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F ed eral H ess * •B ank o f S t . L o u is f!Ai f 1iiq? R E S E A R C H L IB R A R Y Federal Reserve Bank of St. Louis I tide ISSN 016 4-0 79 8 LIBRARY OF CONGRESS CATALOG CARD NUMBER: 16-7264 Federal Reserve Bank o f Richmond Publication Number: P-l Additional copies of this Annual Report may be obtained without chargefrom: Public Services Department Federal Reserve Bank of Richmond P.O. Box 27622 Richmond, Virginia 23261 M HenryJ. Faison Deputy Chairman Robert P. Black President e s s a g e Anne Marie Whittemore Chairman 1991 was a year o f dramatic challenges and changes for the w orld, our nation and region, and the Federal Reserve System. It was a difficult time for monetary policy and bank supervision, and an important year for Federal Reserve Bank operations. I thank my fellow directors with w h om I have had the pleasure o f serving for their very thoughtful deliber ations, and I extend to the Bank staff congratulations for an excellent performance in responding to the demands o f these times in a manner that can only be described as outstanding. Monetary p olicy responsibilities presented major issues for the Board o f Directors and our president in 1991, a year that saw e co n o m ic activity start to pull us out o f recession in the immediate aftermath o f the Persian Gulf War, but subsequently decelerate sharply in the fourth quarter. In this uncertain environment, extensive preparation and especially careful deliberation preceded directors’ votes on the discount rate and President Black’s votes on monetary p olicy actions and targets. W e are hopeful that w e are on a course that will revive e co n o m ic activity and continue to control inflation. Consistent with the con viction that monetary p olicy should focus on long-run price stability, this Report's f r o m t h e C h a ir m a n article b y Vice President Robert L. Hetzel proposes a way to measure inflation e x p ec tations through the use o f indexed bonds and thereby assist m onetary policymakers. The year was a demanding one for the Bank’s supervision and regulation staff as the Fifth District, like other regions in the cou n try, experienced an increase in problem s at som e o f its depository institutions. Mean while, mergers created three o f the nation’s largest bank holding com panies, w hich will be headquartered in the District. Important consolidation decisions were also made within the Federal Reserve Bank o f Richm ond and the Federal Reserve System as a w hole. Within the Bank, the Richm ond office began handling all book-entry securities operations for the Fifth District. Within the System, Richm ond was selected as the staff headquarters for three com puter centers that will eventually consolidate data processing for all twelve Reserve Banks into three sites in Richm ond, Dallas, and East Rutherford, New Jersey. O f immediate critical service to the System was the Contingency Processing Center located in the Bank’s facility in Culpeper, Virginia, w hich provided almost four m onths’ backup for the disabled co m puter system at the Federal Reserve Bank o f Minneapolis. I thank our mem ber banks and our other constituents for helping the Federal Reserve Bank o f Richm ond perform so well in this challenging but extrem ely interesting year. Chairman of the Board 3 I n d e x e d t o M B o n d s o n e t a r y P a s a n A id o lic y A principal long-term goal of Federal Reserve monetarypolicy is to restorepricestability to the UnitedStates economy. In thisarticle, theauthor suggests that a measure of thepublic’s inflation expectations would assist the Fed in attaining its goal and proposes that, to provide such a measure, the U.S. Treasury issue bonds in dexed to eliminate losses resultingfrom infla tion. The article ispresented here to stimulate further discussion of issues related to the effort to eliminate inflation. The views expressed are the author's and not necessarily those of the Bank or the Federal Reserve System. The Proposal...........................................................................5 The Yield Gap as an Indicator of Monetary P olicy............... 6 Avoiding Inflation and Disinflation........................................ 6 Possible Distortions in the Yield G ap.................................... 7 Issues for Debt Management..................................................9 British Experience................................................................... 9 Summary and Concluding Comments.................................. 12 Endnotes...............................................................................13 References.............................................................................15 4 Robert L. Hetzel ontracts requiring payment o f dollars in the future for future delivery o f good s and services are a regular • part o f eco n o m ic life. W orkers enter into c o n tracts, formal and informal, for a dollar wage for the next year. Colleges set tuition payments on ce a year. Rents for apartments are set annually and hom eow ners contract for mortgage payments in dollars. The purchas ing p ow er represented b y these dollar payments, how ever, depends upon the rate o f inflation realized after the contracts are signed. People must forecast inflation in order to estimate the purchasing p ow er o f future dollar payments. This article argues that it w ou ld be helpful to the Federal Reserve System to have a measure o f the public’s inflation forecast. The Fed, through its control o f the m on ey stock, controls the long-run rate o f inflation. There is, how ever, always considerable short-run uncertainty regarding the w ay in w hich changes in its p olicy instrument (reserves or the federal funds rate) will ultimately affect m oney growth and inflation. A measure o f the inflation forecast by the public w ou ld offer the Fed a useful “ outside” assessment o f the inflationary consequences thought likely to follow from its p olicy actions. This inflation forecast cou ld be inferred from the yield gap betw een the interest rates paid on co n v e n tional bonds and on bon ds indexed to the price level.1 Unfortunately, indexed bonds are not n ow traded in the United States. This paper proposes that the U.S. Treasury issue indexed bonds to create a measure o f the p u b lic’s inflation forecast. r > Indexed Bonds THE PROPOSAL A measure o f the inflation expected by the public cou ld be created by legislation requir ing the Treasury to issue zero-cou pon bonds with maturities o f one year, tw o years, and so on out to twenty years. A zero-cou p on b o n d is a prom ise to make a future one-time payment. Z e ro-cou p on bonds sell at a dis count and yield a return through capital ap preciation. Under the proposal, half the bonds issu ed w o u ld b e c o n v e n tio n a l (n o n indexed) zero-cou p on bonds that w ou ld offer a principal payment o f a given dollar amount. The other half w ou ld offer a prin cipal payment in dollars o f constant purchas ing p ow er achieved by indexing the principal payment to the price level. For example, if the principal payment o f the conventional ze ro-cou p on b on d were $100 and the price level were to rise by 5 percent in the year after the sale o f the bonds, an indexed b on d with a maturity o f one year w ou ld pay $105.2 Holders o f indexed bonds d o not have to w orry about the depreciation o f the dollars in w h ich they are paid. For a zero-cou p on b on d sold in, say, 1992, both the amount bid Figure 1 TIME PROFILE OF EXPECTED FUTURE PRICE LEVEL 8 12 Years in the Future Note: Hypothetical observationsarebasedonassumed4percent rateof inflation. and the purchasing p ow er afforded by the principal payment are measured in 1992 dollars. The discount on the bond, therefore, is a measure o f the real yield (real capital appreciation) offered by the bond over its life. The yield on indexed bonds w ou ld offer a direct measure o f the real (inflation-adjusted) rate o f interest. Furthermore, the existence o f indexed bonds o f different maturities w ou ld provide a measure o f the term struc ture o f real rates o f interest.3 Because holders o f the indexed bonds are guaranteed payment representing a k now n amount o f purchasing pow er, they d o not have to forecast inflation. In contrast, holders o f the nonindexed bonds would have to forecast future changes in the value o f the dollar. Consequently, the yield on the n on indexed bonds w ould incorporate an inflation premium to com pensate for the expected depreciation in the purchasing pow er o f the dollar, and the difference in yields betw een the nonindexed and indexed bonds, there fore, w ou ld measure the inflation expected by investors over the life o f the bond. The existence o f bonds o f different maturities w ou ld offer a term structure o f expected future inflation. Given the current price level, this term structure w ou ld yield a time profile o f the future price level expected by the public. Figure 1 illustrates a hypothetical exam ple in w hich the public expects future inflation to remain steady at 4 percent a year. (The contem pora neous price level is also taken to be 138, the current value o f the CPI.) If nonindexed and indexed zero-coupon bonds are issued at maturities ranging from one year to twenty years, the yield gap on suc cessive issues w ou ld permit inference o f a term structure o f future inflation. These yearly expected inflation rates, when applied to the current price level, w ould allow c o n struction o f the time profile o f the future price level expected by the public show n in Figure 1. 