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an 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 Our turbulent economy The new Federal Financing Bank m ay 1974 Our turbulent economy 3 In the face o f current uncertain circumstances and conflicting proposals, caution is called for in setting economic policy in the short run. I f underlying de m and is strong, an expansive policy would worsen inflationary pressures. I f dem and is w eaken ing, a sharply restrictive policy would m ean an unaccep table unem ploym ent rate. The new Federal Financing Bank 9 While this newly-created bank m ay not be a panacea for federal agency financing problem s, an official centralized borrowing m echanism for these agencies is long overdue. Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department Federal Reserve Bank of Chicago, P. 0. Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Department with a copy of any material in which an article is reprinted. Business Conditions, May 1 9 7 4 3 Our turbulent economy Remarks of Mr. Robert P. Mayo President of the Federal Reserve Bank of Chicago before the Rotary Club of Chicago May 7, 1974 The current state o f the U. S. econom y presents a picture o f crosscurrents, variety, and indeed, tumult unknown in our recent history. A nyone glancing only at overall gross national product data for the first quarter would have to conclude that the U .S. econom y had all the earmarks o f a recession period. Indeed, some economists view it just that way. Yet during the same time that total real output dropped at an annual rate o f alm ost 6 percent, more sharply than any time since 1958, many o f our m ajor industries were operating at or near capacity. While the overall number o f unemployed was rising nearly 10 percent, we had m ajor industries operating below capacity because they could not hire the skilled labor they needed. And despite this overall decline in output, materials and in termediate products o f every sort were in short supply, with producers allocating their output to customers. N ot only did the m ost recent quarterly period show a decline in real output, but the growth during the three previous quarters was significantly below the long-term growth trend. Yet the upward movement o f prices—at an annual rate o f over 10 percent—was the greatest since 1951. The am ount o f slow down which occurred would norm ally be expected to be accom panied by declining growth in borrowing and lower interest rates. Instead we are seeing new records set in short-term rates and long-term rates pressing against record levels. If this is a recession, it is in deed the strangest one the econom y has ever undergone. Inflation and oil A s early as a year ago, when data relating to the first quarter o f 1973 became available, it w as clear that the econom y could not continue the extremely high rate o f growth that w as then in progress. A gradual slow ing through the balance o f 1973 and possibly early 1974 was generally expected, with a return to a so-called “ nor m al” rate o f about 4 percent in the latter h a lf o f 1974. It was logically expected that a slow ing o f the inflation rate would ac com pany this slowdown. Given conditions at the time, all o f these were reasonable ex pectations. And, indeed, second- and thirdquarter output did show the expected slow down. But there was little evidence o f any slowing o f the inflation rate, primarily because o f the intense worldwide demand for food, but also because o f high levels o f demand for a wide range o f other com modities. Then cam e the October War and the Arab oil embargo that caused sharp petroleum product supply disruptions and rapid increases in prices o f petroleum products. The em bargo is now behind us, even though the energy problem is not. A nd we have to learn to live with the increased price o f energy. The new price level for gas oline is not the only consequence. Higher petroleum prices are seeping pervasively through the econom y to raise the cost o f producing virtually everything we use from toothpicks to computers. In large measure, the increase in energy costs was responsible for the unpredicted accelera 4 tion o f the general price level both in late 1973 and in early 1974. Beyond prices, the oil embargo had a serious im pact on industrial output. There were direct production cuts in petroleum products themselves—plus cutbacks in electric power production and natural gas consum ption w hich came from conserva tion measures. Autom obile sales, w hich had been declining gently from the un precedented levels o f the first quarter o f 1973, tumbled drastically, and production was cut severely to prevent enormous in ventory gluts. The recreational vehicle in dustry virtually closed down. Hotels, resorts, and other businesses dependent on the auto vacation traveler felt the pinch. Airlines were forced by fuel shortages and fuel costs to curtail service. In short, a significant portion o f the decline in output during the past two quarters can be ascrib ed to the oil em bargo and to the im pact o f the higher oil prices that still prevail now that the em bargo has ended. A t the sam e time that the em bargo was making us all aware that we were rapidly outgrowing our supplies o f energy and was causing a slow dow