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a n e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f C hicago Agricultural review and outlook Trends in U.S. international trade Banking developments august 1974 Agricultural review and outlook Contents Trends international trade P rL 3 Widely fluctuating prices con tinued to highlight agricultural developm ents in the first half o f the year. Reduced crop p ro duction prospects portend rising grain prices which will p ose fur ther financial difficulties for livestock producers. 8 The role played by rising import and export prices has been the single most dramatic character istic underlying the nation s e x pansion o f international trade over the past 18 months. Banking developments 13 Business Conditions, August 19 7 4 3 gricultural review andoutloo Widely fluctuating prices continued to highlight agricultural developments in the first h alf o f this year. Prices o f farm com modities rose sharply in January, and by mid-February the composite index o f prices received by farmers was up close to the August 1973 peak. But a long and steep downtrend followed as livestock mar ketings rose and as concerns for a virtual depletion o f grain stocks were alleviated by prospects for a large 1974 harvest. By midJune, the index o f farm prices had fallen below the year-earlier level—the first yearto-year decline since July 1971—and was 19 percent below the 1974 high recorded in February. The downtrend reversed abruptly late in the first half. Prices o f agricultural com modities started zoom ing in late June as the m ounting financial losses suffered by livestock producers became evident in reduced feedlot inventories, and as the adverse weather conditions drained the optimism for record crop harvests. By midAugust, it was apparent that the crop dam age would severely curtail production and leave livestock producers with little prospect o f breaking out o f their financial squeeze. As a result, prices o f several m ajor crops had reached new 1974 highs, while livestock prices had recovered most o f their earlier declines. Food prices remained high Food prices reacted sluggishly to the extended first-half declines in farm prices. Retail prices o f food consumed at home accelerated during the first quarter and by March exceeded the previous peak o f December 1973 by 6 percent. Although food prices declined in April, increases in May and June were more than offsetting. By midyear, the index o f grocery store food prices was slightly above the March peak, and exceeded the rapidly rising yearearlier level by 15 percent. The divergent trends between retail food prices and farm prices resulted in further increases in the already widefarm to-retail price spreads. The index o f the farm-to-retail price spread for the market basket o f food* narrowed briefly in January but rose steadily thereafter. By June, the index exceeded the ending 1973 level by 14 percent and the year-earlier level by 28 percent. M ajor factors con tributing to the wider spread were higher costs o f labor, transportation, and packag ing materials. But higher profits for firms involved in m anufacturing, processing, and distributing food also contributed to the widening farm-to-retail price spreads. Foreign demand remained strong Foreign purchases o f U. S. agricultural goods continued to accelerate during the first half o f this year. Paced by higher prices, agricultural exports rose 48 percent above the year-ago mark during the January-June period. For all o f fiscal 1974, agricultural exports were valued in excess o f $21 billion, compared to less than $13 billion in fiscal 1973. The increase more than offset a large gain in imports and provided an agricultural trade surplus o f nearly $12 billion, up from $5.6 billion in fiscal 1973. Shipments o f feedgrains and soybeans dominated the export picture in the first *The market basket contains the average quan tities of domestically produced farm foods purchased annually per household in 1960 and 1961 by wageearners and clerical worker families and workers liv ing alone. Federal Reserve Bank of Chicago 4 Food prices rose further despite recent declines for meat percent, 1967=100 — i— i— 1971 l— i— i— 1972 i— l____ i____ i____ .____ i____ .____ .____ .