Full text of Review (Federal Reserve Bank of St. Louis) : May 1980

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May 1980
Vol. 62, No. 5

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3 An Inflation Generation
7 Lagged Reserve Requirements: Implications
for Monetary Control and Bank
Reserve Management
21 The “Middleman” : A M ajor Source of
Controversy in the Food Industry

“Stabilization Policies: Lessons from the 70s and Implications for the ’80s,” Proceedings of a
Conference co-sponsored by the Federal Reserve Bank o f St. Louis and the Center for the
Study of American Business at Washington University is available in limited supply to our
readers. I f you are interested in obtaining a copy, please address your request to Editor,
Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri 63166.




An Inflation Generation
Commencement Address by Lawrence K. Roos, President, Federal Reserve Bank of St. Louis, to the Graduating
Class of 1980, Westminster College, Fulton, Missouri, May 18, 1980

I t was 34 years ago that Winston Churchill came
to Westminster and warned his audience and the
nation of an ominous threat to our peace and secu­
rity by enemies from abroad. The course of world
events in the intervening years has fully justified
his concern.
Today, I would warn you of a different threat of
similar gravity — a threat that, in this instance, comes
not from abroad but from within our own society.
It is a threat so complex and confusing that, to para­
phrase John Maynard Keynes, not one man in a mil­
lion fully comprehends its true nature. The threat I
would warn you of is accelerating inflation — a burden
which our nation has endured for the past decade
and which, unless appropriate counter-measures are
promptly taken, is likely to have catastrophic eco­
nomic, social, and political consequences in the years
to come.
Your graduating class, the Class of 1980, is part of
an inflation generation. You have already been wit­
nesses to and victims of rapidly increasing prices,
record-high rates of interest, a marked decline in the
value of the dollar on international exchanges, and
the many other manifestations of persistent inflation.
The economic environment you have inherited
stands in sharp contrast to that which faced my grad­
uating class some 40 years ago. Unlike what you are
experiencing, the Class of 1940 was part of a deflation
generation. We had grown up during a time of severe
unemployment and major economic recession. In sharp



contrast to the spiraling price levels of today, prices
in 1940 were actually lower than they had been 10
years earlier. I cite this contrast merely to emphasize
that, while the nature of the economic malaise facing
your class and mine is in a sense quite different, we
have both been confronted with circumstances of crit­
ical significance to the survival of our economic and
political system.
No challenge facing this Class of 1980 is more com­
pelling than that of breaking the momentum of chronic
inflation. Unless this is accomplished, there is no hope
of restoring to this nation the economic growth and
stability necessary for its continued prosperity and
security.

The evils of inflation are many. Some are well
known; others are well hidden. Perhaps the best un­
derstood are its economic costs. It was not so long
ago that “a penny saved” was actually “a penny
earned.” That principle — that saving will be rewarded
— is vital to economic progress. For without saving,
investment (that is, the formation of capital) is not
possible. Without capital formation, labor is denied
the tools with which to increase the production of
goods and services. Unfortunately, however, inflation
has severely eroded the incentive to save. A person
who placed $10,000 in a savings account 15 years
ago would by now have accumulated an additional
$8,000 in compounded interest. After adjusting for the
rise in prices over the past 15 years, however, that
$18,000 is actually worth only about $8,000 in “real”
value.

3

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

This lesson has not been lost on you, nor has it
passed unnoticed by millions of other Americans. As
a result, there has been a retreat from savings and
the associated investment so essential for growth in
productivity. In the past five years alone, the rate of
personal saving has fallen from more than 7 percent
to 4% percent annually. This, in turn, has resulted in
diminished growth of investment in industrial plant
and equipment and a serious drop in commitments to
research and development, both of which underlie
industrial productivity. Since the early part of the
1970s, productivity growth has slowed to about onehalf of its former rate. That rising real income is
impossible without rising productivity should come as
no surprise to you graduates, most of whom, I have
been told, are graduating with degrees in economics
and business administration. You know that when the
pie ceases to grow larger, the portions must grow
smaller. In this case, smaller portions mean a declin­
ing standard of living for all of us.
Yet, as bad as the economic effects of inflation are,
they are less worrisome than another seldom noticed
or, at least, seldom mentioned aspect of the problem:
that is, the threat to our personal political freedom
posed by inflation — the fact that it can destroy the
very foundation of our democratic form of government.
Inflation erodes our political system by robbing us, as
individuals, of the opportunity to approve or disap­
prove the most basic of government decisions — those
of money creation and taxation. Inflation permits gov­
ernment to finance its expenditures in a manner that
hides its actions from the scrutiny of its citizens.
Government expenditures, traditionally, have been
financed either by taxes levied by Congress or by bor­
rowing from the private sector to finance deficits.
These methods have the advantage of forcing Con­
gress to establish, in plain sight of the electorate, a
level of spending and to support that spending
through direct taxation or borrowing. Citizens are
given the opportunity to approve or disapprove of the
government’s actions at the polls. This is the tradi­
tional manner by which elected officials are held ac­
countable for their actions.
In recent years, however, a practice of “backdoor”
financing has evolved which enables government to
circumvent its traditional accountability. In the past
two decades, the federal government, instead of sup­
porting its expenditures by taxation, has come to rely
more and more on deficit spending to finance its oper­
ations. Now deficit spending, by itself, is not neces­
sarily inflationary, if deficits are financed solely by
increased borrowing in private markets. However,



4

M AY

1980

higher interest rates, which are a by-product of gov­
ernment borrowing in private markets, are not popular
choices for elected officials. So instead of “facing the
music” of increased taxes or higher interest rates,
fiscal policymakers have made use of the technique of
“hidden financing” — hidden, that is, from the voters.
When it resorts to hidden financing, the govern­
ment creates money through the monetization or pur­
chase of its debt by the Federal Reserve. When the
Fed monetizes federal deficits, it increases commercial
bank reserves and thereby expands the supply of
money available for spending. Increases in the money
supply lead to accelerated inflation, reducing the pur­
chasing power of individuals as assuredly as if taxes
had been increased in the first place. In fact, taxes
have been increased for inflation is a tax. It is a tax
that is neither subject to voter approval nor directly
associated with voter-approved government spending
decisions. Our founding fathers would have called
such an arrangement “taxation without representation”
and, indeed, it is truly that.
Hidden financing has enabled the government to
expand its role substantially without a specific man­
date from the electorate. Whereas in 1940 federal
government expenditures amounted to 13.5% of the
gross national product, last year they consumed 21%
of the resources of the economy. When you include
welfare, social security, and debt service costs, the
government’s share of economic consumption has
grown from one-sixth of the total economy in 1940
to one-third today. Would this great expansion in the
size of government have occurred had the American
people been given the opportunity explicitly to de­
cide the issue at the polls? I doubt it!
In view of the serious nature of the economic and
political consequences of inflation, I would be remiss
if I did not suggest a workable way of alleviating
the problem.
Clearly, inflation is not a self-generating and un­
controllable phenomenon. It occurs only when money
growth outstrips the growth of production of goods
and services. It can be diminished in one of two ways:
either by increasing production or by slowing the rate
of money growth. Both of these alternatives meiit
consideration.
Unfortunately, almost all available options for in­
creasing productivity involve long-range actions and
long-run responses. Tax reforms, for example, would
increase incentives to save and invest, and thereby
increase productivity. A lessening of government reg­
ulation would tend to lessen costs of production and

F E D E R A L R E S E R V E BANK O F ST. L O U IS

increase output. Reductions in the size of government
would free resources for use by the private sector and
thereby increase the output of goods and services de­
manded by consumers. However, all of these are
changes of an institutional nature that entail legis­
lative actions as well as a fundamental reordering of
expressed national priorities. While highly desirable,
it would be unrealistic to believe that they could be
brought to fruition quickly enough to have a demon­
strable early effect on inflation.
A reduction in the rate of money growth, on the
other hand, offers a means of reducing inflation fairly
quickly. The Federal Reserve, through its open mar­
ket operations, can increase or decrease bank re­
serves almost instantaneously and thereby can quickly
expand or contract the amount of spendable money
in the hands of the public. By gradually reducing the
growth of the money supply, the Fed can bring down
inflation over a predictable and reasonably short pe­
riod of time. In this connection, I would point out
that there is no responsible way to reduce the basic
rate of inflation instantaneously. To seek an immediate
solution by drastically slamming on the money growth
brakes would have a shocking effect on the economy
in terms of lost output and high unemployment. It
would create intolerable conditions of recession which
in turn would bring forth pressures for inflationary
actions to spend our way out of our distress. However,
a gradual reduction in the growth of the money sup­
ply, say at a rate of 1 or 2% per year, would exert
minimal economic stress and would significantly re­
duce inflation within a few years.
Although such a policy has been the stated object
of the Federal Reserve System for almost a decade,
the manner in which the policy was implemented in
the past tended to frustrate the Fed’s good intentions.
Prior to October 6, 1979, the Fed had two incom­
patible monetary policy goals: the reduction of money
growth and the stabilization of interest rates in the
short run. The simultaneous achievement of these two
objectives was frequently impossible. Whenever money
growth targets were incompatible with interest rate
targets, the objective of money growth control was
abandoned in favor of short-run interest rate stabiliza­
tion. This not only contributed to rising inflation, but
caused the Federal Reserve to lose credibility in the
eyes of the public as its record of performance failed
to measure up to its stated objectives.
Fortunately, this has changed. There is now solid
reason for optimism that monetary policymaking has
finally turned the corner and will be a more success­
ful tool in coping with inflation than in the past.



MAY

1980

Last October, the Federal Reserve announced new
operating procedures which, in effect, eliminate the
previous dilemma of concurrently setting interest rate
and monetary growth targets. Stabilization of interest
rates, in the short run, has been abandoned as a tool
of policy, and the goal of reducing money growth has
been reaffirmed. What is even more heartening is
that evidence to date indicates that the Fed will be
successful in achieving its money growth targets.
Money growth has been substantially reduced from
the inflation-generating levels of the pre-October pe­
riod. If this trend is continued, there is ample reason
to believe that we will experience reduced inflation in
the months and years ahead. Interest rates have been
permitted to fluctuate freely. Furthermore, the initial
dramatic interest rate increases, which were attrib­
utable to early doubts about the Fed’s ability to
achieve its announced goals, have been reversed. As
more people become convinced that the rate of growth
of money is indeed being controlled and will con­
tinue to be reduced, inflationary expectations will
recede and interest rates will continue to decline.
If one were to describe the current state of mone­
tary policy-making in terms that the late Winston
Churchill might have used, it could be said that “the
tide of battle is turning, but the day is not yet won.”
Significant economic, intellectual, and political bar­
riers must still be overcome before the public can feel
truly confident that the Fed’s new procedures will be
permitted to be carried through to fruition. Interest
rates, although easing, are still at relatively high levels,
and important parts of the economy such as housing,
farming, and other interest-sensitive activities are feel­
ing the effects of credit restraint. Continued restraint
will mean a period of softness in the economy, and
individuals who are adversely affected can be expected
to call vociferously for a return to a more stimulative
monetary policy. Moreover, many disciples of interest
rate stabilization find it difficult to accept control of
money and credit as a legitimate basis for the imple­
mentation of monetary policy. Finally, 1980 is an elec­
tion year, and the bitter medicine of monetary re­
straint has never been welcomed by candidates for
public office. Pressures such as these will undoubtedly
continue to test the resolve of policymakers to persist
in their efforts to eliminate inflation.
Whether or not yours will continue to be an in­
flation generation depends directly on our ability,
collectively, to resist the pressures of those who, un­
willing to tolerate the pain of the moment, will call
for a return to the expansive policies that created the
current inflation. In their desire for relief in the short
run, they would have us believe that a little inflation

5

FED ERA L. R E S E R V E BANK O F ST. L O U IS

is not so bad, that we can adjust to it and learn to
tolerate it.
This is simply not true. There is no hope for a per­
sistent “little inflation.” Wherever nations have ac­
cepted inflation as a way of life, they have discovered
that today’s 10% inflation becomes tomorrow’s 12%,
the next year’s 15% inflation, and so on.
This trend need not continue here, if we have the
discipline to accept a certain amount of temporary
pain for the promise of better circumstances in the
future. While yours is presently an inflation genera­
tion, it need not remain so. Indeed, it must not re­
main so.