5 1991 Annual Report Consider an indexed one-year-maturity zero-cou p on b o n d that is a prom ise to pay $100 in one year, with the $100 indexed to the consum er price index. If the real rate o f interest were 3 percent, the b on d w ou ld sell for $97. If the public believed that the oneyear inflation rate w ou ld be 4 percent, a comparable nonindexed b on d w ou ld sell for $93, returning 4 percent in com pensation for the expected inflation and a 3 percent ex pected real yield. The interest rate on the n onindexed b on d w ou ld then be 7 percent, with a 3 percent real interest rate on the indexed bond. The “ yield gap” betw een these tw o rates is the 4 percent inflation rate expected by the market. THE YIELD GAP AS AN INDICATOR OF MONETARY POLICY In order to achieve its inflation objective, the Fed could, in principle, change its p olicy instrument in response to discrepancies b e tween the actual price level and a target path for the price level. Because individual p olicy actions affect prices only with long lags, how ever, such a straightforward strat egy cou ld be destabilizing. In practice, the Fed m onitors indicator variables to deter mine whether the changes in its policy instru ment are consistent with the inflation rate it considers acceptable. om e econom ists have suggested that the Fed change its p olicy instrument in response to m ovem ents in the prices o f actively traded com m odities. These prices do m ove freely in response to changes in expenditure p ro duced by monetary policy actions; however, they often m ove in response to marketspecific disturbances. At such times, c o m m odity prices might give misleading signals about the thrust o f m onetary policy. 6 Milton Friedman has long advocated a low, stable rate o f grow th o f M2 as the guide to monetary policy. M2 has maintained a reliable relationship to the public’s dollar expenditure over long periods o f time. In fact, the ratio o f dollar GNP to M2, k n ow n as M2 velocity, is currently about 1.63, little changed from its value in 1914 w hen the Federal Reserve was founded. Over periods o f time as long as several years, how ever, M2 velocity fluc tuates significantly. Many econom ists also fear that future financial innovation could alter the long-run relationship betw een M2 and GNP. It is possible that a consensus will never emerge that a particular m onetary aggregate is a reliable indicator o f the stance o f monetary policy. In contrast to these alternatives, the yield gap between nonindexed and indexed bonds w^ould offer a direct measure o f expected inflation. This measure w ou ld offer useful information to monetary policym akers b e cause it w ould be form ed by market partici pants w h o have a direct financial interest in forecasting inflation. AVOIDING INFLATION AND DISINFLATION The lag betw een changes in the Federal Reserve’s p olicy instrument and changes in prices means that it is difficult to associate particular policy actions with inflation. This difficulty lowers the cost o f exerting political pressure for an inflationary policy; m oreover, the quicker impact o f stimulative monetary p olicy on output than on prices generates political pressure to trade o ff immediate out put gains against a delayed rise in inflation. Indexed bonds o f the sort p rop osed here w ou ld balance these pressures by threaten ing an immediate rise in the yield gap between indexed and nonindexed bonds. The Fed w ould have a clear and m ore immediate justi fication for resisting inflationary pressures. Further, with indexed bon ds, public pressure for an inflationary monetary policy Indexed Bonds that was associated with a rise in the yield gap in itself w o u ld p rod u ce countervailing pressure. Holders o f n on in dexed bonds w ould suffer a capital loss w hen the yield gap rose. All creditors receiving payment in n on in dexed dollars in the future w ou ld feel w orse off. The yield gap w ou ld restrain pressure for inflationary policy by offering an immediate and continuous market assessment o f the potential impact o f such a policy. Surprise inflation acts like a capital levy im posed on m on ey and governm ent securi ties. The essentially fiscal transfer that arises from surprise inflation does not have to be legislated explicitly. Federal Reserve inde pen dence is designed to prevent monetary p olicy from b ecom in g the handmaiden o f fiscal policy. Institutional arrangements, like the federal structure o f the Fed with its regional bank presidents and long terms for m em bers o f the Board o f G overnors, give substance to central bank independence. The continuous market assessment o f the level o f future inflation offered by the yield gap betw een n on in dexed and indexed bonds w ou ld constitute an additional safeguard against surprise inflation. POSSIBLE DISTORTIONS IN THE YIELD GAP The inform ation on exp ected inflation offered b y the yield gap betw een nonin dexed and indexed bonds o f equal maturities w ou ld be diminished if the gap fluctuated in response to tax and/or risk premium factors. These possibilities are considered in turn. Tax D istortions Ideally, for both the nonindexed bon d and the indexed bond, incom e subject to taxation w ou ld be indexed for inflation. That is, holders o f both types o f bon ds w ou ld pay taxes on ly on the increase in purchasing p ow er gained from holding the bonds, rather than on any increase in the dollar value o f the b o n d that only com pensates for inflation. In order to illustrate this point, consider the follow in g hypothetical example. Suppose that, for both the indexed and non in dexed bonds, on ly the return that represents a gain in purchasing pow er is taxed. As before, if the real rate o f return is 3 percent, an indexed b o n d that prom ises to pay $100 o f constant purchasing p ow er next year w ou ld sell for $97 in the current year. If, subsequently, in flation turns out to be 4 percent, the holder o f the indexed b on d will receive $ 104. In this case, taxable incom e w ou ld be calculated as the $7 in total incom e minus the $4 inflation adjustment, w hich is a capital depreciation allow ance to maintain the purchasing p ow er o f the investor’s capital. The holder o f the nonindexed b on d also w ou ld be taxed only on the real portion o f the b o n d ’s yield.4 I f, alternatively, taxable incom e were not indexed for inflation, an increase in the inflation rate w ou ld increase the H| taxes paid by the holders o f indexed I t bonds, w hich w ou ld reduce the real wMm after-tax yield on the bon ds even if there had been n o reduction in the real before-tax yield. Unless the tax cod e were in dexed, the yield on the indexed b on d w ou ld rise as inflation rose to com pensate for the increase in taxes im posed b y higher inflation. The yield on the indexed b o n d w ou ld then offer a distorted measure o f the econ om y w ide real rate o f interest. With the relatively m oderate levels o f inflation experienced in the 1980s, how ever, the distortions caused by the present absence o f inflation indexing in the tax co d e w ou ld not greatly impair the usefulness o f the indexed b o n d as a measure o f the real rate o f interest. M oreover, if the tax treatment for the n on in dexed and indexed b on d were the same, information about expected inflation contained in the yield gap betw een the non in dexed and indexed b on d w ou ld not be distorted by changes in the rate o f inflation. 