n in several industries, it was also acting in an expansionary direction—providing incentives for the coal industry and rail transportation, and accelerating work schedules on nuclear power plants. Today, dom estic oil explora tion activity is at a level not seen since the early 1950s. Expansion in these areas add ed strongly to a dem and for capital goods that had been underway for several quarters as a result o f strong pressures on capacity, the need for modernization, and the requirements to meet environmental and safety regulations. Even the depressed auto industry began m aking m ajor capital investm ents to meet w hat is generally viewed as a perm anent shift in consumer demand toward smaller and more efficient cars and to meet the pollution control re quirements which becom e much more stringent with the 1975 model year. Federal Reserve Bank of Chicago Thus we had a very strange econom ic environment in the first quarter o f 1974. While all recent surveys o f consumer at titudes have been very pessim istic in tone, the consumer has been spending his money. Consumer spending grew nearly twice as fast as the growth in disposable in come. But the consum er was enjoying it less. While spending was up, the real level o f goods and services that this spending purchased was down slightly, and one place the consumer did n ot spend his money was for new housing. Expenditures on housing were curtailed by high interest rates, reduced personal saving, and uncer tainty about the cost and availability o f fuel. In addition, the shifting o f savings from norm al channels into areas yielding markedly higher returns sharply curtailed the availability o f mortgages. I f we were in the m idst o f a typical recession, this decline in real consumer spending would be accom panied by a slow down in capital spending. But, instead, we are w itnessing accelerated capital spend ing and appropriations combined with fairly rapid returns to m ore normal con ditions in m any areas affected by the petroleum embargo, along with a slight decline in the unem ploym ent rate. In addi tion, we are on the threshold o f w hat promises to be a record year in agricultural output, weather permitting. It seems to me that two things are holding back the resumption o f rapid econom ic grow th— inflation and capacity limitations. The outlook for any significant reduc tion in the current rapid rate o f inflation is dim in the next few m onths. The full im pact o f increased energy costs has yet to work its w ay through the price system to the final sales level. We are just at the beginning o f a long period o f labor negotiations in w hich settlements are bound to include “ catch-up” provisions that will add further to costs. Despite the promise o f a bumper U. S. harvest, world food stocks are low, so that demand will Business Conditions, May 1 9 7 4 put a floor under agricultural prices. A t the sam e time, energy and fertilizer price hikes will increase the costs o f producing our food. Under the best o f circumstances, it seems likely that several quarters will elapse before the rate o f inflation recedes to levels on the high side o f w hat were our goals only tw o years ago. Just as it is going to take substantial time to subdue inflation, so an extended period o f capital expansion is needed to add production capacity in those in dustries that are particularly short o f capacity. Production o f alm ost every raw material used to feed our industrial machine, from paper to steel, must be ex panded if substantial econom ic growth is to resume. M assive additions have to be made to our coal, petroleum, and electric in dustries, particularly i f the nation decides to m ove toward energy self-sufficiency. Even in industries where capacity is ade quate to permit growth, capital investment is required to meet environmental prob lems, to com ply with the occupational health and safety regulations, and to in crease productivity as an antidote to rising costs o f energy, materials, and labor. Slower growth indicated The outlook, then, for the next few quarters, is likely to be one o f slower growth o f the econom y—slower than the 4 percent or so annual growth we have come to consider norm al—with the fixed capital investm ent sector (except housing) signi ficantly stronger than the consum er area. T his sluggishness is likely to be accom p a n ie d b y le v e ls o f unemployment som ewhat above those we have custom ari ly set as our national objective in the postwar period, and som ewhat higher than we would like to see. The reward for goin g through this pain will be a slowdown in the general rise in the price level, but it is goin g to be slow in com ing. This means that considerable political pressure is go 5 ing to build up for stimulative fiscal and monetary policy. We have already heard several calls from leading political figures for a major tax cut to stimulate consumer spending and employment. Yet it is easy to make the case that virtually all o f the first-quarter drop in output and the increase in un em ploym ent resulted from cutbacks in the auto and petroleum-related industries, and residential construction. We will probably not know where the econom y is heading over the longer term until second-quarter data are available. Given the special cir