6

MAY

1980

I have described the devastating consequences of
a continuation of accelerating inflation, and I have
offered what I believe to be a practical and workable
way to eliminate the problem. It is up to you as
thinking men and women to take the lead in stand­
ing for what is in the best interests of the free society
of which you are a part. Your generation has a clear
choice. It can go down in history as one which toler­
ated inflation and thus gave witness to the decline of
America as a great economic power, or it can leave
its mark as the generation which eliminated inflation
and restored the foundation of stability and growth
so necessary to our national survival. I have full con­
fidence that you will make the proper choice.

Lagged Reserve Requirements: Implications
for Monetary Control and Bank Reserve
Management
R. ALTON GILBERT

I D e p o s i t o r y institutions meet reserve require­
ments imposed by the Federal Reserve by holding
vault cash and reserve balances at the Federal Reserve
Banks.1 Until September 1968, member banks calcu­
lated their required reserves based on deposit liabil­
ities at the start of each day, for the seven days
ending on Wednesdays. Reserves held to meet those
requirements consisted of vault cash at the start of
business over the same period, plus reserve balances
at Federal Reserve Banks at the end of each day, for
the seven days ending on Wednesdays.2 Thus, there
was a one-day lag between the period over which
deposit liabilities and vault cash were calculated and
the period over which member banks held the re­
quired reserve balances, since deposit liabilities and
vault cash at the start of each day are the same as
those at the end of the previous day. This one-day
lag allowed member banks to calculate their required
reserves and reserves held as vault cash for a week
before making the final adjustments to their reserve
balances on Wednesdays. This system is called con­
1Legislation enacted in March 1980 imposes member bank
reserve requirements on all depository institutions. Although
this paper discusses the effects of reserve requirements on
banks, the analysis applies also to nonbank depository insti­
tutions that are required to hold reserves with the Federal
Reserve.
2Before September 1968, country member banks based their
calculations of required reserves and vault cash on balances
at the start of business over 14-day periods ending every
other Wednesday. Reserve balances were calculated as bal­
ances at the end of each day over the same 14-day periods.
In September 1968, settlement periods for country banks were
shortened to one week. Another change in reserve require­
ments that occurred in September 1968 was a liberalized
carryover provision. Before that time, member banks could
eliminate reserve deficiencies up to 2 percent of required re­
serves in one settlement period by holding additional reserves
the next settlement period. Since September 1968, member
banks may also carry over excess reserves of up to 2 percent
of required reserves to meet reserve requirements in the next
week. This paper does not consider implications of the carry­
over provision for monetary policy.




temporaneous reserve accounting (CRA) since, ex­
cept for the one-day lag, assets and liabilities used in
calculating reserves and required reserves are those
of the same week.
In September 1968, the Federal Reserve changed
the tim ing of reserve accounting by extending the
one-day lag to a two-week lag. Under this lagged
reserve accounting (LRA) system, required reserves
for each settlement week (seven days ending each
Wednesday) are based on deposit liabilities held
two weeks earlier. Average vault cash held two weeks
earlier is counted as part of reserves in the current
week, and vault cash held in the current week is
counted as reserves two weeks in the future. By the
beginning of each reserve settlement week (Thurs­
day through the following Wednesday), member banks
know the average balances they must hold at Reserve
Banks to meet required reserves for the current week.3
Table 1 describes how reserves and required reserves
are calculated under both CRA and LRA.
The Federal Reserve Board adopted LRA to sim­
plify the conduct of monetary policy and reserve man3Following the end of each settlement week, member banks
send reports to Reserve Banks indicating the amounts of
their liabilities subject to reserve requirements and vault cash
for each day of the settlement week. These reports, for the
week ending each Wednesday, are due at Reserve Banks by
the following Monday. Within two days after receiving these
reports, Reserve Banks send statements to member banks in­
dicating the average reserve balances they must hold during
the period from Thursday through the following Wednesday.
To illustrate the timing of these reports, consider the process
by which a member bank learns of its required reserve bal­
ance for the settlement week June 19-25, 1980. Required
reserves for that settlement week are based upon deposit lia­
bilities at the end of business each day June 5-11. The
bank sends a report to its Reserve Bank by Monday, June 16,
indicating its deposit liabilities and vault cash for the period
June 5-11. By June 18, the Reserve Bank sends the member
bank a statement of the daily average reserve balance the
bank must hold at the end of business June 19-25 to meet
reserve requirements for that period.

M AY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

1980

Table 1
Timing of Reserve Requirements Under
Contemporaneous and Lagged Reserve Accounting

Item
Deposit liabilities
subject to reserve
requirements

D escription of relevant period
C R A — average balances at the start of each
day for seven days ending W ednesday
of the current week

19-25

L R A — average balances at the end of each
day for seven days ending W ednesday
two weeks prior to the last day
of the current settlement w eek

5-11

Vault cash counted as
reserves in the
current week

C R A — same as for deposit liabilitie s

19-25

L R A — same as for deposit liab ilities

5-11

Reserve balances
counted as reserves
in the current week

C R A — average balances at the end of each
day for seven days ending W ednesday
of the current week

19-25

L R A — average balances at the end of each
day for seven days ending W ednesday
of the current week

19-25

agement by individual member banks. Because the
total required reserve balances of member banks each
week are known in advance under LRA, the Federal
Reserve can adjust total reserve balances to the re­
quired amount in an orderly fashion throughout the
week. Moreover, an individual member bank can
manage its reserve position by maintaining its re­
serve balance at predetermined levels each week.
Since LRA allows both the Federal Reserve and indi­
vidual banks to know with certainty the required
reserve balances for each week, it was expected to
moderate fluctuations in short-term interest rates near
the end of settlement weeks. According to the official
statement of the Board of Governors:
“The amendments were designed to facilitate more
efficient functioning of the reserve mechanism. They
did not represent any change in Federal Reserve
monetary policy, but were expected to reduce un­
certainties, for both member banks and the Federal
Reserve, as to the amount of reserves required to be
maintained during the course of any reserve-computation period. Adoption of the amendments was, there­
fore, expected to moderate some of the pressures of
reserve adjustments within the banking system that
occasionally develop near the close of a reserve period
and produce sharp fluctuations in the availability of
day-to-day funds.”4
4Board of Governors of the Federal Reserve System, Fifty-fifth

Annual R eport o f the Board o f Governors o f the F ederal R e­
serve System, 1968, p. 82.



8

Relevant days for
settlement w eek of
June 19-25, 1980

This article investigates the impact of the timing of
reserve accounting on the conduct of monetary policy
and on reserve management by individual banks.

IMPLICATIONS OF LRA AND CRA FOR
MONETARY POLICY
Effects on Variability of Money Market
Conditions and Open Market Operations
Several studies have shown that the variability of
money market conditions near the end of reserve
settlement periods increased after the adoption of
LRA. Changes in the federal funds rate from Tues­
days to Wednesdays were greater after LRA was
adopted, as were changes in the federal funds rate
from week to week. Not only have short-term interest
rates fluctuated more under LRA, but open market
purchases and sales of securities by the Federal Re­
serve to stabilize short-term interest rates have also
increased.5 Thus, although the Federal Reserve has
undertaken more actions to stabilize short-term inter­
est rates since the adoption of LRA, interest rates
5Warren L . Coats, Jr., “Lagged Reserve Accounting and the
Money Supply Mechanism,” Journal o f M oney, Credit and
Banking (M ay 1 9 7 6 ), pp. 167-80; William Poole and Charles
Lieberman, “Improving Monetary Control,” Brookings Papers
on Econom ic Activity (1 9 7 2 ), pp. 293-342; Albert E . Burger,
T he Money Supply Process (Belmont, CA; Wadsworth Pub­
lishing Co., 1 9 7 1 ), pp. 52-56.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1980

have been less stable than under CRA, just the oppo­
site of the expected outcome.

multiple of the increase in reserves, increasing by $2
to $102.50 (table 2, section C).

One reason for the increase in variability of short­
term interest rates and in Federal Reserve defensive
open market operations is that LRA does not allow
the banking system to adjust within a week to a
change in total reserves by changing total required
reserves. LRA predetermines required reserves for
each week, based on deposit liabilities two weeks
earlier. Suppose that reserves increase, causing banks to
have excess reserves. If banks invest their excess re­
serves, demand deposit liabilities will rise in the cur­
rent week, hut excess reserves o f the banking system
will remain unchanged. Random changes in reserves
under LRA, therefore, will cause either greater fluc­
tuations in short-term interest rates or more defensive
open market operations by the Federal Reserve to
offset fluctuations in reserves, or both, because excess
reserves or deficiencies in the current week remain
regardless of actions by banks. Empirical studies indi­
cate that, in fact, both effects have occurred.

Under LRA, banks cannot change their required
reserves of $20 in the current week by increasing their
demand deposit liabilities, since current reserve re­
quirements are based upon deposit liabilities of two
weeks earlier. If the Federal Reserve does not inter­
vene to eliminate the excess reserves, banks will bid
up the prices of securities (reducing interest rates)
until they are willing to hold excess reserves of $.50.
Demand deposit liabilities of the banking system
would rise as individual banks invest their excess
reserves. Expansion of demand deposits in the current
week would be limited by a Federal Reserve policy of
stabilizing short-term interest rates. If banks began
bidding up the prices of securities to invest excess
reserves, the Federal Reserve would eliminate the
excess reserves through open market operations.

Under CRA, if banks invest their excess reserves,
their required reserves for the current week will rise
as their demand deposit liabilities rise. Thus, unlike
the situation under LRA, banks can eliminate a dif­
ference between total reserves and required reserves
during the week.
The following illustration demonstrates differences
in reserve adjustment under CRA and LRA. Suppose
banks have combined balance sheets like those pre­
sented in table 2. At the beginning of a settlement
week, net demand deposit liabilities are $100; they
were also $100 two weeks earlier. Reserves of $20
consist of $5 in vault cash and $15 in reserve bal­
ances; vault cash was also $5 two weeks earlier
(table 2, section A). With a reserve requirement of
20 percent on demand deposit liabilities, banks are
initially in equilibrium with zero excess reserves un­
der either CRA or LRA. The remaining bank assets
are invested in government securities ($30) and loans
to the nonbank public ($50).
Suppose that in the current settlement week de­
mand deposit liabilities rise, as customers deposit an
additional $.50 of their currency (table 2, section B ).
Banks deposit the additional currency in their re­
serve accounts. Under CRA, banks now have excess
reserves of $.40 and have an incentive to purchase
securities from the nonbank public (or make addi­
tional loans) until excess reserves are reduced to
zero. As each bank invests its excess reserves, demand
deposit liabilities of the banking system rise by a



Problems in Controlling Bank Reserves
If the Federal Reserve is attempting to control
growth of money by controlling bank reserves, LRA
creates a more serious problem for the conduct of
monetary policy than merely increasing defensive
open market operations.6 The primary determinant of
reserves that are supplied each week may be the
deposit liabilities that the banking system created
two weeks previously, rather than the objectives for
money growth.
The Federal Reserve can implement monetary
policy by supplying the banking system with the
amount of reserves believed to be consistent with
objectives for growth of monetary aggregates.
Under CRA, the Federal Reserve could rely upon
banks to adjust aggregate deposit liabilities to
60n e feature of LRA that promotes short-term control of bank
reserves is that the vault cash portion of reserves is lagged.
Before September 1968, the Federal Reserve did not know the
amount of reserves member banks were holding each week as
vault cash, since member banks did not report their vault
cash holdings to the Federal Reserve until the following week.
Under current accounting procedures, the Federal Reserve can
calculate the amount of vault cash counted as reserves for the
current week, since member banks have reported their vault
cash holdings of two weeks earlier. Member bank vault cash
fluctuates so much from week to week that to reinstate count­
ing vault cash as reserves for the same week it is held could
cause substantial errors by the Federal Reserve in estimating
member bank reserves in individual weeks. To illustrate the
potential for such error, suppose the Federal Reserve counts
vault cash as reserves for the same week in which it is held
and assumes that vault cash held in the current week equals
that held two weeks ago (the latest information available).
Simulating such a method of estimating reserves for each set­
tlement week in 1976-78 indicates that errors in estimating
vault cash would be more than 1 percent of total reserves for
about 60 percent of the weeks, and more than 2 percent of
total reserves for about 30 percent of the weeks.