7 1991 Annual Report Possible Risk Prem ium Distortion Because the public might be willing to pay something to hold an asset w hose value is not arbitrarily affected by unanticipated inflation, it is possible that a risk prem ium might bias the yield gap upward. The yield gap w ou ld then overstate expected inflation. Also, the risk premium could vary so that the yield gap w ou ld change even with n o change in e x pected inflation. (Note that if the yield gap incorporated a risk premium, the Treasury w ou ld have to com pensate investors for the inflation risk entailed b y holding its n on indexed bonds. Indexed bon ds w ou ld not carry this cost.) W hether a risk premium w ou ld, in fact, be incorporated in the yield gap is o f course an empirical question. W ood w a rd (1990) exam ined the behavior o f the yield gap betw een n on in dexed and indexed British bonds and con clu d ed that any risk premium must have been very small.5 If the risk premium had been significant, the yield gap betw een c o n ventional and indexed bon ds w ou ld have Figure 2 YIELDS ON INDEXED AND NONINDEXED BONDS Percent Note: Monthly observations of yields on indexed bonds issued in April 1982 and maturing in August 2011 and of yields on conventional bonds maturing in August 2011. Data were furnished by G. Thomas Woodward. im plied implausibly low estimates o f e x pected inflation for Britain for the 1980s. Fur thermore, W oodw a rd’s measure o f real yields (adjusted for preferential tax treatment o f indexed bonds) produces surprisingly high values. Because real yields averaged around 5.5 percent, it is implausible that holders o f indexed bonds were foregoing m uch yield as protection against surprise inflation. (See Fig. 2.) The magnitude o f a possible risk premium also w ou ld depend upon monetary policy. Suppose that the central bank had made a credible com m itm ent to price stability. With such a policy, random shocks w ou ld still cause the central bank to miss its price level target, but these misses subsequently w ou ld be offset. Consequently, the price level w ould fluctuate around a fixed value, and the magnitude o f any discrepancy between yields o f n on in dexed and indexed bon ds due to a risk premium w ou ld decline as maturities lengthened. Alternatively, suppose that the central bank allow ed contem poraneous price level shocks to be incorporated permanently in the future price level target. Consequently, the price level w ould wander randomly over time. (The central bank cou ld allow this kind o f pricelevel drift even if it did not introduce a systematic bias in favor o f inflation.) The difficulty in predicting the real purchasing p ow er o f a prom ise to pay a fixed dollar amount in the future w ou ld increase as the time horizon lengthened. With this policy, the magnitude o f any discrepancy between yields o f non in dexed and indexed bonds due to a risk premium w ou ld not decline as maturities lengthened. Even if the yield gap betw een non in dexed and indexed bonds were to incorporate a risk premium, changes in the yield gap w ould still co n v e y important information to the central bank. Increases in the yield gap w ou ld be o f concern to the central bank even if they were caused by an increase in the risk premium, Indexed Bonds rather than by an increase in expected infla tion. A central bank must assure markets that its independence is a safeguard against sur prise inflation. An increase in the size o f the risk premium caused b y increased con cern for surprise future inflation w ould indicate to the central bank a need to reinforce the credibility o f its com m itm ent to m onetary stability. ISSUES FOR DEBT MANAGEMENT The idea o f indexed bonds has been advanced num erous times in the past. The Treasury possesses the authority to issue indexed bonds, but has always resisted doing so. In congressional hearings on in dexed bon ds (U.S. Congress, 1985), Francis Cavanaugh, the D irector o f the O ffice o f G overnm ent Finance and Market Analysis o f the Treasury, detailed the reasons. Mr. Cavanaugh argued that the Treasury did not k n ow w hether anyone w ou ld buy indexed b on d s.6 If there were no demand for them, their issuance w ou ld increase the Treasury’s cost o f funding the governm ent’s debt. costly, however, it seems implausible that no savers w ou ld be interested in protecting against such risk. Consider, for exam ple, the experience o f som eone w h o bought and held a 30-year governm ent b o n d 30 years ago. In 1961, the long-term governm ent b o n d yield was 3-9 percent. On average, over the three years 1959, I960, and 1961, CPI inflation averaged 1.1 percent. Assuming, given this experience, that in 1961 investors believed that the long-term rate o f inflation w ou ld be 1.1 percent, a purchaser o f a 30-year b on d w ou ld have anticipated a yearly gain in real terms o f 2.8 percent (3.9 percent minus 1.1 percent). In fact, over the 30-year period from 1961 to 1991, CPI inflation averaged 5.2 percent. The investor lost 1.3 percent o f his capital each year (3.9 percent minus 5.2 per cent) because o f inflation (not counting taxes paid on co u p o n payments). Instead o f a 30 percent gain in capital from holding the bond for 30 years, the investor lost 30 percent o f his capital. Munnell and G rolnic (1986) make a persuasive case that, at a minimum, pension funds and holders o f IRAs w ould be interested in indexed bon d s.8 BRITISH EXPERIENCE . . . we have yet to see any strong evidence o f potential demand for such an indexed bond in this country. . . . An indexed bond, because o f its novel features, would not realize the full benefits o f the liquidity of the conventional Treasury market, and its relative lack o f liquidity would be reflected in the bid price received by the Treasury in an indexed bond auction. . . . Thus a require ment that the U.S. Treasury issue indexed bonds, especially fixed amounts each year, could lead to significant increases in the cost o f financing the public debt (U.S. Congress, pp. 17 and 20).7 According to this argument, there is uncer tainty over whether anyone w ould value the inflation protection offered by indexing. Because inaccurate inflation forecasts are British Indexed Gilts Britain has issued indexed bon ds (gilts) since 1981. Unfortunately, indexing in Britain is p oorly designed for measuring expected inflation. British bonds are indexed to the retail price index (RPI), w hich is a p oor measure o f inflation because it includes the cost o f mortgage interest payments. Also, co u p o n and principal payments are indexed with an eight-month lag.9 This eight-month lag makes real yields on indexed bonds with a maturity even as long as five years sensitive to variations in inflation. The difference betw een yields on non in dexed and indexed bonds, therefore, cannot reliably be used to measure expected inflation over periods as short as a few years. 9 1991 Annual Report The practice o f issuing only long-term indexed bon ds com pou n d s the difficulty o f measuring the p u b lic’s expected inflation over periods as short as a few years. In order to observe a yield gap on bonds o f short maturity, it is necessary to wait until the passage o f time reduces the maturity o f the long-term bonds. Even though indexed bon ds w ere first issued in 1981, there is still a paucity o f indexed bonds with a short period to maturity. As o f the end o f 1990, the average maturity o f indexed bonds outstand ing was 18.9 years. There were on ly <£1.05 billion o f indexed securities outstanding with maturities o f five years or less. Also, for short term maturities, the absence o f nonindexed bon ds with exactly the same maturity as in dexed bonds becom es m ore o f a problem . n a personal com m unication with the author, Alan Walters noted that in Britain the Exchequer varied the rela tive supplies o f nonindexed short-term debt and long-term indexed bonds in response to changes in the yield gap betw een the tw o kinds o f debt. In order to ensure that the yield gap reflects expectations o f inflation, rather than relative supplies, he recom m ended that in the future indexed and nonindexed debt be issued in fixed p rop ortion s.10 British Monetary Policy The usefulness o f a yield gap betw een nonindexed and indexed bonds as a measure o f expected inflation has been questioned on the basis o f the British experience. In an article in the Financial Times (April 29, 1991), Anthony Harris stated that the “ gap has tracked current inflation faithfully, but has no forecasting value at