cumstances o f the last six months, it seems very unlikely that we are in a recession in any norm al sense o f that word. Policies ap propriate to bringing about rapid recovery in a more typical business slowdown could easily bring on substantially worse infla tion than we are now experiencing without significantly increasing real growth. This brings me, then, to the question o f ap propriate econom ic policy for the next several months. Sources of current inflation The current situation presents a for midable challenge to econom ic policy. With the decline in real output during the first quarter and the continuation o f sharp ly rising prices there is now more than the usual am ount o f uncertainty concerning the underlying state o f total demand relative to total capacity. For purposes o f fram ing economic policy, we must start with the critical fac tors involved in the current situation and the possible remedial steps that m ight be taken to improve that situation. But it is also im portant to review how we got to this unenviable position in order to avoid re peating past errors. F ollow ing the econom ic downturn o f 1969-70, monetary policy, in m y opinion, was not excessively expansive in 1970 and 1971. B ut the growth in monetary 6 aggregates during 1972 and the first part o f 1973 was higher than warranted by sub sequ en t econom ic developments, and higher than desired by the Federal Reserve. Given the lagged effects o f mone tary expansion on aggregate econom ic ac tivity, and the fact that the econom y was fast approaching capacity output in the latter part o f 1972, this unintentional ex pansion o f the aggregates m ost likely add ed to inflationary pressures. Nevertheless, other factors share even more importantly the responsibility for the current inflation problem. F iscal policy, in terms o f budget deficits, was excessively expansionary in 1971 and 1972. Providing for the financing o f the deficits is one reason for the monetary expansion we have witnessed. The successive deval uations o f the dollar were also important. C ou pled w ith sim u lta n eou s stro n g econ om ic expansion o f industrialized nations abroad, the devaluations led to sharper-than-anticipated export demand for U. S. goods. In addition, crop failures abroad led to much larger-than-foreseen demands for U. S. agricultural output and this resulted in sharp increases in dom estic food costs. Finally, o f course, the oil embargo, com ing at a time when U. S. im port demands for petroleum products were rising sharply, resulted in shortages o f petroleum and petroleum-based products and sharp in creases in prices for such products in a very short period. I would also add my personal opinion that the wage-price control program which was just buried w as kept alive too long. The controls had the unfortunate dam aging effect o f m asking inflationary pressures. They caused distortions in relative wages, prices, and output, and they made it in creasingly difficult to acquire accurate econom ic intelligence. V iew ing our current situation from a s lig h tly longer-term perspective, the quickening in the pace o f inflation follow Federal Reserve Bank of Chicago ing 1967 brought into sharp relief a serious problem associated with the goal o f foster ing full employment o f resources as ex pressed in the Em ploym ent A ct o f 1946. While public policy attempts to achieve full employment with relatively stable general prices, the latter goal has been subordinate to the employment goal for a number o f years. It appears to me that som e labor unions and some businesses increasingly have com e to act on the assum ption that in creased wages and increased costs can be passed through to final product prices almost with impunity. Given the com m it ment to full employment, unwarranted in creases in prices and wages—unwarranted in the sense o f m aintaining employment levels given demand and productivity conditions—have tended to be under written by governm ent policy in order to avoid unemployment. Resulting general price increases renew the cycle. It seems clear that this pointless spiral o f wagecost-price inflation must be brought under control without denying a role for collec tive bargaining and for market pricing which allows for relative price changes and possible incom e share changes as econom ic conditions change through time. Establishing a permanent price-wage review board with principally a public reporting responsibility, along with some adjustment in the priorities attached to employment and inflation, m ight be one way o f approaching the problem short o f direct controls. H ow ever, this problem and the problem o f closer and more appropriate coordination o f longer-run m onetary and fiscal policies are matters that will be grappled with in future periods. The press ing question now is w hat policy actions should be taken in the current adverse situation. Several factors must be con sidered here, and they lead me to a conclu sion regarding short-term policy that some may view as an unacceptable position. Business Conditions, May 1 9 7 4 Uncertainty and conflicting policy proposals I believe we must recognize that the current situation differs substantially from anything we have experienced in re cent econom ic history. Supply