9

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

MA Y

1980

Table 2
Effects of a Currency Inflow on the Banking System
Section A: Initial situation
Banking system
Reserves

$20.00

V ault cash

$ 5.00

Reserve
balances

15.00

N onbank public

Demand deposits

$100.00

Currency

$ 40.00

Demand deposits
Securities

S ecurities

30.00

Loans

50.00

Contem poraneous reserve accounting

$50.00

40.00

Required reserves

Lagged reserve accounting

Bank loans

100.00

E xce ss reserves

$20.00

$ .00

20.00

.00

Section B: Custom ers deposit $0.50 in currency
Banking system
Reserves

$20.50

Vault cash

$ 5.00

Reserve
balances

15.50

Demand deposits

Nonbank pu blic
$100.50

Currency
Demand deposits
S ecurities

S ecurities

30.00

Loans

50.00
Required reserves
Contem poraneous reserve accounting
Lagged reserve accounting

$ 39.50

Bank loans

$50.00

100.50
40.00

E xcess reserves

$20.10

$ .40

20.00

.50

Section C: Equilibrium response under contem poraneous reserve accounting
Nonbank pu blic

Banking system
Reserves

$20.50

Vault cash

$ 5.00

Reserve
balances

15.50

Demand deposits

$102.50

C urrency
Demand deposits
S ecurities

S e cu ritie s

32.00

Loans

50.00
Required reserves
Contem poraneous reserve accounting
Lagged reserve accounting

levels consistent with the amount of available re­
serves. If banks were to create more deposit liabil­
ities than could be supported by available reserves,
they would attempt to increase their reserves by sell­
ing securities to the nonbank public and thereby re­
duce deposit liabilities of the banking system to a
level which could be supported by total available
reserves.7




10

$ 39.50

Bank loans

$50.00

102.50
38.00

E xce ss reserves

$20.50

$ .00

20.00

.50

7The ability of the Federal Reserve to control growth of the
money stock by controlling bank reserves may be limited, since
banks may borrow reserves at the discount window. If, for
instance, demand for credit increases but the Federal Reserve
keeps nonborrowed reserves unchanged, banks could accom­
modate the increase in credit demand by creating additional
demand deposit liabilities, and borrow the additional reserves
necessary to meet the higher required reserves. This article
assumes that the Federal Reserve is capable of controlling
total bank reserves weekly; thus the analysis can focus on
how the timing of reserve accounting affects the conduct of

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1980

Table 3
Response of the Banking System to an increase in Loan Demand
Section A: Initial situation
Banking system
Reserves
Vault cash
Reserve
balances

$20.00

Demand deposits

Nonbank public
$100.00

$ 5.00

Currency
Demand deposits
S ecurities

$ 40.00

Bank loans

$50.00

100.00
40.00

15.00

S ecurities

30.00

Loans

50.00
Required reserves
Contem poraneous reserve accounting
Lagged reserve accounting

E xce ss reserves

$20.00
20.00

$ .00
.00

Section B: Initial response to increase in loan demand
Banking system
Reserves

$20.00

V ault cash

$ 5.00

Reserve
balances

15.00

Demand deposits

Nonbank p u blic
$102.00

Currency
Demand deposits
S ecurities

S ecurities

30.00

Loans

52.00
Required reserves
Contem poraneous reserve accounting
Lagged reserve accounting

$ 40.00

Bank loans

$52.00

102.00
40.00

Exce ss reserves

$20.40
20.00

$ -.40
.00

Section C: Equilibrium response under contem poraneous reserve accounting
Nonbank pu blic

Banking system
Reserves
Vault cash
Reserve
balances

$20.00

Demand deposits

$100.00

$ 5.00

Currency
Demand deposits
S ecurities

$ 40.00

Bank loans

$52.00

100.00
42.00

15.00

S ecurities

28.00

Loans

52.00
Required reserves
Contem poraneous reserve accounting
Lagged reserve accounting

Adjustment of the banking system to reserves sup­
plied by the Federal Reserve under CRA is illustrated
in table 3. The banking system is initially in equilib­
rium with zero excess reserves: net demand deposit
liabilities are $100 and, with a 20 percent reserve
requirement, reserves are $20 (table 3, section A).
monetary policy without lengthy discussion of the Federal
Reserve’s ability to predict or offset various factors that affect
total reserves. One way to minimize changes in bank borrow­
ings from the discount window would be to set the discount
rate above short-term market interest rates.




$20.00
20.00

E xce ss reserves
$ .00
.00

Banks respond to a $2 increase in demand for loans
by the nonbank public by increasing their loans and
demand deposit liabilities by $2 (table 3, section B).
Required reserves are now $20.40, whereas available
reserves are only $20. The Federal Reserve keeps
reserves at $20 to meet the objective for money
growth. Banks must eliminate deficiencies that are de­
veloping in their reserve positions by reducing re­
quired reserves. One approach involves selling secu­
rities to the nonbank public to increase their reserves,

11

F E D E R A L R E S E R V E BANK O F ST. L O U IS

thereby reducing demand deposit liabilities of the
banking system. The reserve deficiency is eliminated
when banks sell $2 of their securities, because de­
mand deposits are reduced back to $100 (table 3,
section C ). After making this final adjustment, banks
have accommodated the increase in loan demand by
selling securities, without changing demand deposit
liabilities.8
LRA breaks the link between reserves available to
the banking system in the current week and the amount
of deposit liabilities that banks can create in the cur­
rent week. If banks increase aggregate demand de­
posit liabilities in response to an increase in loan
demand, they are under no immediate pressure to
reduce their deposit liabilities, since excess reserves
remain unchanged at zero. Therefore, in the hypo­
thetical situation presented in table 3, LRA permits
banks to keep total demand deposit liabilities at $102
in the current week without reserve deficiencies.
Two weeks later, required reserves would equal
$20.40, reflecting the $2 increase in demand deposits. If
the objective of monetary policy is to keep total reserves
unchanged at $20, this situation poses a dilemma for
the Federal Reserve. Keeping reserves unchanged at
$20 would produce a sharp increase in short-term
interest rates, as banks attempt to meet their re­
quired reserves. Despite the rise in interest rates, some
banks would have deficient reserve positions, since
they could not alter their required reserves for the
week by selling securities. Unless the Federal Re­
serve would be willing to permit these large fluctua­
tions in short-term interest rates and reserve defi­
ciencies by some banks, it would have to provide the
additional reserves.
The Federal Reserve would also be under pressure
to reduce reserves two weeks after a decline in de­
posit liabilities. Unless the Federal Reserve would re­
duce reserves when required reserves declined, attempts
by the banking system to invest the excess reserves
would reduce short-term interest rates to levels at
which some banks would be willing to hold the ex­
cess reserves.
In summary, the most important implication of the
timing of reserve requirements for monetary control
is that under CRA the Federal Reserve could pro8A bank can increase its reserves and thereby reduce demand
deposit liabilities of the banking system other than by sell­
ing securities to the nonbank public. Fo r instance, it can sell
certificates of deposit. Customers buying certificates of deposit
ay for them with demand deposits. In the process, demand
eposit liabilities of the banking system decline. This ap­
proach to eliminating reserve deficiencies is more complicated
than that described in table 3 ( selling securities to the nonbank
public), since certificates of deposit are subject to reserve re­
quirements. The example of banks selling securities was
selected for expositional convenience only.




12

MA Y

1980

vide the level of reserves each week that would be
consistent with targets for monetary aggregates, and
banks would adjust their deposit liabilities to avail­
able reserves. Under LRA, the Federal Reserve tends
to adjust total reserves each w eek in response to the
total deposit liabilities that banks created two weeks
earlier,9
If LRA creates such difficulties for monetary con­
trol, why has the Federal Reserve tolerated it since
1968? One reason is that many member bankers pre­
fer LRA. The Federal Reserve has been reluctant to
initiate an unpopular change that might accelerate
membership attrition. This consideration is less im­
portant now since recent legislation extends member
bank reserve requirements to nonmember depository
institutions.
Another reason that LRA has not been abandoned
is that it does not create significant problems for
monetary control if the Federal Reserve implements
monetary policy by targeting on the federal funds
rate. Until October 6, 1979, the Federal Reserve con­
ducted open market operations to keep the federal
funds rate within ranges that were presumed to be
consistent with monetary growth objectives. Monthly
ranges for movements of the federal funds rate were
rather narrow, generally within 50 to 100 basis points.
Many of the influences that could change bank
reserves, such as changes in the public’s demand
for currency or Federal Reserve float, were offset
by targeting open market operations on the federal
funds rate. The Federal Reserve attempted to control
monetary growth by adjusting short-term interest rates
to levels at which the amount of money demanded
by the public equalled the desired levels for the
monetary aggregates.10 With the emphasis on response
of money demand to changes in short-term interest
9There is evidence that the Federal Reserve, since adopting
LRA, has adjusted member bank reserves to the deposit liabil­
ities member banks created two weeks earlier. Feige and
McGee estimated the relation between the money stock and
bank reserves for a period before and a period after Septem­
ber 1968. Fo r the period before September 1968, the money
stock (with autocorrelations removed) was most highly cor­
related with reserves in the same week. However, for the
period after September 1968, the money stock was most
highly correlated with reserves two weeks in the future. See
Edgar L. Feige and Robert McGee, “Money Supply Con­
trol and Lagged Reserve Accounting,” Journal o f Money,
Credit and Banking (November 1 9 7 7 ), pp. 536-51. In
another study, using data for a period after September 1968,
monthly money stock, with autocorrelations removed, was
most highly correlated with reserves in the same month and
in the next month. See David A. Pierce, “Money Supply
Control: Reserves as the Instrument Under Lagged Account­
ing,” Journal o f Finance (June 1 9 7 6 ), pp. 845-52.
10Fo r a description of this approach to implementing monetary
policy, see Henry C. Wallich and Peter M. Keir, “The Role
of Operating Guides in U.S. Monetary Policy: A Historical
Review,” Federal Reserve Bulletin (September 1 9 7 9 ), pp.
679-91.

FE D E R A L . R E S E R V E BANK O F ST. L O U IS

rates rather than on response of money supply to
reserves, difficulty in controlling money by controlling
reserves under LRA was not considered an important
issue for monetary policy.11
Implementing monetary policy by targeting on the
federal funds rate has created serious problems for
monetary control. Because the Federal Reserve has
attempted to moderate changes in short-term interest
rates, monetary aggregates have responded positively
to changes in demand for money and credit. When
credit demand has risen, for instance, the Federal
Reserve has not raised its targets for the federal
funds rate fast enough to avoid supplying additional
reserves, and banks have accommodated increases in
credit demand by creating additional demand de­
posits. Conversely, when demand for credit has de­
clined, the Federal Reserve has attempted to moderate
declines in short-term interest rates and, in the pro­
cess, has reduced the supply of reserves.
Because targeting on the federal funds rate re­
sulted in money growth that was too rapid to stay
within desired ranges for money growth, the Fed­
eral Reserve adopted a reserve targeting approach
to implementing monetary policy on October 6,
1979. The Federal Reserve now establishes targets
for growth of a group of bank reserve aggregates
that are presumed to be consistent with objectives
for growth of monetary aggregates. Under this sys­
tem, the federal funds rate is allowed to fluctuate
within a relatively wide range. Although the Federal
Reserve has not completely abandoned the objective
of confining fluctuations in short-term interest rates,
it is placing more emphasis on controlling bank re­
serves.12 Under this recently adopted policy of reserve
targeting, problems of controlling growth of bank
reserves under LRA are more important for mone­
tary policy.

