revisions. The estimated coefficients for NSA M l
over the entire 1971-77 period, displayed in the next to
the last row in Table V, show that, if the one-week
change in NSA M l was initially reported as $5 billion,
for example, after all processing errors are corrected
and benchmark revisions have been made, the actual
change would be estimated to be $5.04 billion. Sim­
ilarly, if the one-week growth in NSA M l was initially

1978

Table V

Tests for Bias in the Prelim inary O n e -W e e k
Not S e a so n a lly A djusted M l Fluctuations
Equation 1:

Equation 2:

AMlt =

%AMlt =

ao + aiAM lPt
Period

OCo

Po

CCi**

R2

Po

+

P i%

AMlPt

Pi**

301 1
Id

numbers initially reported for the respective weeks.10
Again, if the preliminary growth rates yield unbiased
estimates of the underlying growth rates, we would
expect the estimates to show that po = 0 and
= 1,
or, alternatively, that % A M lt = % A M lP t.

DECEMBER

1971

.00

1.01

.95

.02

.98

.95

1972

.08

1.03

.97

1.58

1.00

.97

1973

- .1 1

.94

.79

-2 .0 8

.93

.78

1974

- .07

1.04

.97

-1 .3 6

1.04

.97

1975

- .01

1.03

.98

- .19

1.03

.98

1976

.04

1.02

.99

.60

1.02

.99

1977

.03

1.00

.99

.50

.99

.99

1971-77

- .01

1.01

.96

- .18

1.00

.96

Unbiased
Values

0.00

1.00

1.00

0.00

1.00

1.00

**A11 qcj and 3 i coefficients are significantly different from zero at
the 5 percent level.
#Denotes oc0 or j30 coefficient significantly different from zero at
the 5 percent level.
* Denotes
or B l coefficient significantly different from one at
the 5 percent level.

reported as 10 percent, for example, the estimate for
the actual rate of growth in NSA M l is 9.82 percent.12
The reason that the preliminary changes and growth
rates in the NSA M l so closely match the actual
changes and growth rates is that the estimated co­
efficients do not differ significantly from those values
necessary to assure that the initially reported fluctua­
tions in M l are unbiased (repeated in the bottom row
of Table V ). All of the a 0 and | 0 estimates are numer­
3
ically close to zero and none is significantly different
from zero statistically. Similarly, all of the a , and (3!
estimates are numerically close to one and none is
significantly different from one. Overall, the results
indicate that the week-to-week changes between the
revised NSA M l numbers remain essentially the same
as those initially calculated from the preliminary NSA
money stock numbers.
The R2 statistics for the NSA weekly money stock
relationships over the 1971-77 period indicate that the
initial changes and growth rates reported for NSA
M l closely track the actual movements in NSA M l
despite the existence of processing errors and bench­
mark revisions. Roughly 96 percent of the variation
in the actual week-to-week changes in NSA M l are
anticipated by the movement in the preliminary

10 %AMlt = 5200 (AlnM lt) and %AMlPt = 5200 (AlnMlP,).
11The R2 statistic is the coefficient of determination adjusted
for degrees of freedom.
Digitized for Page 18
FRASER


12 AMI = -.01 + 1 .0 1 (5 ) = 5.04; %AM1 = -.1 8 + 1.00(10)
= 9.82.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

changes reported for NSA M l for the 1971-77 period
as a whole. Similarly, the fluctuations in the initially
reported annualized growth rates for NSA M l account
for 96 percent of the actual movement in the rate of
growth of NSA M l over the entire period. Year-byyear analysis confirms the closeness of the relationship
between the initial and the final NSA M l fluctuations.
These results indicate that the preliminary changes
and growth rates reported in NSA M l provide reason­
ably accurate estimates of the actual changes occur­
ring in the money stock.

DECEMBER

1978

Table VI

Tests for Bias in the Prelim inary O n e -W e e k
S e a so n a lly A djusted M l Fluctuations
Equation 1:

Period

Equation 2:

AMit =
0(0 + O i AM I Pt
C

% Amu =
Po + P i% A M !P t

ao

a i* *

R2

po

P i'*

R2

1971

.24 #

.12 *

.13

5.48 #

.11 *

.14

1972

.40 #

.08 *

.07

8.42 #

.07 *

.06

On the Reliability of the Preliminary
Seasonally Adjusted M l Fluctuations
The results from estimating the relationships for
changes and rates of growth between preliminary
and final seasonally adjusted M l, as shown in Table
VI, indicate that the initially published SA money
fluctuations do not provide accurate estimates of the
actual movements occurring in the money stock after
all revisions have been made. Using the results for the
entire 1971-77 period, presented in the next to last row
of Table VI, if the preliminary change in SA M l was
$5 billion, for example, the estimate of the actual
change that will be reported, after all processing error
corrections, benchmark revisions and seasonal factor
changes have been incorporated, is only $1.12 billion.
Similarly, if the initially reported growth rate in SA
M l was 10 percent, for example, the estimate for the
actual rate of growth in weekly SA M l is only 6.73
percent.
W hat accounts for the wide disparity between the
preliminary changes and the final changes in the SA
money stock? First, compare the estimated coefficients
for the SA money stock relationships in Table VI with
the values necessary to assure their reliability as
shown in the bottom row of Table VI. Not only are
the various estimates of a 0 and | 0 numerically greater
3
than zero, they are all statistically significantly differ­
ent from zero. This means that, even if the preliminary
M l change was reported as zero, the estimate of
actual change that will be reported after all re­
visions have been made is not zero, but rather ranges
from $.18 to $.40 billion, depending upon the year of
comparison, with an estimate of $.27 billion for the
period as a whole. Similarly, if the weekly growth rate
was initially announced as zero percent (that is, the
preliminary SA money stock was unchanged from the
previous week), the estimate is that M l had actually
grown by more than 5 percent for that week, using
the results for the 1971-77 period. Second, none of the
ax and (3! estimates is close to one numerically and all



1973

.24 #

.10 •

.13

4.71 #

.1 0 *

.13

1974

.19 #

.12 *

.29

3.53 #

.12 *

.29

1975

.18 #

.28 *

.39

3 .1 7 #

.28 *

.38

1976

.29 #

.24 *

.34

4.89 #

.24 *

.34

1977

.38 #

.21 *

.44

5.99 #

.21 *

.44

1971-77

.2 7 #

.17 *

.28

5.13 #

.16 *

.25

Unbiased
Values

0.00

1.00

1.00

0.00

1.00

1.00

**AI1 (Xi and $ 1 coefficients are significantly different from zero at
the 5 percent level.
# Denotes
or J30 coefficient significantly different from zero at
the 5 percent level.
* Denotes
or |3i coefficient significantly different from one at
the 5 percent level.