conditions and international considerations must be taken into account more explicitly than they have been in the past. A nd we must recognize that rising energy costs repre sent a loss o f real incom e in favor o f other nations. The extent o f these real income losses is by no means clear at this juncture, nor is it clear how the oil-producing na tions will em ploy the incom e transfers they are now receiving. Finally, we have just seen the end o f a protracted period o f pricewage controls, and the results o f removing those controls are not yet certain. A s indicated earlier, first-quarter econom ic data indicate that the real output decline we suffered so far is concentrated in those few sectors most affected by the energy problem s and most sensitive to high interest rates. Unlike other periods of decline in real output, the overall invest ment picture for the econom y appears to exhibit sustained dem and strength thus far. Financial m arket demands remain strong. Real consum er spending, while not buoyan t, does not show pronounced weakness; the unemployment rate, after increasing sharply, has been declining m arginally in the short run. In the face o f the conflicting signals concerning the present state o f the econom y, policy proposals and recommen dations diverge more sharply than usual. One group advocates sharp restraint in general m onetary and fiscal policy to reduce inflationary pressures, with the resulting unem ploym ent and specific in dustry effects to be dealt with by ap propriate special program s. Special pro gram s, I m ight add, the dimensions and form o f w hich are not at all clear, let alone in place.* 7 Another group believes the underlying demand situation is weak or borders on weakness. For that reason, expansive or at least accom m odative policies are ad vocated to m aintain employment and en courage investm ent spending. It is argued that m ost o f the very sharp price increases we experienced both last year and this year are attributable to nonrecurring special factors. If this be the case, with inflation expected to subside som ewhat later in the year, a sharply restrictive monetary policy would only exacerbate the process o f rising unemployment already started. Tax relief is advocated by some to restore a portion o f the lost real incom e in the lower- and middle-income brackets and as an incen tive to organized labor not to seek a restora tion o f real incom e by means o f increased nom inal wages. The need for caution Given such uncertain circumstances and conflicting proposals, I should like to counsel caution in setting econom ic policy in the short term. I f underlying aggregate demand is strong, an expansive policy would simply worsen the inflationary situation, given supply constraints at tributable to energy problems and defi cient investment in recent years. If un derlying dem and is weakening, a sharply restrictive policy would result in an un acceptable unem ploym ent rate that would elevate pressures for a fast reversal o f policy—a process we have seen enough of in recent years. On balance, I conclude that moderate monetary restriction is called for under present circumstances. I take the position that inflation attributable both to special factors and more generalized pressures re quires restraint even though thatm ight en *Subsequent to the d e liv e ry o f th is speech, three program s to a ssist the ho using in d u s try were es tablished by P re sid e n tia l directive . 8 tail some small increase in the unemploy ment rate for a year or so at least. But I would be reluctant to see the unemploy ment rate rise substantially. Although I am in sym pathy with the concerns o f those who advocate tax relief for the lower- and middle-income brackets, as yet I see no indication that the tax cut proposal would in fact lead to restraint on the wage side in the aggregate. Without such restraint, an expansive policy would, in my opinion, only foster a more severe in flationary situation. My position is not doctrinaire, however. I am willing to revise my opinion i f a viable m eans o f confron ting the problem o f so-called “ stagflation” can be demonstrated, and i f it stands a Federal Reserve Bank of Chicago good chance o f being carried through in all o f its facets. In the absence o f such a demonstra tion, I believe it im portant that we recognize that our current inflation prob lem cannot be resolved quickly at reason able cost. The problem has built up over a long period. It will take a long period to resolve it. Precipitate attempts to solve the problem would only result in the im posi tion o f social costs that would, in my opi nion, be disproportionate to the social benefits received. More than anything, we must now have patience in order to help es tablish a sound basis for sustained growth at more reasonable rates o f price in crease in 1975 and the years ahead. Business Conditions, May 1 9 7 4 9 e new FederafFinancing Ban The Federal Financing Bank, created by an act o f Congress in December 1973, is ex pected to embark on its assigned mission o f c o o r d in a tin g a n d con solidatin g the borrow ing activities o f about 20 federal agencies with its first market borrowing sometime in June. Reports suggest that securities totaling around $500 million m ay be