____ i 1973 1974 half. The volume o f corn shipments rose 12 percent ahead o f the corresponding yearearlier level during the first half, while total feedgrain shipments rose 12.5 per cent. Soybean shipments were up 12 per cent, while shipments o f soybean oil and meal were up 37 and 6 percent, respective ly. The volume o f wheat exports fell 41 per cent behind the record year-earlier level during the first h a lf as sharply higher prices rationed the dwindling supplies. Commodity review and outlook C a ttle a n d h o g p r ic e s registered ex treme fluctuations during the first half. Both rose about $10 per hundredweight early in the year and peaked at around $48 and $40 per hundredweight, respectively, in the second week o f February. The dow n trend that followed, however, ultimately pushed cattle prices down to $36 per hun dredweight and plunged hog prices to a two-year low o f less than $23 per hun dredweight. Following these lows in mid June, cattle and hog prices climbed rapidly and reached the high $40s and high $30s, respectively, by early August. The cycling livestock prices largely reflected slaughter patterns. Cattle and hog slaughter fell slightly short o f the yearearlier pace during the first quarter, in part reflecting the disrupted marketings caused by the truck strike in February. But marketings picked up in the second quarter, and cattle and hog slaughter rose 8 percent above the low year-earlier levels. The increased slaughter coupled with heavier average slaughter weights boosted total commercial red meat production to a near-record high for the first half, 6 percent above the same period a year earlier. The increase in production more than offset a rise in consumption and boosted cold storage o f red meat markedly. T he outlook for livestock prices remains highly uncertain since drought and high feed prices m ay cause secondh a lf m a rk etin g s to vary from the traditionally reliable indications provided in inventory estimates. Placements o f cat tle into feedlots continued to fall during the first half in response to mounting losses exp e r ie n c e d by ca ttle feeders sin ce September o f 1973. As a result, the number o f cattle on feed in the m ajor cattle-feeding states on July 1 was at the lowest level since 1968 and down 21 percent from the record set in 1973. Nevertheless, the inven tory is sufficient to hold fed cattle slaughter substantially above year-earlier levels throughout most o f the second half, if the relationship between inventories and slaughter—which has been widely dis torted for the past six quarters—returns to the more normal level. In addition, the rapid buildup in the total cattle inventory during the past few years—up 6 percent from a year ago on July 1—plus the lagg ing movement o f cattle into feedlots for the past 15 months implies there is a large supply o f heavyweight cattle currently grazing on pasture. The com bination o f Business Conditions, August 19 7 4 drought and tight supplies o f forage and feedgrains suggests that during the next several m onths a proportionately large number o f these cattle m ay m ove directly to slaughter markets or, if profit incentives exist, into feedlots for a brief period. Either course o f marketing, however, will result in a lower quality grade o f meat than traditional grain-fed beef. Hog marketings are also expected to be substantially above year-earlier levels throughout the second half o f 1974. Although the inventory o f hogs intended for market is slightly below a year ago, the level is sufficient to hold second-half slaughter 6 to 10 percent above a year ago. The increase could be even larger if farm ers respond to the high feed prices by li quidating hogs held for breeding purposes. The uncertainty over slaughter has lowered the degree o f certainty in forecasts o f livestock prices. Nevertheless, many observers expect hog prices will average in the low to mid-$30s during the second half, while cattle prices m ay average in the low to mid-$40s. The typical pattern o f high prices in the third quarter followed by lower prices in the fourth quarter is ex pected to prevail, although seasonal fluc tuations are not likely to be as great as a year ago. M ilk p r ic e s held fairly stable during the first quarter after rising sharply during the last h a lf o f 1973. But in the second quarter, the seasonal decline tripled the n orm a l 30 cent reduction per hun dredweight. Nevertheless, milk prices received by farmers remained nearly onefourth above the year-earlier level in June. The extraordinary seasonal decline in milk prices occurred despite lower produc tion as consum er resistance to high retail prices resulted in a larger cutback in con sumption. Total milk production for the first h a lf o f this year was down about 2.5 percent from the year-earlier level. But it appears that fluid milk sales were down 5 percent. This produced an increased flow 5 o f milk into manufactured dairy products where production proved more than the market could bear. The resulting decline in prices o f manufactured dairy products, in turn, activated governm ent purchases in order to maintain price support levels. Although sharply higher milk prices boosted cash receipts, dairy farmers con tinued to operate under extremely tight margins. For the entire first half, the milkfeed price ratio—pounds o f concentrate feed ration equal in value to 1 pound o f milk—averaged close to the low yearearlier level and 15 percent below that of the same period in 