are significantly less than one statistically. Thus, it is
clear that the final changes (or growth rates) in
weekly SA M l are only slightly related to the prelim­
inary changes (or growth rates).
The relatively poor correspondence between the
preliminary and the final fluctuations in SA M l is also
shown by the value of the R 2 statistics for the relation­
ships which range from .06 to .44, depending upon
the year of comparison. Only about 28 percent of the
actual fluctuations in the changes in M l, and only 25
percent of the actual movement in M l growth rates,
are associated with the movements in the respective
preliminary SA money stock estimates over the entire
period. Put somewhat differently, more than 70 per­
cent of the actual variations in weekly SA M l changes
and growth rates are not directly related to the varia­
tions in the preliminary M l estimates for the 1971-77
period as a whole.
Since the seasonal adjustment process requires at
least four years before the seasonal factors are con­
sidered final, only the earlier years, 1971-73, can be
considered “fully” revised for seasonal purposes. Thus,
it can be argued that the more recent of these R 2
statistics are misleadingly high — that the finally re­
vised changes and growth rates in SA M l are even
less closely related to the preliminary SA M l move­
ments than these R 2 estimates indicate. Note that the
Page 19

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

R 2 statistics for the earlier years are the lowest in
Table V I. The SA M l estimates for the later years,
1974-77, are still undergoing seasonal revisions and
will continue to do so for several more years. There­
fore, the R 2 value shown in Table VI for each of these
later years are likely to be reduced when additional
revisions occur. Consequently, the values of R2 shown
for the later years, and for the 1971-77 period taken
as a whole, probably overstate the closeness of the
relationship between the initial movements and the
finally revised SA M l fluctuations.
Why are the preliminary weekly SA M l fluctuations
unreliable while the preliminary NSA M l changes accu­
rately forecast the actual week-to-week changes in
the NSA money stock? One approach to answering
this question is to assess the importance of the dif­
ferent factors which cause the revisions in the pre­
liminary money stock numbers. The preliminary SA
M l numbers are affected by the same processing
errors and benchmark revisions that affect the pre­
liminary NSA M l numbers. In addition, they are
affected by revisions of the seasonal factors. Since the
preliminary NSA M l fluctuations do not generally
appear to be unreliable, the problem with the initial
SA M l numbers apparently is created by the revisions
produced in reestimation of seasonal factors.
The differential impact of processing errors and
benchmark revisions, compared to those errors result­
ing from reestimation of seasonal factors, can be
determined by analyzing the error associated with
using the preliminary rate of growth in weekly SA
M l as an estimate of the actual rate of growth in the
SA money stock. Defining the “estimation error” to
be the difference between the actual and the pre­
liminary weekly rates of growth, the estimation error
for SA M l can be shown to equal the sum of the
estimation errors for NSA M l and the seasonal ad­
justment factors. Analysis of these errors for the
1971-77 period shows that the estimation error asso­
ciated with the preliminary weekly growth rates in the
seasonal factors accounts for approximately 70 per­
cent of the estimation error in SA M l growth rates.13
The preliminary weekly SA M l fluctuations provide
13If ESAM1, ENSAM1, and ESF represent the estimation
errors for SA M l, NSA M l, and the seasonal factors, re­
spectively, it can be shown that ESAM1 = ENSAM1 + ESF.
Consequently, VAR(ESAM l) = VAR(ENSAMl) + VAR
(E S F ) + 2 COV(ENSAMl, E S F ). For the 1971-77 period,
the latter equation had the following values: 623.7 — 164.4
+ 556.6 + 2 (-4 8 .7 ).

Page 20



DECEMBER

1978

generally unreliable guides to the movement in the
actual money stock for any given week because the
reestimation of seasonal factors introduces consider­
ably more erratic revisions than do the correction of
reporting errors and benchmark revisions.

Conclusion
The week-to-week fluctuations in the preliminary
seasonally adjusted M l, as reported each Thursday by
the Federal Reserve, provide biased and generally
unreliable information about the underlying weekly
growth in the seasonally adjusted money stock. Earlier
studies have commented on this problem for the pre­
liminary monthly and quarterly seasonally adjusted
money stock estimates.14 Moreover, the Federal R e­
serve is sufficiently troubled by the lack of correspond­
ence between the preliminary and actual money
growth rates that it has recently established a com­
mittee to study the seasonal adjustment process.
Economists, by and large, have tended to ignore
this issue because these extremely short-run varia­
tions in money are irrelevant for assessing the impact
of money growth on employment, output and prices.
It is only the longer-run fluctuations in money growth
— over a period of several quarters or more — that
generally are considered to influence these economic
variables.
The unreliability of the preliminary weekly growth
rates in the seasonally adjusted money stock only
poses a problem if financial market traders and mone­
tary policy authorities believe these rates accurately
portray the underlying longer-term growth in money.
Whatever explains the current fascination with the pre­
liminary week-to-week fluctuations in the seasonally
adjusted money numbers, it clearly does not result
from their usefulness in detecting the actual week-toweek growth in the seasonally adjusted money stock.
14See, for example, William Poole and Charles Lieberman,
“Improving Monetary Control,” Brookings Papers on Eco­
nomic Activity, (2 : 1972), pp. 293-335; Report of the Ad­
visory Committee on Monetary Statistics, “Improving the
Monetary Aggregates,” Board of Governors of the Federal
Reserve System (Washington, D.C., 1976); Alfred Broaddus
and Timothy Q. Cook, “Some Factors Affecting Short-Run
Growth Rates of the Money Supply,” Federal Reserve Bank
of Richmond Economic Review (November/December
1977), pp. 2-18; Herbert M. Kaufman and Raymond E.
Lombra, “Short-Run Variations in the Money Stock,” South­
ern Economic Journal (April 1977), pp. 1515-27; and Rob­
ert D. Laurent, “Effects of Seasonal Adjustment on the
Money Stock,” Federal Reserve Bank of Chicago Economic
Perspective (September/October 1978), pp. 12-17.

A Comparison of Yields On
Futures Contracts and Implied Forward Rates
RICHARD W. LANG and ROBERT H. RASCHE

j^ I N C E the introduction of futures trading in
3-month Treasury bills in 1976, yields on these futures
contracts have been examined for clues as to market
expectations of the future course of interest rates. Al­
though there are difficulties in isolating these expec­
tations, the yields on futures contracts do embody
information about market expectations of future in­
terest rates.1 However, similar information is also em­
bodied in the forward rates of interest that are implicit
in the spot market yield curve.
Yields on Treasury bill futures contracts (futures
rates) are essentially the market counterpart to the
implied forward rates embodied in the Treasury yield
curve. The correspondence between yields on financial
futures contracts and forward rates derived from a
yield curve is readily apparent in the work of Sir John
Hicks. Hicks interpreted the term structure of interest
rates as a futures market for loans in formulating his
theory about the relationship of long- and short-term
interest rates.2 To the extent that futures rates and
forward rates represent the yield on the same type of
loan contract, market traders will arbitrage between
yields in the futures market and yields in the spot
market (from which implied forward rates are de­
rived) if profitable trading opportunities exist. In this
case, it would not be surprising to find yields on
Treasury bill futures contracts to be closely related to
implied forward rates embodied in the Treasury yield
curve. This paper compares yields on 3-month Treas­
ury bill futures contracts with forward rates derived
from spot yields on Treasury securities, for compa­
rable periods, to examine how closely these interest
rates are related. Specifically, this paper tests the
hypothesis that futures rates are equal to implied foriFor a discussion of these difficulties, see Albert E. Burger,
Richard W. Lang and Robert H. Rasche, “The Treasury Bill
Futures Market and Market Expectations of Interest Rates,”
•his Review (June 1977), pp. 2-9.
2J. R. Hicks, Value and Capital: An Inquiry into Some Funda­
mental Principles of Economic Theory, 2nd ed. (Oxford:
Clarendon Press, 1946), pp. 144-47.