all. . . . The market forecasts the way a picnicker does— by look ing out o f the w in d o w .” Therefore, he c o n cludes, the nonindexed-indexed b o n d gap cannot “ give a valuable steer on m onetary 10 p o licy .” Presumably, Mr. Harris has in mind the failure o f the yield gap to predict the increase in inflation that occurred in 1988. A brief review o f British monetary p olicy in the latter 1980s proves to be helpful in understanding Mr. Harris’ contention that b on d markets are not forward-looking. In Britain, inflation fell from 20 percent in 1980 to an average o f about 3.5 percent in 1986 and 1987. (Figures for inflation are for the RPI excluding mortgage interest pay ments.) Until 1988, actual inflation m oved fairly closely with long-term expected infla tion, inferred from the yield gap between the indexed b o n d issued in 1982 and maturing in 2006 and a conventional b on d with ap proximately the same maturity.11 (See Fig. 3.) Over 1986 and 1987, in particular, the yield gap averaged about 3.5 percent. Actual infla tion began to rise in early 1988 and peaked in 1990 som ewhat above 9 percent. The yield-gap measure o f expected inflation did rise steadily with actual inflation in early 1988, but reached a peak o f on ly about 6 percent in early 1990. What caused the sharp rise in inflation, which was understated by the yield gap? After the Louvre A ccord on February 3, 1987, Nigel Lawson, Chancellor o f the Exchequer, began to peg the DM/<£ exchange rate informally at 3 to 1. At the same time, the real terms o f trade began to appreciate steadily in Britain’s favor. That is, British physical assets and com m odities becam e m ore attractive. This appreciation was prom pted by three factors. First, the Conservative electoral victory in 1987 made Britain appear to be a safe haven for foreign capital. Second, the rise in the price o f oil after its 1986 trough and a large oil discovery announced on March 8, 1988, raised the value o f British exports. Finally, the reduction in marginal tax rates, announced March 15, 1988, increased the attractiveness o f investment in Britain and reduced capital outflow s. Indexed Bonds Figure 3 ACTUAL AND EXPECTED INFLATION IN THE UNITED KINGDOM Annual Percentage Change 10 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Note: Actual inflation is the annual percentage change in the RPI excluding mortgage interest payments over the preceding 12-month period. Expected inflation is inferred from the yield gap between an indexed bond maturing in 2006 and a conventional bond with approximately the same maturity. The yield gap was adjusted for different tax treatment inthe two bonds. The expected inflation series was supplied by G. Thomas Woodward. With a pegged exchange rate, the appreci ation in the real terms o f trade appeared as a rise in British prices, w hich was a ccom m odated b y high m oney grow th. G row th in the monetary base went from about 4 percent in the m iddle o f 1987 to m ore than 10 per cent toward the end o f 1988. In the spring o f 1988, Mr. Lawson allow ed the DM/<£ e x change rate to rise, but only grudgingly. T o retard the p o u n d ’s appreciation, he low ered the UK bank base lending rate to a low o f 7.5 percent in May 1988, from a high o f 11 per cent in early 1987. In June 1988, in response to the sustained rise in inflation that began in early 1988, Mr. Lawson reversed course and began to raise the base rate, w hich reached 15 percent in O ctober 1989. In light o f this experience, were the holders o f British bon ds making forw ard-looking predictions o f inflation? In 1987, the holders o f bonds maturing in 2006 were predicting inflation o f somewhat less than 4 percent over the next 19 years. Can this prediction be defended as forw ard-looking in light o f the increase in British inflation from som ewhat less than 4 percent in 1988 to almost 10 per cent in 1990? With the p ou n d pegged to the mark, British inflation must equal German inflation plus whatever appreciation (or minus whatever depreciation) occurs in the terms o f trade. Historically, German inflation has varied around 3 to 4 percent. If changes in the terms o f trade are inherently unpredict able, then a prediction o f inflation o f 3 to 4 percent was a reasonable estimate.12 Ex post, predicted inflation in the 3- to 4-percent range n ow appears to have been reasonable. Since Britain’s formal entry into the EMS in the autumn o f 1990, the DM/<£ exchange rate has stayed very close to 3 to 1. With the cessation in the appreciation in the British terms o f trade, British inflation had to fall to the German level. By autumn 1991, it had been brought roughly into line with German inflation o f about 4 percent.13 In short, there is nothing in the British ex perience to indicate that bondholders are not forw ard-looking. 11 1991 Annual Report Can Bond M ark e ts Predict In fla tio n ? On the basis o f an examination o f the British experience, Gabriel de K ock (1991) concludes that using a yield gap to measure expected inflation as p rop osed here w ou ld not be useful to the Fed. Based on the British experience, he makes tw o assertions. First, he asserts that the yield on the indexed b on d does not offer a measure o f the e c o n o m y ’s real yield. Second, he claims that the yield gap betw een n on in dexed and indexed bonds possesses n o predictive p ow er for future inflation b eyon d what is furnished by recent, actual inflation. The empirical tests De K ock conducts, how ever, are not capable o f p ro v ing or disproving these assertions.14 De K ock tests w hether the yield gap pre dicts subsequent inflation rates over 12-, 24-, and 36-m onth periods, respectively. Appar ently, he chooses these rates because they are o f “ primary concern to policym akers.” They were not, h ow ever, what bondholders were trying to predict. The author derives his measure o f expected inflation from com par ing the yield on n on in dexed bonds with the yield o f indexed bonds o f roughly the same maturity issued in March 1982 and maturing in July 1996. For example, the first observa tion used b y the author is dated March 1982. The yield gap betw een nonindexed and in dexed bonds then reflects the market’s expec tation o f inflation from March 1982 to July 1996. The author com pares this expectation o f inflation with actual inflation over the m uch shorter periods beginning in March 1982 and ending in March 1983, March 1984, and March 1985. In order to perform the kind o f ex post test o f predictive pow er the author wishes to conduct, it will be necessary to wait until 1996 (or close to that date).15 Despite the inability o f De K ock ’s tests to bring evidence to bear on the ex post predic tive accuracy o f the yield gap as a measure o f expected inflation, his w ork does raise the interesting question o f h ow to interpret 12 evidence on ex post predictive accuracy. W ou ld evidence that investors predict infla tion poorly affect the value to the central bank o f a yield-gap measure o f expected inflation? The answer w ou ld appear to be no. What matters in determining the real rate o f interest is what inflation rate financial markets expect, not whether ex post they predicted inflation accurately. M oreover, evidence from a yieldgap measure o f expected inflation d em on strating that the public in practice predicts inflation p oorly w ou ld provide an incentive to the central bank to alter m onetary p olicy to ensure that at least in the long-term the price level w ou ld be easy to predict. SUMMARY AND CONCLUDING COMMENTS The yield-gap proposal advanced here differs from earlier proposals for indexed bon ds in its recom m endation that (1) equal amounts o f nonindexed and indexed bonds o f the same maturity be issued and (2) the resulting yield gap be used as an indicator o f whether particular m onetary p o licy actions are consistent with the Federal Reserve’s in flation o b jectiv e.16 The Federal Reserve determines the lon g term rate o f inflation. The measure o f ex pected inflation p rop osed here w ou ld allow the Fed to observe w hether there was a discrepancy betw een the rate o f inflation expected b y the public and the rate o f infla tion it seeks to achieve. Monetary p o licy makers w ou ld then be in a better position to make p olicy in a w ay that avoids discrepan cies betw een expected and subsequently realized inflation. The yield-gap measure o f exp ected inflation w ou ld allow m onetary p olicy to be evaluated on whether or not it provides a stable m onetary environm ent characterized by m oderate fluctuations in exp ected inflation and the absence o f infla tionary and disinflationary surprises. ENDNOTES 1 See Hetzel (1990 and 1991) and Bondweek (1991). The idea of indexed bonds is an old one. In his Review article, “ The Concept of Indexation in the History of Economic Thought,” Humphrey (1974) lists a number of early economists who advocated indexed bonds: John Maynard Keynes in 1924; George Bach and Richard Musgrave in 1941; and Milton Friedman in 1951. Humphrey also notes two early examples of indexed bonds. During the American Revolution, the Massachusetts legislature issued bonds with interest and principal tied to an index of the prices of staple com modities. In 1925 the Rand Kardex Co., at the urging of Irving Fisher, issued a 30-year bond indexed to the wholesale price index. In 1985, Senators Quayle and Trible introduced a bill to index government bonds (S. 1088, the “ Price Indexed Bonds Act of 1985” ) and Representative Lungren introduced a similar bill in the House (H.R. 1773, “ The Price Indexed Bonds Act of 1985” ). See the U.S. Congress (1985) Hearings, “ Infla tion Indexing of Government Securities.” 