1972. There appears to be little hope for improved operating margins in the second half. Feed prices will remain high, and while milk prices will recover seasonally during the last half, lagging consumer demand will likely limit the increase. These developments suggest milk production will remain below yearearlier levels throughout the second half. C rop p r ic e s rose sharply early in the year and then trended downward for several weeks. The upward pressures par tially reflected the normal post-harvest seasonal rise. But other factors—such as fertilizer shortages, prospects for the smallest carryover o f grain stocks in a quarter o f a century, and the rumor that bread would cost $1 a loa f—were also im portant. These concerns subsided in late February, however, when preliminary in dications suggested that this year’s wheat harvest would exceed the 1973 record by 20 percent, that farmers intended to boost spring plantings substantially above yearearlier levels, and that domestic feed de mand would be reduced by the financial problems o f livestock producers. The downward pressures were intensified by reports o f large grain harvests in Argen tina and South Africa, expanded soybean production in Brazil, a return to fishing in Peru, and weather conditions that permit ted an early start in spring plantings. From early M ay to early June, crop Federal Reserve Bank of Chicago 6 Agricultural exports to Western Europe and Asia paced fiscal 1974 rise billion dollars 0 1 1 2 i 4 1------1-----1 - - 6 1 1 8 1 Western Europe EEC prices stabilized as prospects for larger harvests were being weakened by an awareness that drought and disease were affecting wheat and that heavy rainfalls would substantially delay spring plant ings throughout the Corn Belt. The resulting upward pressures on crop prices were intensified in July when drought con ditions settled over much o f the Midwest. By mid-August, it was apparent that the 1974 feedgrain and soybean harvest would fall far short o f year-earlier levels and that the increase in wheat harvest would be dis appointingly small. As a result, corn and soybeans were well above earlier highs, while wheat prices were up considerably despite the record harvest. The outlook for crop prices is extreme ly uncertain. The estimated 8 percent in crease in this year’s wheat crop is fairly assured since the harvest is nearly com pleted. However, since the increased production will not offset the reduction in carryover stocks, total wheat supplies for the 1974-75 wheat marketing year will be slightly lower than in the year ended June 30, 1974. And although m any observers feel a reduction in exports will ease the tight supply/dem and balance for wheat, high feedgrain prices will likely provide additional support for wheat prices. Based on conditions as o f August 1, the U. S. Department o f Agriculture estimates this year’s corn harvest will fall below 5 billion bushels, down from 5.6 billion in each o f the past three years. The lower corn crop plus smaller harvests o f oats, barley, and sorghum, would drop feedgrain supplies for the 1974-75 marketing year to the lowest level since 1957-58. The sharply lower supplies will necessitate m ajor ad justments in both exports and domestic utilization. As a result, corn prices will con tinue to fluctuate widely at historically high levels. Much the same outlook holds for soybeans. A ccording to the latest es timates, the 1974 soybean harvest is ex pected to total 1.3 billion bushels, down from 1.6 billion in 1973. While carryover stocks this fall will be larger than a year ago, total supplies m ay be down 9 percent. And with the increased U. S. crushing capacity and the strong foreign demand, the supply/dem and balance for soybeans will be appreciably tighter in the 1974-75 marketing year that starts in September. Financial review and outlook F in a n c ia l d e v e lo p m e n ts in the agricultural sector this year could be termed disastrous if compared strictly with those o f 1973. Alternatively, the financial developments could be characterized as ex tremely favorable if compared to 1972 and most earlier years. Unfortunately, neither comparison provides an accurate ap praisal o f conditions. For the record, how ever, the U. S. Department o f Agriculture recently estimated that net realized farm incom e would approach $25 billion this year, down from $32 billion in 1973 but well above the previous record o f Business Conditions, August 1 9 74 $17.5 billion in 1972. During the first half o f this year, net farm income averaged $28 billion on a seasonally adjusted annual basis. Farm land values are expected to rise 15 percent during the year ending March 1, 1975, down from a record increase o f 25 per cent the previous year but up from the then com paratively high 14 percent advance two years ago. The problem o f using overall averages as a measure o f the current