ward rates, and finds that this hypothesis must be
rejected. Various explanations as to why the rates are
not equal are then examined.
Recently, W illiam Poole and others have argued
that the yields on 3-month Treasury bill futures con­
tracts can be expected to be less than the correspond­
ing implied forward rates, that these futures rates are
unbiased market estimates of future Treasury bill spot
rates, and that it is not necessary to allow for risk
premia when using yields on futures contracts to
measure market expectations of future interest rates.3
If these arguments are correct, a great deal of em­
pirical work in economics that includes variables on
interest rate expectations will be greatly simplified. In
addition, such conclusions would allow policymakers
to easily assess the differences between their own in­
terest rate forecasts and the market’s expectations of
the future course of interest rates. As Poole notes,
policymakers face difficult problems when market in­
terest rate forecasts differ from the policymakers’ fore­
casts, since they then must decide whether their own
estimates of economic activity are incorrect or whether
th e m ark et is m isin terp retin g th e policym akers’ p lans.4

Unfortunately, the results reported in this paper do
not support these conclusions about the relationship
between futures rates and forward rates for futures
contracts, except for the ones closest to delivery, which
were the ones investigated by Poole. Extrapolation of
Poole’s conclusions to other futures contracts is there­
fore unwarranted, and other explanations for the re­
lationship between forward and futures rates must be
explored. One factor considered here is the possibility
of default risk affecting yields on futures contracts.
3William Poole, “Using T-Bill Futures to Gauge Interest-Rate
Expectations,” Federal Reserve Bank of San Francisco Eco­
nomic Review (Spring 1978), pp. 7, 14 and 15; and Kenneth
Froewiss and Michael Gorham, “Everyman’s Interest Rate
Forecast,” Federal Reserve Bank of San Francisco Weekly
Letter (September 8, 1978), p. 1.
4Poole, “Using T-Bill Futures to Gauge Interest-Rate Expecta­
tions,” pp. 16-17.
Page 21

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

EXPECTATIONS OF INTEREST RATES
AND FORWARD RATES
Expectations of future interest rates play an im­
portant role in many areas of economics; topics in
both micro- and macroeconomics deal with interest
rate expectations. Since such expectational variables
generally are not observable, researchers have only
been able to proxy them by using various substitutes,
such as by constructing expectational variables on the
basis of the past history of each variable. This ap­
proach is problematical in that when such expecta­
tional proxies are used in empirical research, a joint
test is made: both the hypothesis and the assumed
expectations-formation mechanism are tested.
One alternative to such joint tests is to survey a
specific group (such as financial consultants) as to
their expectations of interest rates for various future
periods. Such a survey has been reported since 1969
in the Goldsmith and Nagan B on d an d M oney M ar­
k et L etter.5 However, such surveys are subject to
problems that may limit their usefulness. One prob­
lem is basically statistical, but another deals with the
tim ing of the survey. The Goldsmith-Nagan survey
is quarterly, which makes its use for shorter periods
very difficult.
An alternative approach that allows the use of daily
data focuses upon ch an g es in interest rate expectations
rather than levels, and is based upon changes in the
shape of the yield curve from one date to another. A
yield curve relates the yi'elds-to-maturity of a group
of secu rities to their term s-to -m atu rity , fo r securities
with similar characteristics other than maturity. In
particular, all of the securities used in constructing
a yield curve have similar default risk. For example,
yield curves are usually drawn for Treasury securities,
or for corporate Aaa bonds, as of a particular date.
The yield curve indicates the structure of interest rates
on a given date for securities with the same risk of
default and different terms-to-maturity.
Changes in the shape of the yield curve from one
date to another involve changes in implied forward
rates. A forward rate is the yield on a loan or invest­
ment over some period beginning at a specified future
time. Such a forward rate can be obtained by an ap­
propriate combination of buying and selling bonds
outstanding. For example, by selling a 1-year bond
5Other interest rate surveys have been collected by various
researchers, but are not regularly published. For example,
see Edward J. Kane and Burton G. Malkiel, “The Term
Structure of Interest Rates: An Analysis of a Survey of Interest-Rate Expectations,” The Review of Economics and Sta­
tistics (August 1967), pp. 343-55.
Page 22



DECEMBER

1978

and buying a 2-year bond, a 1-year investment is
effectively made that will begin 1 year hence at a
rate of interest established by the difference in the
spot market yields for the 1- and 2-year bonds. The
forward rate on this loan is defined by:
M 4.1M

(1+R2)2

(1-j-Ri)*

where j F j is the forward rate on a 1-year loan to
begin in 1 year, R 2 is the spot rate on 2-year
bonds, and R, is the spot rate on 1-year bonds.
More generally, for a 1-period investment to begin
n -1 periods in the future the forward rate is:
/1 ,
„
(1+n-lFi). - ((1-+f R n^)n - l
l R n

where n 1 F 1 is the forward rate on a 1-period loan
to begin in n -1 periods, R n is the spot rate on
n-period bonds, and R n t is the spot rate on
(n -l)-p erio d bonds.
Thus, the yield curve at any given point in time im­
plies a set of 1-period forward rates to prevail on
forward (or future) transactions. Such forward rates
have economic content, however, only if the implied
transactions are possible in the market, and can be
carried out by market traders.6
In theories of the term structure of interest rates,
the forward rates (n iFx) are often decomposed into a
1-period expected rate („ -iE ,) plus a premium (a li­
quidity premium associated with interest-rate risk or
a term premium associated with investors’ preferences
for bonds with specific ranges of m aturities).7

n-iFi == n-iEi +

Premium

For a set of 1-period forward rates on a given date,
there is then a set of 1-period expected rates stretch­
ing out into the future. Under the assumption that the
premia are stable over time, changes in the structure
of interest rates (measured by changes in the yield
curve) reflect changes in interest rate expectations.
Thus, by examining the changes in the implied for­
ward rates contained in the term structure, research­
ers can obtain an estimate of the ch an g es in interest
rate expectations, even though the lev el of expected
interest rates is not readily estimable.
,;For a thorough discussion of yield curves, forward rates of
interest, and the term structure, see Burton Gordon Malkiel,
The Term Structure of Interest Rates: Expectations and Be­
havior Patterns (Princeton: Princeton University Press, 1966),
Chapters I and II.
7Malkiel, p. 26; Franco Modigliani and Richard Sutch, “Debt
Management and the Term Structure of Interest Rates,” Jour­
nal of Political Economy (Supplement: August 1967), pp.
571-73; Charles R. Nelson, The Term Structure of Interest
Rates (New York: Basic Books, 1972) pp. 20 and 28-31.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

However, such calculations are time consuming and
costly — in terms of both data collection and com­
puter time. One must obtain quotations on securities
outstanding (e.g. Treasury issues), fill in missing data
points by estimating a yield curve, then calculate
forward rates. This is a difficult task if done monthly,
and expensive to do weekly or daily. As a result, it is
expensive to use yield curve data to assess the effect
of new information about economic policies or of the
state of the economy on expectations of future in­
terest rates.