offered with the minimum denom ination being $10,000. This initial offering will facilitate the financing o f such federal agencies as the Environm en tal F inancing Authority, the Small Busi ness Adm inistration, and the W ashington Metropolitan Area Transit Authority. The creation o f the Federal Financing Bank (FFB) culminates m any years o f Treasury Department efforts to obtain authorizing legislation. In its testimony before Congress, the Treasury argued that such a bank w as needed to serve as an in termediary between credit markets and the frequent but uneven borrowing needs o f a grow ing num ber o f individual agencies. The Treasury argued that the expanding num ber o f federal agencies com ing directly to the credit markets for their financing needs was a source o f confusion to market participants, caused disruptions in the market, and resulted in relatively high in terest costs to the borrowing agencies. A s envisioned by the Congress, the FFB will provide agencies that are w holly or partially owned by the U. S. Govern ment with a central source o f financing; hom ogeneous FFB obligations will replace the proliferation o f federal agency issues; the number o f government-related trips to the market will be substantially reduced; high-quality FFB obligations will warrant lower interest rates, with savings passed on to the borrow ing agencies. “ Federal agency” defined N ot all o f the agencies that are generically referred to as federal agencies are authorized to use the FFB. For FFB purposes (and as used in this article), a federal agency is “ an executive depart ment, an independent Federal establish ment, or a corporation or other entity es tablished by the Congress which is owned in whole or in part by the United States.” T h e la rg e governm ent-sponsored agencies are excluded by this definition because they are privately owned. The governm ent-sponsored agencies which are not eligible to use the FFB include the Federal Home Loan Banks (FHLB), the Federal Home Loan M ortgage Corpora tion, the Federal N ational Mortgage A ssociation (FNM A), and the three Farm C redit A d m in is tra tio n agencies—the Banks for Cooperatives, the Federal In termediate Credit Banks, and the Federal Land Banks. However, there is an excep tion to this prohibition. The obligations of a governm ent-sponsored agency can be purchased by the FFB if the obligations are guaranteed by a federal agency that is eligible to use the bank. Thus, obligations o f the Student Loan Marketing Associa tion (SLM A—a privately-owned, govern ment-sponsored agency) that are guaran teed by the Department o f Health, Educa tion, and W elfare (an executive depart ment defined as a federal agency) can be purchased by the FFB. The list o f federal agencies authorized to use the services o f the FFB is quite long. To date, these agencies have financed their activities by issuing their own obligations directly in financial markets or by guaranteeing the obligations o f private 10 b orrow ers or state and local governments. A m ong the better known federal agencies marketing direct obligations are the ExportIm port Bank (Eximbank), the T e n n e s s e e V a lle y A u th o r ity (TV A), the U. S. Postal Service, and the Small Business Adm inistra tion (SBA). The Eximbank and SBA also guarantee obligations o f private borrowers. Other federal agencies that guarantee obliga tions include the Maritime A d ministration, Department o f Hous in g and U rb a n Developm ent (H U D ), F a r m e rs H om e A d ministration (Fm HA), General Ser vices Adm inistration (GSA), and W ashington Metropolitan Area Transit Authority. The case for the FFB A t the end o f fiscal year 1973, outstanding federal and federallyassisted borrowing from the public amounted to $538.6 billion. This represented a net increase o f $44 billion in borrowing over the fiscal year. O f this $44 billion, $19 billion was direct Treasury borrow ing and I $10.7 billion w as governmentsponsored agency borrowing. The remaining $14.3billion, $0.3billion in direct federal agency borrowing and $14 b illio n in federal agency guaranteed borrowing, is now eligible for channeling through the FFB. It is estimated that federal agency direct plus guaranteed borrowing for fiscal years 1974 and 1975 will amount to $13.7 billion and $12.8 billion, respectively. Not all o f this anticipated borrow ing will be ac com plished through the credit markets, the primary concern o f the FFB. Some o f it, such as Federal Housing Adm inistration (FHA) guaranteed mortgages, will be fin a n ce d by lo c a l institutions. The Federal Reserve Bank of Chicago Principal federal agencies or programs eligible to use FFB Farmers Home Administration Export-Import Bank Maritime Administration Rural Electrification Administration Department of Housing and Urban Development Public housing Urban renewal New community debentures Government National Mortgage Association U. S. Postal Service Amtrak Rural Telephone Bank Small Business Administration U. S. Railway Association Department of Defense military credit sales General Services Administration Tennessee Valley Authority Environmental Financing Authority Overseas Private Investment Corporation Department of Health, Education, and Welfare Medical facilities Student Loan Marketing