financial condi tion o f the agricultural sector is that the averages mask the problems o f the entire livestock sector. The losses experienced to date by cattle feeders, hog producers, and dairy farmers, as well as the continued losses that are almost certain in the second h alf can only be described as tremendous. Although figures vary widely, the U. S. Department o f Agriculture estimates that losses on cattle placed into feedlots during the last ha lf o f 1973 amounted to $1 billion, or nearly three-fifths o f the equity capital employed to fatten those cattle. For cattle placed into feedlots during the first h a lf o f this year, the estimates suggest equity losses o f $0.3 billion out o f the total $1.1 billion in equity capital involved. The com bined loss o f $1.3 billion is indicative o f both a bleak financial picture for livestock producers and the probable structural shifts that will occur in cattle feeding in order to find new equity sources. F a rm d e b t continued to accelerate during the first h a lf o f this year, extending a trend that started in 1971. New money loaned by Federal Land Banks (FLBs)— the m ortgage lending arm o f the borrowerowned Farm Credit System—exceeded the rapid year-earlier pace by 27 percent dur ing the first half. The increase exceeded loan repayments and boosted FLB out standings o f 23 percent above a year ago July 1. Loans made by Production Credit A s s o cia tio n s (PCAs)—the short- and intermediate-term credit counterpart o f FLBs—rose 15 percent during the same period w h ich co m b in e d w ith slow 7 repayments pushed midyear outstandings upward by 21 percent. The available evidence suggests that banks also have provided a substantially larger volume o f farm loans during the first half. The continued large increases in farm borrowings are a reflection o f several fac tors. Much o f the growth reflects in creased operating expenses resulting from both larger purchases and sharply higher prices paid. As o f mid-July, the index of prices paid by farmers for production items was 15 percent above the year-earlier level. A large portion o f the increase reflected higher fertilizer and seed prices. A sizable portion o f the increased borrowing, no doubt, is attributable to the financial losses o f livestock producers. In some cases, these losses have necessitated renewals and extensions o f existing loans and, in others, a refinancing o f farm real estate to pay o ff operating loans. Finally, much o f the growth in short-term farm loans represents the tightening credit prac tices o f merchants and dealers who no longer need to promote sales by offering credit to customers. An overall summary o f the agri c u l t u r a l o u t l o o k w o u l d h a v e to acknowledge the possibility that farmers may experience some o f the most rapid and financially painful adjustments experienc ed in years during the next several months. High prices o f grains and soybeans will provide those farmers who are able to harvest a reasonable portion o f their crop with high incom es and encourage ex panded production next year. Returns to farmers that lost the bulk o f this year’s crops may not cover the costs o f plantings. Livestock producers will continue to be buffeted financially as high grain prices ration reduced feed supplies while the possibility o f a partial liquidation o f livestock inventories will scale livestock prices downward. Gary L. Benjam in 8 Federal Reserve Bank of Chicago rends in U.S. international trade International trade, long considered a minor factor in the form ulation o f the economic policy o f the United States, is becom ing increasingly im portant to the nation’s economy. U.S. international trade has increased more rapidly than domestic goods production in recent years. A s a result there has been a steady and substan tial increase in the share o f U.S. output and consumption that goes into or is derived from the foreign market. In the first U.S. exports and imports— nominal and adjusted for price increase* billion dollars 1967 '68 '69 '70 '71 '72 '73 '74 ‘ Quarterly data—adjusted to 1967 unit values. “ Nominal value adjusted to 1967 unit values. tEstimate based on partial price data for second-quarter adjusted figures. quarter o f 1974, for example, nearly 14 per cent o f U.S. production entered the export market, and over 13 percent o f the goods available for sale in the United States were o f foreign origin. In 1967, these percen tages were 7.6 and 6.7 percent, respective ly. The interdependence inherent in an in creasingly open U.S. econom y will un doubtedly require some rethinking o f national econom ic policies as well as o f in dustrial and labor policies. The role played by rising import and export prices has been the most dramatic characteristic of the nation’s expanding international trade over the past 18 months. Upward pressures on prices cam e from several directions in 1973. Shifts in both foreign and domestic demand strained the productive capacity o f some U.S. in dustries. Crop shortfalls cut available world supplies o f agricultural products. Government actions restricted supplies o f basic raw materials, i.e., Arab cut backs in oil production and U.S. restric tions on oilseed exports. Higher prices were a more impor tant factor in the increased value o f im ports than in the increased value o f ex ports. About 80 percent o f the increased value o f imports, but less than h a lf o f the increased value o f exports, w as ac counted for by higher prices in 1973.