FUTURES MARKETS IN
FINANCIAL INSTRUMENTS
Starting in the fall of 1975, the difficulties of exam­
ining changes in market expectations of future interest
rates on a weekly or daily basis have been alleviated.
Trading in futures contracts in financial instruments
began to develop in late 1975, and currently there
are futures markets in seven financial instruments.8
This paper focuses on the futures market in 3-month
Treasury bills.
Futures markets in 3-month Treasury bills allow us
to observe directly the yields or prices on 3-month
bills to be delivered at certain dates in the future.
Thus, they are the market counterpart of the implied
forward loans or investments which can be con­
structed from Treasury yield curve data. But instead
of requiring large efforts at data collection, estima­
tion, and calculation, these yields are readily avail­
able from daily quotations in T h e W all Street Journal
and other newspapers.
As new information about the economy or economic
policy becomes available to market traders, this in­
formation is incorporated into the market prices and
yields of Treasury bill futures contracts. To the extent
that such new information changes market expecta­
tions of interest rates, it is reflected in changes in the
Treasury bill futures rates. Yields on futures contracts
could also be broken down into expectational and pre­
mium components, just as in the case of forward rates
implicit in the yield curve. Again, the lev el of expected
future interest rates may not be readily estimable, but
chan ges in market expectations of future interest
rates can be observed from changes in yields on fu­
tures contracts, under the assumption that the premia
are stable.9
8Currently there are futures markets in 3-month and 1-year
Treasury bills, 15-year Treasury bonds, 3-month commercial
paper, and three GNMA instruments. A number of other fu­
tures markets in other financial instruments have also been
proposed.
#Burger, Lang, and Rasche, “The Treasuiy Bill Futures Mar­
ket and Market Expectations of Interest Rates,” pp. 4-5.



DECEMBER

1978

YIELDS ON FUTURES CONTRACTS
AND IMPLIED FORWARD RATES
FROM YIELD CURVES
Since implied forward rates calculated from the
yield curve are, in theory, rates on forward loans or
investments such as those actually made in the Treas­
ury bill futures market, the question arises as to
whether yields on 3-month Treasury bill futures con­
tracts are equal to 3-month forward rates calculated
from the Treasury yield curve. It would be convenient
if the two sets of yields were equal, so that we would
not have to be concerned with any separate informa­
tional content of either data set (especially since
yields on Treasury bill futures are easier to obtain).
A test for the equality of the two yields, as of a
quotation date, can be made by comparing yields on
Treasury bill futures contracts with yields on implied
forward contracts for the same periods. First, we
choose a set of quotation dates. Then, we obtain the
yields on Treasury bill futures contracts on those dates
for each available delivery date. Next, we obtain quo­
tations on U.S. Treasury securities outstanding on
those same quotation dates. From these data we cal­
culate implied 3-month forward rates that match the
3-month Treasury bill futures contracts. Finally, we
calculate the difference (in absolute value) between
the two sets of rates to determine whether they are
significantly different from each other.

T h e Data
The selection of quotation dates for yields on Treas­
ury bill futures contracts and yields on outstanding
Treasury securities were obtained by random selec­
tions of thirty quotation dates from each of three
periods of roughly equal length — eight to nine
months.10 The first thirty quotation dates were taken
from the period March 1, 1976 to November 30, 1976
(Period I ) ; the second thirty quotation dates were
taken from the period Decem ber 1, 1976 to July 31,
1977 (Period I I ) ; and the last thirty quotation dates
were taken from the period August 1, 1977 to March
31, 1978 (Period I I I ) . Yields on the available futures
contracts for each quotation date were based on the
settlement prices obtained from the “Daily Informa­
tion Bulletin” of the International Monetary Market
of the Chicago Mercantile Exchange. Yields on out­
standing U.S. Treasury securities used to construct
forward rates for each quotation date were obtained
10The random numbers were obtained from The Rand Corpo­
ration, A Million Random Digits with 100,000 Normal Devi­
ates (Glencoe, Illinois: The Free Press, 1955).
Page 23

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

DECEMBER

1978

Table I

Summary Statistics for Absolute
Differences: Futures Rates Less Forw ard Rates
Categories'
1

2

3

4

5

6

7

8

0.13
30
6.47

0.16
0.12
30
7.30

0.35
0.21
30
9.13

0.58
0.34
29
9.19

0.58
0.45
23
6.18

0.51
0.31
11
5.46

0.09
0.06
30
8.22

0.14
0.11
30
6.97

0.34
0.20
30
9.31

0.37
0.26
30
7.79

0.63
0.35
30
9.86

0.88
0.34
29
13.94

0.97
0.26
12
12.92

1.43
0.44
12
11.26

0.19
0.13
30
8.01

0.26
0.15
30
9.49

0.16

0.34
0.22
30
8.46

0.48
0.29
30
9.07

0.56
0.27
30
11.36

0.55
0.31
30
9.72

1.01
0.36
28
14.85

Period 1
(3 / 1 / 7 6 - 1 1 /3 0 /7 6 )
Mean, X
Standard Deviation, S
Number of Observations, N
t-statistic2

0.11

Period II
(1 2 / 1 / 7 6 - 7 / 3 1 / 7 7 )
Mean, X
Standard Deviation, S
Number of Observations, N
t-statijtic2
Period III
(8 / 1 / 7 7 - 3 / 3 1 / 7 8 )
Mean, X
Standard Deviation, S
Number of Observations, N
t-statistic2

0.11

30
7.97

C ategory 1 includes futures rates fo r the futures contract closest-to-delivery ; Category 2 includes futures rates for the futures contract next
nearest-to-delivery, and so on.
2A11 t-statistics are significantly different from zero at the 1 percent level.

from the Federal Reserve Bank of New York’s “Com­
posite Closing Quotations for U.S. Government Se­
curities.” All yields were converted from a discount
basis to a bond equivalent yield basis.
Forward rates were calculated for each quotation
date to match up with each available Treasury bill
futures contract. Thus, if a futures contract were to be
delivered in 30 days, at which time the delivered
Treasury bills would have 90 days to maturity, a for­
ward rate was calculated using the yields on an out­
standing Treasury bill maturing in 30 days and an
outstanding Treasury bill maturing in 120 days. If no
bills were outstanding with the exact number of days
to maturity, say 120, then the yield was estimated
by linearly interpolating from the yields on two se­
curities with maturities surrounding 120 days — say
one with 130 days and one with 115 days. The result­
ing forward rate is the implied yield on a loan or
“security” that begins in 30 days and has 90 days to
maturity — the same time frame as the futures
contract.11
n Spot rates used to calculate forward rates were the average
of the bid and asked yields in the spot market. For futures
contracts to be delivered more than one year in the future,
yields on Treasury coupon securities were used (since Treas­
ury bills are not available) to calculate the forward rates.
Page 24