6 Treasury opposition to the issue of indexed bonds also appears to reflect a general hesitation to innovate in debt management techniques. “ A poorly received Treasury issue, because of faulty design or a misread ing of a new potential market, could adversely affect Treasury’s credibility in the market. So we approach innovation with great care” (U.S. Congress, 1985, p. 20). 2 The bonds would be issued and retired just after the middle of the month, when the CPI is announced for the preceding month. The dollar principal payment on an indexed bond would then be increased by the percentage increase in the CPI from the month preceding its issue to the month preceding its redemp tion. Zero-coupon bonds avoid problems of how to index partially accrued coupon payments when a bond is traded before maturity. 8 Munnell and Grolnic (1986, pp. 4,5) note, “ Anyone saving for a specific goal, such as purchasing a house or sending children to college, should welcome the opportunity to ensure that such savings will not be eroded by inflation. . . . Moreover, in the United States there may well be a niche for index bonds that has not been adequately explored—namely, the financing of fully indexed annuities for retirees. These annuities could play an important role in protecting elderly people against the erosion of their pension income during their retirement years.” Munnell and Grolnic then document that pension plans have not histori cally adjusted payments to beneficiaries to compensate fully for inflation. They also note that there are no financial instruments that can satisfactorily protect purchasing power against inflation. “ Common stocks . . . seem to be a particularly unsuitable investment for producing a stable real in come. While over the past 30 years stocks have pro vided a high average real return, this return has been so volatile that investors have experienced significant periods of negative real earnings. Long-term bonds have fared even less well: their average real return has been near zero and in recent years the variability has been almost as great as that for common stocks. Treasury bills do appear to offer a stable real positive return, but this return is very low and these instruments are a less than perfect hedge against inflation” (Munnell and Grolnic, 1986, p. 18). 3 Forward rates for individual years would be inferred under the assumption that the yield over the life of the bond is a geometric average of the yields over the suc cessive individual years. 4 The issue of how to tax capital gains is perennially contentious. There is a consensus among economists, however, that taxing capital gains representing only paper gains that compensate for inflation distorts in vestment and savings decisions undesirably. 5 Woodward has published a series on the real yield on indexed bonds and on the implied expected inflation rate. A key feature of his series is an adjustment for different tax treatment of nonindexed and indexed gilts. In Britain, holders of indexed bonds do not pay taxes on that part of the income due to capital appreciation, while holders of nonindexed bonds pay taxes on the inflation premium built into interest payments. This difference in tax treatment increases the size of the yield gap between the two kinds of bonds beyond bondholders’ expectation of inflation. Woodward reduces the gap by the estimated amount due to this tax effect. Subtracting this reduced difference from the yield on nonindexed bonds gives a tax-adjusted real yield series. That is, it provides a measure of the real yield that holders of indexed bonds would receive in the absence of favorable tax treatment. 7 Mr. Cavanaugh actually expressed both the concern that there would be no demand for indexed bonds and that there would be too much demand. In the latter case, their issue would be a problem because they would compete with S&Ls for funds (U.S. Congress, p. 23). It is hard to know what to make of the as sertion that the market for indexed bonds would be illiquid. If dealers in government securities find it profitable to sell conventional debt, why would they not find it profitable also to sell indexed debt? 9 An eight-month lag was adopted to simplify calcu lation of accrued interest on bonds with semi-annual coupon payments. With the eight-month lag, immedi ately after a coupon payment, assuming the most recently available price index is for two months in the past, one can calculate the indexed value of the coupon payment six months in the future. 13 1991 Annual Report 10 The Bank of England supplied the author with data on outstanding debt by maturity for both nonindexed and indexed debt. The yield gap between nonindexed and indexed debt did indeed influence relative supplies of the two kinds of debt. Relative supplies, however, did not appear to influence the subsequent yield gap. 11 Data for expected inflation were supplied by Thomas Woodward. They are derived from the yield gap be tween conventional and indexed bonds after an adjust ment for the favorable tax treatment of indexed bonds. See endnote 5 and Woodward (1990). 12 In 1990, expected inflation measured by the yield gap rose to about 6 percent, which was higher than the trend rate of German inflation. Investors in British bonds may have believed that Britain would abandon the 3-to-l DM/<£ exchange rate to avoid the costs of a severe disinflation. They may also have believed that the trend rate of German inflation would rise because of fiscal pressures from German reunification. 13 The DM/£ exchange rate began to fall in 1989. This fall indicated that the terms of trade were no longer appreciating in Britain’s favor. A pegged exchange rate then required a convergence of British and German rates of inflation. This convergence in inflation rates required a drastic monetary deceleration in Britain. In 1989 and the first part of 1990, growth in the broad monetary aggregate M4 was around 20 percent, while growth in the monetary base MO was around 8 percent. By autumn 1991, M4 growth had fallen to around 8 percent and MO growth had fallen to around 2 percent. 14 See De Kock (1991). De Kock supports the first assertion by pointing to the absence of a negative rela tionship between the yield on indexed bonds and future changes in economic activity. Economic theory, however, does not predict a negative (or any predict able) relationship between these two variables. In fact, 14 in any macroeconomic model, the sign of the corre lation between the real rate of interest and future economic activity depends upon the kind of shock impinging upon the economy. In a standard IS-LM model, for example, a positive real sector shock (rightward shift in the IS schedule) will lead to a higher real rate of interest and a higher level of real GNP. The author’s rationale for his test appears to rely on the assumption that a rise in interest rates necessarily reflects a tightening of monetary policy, and conversely. For example, he argues that the yield gap could not have been an adequate measure of inflation expecta tions in Britain in the period from early 1988 through mid-1990. Over this period, long-term market rates rose (monetary policy was tightened according to De Kock) and expected inflation (measured by the yield gap) rose, rather than fell. Measured by growth of the monetary aggregates, however, monetary policy was expan sionary. Growth in the monetary aggregates M0 and M4 was quite rapid. Monetary deceleration did not begin until mid-1990. Market rates could have risen because expected inflation rose. 15 The favorable tax treatment accorded indexed bonds widens the size of the yield gap. Because the author fails to correct for this tax effect, he concludes that the yield gap is a biased measure of inflation. That is, he finds that the yield gap, which includes a tax effect, consistently overpredicts inflation. Also, the author uses a theoretically unsatisfactory measure of inflation. He uses the retail price index that includes mortgage in terest payments. It would have been better to use the retail price index that excludes these payments. 