* Price-quantity relationships for U.S. ex ports and imports exhibited somewhat different patterns. While the volume o f imports increased less than 5 percent in 1973 over 1972, the volume o f exports rose 23 percent—with the trend m oving *U. S. export values quoted in this article are f.a.s. (free alongside ship) port of export. U. S. im port values quoted are “customs import value.” Business Conditions, August 19 7 4 irre g u la rly higher throughout the period. A s was the case for imports, ex port prices increased during 1973 and early 1974, though less sharply than im ports. Prelim inary estimates o f secondquarter 1974 export prices stood about 27 percent above second-quarter 1973 prices. This compares with a 12 percent increase in prices from second-quarter 1972 to second-quarter 1973. Increases in import prices were 49 percent and 17 percent, respectively, for the com parable periods. E xport/im port figures adjusted to reflect constant or “ real” dollars provide an indication o f the effect o f price in 9 creases on the value o f U.S. trade. From 1967 through the second quarter o f 1974, at an annual rate, the nom inal value o f U. S. exports increased $66 billion, and the nom inal value o f U.S. imports in creased $74 billion. A surge in prices o f imported oil pushed the trade balance into deficit in the second quarter o f 1974. Adjusting 1974 dollar values to ac count for price increases since 1967 reduces the export/im port values to “ real’’increases o f $27 billion and $19 billion, respectively. The net export o f “ real” resources (export surplus) con tinued to increase during the first h a lf o f 1974. Unit value indexes in dollars and national currencies, 1973 unit value index, 1967=100 200 S£ 3 C 160 - m imports 120 _ exports 80 40 oL United States Germany France Unit value indexes provide par ticularly striking comparisons of changes in prices attributable to the devaluation of the dollar vis-a-vis the currencies of the major trading partners of the United States. In terms o f dollars, for example, the unit value index o f German exports in 1973 was 61 percent greater than in 1967; when measured in marks, however, the Japan Canada United Kingdom unit value o f German exports was only 6 percent greater in 1973 than in 1967. Similar though less dramatic com parisons can be made for Canada, France, or Japan. In Britain, where in 1973 the pound had depreciated relative to the dollar, unit value increases measured in pounds show larger gains than unit value increases measured in dollars. Federal Reserve Bank of Chicago 10 Petroleum import prices million barrels 300 i dollars 1973 1974 'Includes refined petroleum products. Petroleum and petroleum product imports as a share of total U.S. imports increased from less than 10 percent during JanuaryMay 1973 to nearly 24 percent dur ing the same period in 1974. Although the volume o f petroleum im ports actually decreased slightly in ear ly 1974 from the 1973 period, the total value increased from about $2.6 billion in 1973 to over $9 billion in 1974. Higher prices accounted for the increase. The average price o f imported petroleum and petroleum products was about $2.70 per barrel in January 1973. By the end o f September, the price had increased to about $3.40 per barrel. In October, the Organization o f Petroleum Exporting Countries (OPEC) increased the “ posted price” o f petroleum by 70 percent. (The posted price is a base on w h i c h r o y a l t i e s and ta x es are determined—it is not to be equated with the market price.) On January 1, 1974, the posted price was increased again by nearly 130 percent. Over the period September through December 1973, the a v era g e price o f p etroleu m and petroleum product imports increased from $3.40 per barrel to $5.65 per barrel—by May 1974 the average price stood at more than $11.50 per barrel. While there has been no increase in posted prices in 1974, there has been a continuing movement by some OPEC members toward increasing their share o f ownership in petroleum-producing operations. These OPEC members in p a r t i c u l a r h a v e resisted recen t downward market pressure on oil prices by refusing to sell their share o f petroleum production at less than their asking price. Regardless o f