Once the forward rates matching the available fu­
tures contracts were calculated for each quotation
date, they were compared to the yields on the futures
contracts (futures rates) by taking the absolute differ­
ence between the two. For each quotation date, these
differences were categorized as being associated with
the futures contract nearest-to-delivery (Category 1),
next nearest-to-delivery (Category 2 ), and so on. All
the available contracts for each quotation date were
categorized in this way. W hen the market was first
formed in 1976, only four contracts were traded, ex­
tending out one year into the future. As trading in
Treasury bill futures has increased, the number of
contracts has been extended. By March 1978, the end
of the third sample, there were eight contracts traded,
(This introduces a slight measurement error in the calcula­
tion of the forward rates since the formulae given below and
in the text assume that the spot rates used are for non-cou­
pon securities.) The formula used to calculate the forward
rates is that given by Richard Roll, The Behavior of Interest
Rates: An Application of the Efficient Market Model to U.S.
Treasury Bills (New York: Basic Books, Inc., 1970), p. 16:
_ nRD - (n -9 1 )R n-9i
A comparison of the above formula’s estimates of forward
rates with estimates based on the traditional formula given
in the text showed only minor differences. Consequently, the
above formula was used for computational ease.

DECEMBER

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

extending out two years into the future. Consequently,
the number of observations in Categories 4 through
8 are not always equal to 30 for each sample, and
the first sample does not have as many categories as
the last two samples.

Table II

Test Values of Com parisons of M ean
Absolute Differences Across Sam ples
Comparison of Periods
Categories

Results
Summary statistics for the futures rates minus the
associated forward rates are given in Table I for each
category in each sample period. The mean of the
absolute value of the differences between the rates
are given for each category, as well as the standard
deviation and the number of observations. For each
category in each sample, the hypothesis that the fu­
tures rate is equal to the associated forward rate was
tested by determining whether the mean absolute dif­
ference in each category is significantly different from
zero. The t-value for each test is also given in Table I.
The two futures contracts nearest to delivery (C ate­
gories 1 and 2 ) tended to have the smallest mean
absolute differences between the futures and forward
rates, while the contracts furthest from delivery tended
to have the largest mean absolute differences. All of
the mean absolute differences were significantly dif­
ferent from zero at the 1 percent level. Thus, al­
though the mean absolute differences between the
futures and forward rates for the two futures con­
tracts closest to delivery (Categories 1 and 2 ) were
generally less than 20 basis points, the hypothesis that
the rates are equal is rejected in each sample.
Samples were taken from three different time peri­
ods in order to determine whether the differences
between the futures and forward rates have narrowed
over time. Such an observation would suggest that in
its first year of trading the futures market might have
been poorly developed, or “thin,” in terms of the num­
ber of traders in the market and the availability of in­
formation about the market. W e could then expect
that as the volume of trading in this market increased
and information about possible arbitrage opportunities
between futures and spot markets was more effectively
utilized, the differences between the futures and for­
ward rates would decrease between the first and sec­
ond samples, and would decrease further between the
second and third samples.
Neither casual observation of the data in Table I
nor statistical tests for significant differences across
sample periods support the hypothesis that the differ­
ences between futures and forward rates have consist­
ently narrowed over time. Table II presents the results
of statistical tests to determine whether the mean ab


1978

1 and II

II and III

1 and III
1.93s

1

-1 .7 5 *

3 .8 3 1- 2

2

-0 .6 7

3.5 3 1, 2

3

-0 .1 9

— .3 2 1- 2
4

4

—
2.662

-0 .4 8

-3 .2 1 *

5

0.44

—
1.81 3

- 0 .9 3 1

6

3 .2 8 2

— .9 9 2
3

0.47

7

—

— .4 7 2
4

—

8

_

—
2.912

--

2.852
- 4 .3 9 1- 2

in d ica tes th at critical value of the significance test was determined
using Cochran’s approximation to the Behrens-Fisher problem, see
footnote 12 of text.
2Significantly different from zero at the 1 percent level.
3Significantly different from zero a t the 5 percent level.

solute difference in each category of a sample was
significantly different from the mean absolute differ­
ence in the same category in the other two samples.12
The results shown in Table II do not present a consist­
ent pattern over time.
For example, a comparison of the mean absolute
differences between the first and second samples for
Categories 1, 2, and 3 indicates that the means are not
significantly different from each other at the 5 percent
level. Thus, the slight declines in the mean absolute
differences for the first three categories nearest to
delivery between the first and second samples do not
represent statistically significant differences in the re­
lationship of the futures and forward rates. On the
other hand, the increases in the mean absolute dif­
ferences between the second and third samples for
the first two categories are statistically significant, as
is the decrease for the third category.
On the basis of this evidence, we cannot conclude
that the differences between the futures and forward
rates have been narrowing consistently over time as
the futures market for Treasury bills has become more
developed. Other explanations for the statistically sig12A t-test for the difference between two means generally re­
quires the assumption that the variances of the two samples
are equal. When this assumption cannot be made, one is
faced with what has been called a “Behrens-Fisher prob­
lem.” An approximation to the t-test due to Cochran that
provides a solution is given in George W. Snedecor and
William G. Cochran, Statistical Methods, 6th ed. (Ames,
Iowa: Iowa State University Press, 1967), pp. 114-16. This
method was used in calculating the t-values and their sig­
nificance in Table II for the cases where an F-test of the
equality of the variances of the samples being compared
rejected the hypothesis of equality.
Page 25

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

DECEMBER

1978

Table III

Summary Statistics for Arithmetic
D ifferences: Futures Rates Less Forw ard Rates
___________________________________________________Categories1

Period I
(3 / 1 / 7 6 - 1 1 /3 0 /7 6 )

-0.12

Mean, X

0.01

0.35

0.48

0.49

0.12

0.21

0.22

0.48

0.55

Standard Deviation, S

30

30

29

23

0.45
0.40

Number of Observations, N

30

t-statistic2

-5 .4 8

0 .2 6 1

8.71

5.39

4.27

—
0.08

0.04

0.32

0.37

0.62

0.88

0.97

1.43

0.08

0.17

0.23

0.27

0.38

0.34

0.26

0.44

11

3.73

Period II
(1 2 / 1 / 7 6 - 7 / 3 1 / 7 7 )
Mean, X
Standard Deviation, S
Number of Observations, N
•-statistic*

30
-5 .4 8

30
1.29’

30

30

30

7.62

7.51

8.94

29

12

12

13.94

12.92

11.26

Period III
(8 / 1 / 7 7 - 3 / 3 1 / 7 8 )
-0 .1 9

Mean, X

- 0 .2 3

0.08

0.33

0.47

0.56

0.52

1.01

0.13

0.19

0.18

0.24

0.31

0 .2 7

0 .3 7

0.36

Standard Deviation, S
Number of Observations, N

30

t-statistic2

-

8.01

30

30

-6 .6 3

2.43

30
7.53

30
8.30

30
11.36

30
7.70

28
14.85

'Category 1 includes futures rates for the futures contract closest-to-delivery; Category 2 includes futures rates for the futures contract next
nearest-to-delivery, and so on.
2AU t-statistics are significantly different from zero at the 1 percent level, except for those with footnote 3 references.
3Not significantly different from zero a t the 5 percent level.

nificant spreads between the futures and forward rates
must be explored.