IMPLICATIONS OF LRA AND CRA FOR
RESERVE MANAGEMENT OF
INDIVIDUAL RANKS
Monitoring Deposit Liabilities
One reason for adopting LRA was to simplify re­
serve management for individual banks. Under LRA,
n Kopecky develops a theoretical model in which LRA does not
create problems for money stock control if the Federal Re­
serve implements monetary policy by targeting on the federal
funds rate. See Kenneth J. Kopecky, “The Relationship
Between Reserve Ratios and the Monetary Aggregates Under
Reserves and Federal Funds Rate Operating Targets,” Staff
Economic Studies No. 100, Board of Governors of the Fed ­
eral Reserve System, 1978.
12Richard W . Lang, “The FOM C in 1979: Introducing Re­
serve Targeting,” this R eview (M arch 1 9 8 0 ), pp. 2-25.



MAY

1980

each bank is notified before the beginning of a settle­
ment week concerning the daily average reserve bal­
ance necessary to meet its reserve requirements for the
week. This procedure allows a member bank to focus
its attention on holding predetermined levels of aver­
age reserve balances. In contrast, under CRA, each
bank had to monitor closely its deposit liabilities and
adjust its reserves to meet requirements based on
those deposits each week. More timely monitoring of
deposit liabilities and adjusting reserves to expected
required reserves involve some costs to banks under
CRA.

Estimating Required Reserves
Many banks would have difficulty determining
their required reserves for each settlement week un­
der CRA, even with more timely monitoring of de­
posit liabilities. Some banks, particularly those with
branches, compile information on their deposit lia­
bilities one or two days after the end of each settle­
ment week. Many small banks have check processing
centers perform their accounting functions, and they
receive information on their deposit liabilities with a
lag of one or two days.
Consequently, these banks’ estimates of their re­
quired reserves would be based on incomplete infor­
mation concerning their weekly deposit liabilities.
Errors in calculating required reserves due to incom­
plete information on deposit liabilities would result
in excess reserves or deficiencies.
Whether incomplete information would create
major problems for reserve management under CRA
is an empirical question. Banks may carry over excess
reserves or deficiencies, up to 2 percent of required
reserves, into the next settlement week without pen­
alties or loss of credit for excess reserves. Estimating
required reserves using incomplete information on de­
posit liabilities would not create serious problems for
reserve management if estimated required reserves
were always within 2 percent of actual required
reserves.13
13This section analyzes the magnitude of differences between
estimated and actual required reserves for individual banks
that would tend to occur on a weekly basis under CRA due
to incomplete information on deposit liabilities for each
settlement week. This factor would be important under CRA,
but not under LRA, since individual banks know their
required reserve balances for each settlement period at the
start of the period. Another factor that tends to make a
bank’s reserves differ from required reserves is unpredictable
changes in its reserve balances on the last day of the set­
tlement week due to fluctuations in deposit liabilities. In
considering the appropriate percentage carryover under CRA,
the percentage carryover that would permit individual banks
to manage their reserve positions with incomplete informa­
tion on deposit liabilities should be expanded enough to
facilitate reserve management even when unpredictable fluc­
tuations in reserve balances occur late in settlement periods.

13

MAY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

1980

Table 4
Errors in Estimating Required Reserves with
Incomplete Information about Deposit Liabilities
Percent of banks with the
sp ecified error,
for estim ates based
on deposit liab ilities for:
Percentage error
(absolute value)

First six days
of each week

First five days
of each week

First five days
of each w eek

34.33

76.12

2.31

8.46

3

17.91

46.27

0.79

3.25

4

10.45

29.85

0.38

1.76

5

8.96

23.88

0.29

0.91

6

5.97

16.42

0.20

0.56

7
8

4.48
2.99

11.94
8.96

0.12
0.09

0.32
0.23

9

0.00

5.97

0.00

0.18

10

0.00

4.48

0.00

0.15

Required reserves were calculated for each bank
based on deposit liabilities for seven days ending each
Tuesday (same as deposit liabilities at the start of
business for seven days ending on Wednesdays). Re­
quired reserves were estimated for each week based
on deposit liabilities for five days ending each Sunday
and for six days ending each Monday. Required re­
serves were estimated by assuming that average de­
posit liabilities for the whole week would be what
they were for the first five or six days of each week.
Differences between actual required reserves for each
settlement week, based on complete information, and
estimated required reserves were calculated as per­
centages of actual required reserves. Errors in esti­
mating required reserves can be considered maximum
errors, since it was assumed that banks have no infor­
mation on changes in their deposit liabilities near the
end of each week, whereas they may have information
14These 67 member banks borrowed from the Federal Reserve
during 1977 or early 1978. The reason for using these banks
was that data on their daily deposit liabilities were compiled
for another study, and were available at no additional cost.
If use of data for banks that borrowed from the discount
window creates any bias, the errors in estimating required
reserves would be biased upward; those banks may have
borrowed because they had unanticipated reductions in their
reserve balances late in some settlement weeks due to de­
clines in deposit liabilities. The size distribution of the 67
banks is as follows: total deposits of $0-$10 million, 9 banks;
$10-$25 million, 11; $25-50 million, 21; $50-100 million,
8; $100-$400 million, 9; and over $400 million, 9.

14

First six days
of each week

2

This issue was investigated for 67 Eighth District
member banks using 1977 data on deposit liabilities.
Their total deposits ranged from about $4 million to
just over $1 billion.14




Percent of settlement w eeks in
w hich banks had the specified
error, for estim ates based
on deposit liabilitie s for:

on customer transactions or regular intra-weekly
patterns of deposit liabilities that would help them
estimate required reserves more accurately.
Results of these calculations, as shown in table 4,
indicate that the 2 percent carryover may be too
small under CRA. If banks had information on deposit
liabilities for only the first five days of each week,
76 percent of them would have estimation errors
greater than 2 percent in at least one week. Errors
greater than 2 percent would occur in about 8 per­
cent of the settlement weeks.15 Only three of the 67
banks, however, had estimation errors greater than
5 percent for two or more settlement weeks in the
year, even without information on deposit liabilities
for the last two days of each week. This result indi­
cates that only a few banks that have especially large
fluctuations in deposit liabilities would have difficulty
in estimating required reserves within approximately
5 percent of actual required reserves using incomplete
information.
Even if individual banks occasionally had large
errors in estimating their required reserves, those
15Percentages of settlement weeks in which errors in calculat­
ing required reserves for the 67 banks were greater than
various percentages of actual required reserves are calculated
as follows: There were 51 settlement weeks in 1977. F o r the
67 banks together there were 3417 ( 67 x 5 1 ) settlement
weeks. The total number of weeks during the year in which
any of the banks had errors of more than 2 percent was 289,
based on information about deposit liabilities for the first five
days of each week. F o r the 67 banks as a group, therefore,
errors were greater than 2 percent of required reserves for
8.46 percent (2 8 9 as a percentage of 3 4 1 7 ) of the settle­
ment weeks.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

errors should not create significant differences be­
tween total reserves and total required reserves for
the banking system. Errors by some banks that under­
estimate their required reserves in a given week
would generally be offset by errors of other banks
that overestimate their required reserves. The main
reason to expect such errors to be offsetting is that
banks that have increases in their deposit liabilities
late in a settlement week generally receive them
from banks having deposit outflows late that same
week.
Effects of offsetting errors in calculating required
reserves were examined for the 67 member banks
mentioned above. Estimates of their required reserves
for each week based on deposit information for the
first six days were added for all 67 banks, subtracted
from the sum of their actual required reserves, and
divided by the sum of their actual required reserves.
Differences between the sums of estimated and actual
required reserves were less than 1 percent of actual
required reserves in each settlement week, and the
deviations (in absolute value) averaged 0.26 percent.
With information on deposit liabilities for only the
first five days of each week, the sum of estimated
required reserves deviated from actual required re­
serves by more than 1 percent in only two of the
51 weeks, and deviations for each week averaged 0.37
percent. Since these results are for only a small group
of banks, percentage deviations based upon calcu­
lations for all banks would be smaller. Permitting
banks to carry over more than 2 percent of excess
reserves or deficiencies would facilitate reserve man­
agement by individual banks under CRA, without
affecting substantially the relation between reserves
and required reserves for the banking system.

Size of Adjustments to Reserve Balances in
Response to Changes in Deposit Liabilities
Costs of monitoring deposit liabilities and estimat­
ing required reserves are only two aspects of reserve
management by individual banks that are influenced
by the timing of reserve requirements. A third aspect
is the size of adjustments a bank must make to its
reserve balance to avoid excess reserves or deficiencies
when its deposit liabilities change. Under CRA, re­
quired reserves change during a settlement week in
response to changes in deposit liabilities. Consider­
ing only the effects of fluctuations in deposit liabil­
ities on required reserves seemingly implies that ad­
justments of reserve balances to changes in deposit
liabilities would be necessary only under CRA.
However, changes in deposit liabilities have addi­
tional effects on the reserve positions of individual



MAY

1980

banks. A bank that clears checks through its reserve
balance at the Federal Reserve has reductions in its
reserve balance when its deposit liabilities decline.
Suppose the reserve balance of a bank that clears
checks through its reserve account initially equals
its required reserve balance. Under LRA, a bank must
increase its reserve balance by the amount of de­
clines in its deposit liabilities. Under CRA, a bank
must increase its reserve balance by some fraction of
the decline in deposit liabilities, since required re­
serves decline as deposit liabilities decline. Therefore,
under LRA, a bank that clears checks through its
reserve account must make larger adjustments to its
reserves per dollar of change in demand deposit lia­
bilities to avoid excess reserves or deficiencies than
under CRA.
Under LRA, changes in deposit liabilities during
a settlement week do not affect that week’s reserves
or required reserves for a bank that clears checks
through its correspondent accounts.16 Conversely,
under CRA, required reserves change as deposit liabil­
ities change, but for a bank that clears checks through
correspondent accounts, reserves are unaffected by
changes in deposit liabilities. For that type of bank,
therefore, adjustments to reserves necessary to avoid
excess reserves or deficiencies are larger under CRA.
This conclusion is based upon the assumption that
as checks are cleared through a bank’s correspondent
accounts, its demand balances due from banks change
passively in response to changes in its deposit liabil­
ities during each week. Under such a policy, demand
balances due from banks decline dollar-for-dollar with
reductions in deposit liabilities and increase by the
same amount as do deposit liabilities.17
16Under recent legislation, all depository institutions offering
transactions accounts and nonpersonal time deposits are sub­
ject to member bank reserve requirements. Member banks
must hold their required reserve balances in reserve ac­
counts at Reserve Banks, whereas, nonmembers may have
correspondents hold required reserve balances for them in
the reserve accounts of their correspondents. Analysis in
this section considers reserve adjustments of a bank that
clears checks through its correspondent, but holds its required
reserve balances in a reserve account at its Reserve Bank.
Results for a bank that clears checks through a correspondent
and has the correspondent hold its required reserve balances
with the Reserve Bank might be substantially different. The
terms under which correspondent banks will offer to hold
required reserve balances for nonmembers are not yet
known, since reserve requirements will not be imposed on
nonmembers until this fall. If correspondents offer this ser­
vice in a flexible manner, requiring only that demand balances
of nonmembers be large enough on average over several
weeks or months to compensate the correspondents for ser­
vices provided and reserve balances held, these nonmembers
might not adjust their cash balances to week-to-week changes
in required reserve balances under either CRA or LRA.
17There is evidence that correspondent banks allow respon­
dents this degree of short-term flexibility in cash manage­
ment. See R. Alton Gilbert, “Access to the Discount Window
for All Commercial Banks: Is It Important for Monetary
Policy?” this Review (February 1 9 8 0 ), p. 19.

15

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1980

In contrast, if a bank that clears checks through
correspondent accounts keeps its demand balances
due from banks equal to a fixed proportion of deposit
liabilities on a weekly basis, reserve adjustment pres­
sure due to deposit fluctuations would be greater
under LRA than under CRA. When deposit liabilities
decline, for instance, a bank with such a cash manage­
ment policy would sell more assets under LRA to meet
reserve requirements and to maintain demand bal­
ances due from banks equal to a fixed proportion of
deposit liabilities; this occurs because required reserves
would not decline as deposit liabilities decline. Un­
der CRA, the bank would transfer some of its reserve
balances to demand balances due from banks when
deposit liabilities decline, since required reserves
would also decline in the same week.