whether petroleum prices ease or increase from current levels during the remainder o f the year, there is no expectation that potential short-term price changes will approach the magnitude o f the price changes observed since early 1973. The impact o f the petroleum situa tion on the U.S. trade picture in 1974 will be awesome. If petroleum imports and prices in the second h a lf m atch the levels o f the first half, the U.S. trade deficit in petroleum alone will exceed $20 billion, an increase o f more than $13 billion from 1973. This would more than wipe out expected surpluses in the agricultural, capital goods, and non petroleum industrial supplies sectors. Business Conditions, August 1 9 7 4 11 Trade balance by category billion dollars 20 ‘ Categories do not sum to total. “ Annual rate based on January-May data M a r k e d a c c e le r a t io n in th e grow th o f U .S. e x p o r t s o f a g r ic u ltu r a l p r o d u c ts a n d im p o r ts o f in d u s tr ia l su p p lie s d o m in a te d th e c h a n g e s in th e U .S . tra d e b a la n ce in r e c e n t m o n th s . Agricultural exports accounted for 25 percent o f total exports in 1973, up 6 percentage points from 1972. A s recent ly as 1969, agricultural exports ac counted for only 16 percent o f the total. Imports o f industrial products—which include petroleum and which had been g r a d u a l l y d e c l i n i n g in rela tiv e im portance—increased nearly 2 percen tage points in 1973 from 1972, reaching more than 38 percent o f the total. Moreover, the full im pact o f higher petroleum prices was not felt until 1974 when, during the first five months, the import share o f industrial supplies surg ed to 48 percent o f the total value o f U.S. imports. The level o f U.S. agricultural ex ports in calendar 1973 was great enough to push this category’s trade surplus to more than $9 billion—an increase o f over $6 billion. On the other hand, the U.S. trade deficit in industrial supplies imports created by price increases in petroleum products reached $7 billion— up $3 billion. But this deficit was offset by a $3 billion increase in the surplus for capital equipment exports. This histor ically strong export category post ed a total surplus o f $14 billion in 1973. If the trends observed during the first five m onths o f 1974 continue through the year, the trade surplus for a g ricu ltu ra l g o o d s co ul d expand another $3 billion over the 1973 level, and the surplus for capital goods could grow by about $5 billion. In a com paratively recent development, non petroleum industrial supplies have recorded export surpluses and could ex pand as m uch as $5 billion in 1974 over a marginal surplus in 1973. Federal Reserve Bank of Chicago 12 U. S. trade by geographic area 'Includes military aid. "Crude petroleum imports for November December not included in country totals, tn.e.c. not elsewhere counted. The worldwide pattern of U .S . trade remained relatively stable during the late 1960s and early 1970s, with one notable exception. The m ajority o f U.S. trade, exports and i m p o r t s , is w ith oth er w estern hemisphere countries, with Western Eu rope, and with Japan. About 78 percent o f all U.S. trade in 1973 follow ed this pattern, a decline o f about 3 percentage points since 1967. Within this group, Japan’s share increased somewhat while the share accounted for by the others declined. The one principal exception to the stability in U.S. trade patterns has been with communist bloc countries. Political initiatives since 1972 that thawed trade relationships between the two areas resulted in the United States exporting 13 times more goods to these countries in 1973 than in 1967. U.S. imports from the communist countries increased more slowly and were three times greater in 1973 than in 1967. Still, the value o f U.S. trade with the communist areas remains relatively small—$2.5 billion in exports and $0.6 billion in imports during 1973. Jack L. H ervey Business Conditions, August 19 74 13 Banking developments Bank credit in the first half Despite a sluggish econom y and in creasing costs o f loanable funds, com m er cial banks increased both their loans and holdings o f investment securities in the first h alf o f 1974. Holdings o f U.S. Treasury issues declined seasonally, but this decline was more than offset by the ac q ui si ti on o f other securities—m ainly obligations o f states and political sub divisions and U.S. agencies. At Seventh District member banks, total loans excluding sales o f federal funds rose $4.6 billion, or 8.1 percent, through m idyear—less than the record $5.9 billion (12 percent) increase registered in the com parable period o f 1973. At all commercial banks in the nation, loans increased 6.4 percent during the first six months o f this year, compared with a 10 percent gain a year earlier. While the amount o f bank credit ex tended to