EXPLANATIONS OF
THE DIFFERENTIAL
Given that there are significant differences between
futures and forward rates that have not declined over
time, the question arises as to whether or not these
differences are systematic. If the differences are syste­
matic, can we identify some factor or factors that
would cause such systematic differences? A further
issue is to re-examine the argument that market
traders will arbitrage away differences between fu­
tures and forward rates. This argument was based
on the assumption that a futures contract is essen­
tially identical to an implied forward contract. If a
futures contract is substantially different from an im­
plied forward contract, then market traders will not
necessarily drive futures rates to equality with for­
ward rates. However, even if a futures contract is
essentially identical to an implied forward contract,
the existence of transactions costs in trading spot and
Digitized for Page 26
FRASER


future Treasury bills may provide few profitable arbi­
trage opportunities to traders. In this case, trading in
spot and futures markets will not necessarily result in
equalizing futures and forward rates.
To examine whether there are systematic differences
between futures and forward rates, the mean arith­
metic difference for each category in each sample
period is given in Table III. The arithmetic differ­
ences are systematically negative in all periods for
Category 1, zero or negative for Category 2, and
systematically positive in all periods for Categories
3 through 8. W ith the exception of Category 2 in
Periods I and II, all of the arithmetic differences are
significantly different from zero. Thus, futures rates
for contracts closest to delivery are generally lower
than their associated forward rates, while futures
rates for later-dated contracts are generally higher
than their associated forward rates. Explanations of
the spread between futures and forward rates must
be able to account for both the spread itself and its
change in sign as the delivery date is extended into
the future.

DECEMBER

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Transactions Costs: Poole’s A pproach
In a recent article, W illiam Poole hypothesizes that
futures and forward rates should not be equal because
of the effect of transactions costs on these yields.13 He
argues that transactions costs are basically zero for
futures contracts but positive for trades in the spot
market. Other factors affecting futures and forward
rates (such as term or liquidity premia and interest
rate expectations) are assumed to be about the same,
while the effect of transactions costs would tend to
increase forward rates. Consequently, Poole concludes
that futures rates should be lower than forward
rates.14
Poole obtains empirical support for his hypothesis
by examining the futures contract closest to delivery
(our Category 1). He finds that the mean (arithm etic)
difference between futures and forward rates is in­
deed negative, indicating that futures rates are lower
than forward rates. The mean difference also tends to
be significantly different from zero; a result consistent
with that reported in our Table III.
In Poole’s subsequent discussion of the policy impli­
cations of the Treasury bill futures market, he assumes
that his findings apply to all futures maturities (i.e.,
all categories in Table I I I ) , not just to the contract
closest to delivery.15 This assumption is not supported
by our data. The results shown in Table III indicate
that Poole’s hypothesis holds only for Categories 1
and 2 (the two contracts closest to delivery). For the
other contracts that are delivered further in the future,
the futures rates are higher than the forward rates —
contrary to Poole’s hypothesis.
Poole seems to argue that futures rates are close to
being equivalent to the market’s expectations of future
interest rates.
Quotes on the nearest maturity in the bill futures
market can, therefore, be interpreted for all practical
purposes as the market’s unbiased estimates of the
future spot rates on 13-week bills.16
If the findings in the previous section apply to all
future maturities, then the differences between the
futures rates and the realized spot rates over the last
two years reflect genuine expectational errors rather
than term premiums attached to the futures rates.17
13Poole, “Using T-Bill Futures to Gauge Interest-Rate Expec­
tations,” pp. 7-19.
14Ibid., p. 14.
15Ibid., p. 15.
16Ibid.
iHbid.



1978

The evidence presented here indicates that it is mis­
leading to extrapolate from the evidence on the futures
contract closest-to-delivery to the later-dated con­
tracts. Futures rates on the later-dated contracts are
generally 50 to 100 basis points higher than their as­
sociated forward rates, which suggests the existence
of some substantial differences between the factors
affecting the futures and forward rates.

A D igression

—

A rbitrage Opportunities

The relatively large and statistically significant dif­
ferences in Table III between the futures and forward
rates for the later-dated futures contracts raises the
issue of whether substantial arbitrage opportunities
exist for these contracts. Poole investigated this issue
for the contract closest to delivery and found that
few arbitrage opportunities exist.
Poole defined upper and lower critical points for
profitable arbitrage for the futures rate given the spot
yields, taking into account transactions costs. Values
of the futures rates that lie between these upper and
lower critical points indicate that profitable arbitrage
opportunities do not exist. Poole calculated upper and
lower arbitrage points using daily data between Jan ­
uary 6, 1976 and June 23, 1977 for the contract closest
to delivery. He found that profitable arbitrage oppor­
tunities rarely existed, and were small in magnitude
when they did exist.
By converting Poole’s formulae for the upper and
lower arbitrage points to a bond equivalent yield basis
(from his discount yield basis), we applied his ap­
proach to our three samples of data. In doing so, the
formulae are not exact since the transactions costs
associated with arbitraging the futures contracts fur­
ther from delivery are larger than for the contracts
closest to delivery. This is because maturities for se­
curities in the spot market do not exactly match up
with the maturities associated with the futures con­
tract. In addition, for futures contracts to be delivered
more than one year out, yields on Treasury coupon
securities were used to calculate forward rates (see
footnote 11). Consequently, transactions costs associ­
ated with arbitraging the later-dated contracts would
be higher than the ones used in Poole’s formulae. This
means that our adoption of Poole’s formulae under­
states the upper arbitrage point, and overstates the
lower arbitrage point. The spread between the upper
and lower points is therefore understated, so that there
may appear to be arbitrage opportunities which would
not in fact be profitable if we took all the transactions
costs into account.
Page 27

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Nevertheless, the application of Poole’s
formulae will at least indicate the extent
of arbitrage opportunities using a con­
servative estimate of the transactions
costs involved. For each category of con­
tract in each sample period, Table IV
shows the number of futures rates that
are above the upper arbitrage point, b e­
low the lower arbitrage point, or within
the upper and lower points. Table IV
also shows the number of futures rates
that are within or “close” to (defined as
within .10 of) the upper or lower arbi­
trage points.