16 In a personal communication to the author, Milton Friedman argued for using the yield gap as a target. He would instruct the Federal Reserve to eliminate the gap over time. Indexed Bonds REFERENCES Bondweek. “ Treasury to Get Proposal for InflationIndexed Bonds.” November 11, 1991. De Kock, Gabriel. “ Expected Inflation and Real Interest Rates Based on Index-linked Bond Prices: The U.K. Experience.” Federal Reserve Bank of New York Quarterly Review (Autumn 1991), 47-60. Hetzel, Robert L. “ Maintaining Price Stability: A Proposal.” Federal Reserve Bank of Richmond Economic Review 76 (March/April 1990), 53-55. --------------- . “ A Better Way to Fight Inflation.” Wall Street Journal, April 25, 1991. Humphrey, Thomas M. “ The Concept of Indexation in the History of Economic Thought.” Federal Reserve Bank of Richmond Economic Review 60 (November/December 1974), 3-16. U.S. Congress. “ Inflation Indexing of Government Securities.” Hearing before the Subcommittee on Trade, Productivity, and Economic Growth of the Joint Economic Committee, 99th Cong., 1st sess., May 14, 1985. Woodward, G. Thomas. “ Should the Treasury Issue Indexed Bonds?” Congressional Research Service Report for Congress, December 31, 1987. ---------------. “ The Real Thing: A Dynamic Profile of the Term Structure of Real Interest Rates and Inflation Expectations in the United Kingdom, 1982-89.” Journal of Business 63 Ouly 1990), 373-98. ---------------. “ Evidence of the Fisher Effect from U.K. Indexed Bonds.” Forthcoming Review of Economics and Statistics. Munnell, Alicia H. and Joseph B. Grolnic. “ Should the U.S. Government Issue Index Bonds?” Federal Reserve Bank of Boston New England Economic Review (September/October 1986), 3-21. 15 H ig h lig h t s Automation and Operations The Federal Reserve System’s Contin g e n cy P rocessing Center in Culpeper, Virginia, provided its first extensive backup for a Reserve Bank com puter w hen the Min neapolis Fed was forced to vacate its head quarters after a broken water pipe flood ed several floors o f the building. During the crisis, Minneapolis staff w orked alongside Culpeper staff to avert interruptions in ser vice to Ninth District financial institutions. The Federal Reserve Bank o f Richm ond was selected as one o f three sites and the headquarters for the System’s new ly created Federal Reserve Automation Services fu n c tion. The headquarters staff will oversee the consolidation o f the 12 Reserve Banks’ main frame com puter operations at Richm ond, Dallas, and East Rutherford, New Jersey. Carl E. Powell, form erly first vice president at the San Francisco Fed, was chosen to head the new System function, w hich will reduce the costs and im prove the reliability o f many Reserve Bank products such as wire transfer, automated clearinghouse (ACH), and securi ties services. T o free space appropriate for Federal Reserve Autom ation Services, the Bank relocated Business Applications Services to new quarters within the tow er and made plans to m ove ch eck operations from the tow er to underground floors. The m ove to belowgrade levels will place check operations close to the loading docks and eliminate the need to use elevators to transport checks to and from processing floors. The Richm ond office participated in a pilot program o f image tech n ology for processing large-dollar ch eck returns. In the pilot p ro gram, the Richmond Fed sent facsimiles o f the return items to the participating banks o f first deposit, w hich helped evaluate im prove ments in information flow s and timing. Senior management groupfor Federal Reserve Automation Services: Sharon Reisdorf and Doug Fleming, senior vice presidents; Carl Powell, director; Donna Kelley andJimAllen, senior vicepresidents. 16 All offices in the District com pletely im plem ented check-processing software that was d eveloped at the Baltimore office to im prove on-line settlement o f checks and returns. The new software reduced costs in software maintenance and im proved quality and p rod u ctivity in ch e ck operations. Atlanta Fed offices are scheduled to adopt the software in 1992, and other Reserve Banks have expressed interest in this innovation. The Bank’s newsegment of the Richmond Canal Walk. The Bank added several new electronic payment services. These included the elec tronic delivery o f ACH statements, a data base for converting paper ACH returns to electronic media, and a Fed Online Ex change (FOX) netw ork feature that allows institutions to submit and receive Treasury tax and loan (TT&L) information electroni cally. Also, a new reporting option allows institutions in the FOX com m unications net w ork to file their w eekly reports o f deposits electronically. T o reduce costs and im prove efficiency, the Fifth District consolidated all book-entry securities functions in the Richm ond office. The Baltimore office was ch osen as the System ’s pilot site for testing secon dgeneration currency processing machines. W hen these tests are successfully com pleted in 1992, other Reserve Banks plan to begin installing similar machines. Many Fifth District financial institutions ch ose to participate in the System ’s im proved Functional Cost and Profit Analysis Program, a cost-accounting program de signed to help institutions increase their earnings and im prove their efficiency. Meetings and Other Activities The Bank and the three R ichm ond univer sities co-sponsored a seminar b y Dr. Edward J. Kane, the Everett D. Reese Professor o f Banking and Monetary E conom ics at O hio State University and a noted authority on financial regulatory matters, w h o spoke on the deposit insurance problem . Dr. Kane’s presentation, given in the Bank’s auditorium in Richm ond to a large group o f business, 1991 Annual Report com m unity, and academic leaders, was one in an on goin g series on business and finan cial topics featuring w ell-know n speakers. distributed to all financial institutions and libraries in that state. This Profile was the secon d in a series on Fifth District states. For the second consecutive year, D on Patinkin, a w o rld -re n o w n e d m onetary eco n o m ist and professor at the Israel A cadem y o f Sciences and Humanities, spent several days at the Bank as a visiting scholar. During his tw o-w eek visit, Professor Patinkin con ferred with Bank econom ists and pre sented three seminars— one at the Bank and on e at each o f the tw o local universities that helped sponsor his visit. In cooperation with the Councils on E conom ic Education in the Fifth District, the Bank began issuing a new newsletter, FOCUS ON 5, for teachers o f econom ics in secondary schools. The Bank sponsored tw o conferences on the Com m unity Reinvestment Act. Deputy Chairman Henry Faison participated in a con feren ce in Richm ond for senior bank officers. The conference featured experts w h o focu sed on the opportunities for bank participation in community revitalization and the problem s involved. The other c o n ference, w hich was co-spon sored by the South Carolina Banking Association and held in Columbia, focused on community reinvest m ent training. The Bank helped further im prove the Rich m on d riverfront by constructing a terrace and public walkway as part o f the Canal Walk. The project was initiated to reduce soil erosion into the canal, ease the maintenance on the portion o f the Bank’s property near the canal, and create a m ore aesthetically pleasing environment. A new Bank publication, An Economic Pro file of North Carolina and Its Counties, was 18 System Responsibilities Board Chairman Anne Marie W hittem ore was elected by her Reserve Bank counterparts to lead the Conference o f Chairmen. President Robert P. Black was a voting m em ber o f the Federal O pen Market C om mittee. Mr. Black began attending FOMC meetings in I960 w hen he was an econom ist at the Bank. First