Association Washington Metropolitan Area Transit Authority Government-sponsored agencies not eligible to use FFB Banks for Cooperatives Federal Intermediate Credit Banks Federal Land Banks Federal Home Loan Banks Federal Home Loan Mortgage Corporation Federal National Mortgage Association Treasury estimates, however, that in the next year about $10 billion in new cash needs o f federal agencies will be financed in the credit markets. Also, another $10 billion will be needed for refinancing o f maturing issues. From January 1 through December 31, 1973, no fewer than 75 separate security offerings were m ade by federal agencies now authorized to use the FFB. The amount financed through any individual federal agency offering varied greatly, ranging from the over $500 million 11 Business Conditions, May 1 9 7 4 offerings o f the FmH A to the less than $20 million offerings o f various merchant marine bonds. Som e federal agencies were regular borrowers w hile others marketed debt only infrequently in 1973. TV A power notes and HUD-guaranteed public housing and ur ban renewal notes were auctioned each m onth; G S A participation sales cer tificates were issued only twice; S B A h a d but one direct debenture offering and guaranteed two Small Business Invest ment Com panies offerings. Interestingly, s e v e ra l fe d e ra l agencies which are authorized to borrow from the public, such as the U. S. Postal Service, the E n vironm ental F inancing Authority, and the Rural Telephone Bank, did not go into the credit markets even once in 1973. The varyin g characteristics o f the different federal agency securities have been a source o f confusion to market par ticipants for years. For example, TV A power notes and bonds carry no U. S. Governm ent guarantee; FmHA insured notes pay interest annually, in contrast to the g en era l practice o f semi-annual p a y m e n t s ; H U D -gu a ra n teed urban renewal notes are exempt from federal in com e taxes, whereas m ost other agency securities are not. The disparities inherent in the various federal agency offerings result in the agen cies paying higher interest rates than the Treasury does. Furthermore, each federal agency must cope with the problem o f tim ing its market financing with its credit needs under uncertain market conditions. For example, the newly-created SLM A postponed stock offerings twice during 1973 because o f unfavorable market con ditions. Instead, SLM A raised $200 mil lion by auctioning $100 million o f 182-day notes on two dates in October at a cost that w as $394,000 more per $200 million than the Treasury paid for six-month bills on the sam e dates. Similarly, in November, the Exim bank offered $300 million o f five- year debentures at a net interest cost to the agency o f 7.4 percent. Five-year Treasury notes were yielding 7.07 percent that day, im plying an alm ost $1 million per $300 million lower annual cost to the Treasury than to the Eximbank. How the FFB works The FFB operates under the general supervision and direction o f the Secretary o f the Treasury. The bank’ s policies are determined by a five-member board of directors, with the Secretary o f the Treasury chairing the board, and other members appointed by the President from officers or employees o f the FFB or another federal agency.1 The FFB can buy obligations that federal agencies until now have issued, sold, or guaranteed in the credit markets. This process transfers the myriad o f debt m anagem ent problem s from the agencies to the FFB, which itself has access to Treasury debt m anagem ent expertise, and consolidates the many agency issues un der one roof for distribution to the public. The FFB finances these purchases by selling its own obligations directly in the credit markets. Initially, outstanding FFB obligations up to $15 billion are author ized. In addition, the Secretary o f the Treasury m ay be required by the FFB to purchase up to $5 billion o f FFB obli ga tion s and the Secretary has dis cretionary authority to purchase more. It is expected that FFB obligations will be offered on a regular schedule to 'On May 6, 1974, President Nixon designated that the four board members would be whomever holds the positions of Deputy Treasury Secretary, Un dersecretary of the Treasury for Monetary Affairs, the Treasury Department’s General Counsel, and its Fiscal Assistant Secretary. On the same day, the President issued an executive order creating the Federal Financing Bank Advisory Council. The members of the Advisory Council include the Secretaries of the Treasury, Agriculture, Commerce, HEW, HUD, Transportation, the President of the Export-Import Bank, and the Postmaster General. 