businesses was about the same as the record expansion a year ago, most other types o f loans, including real estate and consumer loans, rose much less. Moreover, loan growth at smaller banks was much slower than last year. Heavy business loan dem ands this year, especial ly at the large m oney center banks, reflect the need for increased working capital stemming from price inflation as well as shifts to bank credit by firms that were un willing or unable to tap the money and bond markets directly as interest rates rose and investors increased their preference for top-quality paper. Treasuries at new low After rising in the first two months o f the year, holdings o f U.S. Government securities at district member banks resum ed their downward trend for a net first-half decline o f $552 million. While this decline was only about half the decrease registered in the first six months o f 1973, there was less available for liquidation. A ll commer cial banks in the nation reduced their port folios o f governm ent securities by $5.5 billion. However, these investments nor mally decline in the first half as the T re a s u ry pays down temporary borrowings in the months o f its heaviest tax receipts. Seasonally adjusted national data indicate an increase in these holdings in the January to June period but a decline in the year ended June 30. At the end o f June, district member banks held only $6.6 billion o f U.S. Govern ment securities—below the previous low reached in mid-1970. Treasuries as a proportion o f earning assets slipped from 9.6 percent to 7.8 percent over the past year. Both cyclical and trend factors explain the shrinkage in portfolios o f Treasury s e c u r i t i e s . B a n k s us ua l ly acquire Treasuries when they expect loan demand to weaken and interest rates to decline. When these expectations are reversed, banks tend to liquidate their holdings o f these securities in order to make higheryielding loans. Early this year, many banks bought Governments in anticipa tion o f the price appreciation that would accom pany an expected decline in market interest rates—an expectation that was not fulfilled. A s loan demand again accelerated, some o f these issues were sold or allowed to run-off at maturity. Part o f the overall decline can be attributed to the paring down o f inventories in trading ac counts in view o f the negative cost o f carry (excess o f the cost o f money over the earn ings o f securities in inventories). 14 Federal Reserve Bank of Chicago the end o f June 1974, five-year Treasury securities were yielding To tal loans Securities about 8.20 percent, in contrast to Loans1 U. S. G ovt. O th er2 and investments1 8.70 percent on federal agency ( p e r c e n t c h a n g e - f ir s t- h a lf 1 9 7 4 ) issues o f a com parable maturity United States and a taxable-equivalent return on (all commercial 6 .4 - 9 .4 4 .5 4.6 banks) prim e five-year m unicipals o f Seventh District almost 10.40 percent to banks and (member banks) 7.4 6 .5 8.1 - 7.7 other corporations in a 48 percent 7.1 C ity 3 11.4 -1 4 .2 8.9 tax bracket. FFrom the standpoint 7.6 3.7 Other - 3 .0 3.5 o f yield, therefore, there has been (p e r c e n t o f to ta l lo a n s a n d in v e s tm e n ts , en d o f June 1974) an incentive for banks to switch out United States o f T reasuries and into other (all commercial securities. 72 .0 7.8 2 0 .2 banks) 100.0 Another reason for the declin Seventh District 19.3 100.0 (member banks 72 .8 7.8 ing importance o f U.S. Govern C ity 3 79 .6 5 .5 14.9 10 0.0 ment securities in bank portfolios Other 10.7 10 0.0 6 4 .4 2 4 .8 is the recent greater emphasis on liability management; that is, the Excludes federal funds sold. ability to acquire loanable funds by Prim arily obligations of states and political subdivisions, S. agency, and U. S.-sponsored agency securities. issuing bank obligations to in 3 Reserve city banks as defined prior to November 9 , 1972 vestors. This has reduced banks’ reliance on governm ent securities as a source o f liquidity. Since the suspen With the rapid rise in market interest sion o f interest rate ceilings on all rates, however, prices o f outstanding maturities o f large certificates o f deposit in securities dropped sharply, discouraging 1973 and the lifting o f ceilings on smaller banks from selling, especially issues with denominations, m ost liability growth has longer maturities. The com position o f been in the form o f time deposits. During Treasury portfolios by maturity categories the first half o f 1974, time deposits at dis is not yet available for smaller member trict member banks increased by almost $5 banks, but data reported by 55 large banks billion, compared with $4.3 billion in the in m ajor district cities show that U.S. notes comparable 1973 period. and bonds with more than five years to maturity rose 40 percent over the sixSecurities other than Governments