Vice President Jimmie R. M onhollon was chairman o f the Conference o f First Vice Presidents and product director for the System’s Functional Cost and Profit Analysis Program. The Director o f Research, J. Alfred Broaddus, Jr., chaired the System Com m ittee on Financial Analysis. H. Lewis Garrett, General Auditor, was appointed Chairman o f the Subcommittee on Audit Autom ation Consolidation. This sub com m ittee and its parent, the System ’s Conference o f General Auditors, will develop a detailed plan to provide audit coverage during and after the consolidation process. Bank , Digest D irectors/R ichm ond Directors/Baltimore Directors/Charlotte Operations Advisory Com m ittee Small Business and Agriculture A dvisory Council Comparative Financial Statements Summary o f Operations Officers Directors (December 31, 1991) (Standing)A. PierceStone; PaulA. DelaCourt; C. R. Hill, Jr.; StephenBrobeck; R. E. Atkinson, Jr.; James G. Lindley (Seated) HenryJ. Faison; Anne Marie Whittemore; EdwardH. Covell Richmond CHAIRMAN Anne Marie Whittemore Partner Paul A. DelaCourt Chairman McGuire, Woods, Battle & Boothe Richmond, Virginia The North Carolina Enterprise Corporation Raleigh, North Carolina DEPUTYCHAIRMAN C. R. Hill, Jr. President Beckley National Bank Oak Hill, West Virginia Henry J. Faison Faison Associates Charlotte, North Carolina Executive Vice President James G. Lindley R. E. Atkinson, Jr. Chairman and Chief Executive Officer Dilmar Oil Company, Inc. Florence, South Carolina Chairman, President, and Chief Executive Officer Chairman Stephen Brobeck South Carolina National Bank Columbia, South Carolina Consumer Federation of America Washington, D.C. A. Pierce Stone Edward H. Covell Virginia Community Bank Louisa, Virginia Executive Director President The Covell Company Easton, Maryland 20 South Carolina National Corporation Chairman, President, and Chief Executive Officer Member Federal Advisory Council Edward E. Crutchfield, Jr. Chairman and Chief Executive Officer First Union Corporation Charlotte, North Carolina Federal Reserve Bank of Richmond Baltimore CH A IR M AN John R. Hardesty, Jr. President Preston Energy, Inc. Kingwood, West Virginia Richard M. Adams Chairm an an d C h ief E xecutive Officer United Bankshares, Inc. Parkersburg, West Virginia Daniel P. H enson, III Senior D evelopm en t D irector Struever Bros. Eccles & Rouse, Inc. Baltimore, Maryland Joseph W . M osm iller Chairm an o f the B oard Loyola Federal Savings and Loan Association Baltimore, Maryland F. Levi Ruark Chairm an o f the B o a rd a n d President The National Bank of Cambridge Cambridge, Maryland Thom as R. Shelton President Case Foods, Inc. Salisbury, Maryland W illiam H. W ynn International President (Standing) RichardM. Adams; F. Levi Ruark; Thomas R. Shelton; John R. Hardesty, fr. (Seated)foseph W. Mosmiller; Daniel P. Henson, III; WilliamH. Wynn United Food & Commercial Workers International Union, AFL-CIO & CLC Washington, D.C. Charlotte CH AIRM AN Anne M. Allen President Anne Allen &Associates, Inc. Greensboro, North Carolina Crandall C. B ow les President The Springs Company Lancaster, South Carolina Jim M. Cherry, Jr. President a n d Chief E xecutive Officer Williamsburg First National Bank Kingstree, South Carolina David B. Jordan President, C h ief Executive Officer, an d D irector Omni Capital Group, Inc. and OMNIBANK Salisbury, North Carolina Harold D. Kingsm ore President a n d Chief Operating Officer Graniteville Company Graniteville, South Carolina William E. Masters President Perception, Inc. Easley, South Carolina L. Glenn Orr, Jr. Chairman, President, and C h ief E xecutive Officer Southern National Corporation Lumberton, North Carolina (Standing) DavidB. Jordan; L. Glenn Orr, fr.; Crandall C. Bowles; HaroldD. Kingsmore (Seated) WilliamE. Masters; Anne M. Allen; JimM. Cherry, Jr. 21 A d v is o r y C o u n c ils O perations A d viso ry Com m ittee (Standing) Gazelle, BeHage, Baldwin, Schmitt, Pillow, Nicks, Albert, Denton, Wilson (Seated) Smith, Lanier, Monhollon, Bunting, Greear, Shearer, Purvis, Thomas Sm all Business and Agriculture A d v iso ry Council (Standing) Dickson, Hagans, Jefferds, Auman, Hane, Clark, Quicke (Seated) Lynch, Reeves, Zimmerman, Blackshear, Stewart 22 Federal Reserve Bank of Richmond Operations Advisory Committee CHAIRMAN William V. Bunting Executive Vice President Crestar Bank Richmond, Virginia William E. Albert Vice President and Cashier The First National Bank of Bluefield Bluefield, West Virginia Sunil F. Antani Executive Vice President Maryland National Bank Baltimore, Maryland Robert Baldwin Senior Vice President Crestar Bank, N.A. Washington, D.C. George E. Beckham Senior Vice President South Carolina Federal Savings Bank Columbia, South Carolina Robert L. BeHage Operations Executive Officer Sovran Bank, N.A. Richmond, Virginia Vernon D. Conway Vice President Kenneth L. Greear James W. Ricci United National Bank Charleston, West Virginia D C. Hastings Educational Systems Employees Federal Credit Union Bladensburg, Maryland Kenneth L. Richey Vice President President and Chief Executive Officer Virginia Bank and Trust Company Danville, Virginia Walter A. Howell Executive Vice President Citizens & Southern National Bank of South Carolina Columbia, South Carolina Charles C. Schmitt Executive Vice President One Valley Bank Charleston, West Virginia Ashpy P. Lowrimore Executive Vice President and Cashier Southern National Bank of South Carolina Florence, South Carolina Clement E. Medley, Jr. Executive Vice President Vice President Senior Vice President—City Executive President and Chief Executive Officer First Federal Savings and Loan Association of Dunn Dunn, North Carolina Ricky B. Nicks Loyola Federal Savings and Loan Association Glen Burnie, Maryland H. Jerry Shearer Bank of Charleston, N.A. Charleston, South Carolina Rita A. Smith West Virginia Savings League Charleston, West Virginia Thomas J. Strange Vice President Senior Vice President South Carolina Credit Union League, Inc. Columbia, South Carolina Charles E. Thomas Vice President West Virginia Credit Union League, Inc. Parkersburg, West Virginia Rick A. Wieczorek Vice President District of Columbia Credit Union League Washington, D.C. C. L. Wilson III Wachovia Operational Services Corporation Winston-Salem, North Carolina Richard D. Pillow Investors Savings Bank Richmond, Virginia Raymond L. Gazelle Virginia Credit Union League Lynchburg, Virginia Charles M. Purvis Citizens Bank of Maryland Laurel, Maryland Harrison Giles First Carolina Corporate Credit Union Greensboro, North Carolina Senior Vice President Executive Vice President The Riggs National Bank of Washington, D.C. Washington, D.C. Daniel E. Lanier, Sr. Mercantile-Safe Deposit & Trust Company Baltimore, Maryland David A. Denton Vice President President Vice President President Senior Vice President Branch Banking and Trust Company Wilson, North Carolina Executive Vice President NCNB National Bank of North Carolina Charlotte, North Carolina Small Business and Agriculture Advisory Council CHAIRMAN C. Champ Clark President C. C. Clark Farm Chilhowie, Virginia William M. Dickson Joan H. Zimmerman Southern Shows, Inc. Charlotte, North Carolina VICECHAIRMAN John W. Hane Partner/Manager Blackwoods Farm Fort Motte, South Carolina Watts Auman President and Chief Executive Officer Owner President and General Manager Spring Valley Farm Ronceverte, West Virginia Michele V. Hagans President Manager Fort Lincoln New Town Corporation Washington, D.C. Joseph C. Jefferds, Jr. President Jefferds Corporation St. Albans, West Virginia Auman Farm West End, North Carolina Leonard A. Blackshear Louise Lynch Owner Chairman Courtesy Associates, Inc. Washington, D.C. Robert A. Quicke Southside Transportation Co. Inc. Blackstone, Virginia George B. Reeves President Reeves Agricultural Enterprises, Inc. Chaptico, Maryland Robert W. Stewart, Jr. Retired Chairman and CEO Engineered Custom Plastics Corporation Easley, South Carolina Associated Enterprises, Inc. Annapolis, Maryland 23 C o m p a r a t iv e F in a n c ia l S t a t e m e n t s C O N D IT IO N December 31, 1991 December 31, 1990 Assets Gold certificate account Special Drawing Rights certificate account Coin Loans to depository institutions Federal agency obligations U.S. government securities Bills Notes Bonds Total U.S. government securities Cash items in process o f collection Bank premises Furniture and equipment (net) Other assets Interdistrict settlement account Accrued service income TOTAL ASSETS $ 948,000,000.00 961,000,000.00 98,795,794.25 