A bank that increases loans to its customers will not
know immediately whether there is a general increase
in demand for bank loans, or whether the increase in
demand is limited to its own customers. Therefore,
the bank will base the interest rates it charges in the
current week on interest rates prevailing up to the
current week.

This analysis indicates that it is unclear whether
adjustments to reserve positions are larger under CRA
or LRA. Adjustments by an individual bank to its
reserve position in response to given changes in de­
posit liabilities are analyzed under various assump­
tions in the Appendix. The largest adjustment occurs
for a bank that clears checks through its reserve bal­
ance and is subject to LRA. The smallest adjust­
ment (actually zero) results for a bank that clears
checks through its correspondent accounts and is sub­
ject to LRA. (The latter example assumes that bal­
ances due from banks are allowed to fluctuate
passively with changes in deposit liabilities.) Under
CRA, adjustments to reserve positions are smaller if
the bank clears checks through its correspondent ac­
counts, although the advantage of clearing through
correspondent accounts in terms of m inim izing reserve
adjustments would not be as great as under LRA.

If the Federal Reserve kept bank reserves un­
changed two weeks after the increase in loan demand,
there would be sharp upward pressure on short-term
interest rates. Loans that were profitable at the inter­
est rates that prevailed two weeks previously may no
longer be profitable because of the increased cost of
borrowing reserves.

Risks due to Changes in Interest Rates
A final issue concerns the risks that a bank incurs
due to delayed effects of changes in demand for bank
credit on interest rates under LRA. A bank increases
demand deposits of borrowers when it makes addi­
tional loans. If borrowers temporarily hold larger
demand deposits before making payments, required
reserves of the lending bank will be larger in two
weeks. When the borrowers withdraw deposits, the
lending bank will lose reserves to other banks and
must borrow them back through the federal funds
market to meet reserve requirements in the current
week. A bank that increases its loans may continue
to borrow federal funds for several weeks to finance
the increase in loans before arranging longer-term
financing.
The cost of financing customer loans, therefore,
depends upon interest rates two weeks in the future.

16




Under LRA, an increase in loan demand would not
drive up short-term interest rates in the first week of
increased demand. Thus, banks could accommodate
the increased loan demand by creating demand de­
posit liabilities without experiencing reserve deficien­
cies in the current week. Pressures on interest rates
would occur two weeks after the increased loan de­
mand, when required reserves increase.

An increased demand for bank loans has a more
immediate effect on short-term interest rates under
CRA. As demand deposit liabilities increase, banks
begin bidding for additional reserves to meet higher
required reserves. These increases in short-term in­
terest rates signal banks that credit demand has risen,
and they can adjust their loan terms more quickly.
As stated previously, a primary goal of Federal
Reserve policy prior to October 6, 1979 was to moder­
ate fluctuations in short-term interest rates. Effects of
this policy on changes in interest rates over two-week
periods are shown in table 5. Over a period of 142
weeks from January 1977 through early October 1979,
the federal funds rate rose by more than 50 basis
points over two-week periods on only five occasions
and never rose as much as one percentage point.
Banks could accommodate increases in loan demand
anticipating that the Federal Reserve would not per­
mit the federal funds rate to rise by more than about
50 basis points during the succeeding two weeks. The
Federal Reserve implemented monetary policy under
LRA in a manner that minimized interest rate risks to
member banks.
Under its new operating procedures adopted in
October 1979, the Federal Reserve places less em­
phasis on stabilizing the federal funds rate and more
emphasis on controlling member bank reserves. Con­
sequently, increases in the federal funds rate of more
than 50 basis points over two-week periods have been

MAY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

Table 5
Distribution of Changes in the Federal
Funds Rate Over Two-Week Periods
Before and After October 6, 1979

Changes in the average
federal funds rate over
periods of two weeks
(in percentage points)
2.000
1.000
0.750
0.500
0.250
0.100

Percentage of weeks when
changes were in the
follow ing ranges:
142 weeks
ending
O ctober 3, 1979

34 weeks
ending
M ay 28, 1980

or greater

11.76

to
to
to
to
to

0.749
0.499
0.249

0.050 to
0.000 to
-0.049 to
-0.099 to
-0.249 to
-0.499 to
-0.749 to
-0.999 to
-1.999 to
Below

0.099
0.049
-0.001
-0.050
-0.100
-0.250
-0.500
-0.750
-1.000
-1.999

17.65
02.94
02.94
05.88
08.82
02.94

1.999
0.999

00.70
02.82
16.90
21.83
14.79
14.79
05.63
16.20
04.93
00.70
00.70

05.88
05.88
02.94
05.88
11.76
14.71

much more frequent since early October of last year.
These results indicate that the Federal Reserve has
removed much of the protection that was previously
available to banks from effects of changes in short­
term interest rates. Thus, in weighing the advantages
of LRA relative to CRA, banks should consider
whether they prefer LRA or CRA under a policy of
reserve targeting, since the option of reserve manage­
ment under LRA with the former policy of stabilizing
short-term interest rates is no longer available.

1980

reserve accounting (CRA), which was in effect prior
to the adoption of LRA, reactions by banks to excess
reserves or deficiencies yielded changes in total re­
quired reserves that brought aggregate reserve posi­
tions back into equilibrium within the current week.
The major problem for the conduct of monetary
policy under LRA is that the Federal Reserve has
created reserve balances each week based on deposit
liabilities that banks created two weeks previously.
In essence, the Federal Reserve has tended to supply
reserves to accommodate the growth of bank credit,
instead of pursuing an independent monetary policy.
LRA was expected to simplify reserve management
of individual banks. It is not possible to draw a gen­
eral conclusion about the realization of this expecta­
tion because several aspects of bank reserve manage­
ment are affected by the timing of reserve accounting.
A return to CRA would require banks to monitor
their deposit liabilities on a more timely basis and
to adjust their reserve balances each week in response
to changes in the week’s deposit liabilities. Some
banks may have difficulty calculating their deposit
liabilities on a timely basis and would have to esti­
mate their required reserves based on incomplete
information. Most banks, however, might be able to
estimate their required reserves each week within
about 5 percent of actual required reserves even
ivithout information on their deposit liabilities for
the last one or two days of each settlement week.

CONCLUSIONS

Another aspect of reserve management affected by
the timing of reserve accounting is the size of adjust­
ments that banks must make to reserve balances in
response to changes in deposit liabilities. Banks that
clear checks through their reserve accounts at the
Federal Reserve must make larger adjustments in
their reserves for a given change in demand deposit
liabilities under LRA than under CRA. The opposite
result obtains for banks that clear checks through
correspondent accounts, since adjustments to reserves
are smaller under LRA than under CRA.

Under lagged reserve accounting (LRA), required
reserve balances of individual banks and the banking
system are predetermined each week, based upon
deposit liabilities and vault cash two weeks earlier.
The Federal Reserve Board expected LRA to reduce
the variability of short-term interest rates near the
end of reserve settlement weeks. LRA has had the
opposite effect, primarily because it contains no
mechanism for eliminating excess reserves or defi­
ciencies within the current week that result from
fluctuations in total reserves. Under contemporaneous

A final aspect that must be considered concerns
risks associated with changing interest rates. Under
LRA, changes in interest rates over the succeeding
two weeks influence the profitability of investment
and lending decisions made by banks in the current
week. Moreover, a change in demand for bank credit
tends to affect short-term interest rates, with a twoweek lag. Under CRA, changes in demand for bank
credit would have more immediate effects on interest
rates. In the past, the Federal Reserve minimized
these risks by moderating fluctuations in interest rates.




17

F E D E R A L R E S E R V E BANK O F ST. LO U IS

MA Y

However, the Federal Reserve has recently permitted
larger fluctuations in short-term interest rates in an
attempt to control money growth by controlling
growth of bank reserves. Consequently, banks are

1980

now more vulnerable under LRA to making unprof­
itable investment decisions due to fluctuating short­
term interest rates. This problem is reduced under
CRA.

Appendix: Reserve Adjustments Under CRA and LRA
This Appendix analyzes the size of reserve balance
adjustments a bank must make to avoid deficiencies caused
by a decline in its demand deposit liabilities under
CRA and LRA. At the beginning of a settlement week,
the bank holds reserves just equal to its required
reserves. During the week, demand deposit liabilities de­
cline, and the bank adjusts its reserve balances to equal
required reserves. Reserve adjustments depend on whether
the bank is subject to CRA or LRA and on whether it
clears checks through its reserve account or through
accounts at correspondents.1
iResults would be symmetrical for an increase in dema.
deposit liabilities.

RESERVE ADJUSTMENT PRESSURE
UNDER CRA
A bank’s gross demand deposits are assumed to equal
$100 at the start of business on Thursday (table A l) .
With demand balances due from other banks of $5 and
no uncollected funds, net demand deposits equal $95.
The reserve requirement on net demand deposits is 20 per­
cent and, with $2 in vault cash and $17 in the reserve
balance, total reserves just equal required reserves. By
the end of business on Thursday, gross demand deposits
decline to $98 and remain at that level throughout the
week. Because the bank prefers to keep its vault cash
equal to 2 percent of its gross demand deposit liabilities,

Table A1
Effects of a Decline in Deposit Liabilities on the Reserves of a Bank
C le a r ch e cks through reserve account
G ross demand
deposits

Vault cash

Demand balances
due from banks

Net
demand deposits

Reserve balance

Day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

End
of day

Thursday

$100

$98

$2.00

$1.96

$5

$5

$95

$93

$17.00

$15.04

Friday

98

98

1.96

1.96

5

5

93

93

15.04

15.04

Saturday

98

98

1.96

1.96

5

5

93

93

15.04

15.04

Sunday

98

98

1.96

1.96

5

5

93

93

15.04

15.04

Monday

98

98

1.96

1.96

5

5

93

93

15.04

15.04

Tuesday

98

98

1.96

1.96

5

5

93

93

15.04

15.04

W ednesday

98

98

1.96

1.96

5

5

93

93

15.04

Sum

$13.76

15.04

$653

$105.28

C le a r ch e cks through correspondent account
G ross demand
deposits

Vault cash

Demand balances
due from banks

Net
demand deposits

Reserve balance

Day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

End
of day

Start
of day

Thursday

$95

End
of day

$100

$98

$2.00

$1.96

$5.00

$3.04

$94.96

$17

Friday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

Saturday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

$17

Sunday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

M onday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

Tuesday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

W ednesday

98

98

1.96

1.96

3.04

3.04

94.96

94.96

17

17

Sum

18




$13.76

$664.76

$119

F E D E R A L R E S E R V E BANK O F ST. L O U IS

it reduces vault cash to $1.96. Given this reduction in
gross demand deposits and adjustment to vault cash, the
amount by which the bank has to adjust its reserve
balance to avoid a reserve deficiency depends primarily
on how the bank clears checks.

Clearing Checks through Reserve Balances
Some banks receive payment for checks deposited with
them by depositing the checks with their Reserve Banks
for credit to their reserve accounts. When these banks’ de­
mand deposit liabilities decline, their reserve balances
decline by the same amounts. This response is illustrated
in table A l. During Thursday, the bank’s reserve balance
declines from $17 to $15.04. That change reflects the $2
decline in gross demand deposits and the $.04 reduction
in vault cash, which is deposited in the reserve account.
The bank that clears checks through its reserve account
is assumed to maintain its demand balances due from
other banks at $5, since the bank holds those balances
for reasons other than clearing checks.
If a bank is subject to CRA and clears checks through
its reserve account, the decline in gross demand deposits
reduces required reserves and reserve balances. Suppose
this bank waits until the last day of the settlement week
(Wednesday) to adjust its reserve balance. The magni­
tude of the adjustment necessary to avoid a reserve de­
ficiency is calculated in table A2. Required reserves are
calculated as the sum of required reserves each day of the
settlement week. Under CRA, required reserves are based
on deposit liabilities at the start of business on Thursday
through Wednesday. The sum of net demand deposits is
$653 and, given a 20 percent reserve requirement, re­
quired reserves are $130.60. Sum of vault cash over the
same period is $13.76. The sum of reserve balances at the
end of each day over the week would be $105.28 without
an adjustment to the deposit outflow. Thus, the bank
would have to increase its reserve balance on Wednesday
by $11.56 to avoid a reserve deficiency.