month period. Total Treasuries held by rose $1.1 billion, or 7 percent, in the first these banks were down about 12 percent in half o f 1974. A m ajor factor explaining this period with all o f the decline at banks’ shifts out o f Governments into tributable to issues maturing within a other securities is undoubtedly the rapid year. growth in the volume o f agency issues sold In addition to the short-run cyclical and increased activity in the secondary forces, there are a number o f long-run fa c market for these securities. Outstanding issues o f federal agencies and federaltors that continue to shrink the importance sponsored agencies now total more than o f U.S. Government issues in bank port $80 billion, o f which all except $5 billion folios. One, which dates back to the Tax are privately held. A gencies are being sub Reform Act o f 1969, requires banks to treat stituted for Trreasuries to a greater degree capital gains as ordinary incom e for tax as collateral against governm ent deposits. purposes. This increased banks’ incentives Banks can also rely more on agencies as to reach out for higher-yielding assets. At Treasuries down most at large banks Business Conditions, August 1 9 74 secondary reserves due to the increased ease with which they can be sold in the open market. A gency issues, however, are still a less important com ponent o f “ other” securities than state and local obligations. At the end o f last year, district member bank invest ment in these latter obligations was more than three times the size o f their agency portfolios. To a large extent financing of local governm ents is a vital service to a bank’s community. A large portion o f such investments resembles the loan portfolio in that m unicipal demands for funds tend to m ove in the same direction as private loan demand. Thus, these investments ab sorb funds rather than provide a source o f liquidity when loans are rising. The com position o f investment port folios is related, o f course, to the amount o f various kinds o f debt instruments offered. This is particularly true o f the banks that perform underwriting and distribution functions. During the first half o f 1974, the Treasury paid down (largely because o f the seasonal pattern o f tax receipts) a net o f more than $2 billion o f debt; net federal agency offerings amounted to about $4 billion and state and local governments issued more than $12 billion o f long-term bonds plus substantial amounts o f short term notes. City versus “ country” banks District and national aggregates con ceal significant differences between major city banks and the vast majority o f smaller banking institutions in both total credit growth and in the com position o f earning assets. Total loans and investments o f reserve city banks (defined to be consistent with historical statistics) increased 9 per cent, compared with a gain o f less than 4 percent at other member banks. This difference reflects not only differences in 15 loan demand but also the greater capacity o f the large banks to compete for funds, es pecially through the issue o f negotiable certificates o f deposit. These obligations were up $3 billion in the six-month period. Total time deposits rose 15 percent at the city banks but only 6 percent elsewhere. As would be expected at a time when the strongest credit demands are coming from the business sector, loans grew more rapidly at the big city institutions, in creasing the already heavier concentra tion o f the assets o f these banks in loans. At midyear, almost 80 percent o f city bank earning assets were in loans, compared with 64 percent for smaller banks. Despite their greater access to money market funds, city banks reduced their holdings o f Treasuries much more than did other banks, probably reflecting greater li quidity pressures as well as pared-down trading accounts. It is not clear, however, whether the slower loan growth at smaller banks was a result o f slower credit demands on the part o f their customers or the inability on the part o f the banks to ac commodate these demands. Although the relative importance of U.S. Government securities in portfolios has been falling at both reserve city and country banks, these securities still con stitute a much larger share o f earning assets at the smaller banks. At midyear, Treasuries represented 10.7 percent of loans and investments at country banks, compared with 5.5 percent at city banks. On the other hand, the pace o f ac quisition of non-Treasury securities was about the same for both groups o f banks— roughly T/i percent—in the first half. But the “ other securities” category accounted for 24.8 percent o f country banks’ loans and investments, a share gain o f 4.4 percentage points over the past four years, largely at the expense o f holdings o f U.S. Government securities. ■
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