105,000,000.00 478,120,549.04 $ 1,008,000,000.00 961,000,000.00 105,399,370.81 5,500,000.00 590,231,351.74 10,491,442,040.07 8,030,219,833.90 2,557,422,797.59 10,472,630,017.39 8,507,532,420.48 2,900,468,325.79 21,079,084,671.56 21,880,630,763.66 608,084,027.83 122,786,026.17 32,169,642.12 2,025,123,541.59 321,133,485.56 5,006,657.05 341,348,225.88 122,201,413.95 31,064,976.72 2,892,933,948.51 -5,673,760,517.80 5,122,043.92 $26,784,304,395.17 $22,269,671,577.39 $23,425,486,317.00 $18,904,361,212.00 2,210,349,620.36 9,165,000.00 65,775,164.96 2,653,964,940.55 9,300,000.00 15,557,083.89 2,285,289,785.32 2,678,822,024.44 541,202,140.88 191,311,951.97 118,955,637.30 271,411,903.65 $26,443,290,195.17 $21,973,550,777.39 170.507.100.00 170.507.100.00 148.060.400.00 148.060.400.00 $26,784,304,395.17 $22,269,671,577.39 Liabilities Federal Reserve notes Deposits Depository institutions Foreign Other Total deposits Deferred availability cash items Other liabilities TOTAL LIABILITIES Capital Accounts Capital paid in Surplus TOTAL LIABILITIES AND CAPITAL ACCOUNTS 24 Federal Reserve Bank of Richmond E A R N IN G S A N D E X PE N SE S 1990 1991 Earnings Loans to depository institutions FDIC assumed indebtedness Interest on U.S. government securities Foreign currencies Income from services Other earnings Total current earnings $ 1,088,903.10 4,352,731.95 1,600,439,604.86 152,907,455.51 64,150,968.36 838,712.89 $1,823,778,376.67 $ 5,208,025.73 14,830,154.07 1,791,699,651.19 160,792,748.66 64,590,429.92 757,144.90 $2,037,878,154.47 Expenses Operating expenses Cost o f earnings credits Net expenses CURRENT NET EARNINGS 107,354,220.08 14,382,148.18 121,736,368.26 $1,702,042,008.41 $1,925,241,755.79 11,254,136.75 23,177,649.40 5,911.71 34,437,697.86 5,866,671.72 132,642,248.68 13,033.49 138,521,953.89 0 61,619.22 61,619.22 + 34,376,078.64 0 16,063.89 16,063.89 + 138,505,890.00 6,210,205.74 6,947,500.00 18,464,922.00 6,766,914.72 6,446,700.00 18,507,249.00 $1,704,795,459.31 $2,032,026,782.07 $ $ Additions to current net earnings Profit on sales o f U.S. government securities (net) Profit on foreign exchange transactions All other Total additions Deductions from current net earnings Losses on foreign exchange transactions All other Total deductions Net additions or deductions Cost o f unreimbursed Treasury services Assessment for expenses o f Board o f Governors Federal Reserve currency costs NET EARNINGS BEFORE PAYMENTS TO U.S. TREASURY 100,263,888.19 12,372,510.49 112,636,398.68 Distribution o f N et Earnings Dividends paid Payments to U.S. Treasury (interest on Federal Reserve notes) Transferred to surplus TOTAL $1,704,795,459.31 8,693,666.59 2,014,703,415.48 8,629,700.00 $2,032,026,782.07 $ $ 9,770,118.63 1,672,578,640.68 22,446,700.00 Surplus A ccount Balance at close of previous year Addition o f profits for year BALANCE AT CLOSE OF CURRENT YEAR $ 148,060,400.00 22,446,700.00 170,507,100.00 139,430,700.00 8,629,700.00 $ 148,060,400.00 Capital StOCk A ccount (Representing amount paid in, which is 50% of amount subscribed) Balance at close of previous year Issued during the year $ 148,060,400.00 26,331,050.00 174,391,450.00 3,884,350.00 $ 139,430,700.00 12,172,000.00 151,602,700.00 3,542,300.00 $ 170,507,100.00 $ 148,060,400.00 Cancelled during the year BALANCE AT CLOSE OF CURRENT YEAR 25 S u m m a r y o f O p e r a t io n s Operation Number Amount (^thousands) 1991 1990 1991 1990 Currency and coin processed Currency received and verified Currency verified and destroyed Coin bags received and verified 1,959,126,000 740,139,000 261,876 1,983,165,000 652,908,000 271,156 25,000,656 7,719,990 24,016,852 5,302,701 203,200 Checks handled Commercial—processed * Commercial—packaged items U.S. government 1,550,648,000 367,468,000 60,422,000 1,526,891,000 339,774,000 66,707,000 Collections items handled U.S. government coupons paid Noncash items 24,358 106,172 32,859 126,268 55,108 278,960 10,603 278,658 Commercial book-entry transfers originated 284,110 247,973 2,309,359,000 1,824,636,000 5,652,028 5,471,584 282,818,000 238,973,000 1,448,377 1,129,760 454 463 4,635,089 16,025,063 Funds transfers sent and received Food stamps redeemed Loans advanced *Excluding checks on this Bank. 26 194,359 1,019,044,000 1,039,571,000 121,636,000 119,968,000 129,200,000 128,155,000 8,818,391,000 9,782,720,000 (December 31, 1991) R ich m o n d Robert P. Black, President Jimmie R. Monhollon, First Vice President Lloyd W. Bostian, Jr., Senior Vice President J. Alfred Broaddus, Jr., Senior Vice President and Director of Research Roy L. Fauber, Senior Vice President James McAfee, Senior Vice President and General Counsel Joseph C. Ramage, Senior Vice President James D. Reese, Senior Vice President Bruce J. Summers, Senior Vice President* Fred L. Bagwell, Vice President Dan M. Bechter, Vice President William H. Benner, Jr., Vice President Timothy Q. Cook, Vice President William E. Cullison, Vice President Wyatt F. Davis, Vice President Michael Dotsey, Vice President George B. Evans, Vice President William C. Fitzgerald, Associate General Counsel Marvin S. Goodfriend, Vice President aJid Associate Director of Research Robert L. Hetzel, Vice President Thomas M. Humphrey, Vice President Yash P. Mehra, Vice President Michael W. Newton, Vice President John W. Scott, Vice President Andrew L. Tilton, Vice President Walter A. Varvel, Vice President Roy H. Webb, Vice President Kemper W. Baker, Jr., Assistant Vice President Jackson L. Blanton, Assistant Vice President William A. Bridenstine, Jr., Assistant General Counsel Bradford N. Carden, Assistant Vice President Betty M. Fahed, Assistant Vice President Sharon M. Haley, Assistant Vice President and Secretary Eugene W. Johnson, Jr., Assistant Vice President Thomas P. Kellam, Assistant Vice President Anatoli Kuprianov, Research Officer Harold T. Lipscomb, Assistant Vice President Susan Q. Moore, Assistant Vice President Joseph F. Morrissette, Assistant Vice President Virginius H. Rosson, Jr., Assistant Vice President G. Ronald Scharr, Assistant Vice President Gary W. Schemmel, Assistant Vice President Marsha S. Shuler, Assistant Vice President James R. Slate, Assistant General Counsel Robert E. Wetzel, Jr., Assistant Vice President William F. White, Assistant Vice President Howard S. Whitehead, Assistant Vice President Bobby D. Wynn, Assistant Vice President Arthur J. Zohab, Jr., Assistant Vice President Malcolm C. Alfriend, Examining Officer Whitley K. Crane, Information Systems Officer Floyd M. Dickinson, Jr., Examining Officer A. Linwood Gill III, Examining Officer Jeffrey S. Kane, Examining Officer Jeffrey M. Lacker, Associate Research Officer Lawrence P. Nuckols, Examining Officer Virginia W. Shelor, Information Systems Officer Charlotte L. Waldrop, Examining Officer H. Lewis Garrett, General Auditor Edgar A. Martindale III, Assistant General Auditor B. Wayne Deal, Audit Officer Susan A. Saavedra, Audit Officer B altim ore C ulpeper Ronald B. Duncan, Senior Vice President William E. Pascoe III, Vice President John S. Frain, Assistant Vice President Margaret M. Murphy, Assistant Vice President William J. Tignanelli, Assistant Vice President John I. Turnbull II, Assistant Vice President R. William Ahern, Automation Officer Patricia S. Tunstall, Operations Officer John G. Stoides, Senior Vice President James J. Florin III, Assistant Vice President Thomas C. Judd, Assistant Vice President Julius Malinowski, Jr., Operations Officer C harleston Richard L. Hopkins, Vice President C harlotte C olum bia Albert D. Tinkelenberg, Senior Vice President Samuel W. Powell, Jr., Vice President Robert F. Stratton, Vice President Jeff A. Walker, Vice President Marsha H. Malarz, Assistant Vice President Lyle C. DeVane, Operations Officer Ronald D. Steele, Check Operations Officer Woody Y. Cain, Vice President "On leave of absence. 27 F ift h F e d e r a l R e s e r v e D is tr ic t O ffic e s R ic h m o n d 701 East Byrd Street Richmond, Virginia 23219 (804) 697-8000 B altim ore 502 South Sharp Street Baltimore, Maryland 21201 (410) 576-3300 C h arlotte 530 East Trade Street Charlotte, North Carolina 28202 (704) 358-2100 C h a rleston 1200 Airport Road Charleston, West Virginia 25311 (304) 345-8020 C o lu m b ia 1624 Browning Road Columbia, South Carolina 29210 (803) 772-1940 C u lp e p e r Mount Pony Road, State Route 658 Culpeper, Virginia 22701 (703) 829-1600 Photo Identifications Cover: View across Kanawha Plaza Contents page: The Bank’s new public walkway and terrace along the Haxall Canal Digest page: Southeast corner of the Bank’s building and grounds 28