Clearing Checks through Accounts at
Correspondents
Many banks collect checks deposited with them by de­
positing these checks with their correspondents for credit
to their demand balances due from correspondents. For
these banks, reductions in deposit liabilities do not affect
their reserve balances but reduce their demand balances
due from correspondents. In the case presented in table
A l, the bank allows its demand balances due from cor­
respondents to decline by the amount of the $2 reduction
in gross demand deposits. It then deposits $.04 of vault
cash in its demand balances due from correspondents.
Thus, net demand deposits are reduced only slightly since
the reduction in gross demand deposits is largely offset
by the reduction in demand balances due from corre­
spondents.
Calculations in table A2 indicate that the bank would
have to increase its reserve balance by only $.192 on
Wednesday to avoid a reserve deficiency. These calcula­
tions indicate that, even under the same reserve account­
ing system (C R A ), the magnitude of reserve adjustments



MAY

1980

Table A2
Increase in Reserve Balances Necessary
to Avoid Reserve Deficiences with a
Decline in Deposit Liabilities_________

Vault cash

Contem poraneous
reserve
requirem ents

Lagged
reserve
requirements

Clea r ch e cks
through:

C lea r ch ecks
through:

Reserve
account

Correspondent
account

CorreReserve spondent
account account

$ 13.76

$ 13.76

$ 14.00

$ 14.00

Reserve balance

105.28

119.00

105.28

119.00

Total reserves

119.04

Required reserves 130.60
Difference between
required and total
reserves
$ 11.56

$

132.76

119.28

133.00

132.952

133.00

133.00

.192

$ 13.72

$

.00

differs greatly for banks that clear checks through their
reserve accounts and those that clear checks through
correspondent accounts. The important difference is that
changes in deposit liabilities change the reserve balances
of banks that clear checks through their reserve balances,
whereas reserve balances of banks that clear checks
through accounts at correspondents are not directly af­
fected by changes in deposit liabilities.

RESERVE ADJUSTMENT PRESSURE
UNDER LRA
Calculation of reserves and required reserves for a
bank subject to LRA requires assumptions about the
bank’s deposit liabilities and vault cash two weeks earlier.
Net demand deposit liabilities are assumed to have aver­
aged $95 and vault cash to have averaged $2 during the
settlement period two weeks earlier. Under LRA, there­
fore, the sum of reserve requirements for each day in the
current settlement week is $133 ($95 x 7 x 0 .2 0 ), and
the vault cash portion of reserves amounts to $14 ( $ 2 x 7 ) .
Therefore, at the start of business on Thursday, reserves
equal required reserves.

Clearing Checks through Reserve Balances
A decline in demand deposits has the same effect on
the reserve balance of a bank that clears checks through
its reserve balance, whether it is subject to LRA or CRA.
Unless the bank adjusts its reseive balance to offset the
decline in demand deposit liabilities, the sum of its
reserve balances over the current week will be $105.28.
If subject to LRA, the bank must increase its reserve
balance by $13.72 on Wednesday to avoid a reserve
deficiency. Note that this adjustment is larger than that

19

MAY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

for the bank subject to CRA that clears checks through
its reserve account. The decline in demand deposit lia­
bilities has the same effect on reserve balances in both
cases, but the adjustment to the reserve balance neces­
sary to avoid a reserve deficiency is smaller for the bank
subject to CRA, because its required reserves decline
during the current settlement week as demand deposit
liabilities decline, whereas, under LRA, required reserves
remain unchanged.

Clearing Checks through Accounts at
C orrespondents
Changes in deposit liabilities have no effect in the
current week on the reserve positions of banks that clear
checks through accounts at correspondents. Their re­
quired reserves and vault cash portion of reserves are
predetermined for the current week, and changes in de­




20

1980

posit liabilities do not directly affect their reserve balances
in the current week. Therefore, if such a bank begins a
settlement week with its reserve balances just equal to
required reserve balances, no adjustment of reserve bal­
ances is necessary in the current week to avoid excess
reserves or deficiencies in response to changes in deposit
liabilities.

SUMMARY
Effects of returning to CRA on the reserve adjustment
pressure on a bank would depend upon how the bank
clears its checks. For a bank that clears checks through
its reserve account, adjustments to reserve balances for
given changes in deposit liabilities would be smaller under
CRA. For a bank that clears checks through balances at
correspondents, reserve adjustment pressure in response
to deposit fluctuations would tend to increase from zero
to some relatively small amount.

The “Middleman”: A Major Source
of Controversy in the Food Industry
CLIFTON B. LUTTRELL

T

I HE “middleman” in the food industry histori­
cally has been the bete noire of many farmers and
consumers. This legendary person, allegedly respon­
sible for the differences between the prices of food
products received by farmers and the prices paid by
consumers, is depicted as having sufficient power over
prices to simultaneously underpay farmers for their
products and overcharge food consumers. As evidence
of this power, it is often noted that a loaf of bread
priced at approximately 40 to 50 cents contains only
6 to 7 cents worth of wheat, or that a sirloin steak
served in a restaurant for $10 or more came from a
beef animal sold by the farmer for only 70 cents per
pound.
The farmer’s frustration with the apparent power
of the middleman in the depression years of the early
1870s led to a rapid expansion of the cooperative
movement, by which the farmer expected to eliminate
the middleman and retain the profits.1 Although
farmer-owned cooperatives now operate in almost
every stage of farming and food-processing, criticism
of the middleman still persists.
1H. E . Erdman in a study for the University of California,
Agricultural Experiment Station; published in Henry C. and
Anne Dewees Taylor, T he Story o f Agricultural Economics
in the United States, 1840-1932 , (Ames: The Iowa State Col­
lege Press, 1 9 5 2 ), pp. 689-92; and Geoffrey S. Shepherd, et.
al., in Marketing Farm Products, (Ames: The Iowa State
University Press, 1 9 7 6 ), p. 252.




Criticism of the role of the middleman in the food
processing and marketing industry has appeared in
numerous studies, hearings, and reports. For instance,
one study in 1967 reported that
. . allegations of
excessive merchandising costs (of farm products)
cannot be brushed aside.”2 The U.S. Department
of Agriculture in 1979 reported that “the widening
(of food price) spreads to the point where there
are probably excess returns over costs is an unwel­
come development for consumers and inflation fight­
2Harold F . Breimyer, Agricultural Policy: A R eview o f Pro­
grams and N eeds, Technical Papers, National Advisory Com­
mission on Food and Fiber (August 1 9 6 7 ), p. 103. Other
examples of such views include: Report of the National Com­
mission on Food Marketing, F o o d from Farm er to Consumer
(June 1 9 6 6 ), pp. iii and 1, and pp. 109-10; F o o d Prices, Hear­
ings before the Subcommittee on Production and Stabilization
of the Committee on Banking, Housing and Urban Affairs,
93 Cong., 1 Sess., (Government Printing Office, 1 9 7 3 ), p. 1;
F o o d Chain Pricing Activities, Hearings before the Joint E co­
nomic Committee, 93 Cong., 2 Sess., (Government Printing
Office, 1 9 7 4 ), p. 1; T he Market Functions and Costs For
F o o d B etw een Am erica’s F ields an d Tables, prepared by
Economic Research Service and Agricultural Marketing Serv­
ice for the Subcommittee on Agricultural Production, Market­
ing and Stabilization of Prices of the Committee on Agricul­
ture and Forestry, United States Senate (M arch 25, 1 9 7 5 );
Prices and Profits o f Leading F o o d Chains 1970-74, Hearings
before the Joint Economic Committee, 95 Cong., 1 Sess.,
(Government Printing Office, 1 9 7 7 ); Ward Morehouse, III,
“Food Retailers Say Carter Shares Blame for High Food
Costs,” The Christian Science Monitor, August 10, 1979. Also
statements by Senator William F . Proxmire and Joseph L.
Alioto in F o o d Chain Pricing Activities, pp. 1 and 22.

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

ers.”3 President Carter was sufficiently concerned with
the food marketing industry that he summoned 16 top
industry executives to the White House last August
and noted that . . last winter (of 1978) when food
prices were going up (at the farm level), there was
no lag in the food-retail spread. Now that they are
going down to the farmer, there is a substantial lag.”4

M AY

Table 1
Percent of Retail Costs of Food-Farm
Products Accruing to Farmers
Years

Percent

Implicit in the criticism of the middleman s role is
the view that food prices to consumers are established
by the middleman independently of farm commodity
price movements.5

1920-29

40.9

1930-39

36.5

1940-49

49.9

1950-59

43.2

1960-69

39.2

In contrast to this view, it is shown in this article
that:

1970-79

40.3

1920-79

41.5

1. Changes in the portion of retail food costs re­
ceived by farmers largely result from farm prod­
uct supply fluctuations that cause changes in
the prices of farm commodities rather than
from changes in the middleman’s share.
2. Changes in the middleman’s receipts (gross re­
ceipts less the costs of farm products) essentially
result from inflation.
3. Changes in farm product prices and inflation
are the two primary causes of changes in retail
food prices.
4. Retail food prices reflect farm product price
changes only after a time lag, and the existence
of this lag may account for much of the criticism
of the middleman.

Farm Product Price Fluctuations Account
for Change in Farm ers Share
The farmer’s share of the cost of a market basket
of food (see definition, p. 23) has altered only
slightly since the 1920s as indicated in table 1. The
farmer’s share represents the difference between the
retail costs to consumers and net receipts of the mid­
dleman. It was approximately the same in the 1970s
as in the 1920s, averaging 40.9 percent and 40.3 per­
cent in the 1920-29 and 1970-79 decades, respectively.
Over the entire period from 1920 to 1979, the farmer’s
share averaged 41.5 percent.
Despite the overall consistency of the portion of
food costs accruing to farmers during 1920-1979,
sizeable fluctuations have occurred in one- to fiveyear periods. These fluctuations reflect changes in
3USDA, Farm Index (September 1 9 7 9 ), pp. 4-5.
4“Carter Grills Food Industry Executives on Prices and Profits,”
St. Louis G lobe Democrat, August 14, 1979.
5Alioto in F o o d Chain Pricing Activities, p. 22.




22

1980

Source: USDA, Farm -Retail Spreads F or F o o d Products,
Miscellaneous Publication No. 741 ( 1 9 7 2 ) ; Agricul­
tural Statistics; and Farm Index.

farm product prices rather than changes in receipts
to the middleman. Changes in farm product prices
are due primarily to changes in short-run supply. Di­
verse weather and biological conditions, as well as al­
tered international relationships, contribute to yearto-year changes in the supply of farm products.
Because the demand for farm products is relatively
inelastic, small changes in the quantity produced —
resulting from abnormal weather or other factors —
have a relatively large impact on prices.
Some analysts contend that year-to-year changes in
production account for the majority of short-run price
fluctuations, especially for those crops and livestock
products that cannot be stored in large quantities.6
Over the longer run, however, factors such as chang­
ing international trade policies, wars, and domestic
monetary policies have had a significant impact on
farm product prices through their effects on farm
product demand.
Parallel movements in the farmer’s share of the
market basket of food and in its real farm value are
indicated for selected periods in table 2. Changes in
the farmer’s share moved in the same direction as
real farm value during each period of change since
1947. For example, during the major declines in real
value in 1947-49, 1951-56, 1958-64, and 1973-76, the
farmer’s share declined 5, 9, 4, and 7 percentage
points respectively; and during 1971-73 when real
farm value rose $131, the farmer’s share increased 7
percentage points.
6See William G. Tomek and Kenneth L . Robinson, Agricultural-Product Prices, (Ith ica: Cornell University Press, 1 9 7 2 ),
p. 75.