DECEMBER

1978

Table IV

Futures Rates Relative to A rb itra g e Points
____________________________ Category1
_________
1

2

3

4

5

6

Number of Futures Rates:
Below Lower Point
Above Upper Point
Within Points
W ithin or "C lo se"2

10
0
20
28

6
1
23
27

0
19
11
18

1
18
10
11

0
12
11
13

0
5
6
8

Number of Observations

30

30

30

29

23

11

7

8

Period 1
(3 / 1 / 7 6 - 1 1 /3 0 /7 6 )

Period 1
1
(1 2 / 1 / 7 6 - 7 / 3 1 / 7 7 )
Number of Futures Rates:
Below lower Point
Above Upper Point
Within Points
Within or "C lo se"2

Aggregating over all three sample
5
2
1
0
0
0
0
0
periods, the results for Categories 1 and
0
5
20
14
18
26
12
12
2 tend to support Poole’s findings. Over
25
23
16
12
9
3
0
0
75 percent of the futures rates in C ate­
29
14
26
19
15
6
1
0
gories 1 and 2 are within, or “close” to, Number of Observations
30
30
30
30
30
29
12
12
the upper and lower arbitrage points,
Period III
taking all three periods as a whole. How­
(8 / 1 / 7 7 - 3 / 3 1 / 7 8 )
ever, the percentage for Period III alone
Number of Futures Rates:
is considerably lower than for Periods I
Below Lower Point
21
4
17
0
0
0
0
0
and II. Furthermore, the percentage
Above Upper Point
0
0
5
8
12
15
17
27
tends to decline as the delivery date
Within Points
9
13
21
22
18
15
13
1
extends further into the future. For cate­
Within or "C lo se"2
17
17
28
23
22
18
14
2
gories 6, 7, and 8 over all three sample Number of Observations
30
30
30
30
30
30
30
28
periods, the number of futures rates
1 includes futures rates for
Category 2
within, or “close” to, the upper and lower ■Category futures rates for the futures the futures contract closest-to-delivery ;so on.
includes
contract next nearest-to-delivery, and
arbitrage points are only 45, 36, and 5 in clu d es futures rates that are within the upper and lower arbitrage points as well as
those th at are "close” in that they are within .10 of the upper or lower points.
percent, respectively. Of course, the cal­
culation of the arbitrage points for these
calculations of the upper arbitrage points for the laterlater-dated contracts are most likely to be subject to
dated contracts are substantially underestimated, it
error since they are based on yields on Treasury cou­
appears that systematic arbitrage opportunities fre­
pon securities rather than Treasury bills, and since the
quently existed for the later-dated futures contracts
spot maturities of the securities used do not match
during our sample periods.18
up exactly with the later-dated futures contracts.
Nevertheless, there are still some puzzling features
If profitable arbitrage opportunities exist but are
about the results.
not acted upon by market traders, then we should not
expect futures and forward rates to be as closely re­
First, when the futures rate falls outside the upper
lated as we had earlier suggested, and we certainly
and lower arbitrage points for the two contracts closest
should not expect them to be equalized. Such a situ­
to delivery (Categories 1 and 2 ), it is almost always
ation could explain the results obtained earlier, that
b elo w the lower arbitrage point. Futures rates for
futures rates and forward rates are not equal. How­
later-dated contracts, on the other hand, are almost
ever, such a situation implies that there is a market
always a b o v e the upper arbitrage point when they
fall outside the upper and lower bounds. Second,
when the futures rate is above the upper arbitrage
point for the later-dated contracts, the difference
between the futures rate and the upper bound ranges
from less than 10 basis points to over 100 basis points
(one full percentage point), and generally averages
over 30 basis points in each category. Thus, unless the
Digitized for Page 28
FRASER


18That frequent arbitrage opportunities have existed in the
futures market has also been argued in two other papers.
See Donald J. Puglisi, “Is the Futures Market for Treasury
Bills Efficient?” The Journal of Portfolio Management (W in­
ter 1978), pp. 64-67; and Anthony J. Vignola and Charles
J. Dale, “Is the Futures Market for Treasury Bills Efficient:
A Comment,” The Journal of Portfolio Management (Winter
1979), forthcoming.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

inefficiency or failure present. Such inefficiency or
failure could be due to lack of information about
trading opportunities or to institutional constraints on
trading. Since information about trading in futures
markets is likely to improve over time, and since insti­
tutional constraints encourage innovations that reduce
their effectiveness, such a situation of market ineffi­
ciency or failure will probably be reduced over time.
If transactions costs are substantially larger than
those used here, it may be that profitable arbitrage
opportunities rarely existed despite the large spreads
between the futures and forward rates for the laterdated contracts. In this case, we again should not
expect futures and forward rates to be as closely
related as was earlier suggested. Given transactions
costs, futures rates and forward rates may not be
equalized.
However, Poole’s argument based on transactions
costs led him to conclude that futures rates should be
lower than forward rates. Even though transactions
costs might explain why futures rates and forward
rates are not equalized, it is still puzzling that futures
rates are substantially higher than their associated
forward rates for the later-dated contracts, contrary to
Poole’s argument. This suggests that factors other
than transactions costs may affect futures, rates differ­
ently than forward rates, and we now turn to a con­
sideration of these other factors.

D efault Risk
Poole implicitly assumes that factors other than
transactions costs have the same effects on both fu­
tures and forward rates. Thus, since transactions costs
are expected to increase forward rates, and since
transactions costs are close to zero for futures con­
tracts, Poole concludes that futures rates will be less
than their associated forward rates.19 That this con­
clusion is not supported by evidence for the laterdated futures contracts suggests that there are other
factors embodied in futures and forward rates that
have effects in th e op p osite direction to the transactions-cost effect discussed by Poole. Furthermore,
this effect is stronger for the later-dated futures con­
tracts than for those close to delivery.
Both futures rates and forward rates can be broken
down into expectational and premium components.
Since one-period expectations of future interest rates
should be the same in both rates, we must consider
the premium components of these rates. The premium
19Poole, “Using T-Bill Futures to Gauge Interest-Rate Expec­
tations,” p. 14.