12 Federal Reserve Bank of Chicago The volume of borrowing eligible for FFB purchase has been growing rapidly billion dollars 700 outstanding debt held by public 600 - federal agency guaranteed direct federal agency 500 400 300 200 - I0 0 - 1968 '69 ‘70 *7! '72 fiscal years '73 '74* ‘ Estimate. SOURCE: Special Analyses, Budget of the U. S. Government, fiscal years 1969 to 1975. facilitate m arketing and investment plan ning. This principle already applies to Treasury obligations, with major refinanc ing required once in each calendar quarter. In s o fa r as possible, the authorizing legislation requires maturity structure con formity between FFB debt and assets. Since FFB assets will consist o f federal agency obligations with varying maturi ties, it is expected that, in time, short-, intermediate-, and long-term FFB obli gations will be marketed. The FFB is not expected to handle directly federal agency obligations fi nanced by local financial institutions such as the thousands o f individual F H A /V A guaranteed mortgages. However, the FFB could handle these guaranteed mortgages indirectly by purchasing the securities o f th e G o v e r n m e n t N a tio n a l M ortgage Association, which are participations in pools o f these guaranteed mortgages. For federal agencies selling their obligations to the FFB, neither their budget status nor their method o f budget accounting is affected by the authorizing legislation. The receipts and dis bursements o f the FFB itself are to be excluded from the U. S. Govern ment budget totals and are exempt from any statutory limitations on expenditures and net lending o f the United States. The funds raised by the FFB do not represent new federal debt, but merely replace funds that federal a g e n c ie s w ould h a v e ra ised themselves. Statutory limits on agency borrow ing authority and loan guarantee activity are un '75* affected by the creation o f the FFB. Certain agency obligations are themselves subject to the overall lim it on the public debt. To avoid duplication, FFB obligations will be exempt from that limit. Because incom e from state and local obligations is exempt from federal taxa tion, the coupon rate on these obligations is generally less than that on Treasury securities o f com parable maturity. When the FFB buys the obligations o f a local public body that are guaranteed by a federal agency, the authorizing act con tains a special provision to ensure that the borrow ing costs to the local public body are not increased. The cost to the local body will be the amount that the head o f the guaranteeing federal agency, in consulta tion with the Secretary o f the Treasury, es timates it would be i f the bank were not used. The guaranteeing federal agency, in turn, is authorized to make paym ents to the FFB from its appropriations to cover the differential. Business Conditions, May 1 9 7 4 While financing through the FFB is voluntary on the part o f authorized federal agencies, the ability to obtain financing when needed, independent o f market con ditions and at rates com parable to Treasury rates, should lure federal agen cies to the FFB. The FFB is expected to begin operations slowly, financing the credit needs o f the smaller, less wellknown, or newer federal agencies first. Characteristics of FFB obligations T he language o f the authorizing legislation does not state directly that FFB obligations are guaranteed by the United States. Legal precedent exists, however, for FFB obligations to be considered 13 general obligations o f the United States. The pertinent language o f the legislation says that (1) the FFB m ay require the Secretary o f the Treasury to purchase up to $5 billion o f its obligations, and (2) the Secretary is authorized to purchase any ad ditional am ount with the purchase o f such obligations being treated as public debt transactions o f the United States under the Second Liberty Bond Act. T his language is sim ilar to the E xim bank legislation that says the Secretary o f the Treasury is directed to purchase the obligations o f the Exim bank issued to him by the bank. The opinion o f the U. S. Attorney General was th a t these o b lig a tio n s are general obligations o f the United States backed by its full faith and credit, and that legal The FFB should smooth out irregular monthly patterns in federally-related borrowing billion dollars *Other than regular weekly and monthly bill offerings and Federal Reserve and government account exchanges. fBased on 75 major federal agency credit market offerings now eligible for FFB purchase. 14 Federal Reserve Bank of Chicago FFB obligations are like Treasury obligations in that they a re: • available in “ book entry,” registered, and bearer form; • eligible for Federal Reserve wire transfer at all Federal Reserve banks or branches; • exempt from state and local taxation to the sam e extent as Treasury securities; • lawful investm ents and acceptable as security for all fiduciary, trust, and public funds (including Treasury Tax and Loan accounts), the investment or deposit o f w hich is under the authority o f any officer o f the United States; • eligible as collateral Reserve bank advances; for Federal • eligible for Federal Reserve market purchases; open • payable as to principal and coupon in terest at Federal Reserve banks or at the Treasury; • payable by Treasury check for interest on registered securities; • e lig ib le fo r d en om in a tion a l ex changes, transfer, and interchanges among bearer, registered, and book en try form at Federal Reserve banks or at the Bureau o f Public Debt o f the Treasury;• • eligible for relief in the event o f loss, theft, or destruction in the same m anner as Treasury securities; • eligible for purchase by national banks without restriction; • eligible for investm ent by federal credit unions and small business invest ment companies; • countable as liquid assets by members