MAY

FEDERAL. R E S E R V E BANK O F ST. LO U IS

1980

Definition of the market basket of food.
food purchased change, at least slightly, from year
to year.

“The market basket of food is the average quantity
of U.S. farm-originated food purchased annually per
household in 1960-61 by families of urban wage
earners, clerical workers, and workers living alone.
The retail cost is less than expenditures for food by
a typical family because:

“Decreases in the fanner’s share are sometimes at­
tributed to substitution of highly processed (conven­
ience) foods for less highly processed or unpro­
cessed foods. The substituted products, it is asserted,
have larger farm-retail spreads and higher retail prices
relative to their farm values than the foods for which
they are substituted. However, changes in the market
basket sample are infrequent. When a change occurs,
weights are revised so changes in the sample do not
alter the total retail cost and farm value. Thus, in­
creased use of convenience foods has not caused the
decreases in the farmer’s share shown by the present
market-basket statistics. The farmer’s share, however,
has been influenced by changes in marketing services
not identified with individual foods. For example, to
the extent that more elaborate facilities in supermar­
kets have increased farm-retail spreads and retail
prices, this increase in marketing services has affected
the farmer’s share.”1

(1) It does not include costs of food consumed in
away-from-home eating establishments.
(2) It is a weighted average of food expenditures
by single persons living alone as well as of those by
families.
(3) The market basket includes only foods origi­
nating on U.S. farms. It does not include fishery
products or coffee, bananas, and other imported
foods.
“Further, the market basket retail cost is an esti­
mate of the cost of the types and quantities of farm
foods purchased by urban wage earners and clerical
workers in 1960-61. The types and quantities of

1USDA: Agricultural Marketing Costs and Changes, Major
Statistical Series (Ju n e 1 9 7 0 ), p. 3.

Table 2
Change in Farmer’s Share, Real Retail Cost,
Farm Value, and Middleman’s Receipts for Market
Basket of Food for Selected Periods1
Date

Farm er’s share
(percentage points)

Retail
cost
$

-5 8

Farm
value
$

-8 4

M iddlem an's
receipts

1947-49

-5

1950-51

+2

+ 35

+ 37

-2

1951-56

-9

-1 1 6

-1 5 3

+ 36

1957-58

+1

+33

+22

+11

1958-64

-4

-8 8

-7 7

-1 0
-1 5

$ + 25

1964-66

+4

+ 38

+ 52

1966-67

-3

-4 2

-39

-3

1968-69

+2

-2

+ 14

-1 6

1969-71

-3

-4 2

-4 2

+1

1971-73

+7

+ 1 24

+131

-8

1973-76

-7

-43

-9 0

+47

1977-78

+1

+35

+35

+1

-1 2 6

-1 9 4

+ 67

1947-78

1Values adjusted for inflation with the consumer price index. The periods selected include
those consecutive years since 1947 during which the farmer’s share was either declining or
increasing.
Source: USDA, Farm -Retail Spreads F or F o o d Products, Miscellaneous Publication No. 741
(1 9 7 2 ) ; Agricultural Statistics-, and Farm Index.




23

M AY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

1980

R e a l Retail Cost, Farm V a l u e

♦Deflated b y Consum er P rice Index.

The close relationship between the farmer’s share
and the real farm value of the market basket of food
is illustrated graphically in chart 1. During these
selected periods, movement in the farm value of the
market basket corresponded to movement in the farm­
er’s share, with sharp changes in farm value associ­
ated with sharp changes in the market share accruing
to farmers.

Source: U.S. Departm ent of Agriculture

consumer price index. The rate of increase in the mid­
dleman’s receipts over the 28-year period averaged 3.8

Table 3
Rate of Change in Middleman’s
Receipts from Food Sales and
Rate of Inflation

Middlemans Receipts Change with Inflation
The middleman’s receipts for the market basket of
food are not as variable as the farm value. Weather
and other factors that affect the farmer’s receipts have
less of an effect on the middleman, since changes in
demand for resources and output in this sector prima­
rily reflect general inflation rather than weather or other
short-run supply or demand disturbances. Conse­
quently, the rate of increase in the middleman’s re­
ceipts corresponds to the rate of inflation in the over­
all economy. Table 3 indicates the close relationship
between the middleman’s return from a market bas­
ket of food and the overall rate of inflation as mea­
sured by the consumer price index. During some of
the periods, namely 1950-55, 1955-60, and 1975-78, the
middleman’s receipts rose more slowly than the
consumer price index. In the periods 1960-65 and
1970-75, however, they rose more quickly than the



24

Rate of change
M iddlem an’s
receipts1

Consum er
p rice index

1.8%

2.2%

1955-1960

1.5

2.0

1960-1965

1.4

1.3

1965-1970

4.2

4.2

1970-1975

8.8

6.7

1975-1978

6.4

6.6

1950-1978

3.8

3.6

1950-1955

iFarm-retail spread of market basket of farm-food products
adjusted for change in quantity of food in market basket.
Source: USDA, Farm -Retail Spreads for F o o d Products,
Miscellaneous Publication No. 741 (1 9 7 2 ) , p. 106;
Agricultural Statistics (1 9 7 8 ) , p. 446; Agricultural
Outlook (Decem ber 1 9 7 9 ), p. 16; E conom ic R e­
port o f the President (January 1 9 7 9 ), p. 240; and
Econom ic Indicators (D ecem ber 1 9 7 9 ), p. 23.

F E D E R A L R E S E R V E BANK O F ST. LO U IS

MAY

1980

Table 4
Retail Food Costs Closely Related to Farm Value of Food
Products and Inflation
Change in
farm value
plus im pact
of inflation on
m iddlem an’s
receipts

Change
in farm
value

Impact of
inflation on
m iddlem an’s
receipts1

45

$-36

$ 52

73

14

58

1960-65

41

23

39

62

1965-70

191

62

143

205

1970-75

648

306

288

594

1975-78

280

85

232

317

1950-78

$1,278

$454

$812

$1,267

Years

Change
in retail
food costs

1950-55

$

1955-60

$

17
72

M iddlem an’s receipts from market basket of farm-food products at beginning of period
multiplied by the percentage increase in the consumer price index during the period.
Source: USDA, Miscellaneous Publication No. 741 (1 9 7 2 ) ; Farm -Retail Spreads fo r F ood
Products, p. 106; Agricultural Statistics (1 9 7 8 ) , p. 446; Agricultural Outlook (D e ­
cember 1 9 7 9 ), p. 16; Econom ic R eport o f the President (January 1 9 7 9 ), p. 2 40; and
Econom ic Indicators (Decem ber 1 9 7 9 ), p. 23.

percent per year, or 0.2 percent faster per year than
the consumer price index. Essentially all of the in­
crease in the middleman’s receipts relative to the
consumer price index occurred during 1970-75.
The close relationship between the middleman’s
receipts and inflation is further demonstrated by as­
sessing the statistical relationship between them. The
correlation coefficient between the annual rates of
change in the middleman’s receipts and the consumer
price index for the period 1947-78 is .894.

Food Prices Change With Farm
Product Prices and Inflation
Changes in the retail cost of food are closely as­
sociated with changes in the farm value of food prod­
ucts plus the rate of inflation. As shown in table 4,
the change in the farmer’s share of the market basket
of food, when added to the impact of inflation on the
middleman’s receipts, accounts for virtually all the
change in retail costs of the market basket of food
for the 1950-78 period. For example, from 1955 to
1960, the real retail cost of a market basket of food
rose $73, while the farm value of the original prod­
ucts plus the impact of inflation on the middleman’s
receipts totaled $72. During the more rapid increases
in food prices since 1965, the increase in the farm
value of the market basket of food products, added



to the impact of inflation on the middleman’s receipts,
totaled $1,116 or 99.7 percent of the increase in the
retail cost of the food. As shown in chart 1, after
adjustment for inflation, the retail cost of a market
basket of food and the farm value of the original
food products move almost identically.
An alternative assessment of the relationship be­
tween farm value, the middleman’s receipts, and retail
food costs is obtained by correlating annual changes
in retail food costs with those for farm value and the
middleman’s receipts for the 1947-78 period. After ad­
justing for inflation, the correlation coefficient between
changes in retail cost and farm value is .922. This
value is significantly different from zero at the 5 per­
cent level. In contrast to the significant coefficient of
correlation between real retail food costs and the farm
value of food, the correlation coefficient between the
middleman’s receipts and retail food costs is not sig­
nificantly different from zero at the 5 percent level.

Effect of Time Lag on Prices
The full impact of farm price changes on food
prices occurs only after a substantial time lag. The
time lag is related to the timing of food purchases by
consumers and the maintenance of food and farm
commodity inventories by the middleman. Because

25

FED ERA L. R E S E R V E BANK O F ST. LO U IS

consumers randomly purchase food day-to-day around
some average level, retailers, wholesalers, and proces­
sors must hold inventories to accommodate these fluc­
tuations. Consider, for example, the retail outlet spe­
cializing in high quality beef. The retailer must carry
sufficient stocks to accommodate his customers. Orders
are placed to packers for shipments at regular inter­
vals to replenish stocks so that a sufficient amount of
beef will be avilable for sale at retailers within seven
to ten days after shipment. The packer, in turn, must
carry an inventory of cattle ready for slaughter and
an inventory of beef ready for shipment to avoid los­
ing customers. He must carry an inventory of slaugh­
ter cattle in order to avoid day-to-day fluctuations in
slaughtering operations that would impair the effi­
ciency of his labor force, plant, and equipment.7
The above description shows that a period of time
necessarily elapses before a change in farm output of
fed cattle has its full impact on retail price. In fact,
several days may pass from the time a reduced num­
ber of fat cattle are transferred from the farmer’s
feedlot to packers’ before it is recognized that the
reduction in the number marketed is not merely a
random fluctuation. Only when cattle and beef stocks
are reduced to less than desired levels at both packer
and retail levels is the price of cattle bid up and
higher prices charged for beef purchases.
This time lag was investigated for a number of
food commodities in order to determine the length
of time required for retail prices to adjust to changes
in farm product prices and the extent to which retail
prices change in response to a given change in farm
product prices. The following distributed lag price
equation was estimated:
m

A In CPj.t = a + Z b , A In F P j,t-i + uj,,
i= 0

where CPj and FPj are the consumer price and farm
price, respectively, of the j th product. The b’s are the
coefficients which indicate the rates of change in the
consumer price over each time lag for each percent­
age change in the farm price of the j th product, and
Uj is the random error term. The “t” subscripts denote
the time periods (months).
Thirteen foods or food groups were tested using the
Almon polynomial distributed lag technique. The
Cochrane-Orcutt procedure was used to correct for
7About one-half of the cattle marketed from commercial feedlots are owned by packers for eight days or more. See Report
of the National Commission on Food Marketing, F o o d from
Farm er to Consumer (June, 1 9 6 6 ), p. 24.




26

MAY

1980

serially dependent disturbances.8 Estimates were
made for the time period from January 1950 through
December 1978, except for fresh fruit, canned hams,
round roast, and sirloin steak. For these commodities,
the time periods began in January of 1967, 1964, 1964,
and 1961, respectively. Although lags of 12 periods
(months) or more were investigated, the results sug­
gested relatively short 4-month lags, with the excep­
tion of cereals and bakery products, white bread, and
canned hams which produced 20-, 16-, and 7-month
lags, respectively.9
The relatively high R2s in table 5 indicate that
much of the month-to-month change in the retail
price of food is explained by a constant term and
relatively recent changes in farm price. For example
more than 50 percent of the retail price movement of
fresh whole chickens and each of the meats, except
bacon and canned hams, is explained by the current
and past three-month ( or less) lagged change in farm
prices. Changes in farm prices account for a large
percentage of the change in retail egg prices, but for
a relatively small percentage of the change in retail
prices of items such as fresh fruit, cereals and bakery
products, and white bread. The full impact of changes
in farm prices over the effective lag periods are shown
in table 6.
The percentage of the retail price change explained
by a change in farm price is directly related to the
share of the retail value accruing to the farmer. As
shown in table 7, the farmer’s share of the retail value
of choice beef is relatively high, and 64 percent of the
change in the price of beef and veal and 66 percent
of the change in the price of chuck roast is explained
by the change in slaughter steer prices. Similarly, the
farmers share of the value of eggs is relatively high,
and 71 percent of the change in retail egg price is
explained by the change in the farm price. On the
other hand, only a small share of the retail value of
cereals and bakery products and white bread accrues
to farmers who produce the wheat from which these
products are made. Consequently, changes in farm
commodity prices have much less impact on the
changes that occur in the retail prices of these
products.
If all of the retail food price changes in the shortrun result from changes in farm prices, the sum of the
coefficients (table 6) should approximate the fanner’s
8A third degree polynomial was assumed. No endpoint con­
straints were used. All data were seasonally adjusted using
the X - l l technique.
9W ith the exception of a few instances that did not materially
change the results, the coefficients of any lags that extended
beyond the time periods designated in tables 5 and 6 were
not significantly different from zero.