DECEMBER

1978

associated with a forward or futures rate is generally
considered to be a liquidity premium associated with
interest-rate risk, or a term premium associated with
investors’ maturity preferences.
For a liquidity premium embodied in a futures rate
to be different from the liquidity premium embodied
in a comparable forward rate implies that the interestrate risk associated with the futures contract is differ­
ent than that associated with the comparable implied
forward contract. For futures rates to be higher than
forward rates for the later-dated contracts as a result
of differences in liquidity premia, a given rise in
interest rates would have to generate a larger risk of
capital loss in the futures contract than in the implied
forward contract. It is not obvious why this would be
the case.
For a term premium embodied in a futures rate to
be different from the term premium embodied in a
comparable forward rate implies that investors’ ma­
turity preferences vary both across maturities and
across financial instruments. It is again not obvious
why this would be the case.
One factor that has been ignored in the discussion
of futures contracts is default risk. Treasury bills
traded in the spot market are considered to be default
free. Hence, implied forward rates would not embody
premia related to default risk. However, a futures
contract is not guaranteed by the U.S. Government,
but is rather guaranteed by the exchange on which it
is traded. Although the futures contract involves de­
livery of Treasury bills that are default free, the con­
tract itself is not default free. Consequently, the
futures rate may contain a risk premium associated
with default risk.
This default risk factor would be more important
for the futures contracts that are further from deliv­
ery, those for which Poole’s hypothesis fails to be
supported in our samples. The furthest-dated futures
contracts involve delivery of Treasury bills which
have not yet been issued; they do not exist. The
possibility exists, although it may be small, that there
would not be a sufficient amount of 3-month Treas­
ury bills available to meet the deliveries required by
the number of open futures contracts held for deliv­
ery. Although the Chicago Mercantile Exchange
guarantees that a settlement would be made, at least
a monetary settlement, the item promised for delivery
(3-month Treasury bills) may not be delivered.20
-°Defaults on futures contracts for commodities are rare, but
result in quite an uproar when they do occur. A recent ex­
ample was the May 1976 default on the delivery of Maine
Page 29

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

This risk of default, or risk of non-delivery of the
Treasury bills, would tend to make yields on the laterdated futures contracts higher than the yields on the
two contracts closest to delivery (where Treasury
bills that can be used for delivery have been issued),
other things constant. The results shown in Table III
are consistent with this hypothesis. However, whether
or not the size of the spreads between the futures and
forward rates for the later-dated contracts can be
accounted for solely by default risk is an open
question.

SUMMARY AND CONCLUSIONS
Since yields on futures contracts are the market
counterpart of implied forward rates of interest de­
rived from the yield curve, the hypothesis that fu­
tures rates and forward rates are identical was tested
using data from the Treasury bill futures market and
the spot market for Treasury securities. The results
indicate that futures rates are significantly different
from the associated forward rates. Furthermore, the
differences between the two rates have not narrowed
consistently over time. Thus, it is difficult to attrib­
ute the significant differences between the two rates
as being due to the initial “thinness” in the devel­
opment of the Treasury bill futures market.

DECEMBER

1978

results on the contract closest-to-delivery should not
be extrapolated to other futures contracts.21
An explanation which is consistent with the empiri­
cal results is that there is a default risk premium that
affects and is embodied in the futures rates (since the
futures contracts themselves are not obligations of the
U.S. Government) but that does not affect the for­
ward rates. The default risk would be greater for the
later-dated contracts, which involve delivery of Treas­
ury bills not yet issued, than for the contract closest
to delivery, which Poole investigated. Although fur­
ther testing and examination is required to fully
explore the implications of the evidence given here,
the consideration of the default risk of futures con­
tracts should be a useful starting point.
The results of this study imply that we cannot
interpret yields on later-dated 3-month Treasury bill
futures contracts as the market’s unbiased expecta­
tions of future spot rates on 3-month Treasury bills.
Futures rates do not necessarily reflect the expected
lev el of future interest rates. However, these results
do not conflict with the proposition that chan g es in
market expectations of future interest rates can be
inferred from chan g es in futures rates.

Poole’s argument that the two rates should not be
equal, but that the futures rate should be below the
forward rate, was also examined. Poole’s results were
based on the effect of transactions costs on forward
and futures rates, and were supported by evidence
using the futures contract closest to delivery. Results
from our samples for later-dated futures contracts
do not support Poole’s hypothesis. Instead, we find
that the futures rates are consistently above the for­
ward rates for the later-dated contracts. Thus, Poole’s

The examination of interest rate expectations em­
bodied in futures rates is therefore more complicated
than Poole’s results suggest. Furthermore, if default
risk is a significant factor affecting futures rates, then
estimates of term or liquidity premia in forward rates
will not be comparable to the premia embodied in
futures rates. This would make the estimation of the
levels of expected future interest rates even more
difficult. Consequently, policymakers who want to
compare their own interest rate forecasts to the mar­
ket’s expectations should use caution in employing
futures rates to measure market expectations.

potato futures. Recently a bill was introduced in Congress
that would ban all futures trading in potatoes.

21Poole, “Using T-Bill Futures to Gauge Interest-Rate Expec­
tations,” p. 15.

Page 30



F E D E R A L R E S E R V E B A N K O F ST. L O U I S

DECEMBER

1978

REVIEW INDEX - 1978
Issue

Jan.

Title

Inflation and T axes: Disincentives fo r Capital
Form ation

Issue

July

Pitfalls to the Current Expansion
D oes the F ederal Reserve Invest M em ber Bank
Reserves?
C oordinated International Econom ic Expansion:
A re Convoys or Locom otives the Answer?

Aug.

Oil Im ports and the F all o f the D ollar
An Explanation o f M ovements in the Labor
Force Participation Rate, 1957-76
M oney-Income R elationships and the Exchange
Rate R egim e

Sept.

Inflation, U nemployment, and M oney: Com par­
ing the Evidence from Tw o Sim ple M odels
D oes the Stage o f the Business Cycle A ffect the
Inflation Rate?
Effects o f State Reserve Requirements

Oct.

Taxation o f Capital Gains: Principle Versus
Practice
Budget Deficits and T rade D eficits: Is there a
Link?
Econom ic G row th and U nemployment: A R e­
appraisal o f the Conventional View

Nov.

M ovements in the Foreign Exchange Value o f
the D ollar During the Current U.S.
Expansion

International Reserves and the R ole o f Special
Drawing Rights
O utlook fo r F o o d and Agriculture
Feb.

T h e M echanics o f Intervention in Exchange
M arkets
A Tax-Based Incom es Policy (T IP ): W hat’s It
A ll A bout?
D oes th e St. Louis Equation N otv B elieve in
Fiscal Policy?

Mar.

T h e F ederal Open M arket Com m ittee in 1977
B ank Reserve Requirem ents and T heir E n force­
ment: A Com parison A cross States

Apr.

T h e Recent U.S. Trade D eficit — N o Cause for
Panic
H ave M ultibank H olding Com panies A ffected
Com m ercial Bank Perform ance?
O perations o f the F ederal Reserve Bank o f St.
Louis — 1977

May

A Perspective on the Econom y: T h ree Y ears o f
Expansion

Commentary on Monetary Economics: A n Inter­
view with Karl Brunner

C om paring Per Capita Output Internationally:
Has th e United States Been Overtaken?
Rising Farm land Prices and Falling Farm Earn­
ings: Is Agriculture in T rouble?
June

Im ports and Jo b s — T h e O bserved and the
U nobserved
Benchm ark Revisions o f the M oney Stock and
Ranges o f M oney Stock G row th




Title

Dec.

T h e Econom ic Consequences o f W age-Price
Guidelines
Is Inflation A ll D ue to M oney?
Are Preliminary W eek-to-W eek Fluctuations in
M l Biased?
A Com parison o f Y ields On Future Contracts
and Im plied Forw ard Rates

Page 31