o f the Federal Home Loan Bank System. holders o f these obligations “ have a c quired valid general obligations o f the United States, and are therefore in a posi tion to reach beyond Exim bank and its assets to the United States for source o f payment, if necessary.” Most o f the federal agency obligations which can be sold to the Federal F inancing Bank are either fully- or partially-guar anteed by the United States. N otable ex ceptions are TV A obligations and certain U. S. Postal Service obligations. Income from FFB obligations is ex empt from state and local taxes but subject to federal incom e taxes. This tax status is the same as that currently accorded in com e from Treasury securities and some federal agency obligations. Incom e from some federal agency obligations—such as those o f the Exim bank and FmH A —is sub ject to state and local taxation as well as federal taxation. Incom e from other federal agency obligations—such as HUDguaranteed public housing notes and bonds—is subject to state and local taxa tion but exempt from federal taxation. Purchases o f FFB obligations by national banks are not subject to the 10 percent o f capital stock limitation. This treatment is similar to that o f Treasury securities and some federal agency obli gations. The 10 percent limitation does apply to the obligations o f T V A and the U. S. Postal Service. Federal Reserve member banks may use FFB obligations as collateral for ad vances from the Federal Reserve System. Treasury securities and m ost federal agen cy obligations can also be used as col lateral. In addition, obligations o f the FFB, Treasury, and m ost federal agencies are lawful investments and acceptable as security for all fiduciary, trust, and public funds under the authority and control o f the United States, including Treasury Taut and Loan accounts. The types o f federal agency obligations that are not eligible for these collateral purposes are the individual 15 Business Conditions, May 1 9 7 4 m ortgages guaranteed by F H A or VA. FFB obligations can be purchased by the Federal Reserve in its open market operations. Technically, all direct and ful ly guaranteed obligations o f federal agen cies, as well as Treasury obligations, are eligible for open market purchases. Guide lines for open market operations in federal a g e n cy secu rities, however, prohibit purchases o f issues sm aller than $200 m illion for over five-year maturities and $300 m illion for shorter maturities, ruling out m any federal agency issues. FFB securities, like Treasury secu rities, are available in “ book entry,” registered, and bearer form, and eligible for Federal Reserve wire transfer. Current ly, m ost government-sponsored but very few federal agen cy securities are available in “ book entry” form and eligible for wire transfer. O nly U. S. Postal Service bonds a n d F m H A certificates o f beneficial ownership have these features. Submission of financing plans Because the FFB will be directed by the Secretary o f the Treasury, FFB financ in gs will be coordinated with direct Treasury debt m anagem ent operations. To further coordinate federal borrow ing, the legislation creating the FFB re quires federal agencies to submit their financing plans to the Secretary o f the Treasury for prior approval as to the method, source, timing, and terms and con ditions o f financing obligations issued or sold in credit markets. Prior approval is not required, however, for the financing plans o f obligations guaranteed by federal agencies, obligations o f Fm H A, nor obli gations o f TV A . A s with use o f the FFB, governm ent-sponsored agencies are also excluded from this submission provision. The FHLB and FN M A, however, are al ready required by law to obtain Treasury approval on certain aspects o f their market borrowings. While not required by law, the other privately-owned agencies have, as a matter o f practice, consulted with the Treasury on proposed borrowings. Once the required federal agencies have submitted their financing plans, the Secretary must approve them within 60 days unless market conditions are adverse; in such cases, the Secretary must submit a detailed explanation o f these conditions to Congress. In no case, however, can the approval be withheld for m ore than 120 days. The outlook for the FFB Rather than diverting funds away from any existing or yet-to-be-created fed era l credit program, the Federal Financing Bank provides a convenient and im m ediately-available source o f finan cing for these program s. Initially, at least, the larger, already market-established federal agencies are likely to be cautious in seeking financing through the new FFB. With characteristics so closely paralleling those o f Treasury securities, however, FFB obligations should find wide market accep tance at interest rates comparable to Treasury rates. Given time to demonstrate its debt m anagem ent capabilities, the FFB should be able to replace the plethora o f federal agency obligations now competing with one anotherin the creditmarkets with its ow n high-quality obligations. While the FFB is not a panacea for federal agency financing problems, the benefits to be derived from centralizing federal agency borrow ing could prove to be significant. A nne M arie Laporte
@FedFRASER