FEDERAL. R E S E R V E BANK O F ST. LO U IS

MAY

1980

Table 5
Rate of Change of Retail Food Prices as a Function of Current and Lagged
Rates of Change of Farm Commodity Prices1
Dependent
variable
(change in
retail food
p rices)

Independent
variable
(change in
farm product
prices)

Constant
term

Fresh
vegetables

Fresh market
vegetables

Fresh fruit

Lagged
R2

DurbinW atson
statistic

Rho

Standard
error

2

.37

2.02

-.264

.038

.06
(3.83)

.06
(2.70)

.22

1.95

-.008

.022

.02
(4.27)

.02
(6.10)

.02
(6.85)

.32

2.03

.081

.006

.03
(4.43)

.03
(6.12)

0.2
(6.24)

.21

1.99

-.085

.008

.001
(0.57)

.48
(20.84)

.18
(13.73)

.02
(6.91)
2

2

.54

2.25

-.449

.028

Slaughter hogs

.001
(1.14)

.13
(6.51)

2

.49

2.00

-.030

.025

Canned hams

Slaughter hogs

.003
2.37)

.04
(2.55)

.07
(7.93)

.09
(8.42)

.45

2.00

-.041

.015

Meats3

Meat anim als

.001
(2.36)

.20
(10.40)

.24
(14.62)

.12
(9.66)

.08
(9.14)
2

.50

2.00

-.186

.013

Beef and veal

Slaughter steers

.002
(3.26)

.12
(8.27)

.25
.14
(21.47) (17.23)

2

.64

1.98

-.194

.011

C h uck roast

Slaughter steers

.001
(1.63)

.13
(6.45)

.22
(23.50) (18.75)

2

.66

2.01

-.259

.016

Round roast

Slaughter steers

.002
(2.11)

.13
(6.11)

.28
.13
(12.96) (11.19)

2

.55

2.13

-.412

.014

S irlo in steak

Slaughter steers

.002
(2.38)

.11
(5.60)

.28
.15
(16.45) (12.69)

2

.59

2.02

-.407

.014

W hole milk

M ilk

.001
(3.12)

.19
(5.76)

.14
(4.77)

.34

1.99

-.200

.007

Eggs

Eggs

.000
(0.07)

.63
(26.73)

.14
(7.02)

.08
(2.86)
2

.71

2.26

-.508

.028

Current

1
month

2
months

3
months

.002
(1.31)

.18
(8.83)

.21
(12.43)

.08
(6.39)

Fresh market
fruit

.003
(1.83)

.11
(4.67)

.07
(3.23)

C ere a ls and
bakery
products

A ll wheat

.003
(7.81)

.01
(2.60)

W hite bread

A ll wheat

.003
(6.74)

Fresh whole
ch icken s

B roilers

Bacon

.28
.17
(16.25) (12.75)

.11
(5.72)
2

1t-statistics are in parenthesis.
2Insignificant.
3Includes beef, veal, pork, and lamb.

share of the retail food price (table 7). Despite the
problem of comparability of some of the food groups,
the relationship between the farmer’s share and the
sum of the coefficients is apparent. For example, the
farmer’s share of the retail receipts from fresh fruit
was 28 percent and the sum of the coefficients for
fresh fruit was .32. Similarly, close relationships are
noted for pork, meat products, choice beef, and fresh
milk. Using the estimated standard error for each sum
coefficient, the farmer’s share is not significantly dif­
ferent from the sum of the coefficients for five of the
nine food groups.



Time Lag Explains Much of
“Middleman” Complaint
The lagged impact of farm commodity price
changes on food prices explains much of the criticism
of the food processing and marketing sector. In gen­
eral, such criticism has occurred during periods of
falling farm prices, when food prices fail to decline
in step with farm prices. A look at the lagged impact
of a decline in slaughter steer prices on the price of
sirloin steak indicates why such views are held. If
slaughter steer prices decline from $1.00 to $.90 per

27

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

M AY

1980

Table 6
Rate of Change in Retail Food Prices and
Sum of Lagged Rates of Change of Farm Commodity Prices
Dependent variable
(change in
retail food)

Independent variable
(change in
farm product)

Sum 1

M ean
lag
(months)

Fresh vegetables

Fresh market vegetables

.48
(9.41)

0.9

Fresh fruit

Fresh market fruit

.32
(5.32)

1.4

C e rea ls and bakery
products

A ll wheat

.27
(10.52)

8.2

W hite bread

A ll wheat

.25
(9.31)

5.7

Fresh whole
ch icken s

B roilers

.73
(14.85)

0.6

Bacon

Slaughter hogs

.62
(14.53)

1.3

Canned hams

Slaughter hogs

.45
(11.38)

3.1

M eats2

M eat anim als

.56
(15.70)

0.9

Beef and veal

Slaughter steers

.54
(20.67)

1.2

C h u ck roast

Slaughter steers

.73
(20.18)

1.1

Round roast

Slaughter steers

.50
(11.96)

1.1

S irlo in steak

Slaughter steers

.57
(14.09)

1.2

W hole milk

M ilk

54
(13>4)

1.3

Eggs

Eggs

.79
(19.42)

0.2

1Derived from values in table 5. Includes sum of all coefficients for current and lagged
months —- 4-month lags except for cereals and bakery products, white bread and canned
hams where 20-, 16-, and 7-month lags were used, respectively; t-statistics are in parenthesis
2Includes beef, veal, pork, and lamb.

pound (10 percent) in the current month, sirloin steak
will respond by declining only 1.1 percent (0.11 x 10
percent) during the current month (table 5 ).10 Over a
three-month period, however, the total drop in the
price of sirloin steak would be 5.7 percent.
The immediate impact of a change in the price of
wheat on bread, bakery and cereal products and of
slaughter hogs on canned ham is even less than that
of slaughter steers on sirloin steak prices. Prices of
10These time lags are averages for the time periods over which
the estimates were made. They may have shortened in
more recent years if efficiencies in inventory maintenance
have been realized.



28

wheat and hogs can decline gradually over much
longer periods of time without having a large impact
on the consumer price of these products, as shown by
the longer lags involved.
The apparent failure of retail prices in recent years
to respond immediately to a decline in farm prices re­
flects the impact of inflation on the middleman’s
receipts. With higher rates of inflation, food prices
often do not appear to respond at all to a decline in
farm product prices. For example, given an inflation
rate of 12 percent per year, a 10 percent decline in
the price of slaughter steers will result in stable sir­
loin steak prices in the current month. Although the

MA Y

FED ERA L. R E S E R V E BAN K O F ST. LO U IS

the lag between the timing of price changes at the
farm and retail levels is taken into account.11

Table 7
Farmer’s Share of Retail Price and
Sum of Lagged Coefficients of
Specified Foods
Farm er’s
share1

Sum of
coefficients2

Fresh vegetables

33%

.48

Fresh fruit

28

.32

Foods

Ce re a ls and bakery
products

12

.27

Frying ch icken s

56

.73

P ork

55

.54

M eat products

57

.56

C h o ice beef

65

.59

Fresh m ilk

50

.54

Eggs

64

.79

1Farmer’s share and sum of coefficients from table 5 data
were calculated for the same years.
2In some instances the retail food group for which the co­
efficients were obtained does not precisely correspond with
the group in the farmer’s share column. For example, the
sum of the coefficients for fresh whole chickens was com­
pared with the farmer’s share for frying chickens, the
average of bacon and canned ham with pork, and the
average of beef and veal, chuck roast, round roast, and
sirloin steak with choice beef.

Source: USDA

decline in steer prices will exert a 1 percent down­
ward movement on sirloin steak prices, this will
be offset by the impact of inflation on the middle­
man’s cost. This, however, is not evidence that food
prices fail to adjust downward in response to declin­
ing farm commodity prices. Sirloin steak prices would
have risen by 1 percent if the price of slaughter steers
had not fallen. Further, there is evidence that food
retailers treat increases and decreases in wholesale
prices symmetrically — both are passed on fully after




1980

Conclusion
Much of the criticism of the food processing and
marketing sector of the economy is based on erroneous
perceptions of the food processing and marketing in­
dustry. Price movements of farm and retail food prod­
ucts offer no evidence that the middleman manipu­
lates prices.
In the short run, the farmer’s share of retail food
costs fluctuates quite sharply. However, these fluctua­
tions result almost entirely from changes in farm
prices that are caused by changes in short-run supply
or demand rather than by changes in the middleman’s
receipts. The middleman’s receipts change at about
the same rate and in the same direction as general
inflation. Hence, changes in food costs are almost en­
tirely explained by changes in farm prices and in the
rate of overall inflation.
Much of the criticism of the middleman apparently
stems from a lack of understanding of the time lag
between farm price changes and their full impact on
food prices. Food prices do not rise and fall in step
with the changes in farm prices. Instead, the period
of time between the change in farm prices and the
full effect of this change at the retail level varies
from about two months for eggs to more than a year
and a half for cereals and bakery products. Conse­
quently, retail food prices may remain stable during
the first few days following a sharp decline in farm
prices, and they may even rise temporarily if general
inflation is at a high rate. Nevertheless, retail food
prices eventually move either up or down in response
to farm price changes and the rate of overall inflation.
u Dale Heien, “A Study of the Relationship Between FarmLevel Prices and Retail Food Prices,” prepared for the Coun­
cil on W age and Price Stability (September 1 9 7 6 ). Fo r a
discussion of the function of inventories in pricing see Armen
A. Alchian and William R. Allen, University Economics, 3rd
ed. (Belmont, California, Wadsworth Publishing Company,
Inc., 1 9 7 2 ), pp. 139-41.

29

EIGHTH

FED ER A L

RESERVE

DISTRICT

o

Kirksville

V

q u in c y

□n n i b a l^

^

B e d fo rd Q

Seym o urjp p w -

^Vincennes

^ _

#<

M adison]^^^^

O W a s h in g to n

Centralia

. Murphysboro
\

D a n v ille J

Q M a r io n

J

Carbondale

V

.
Cape G ira rd e a u j

n

r*.

EN SBO RO
O
Elizabethtown
_ «^*

|i\(

-

q

^
(g )^

/
/

Bowling Green
(§)
O G Iasg o w

f lB H

Sikeston^-^* Paducah

o

M a d iso nville

C LA R K SV ILLE -H O P K IN S V ILLE

q Mayfield
M u rrayO

^

OUnion City

^ D yersburg

Legend
©

• o

Q H u m b o ld t

H ead O ffic e of the FRB, St. Louis

®

Branch O ffic e s of the FRB, St. Louis

I

Standard Metropolitan Statistical Areas

B

Places

I

Places of 40-50,000

Jackson ®

over 50,000

District States

<§> Places of 30-40,000

Hot Springs"

•

Places of 10-20,000

O

Places of 20-30,000

Population is based
on the 1970 census.

— State Boundaries
__
EXA RKA N A
Magnolia
q

— District Boundary

Camden
O

Greenwood
’•^Greenville

El Dorado




•

Columbusl
StarkvilleQ

* I
Scale in Miles

32

64

961

Federal Reserve Bank of St. Louis DECEMBER 1975

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