Full text of Business Review (Federal Reserve Bank of Philadelphia) : July/August 1982

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JULY-AUGUST 1982

&
Implementinq
the
monetary
Control
Act
in a Troubled
Environment
for Th rifts




Interest Rates:
How fTluch
Does
Expected Inflation
matter f

JULY/AUGUST 1982

INTEREST RATES:
HOW MUCH
DOES EXPECTED INFLATION MATTER?
H erbert Taylor

. . . Interest rates should move with
inflation rates, but perhaps not point for
point.
IMPLEMENTING
THE MONETARY CONTROL ACT
IN A TROUBLED ENVIRONMENT
FOR THRIFTS

Janice M. M oulton
Federal Reserve Bank of Philadelphia

100 N orth S ix th S treet
Philadelphia, P e n n sy lv an ia 19106

The BUSINESS REVIEW is published by
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*

*

*

*

*

The Federal Reserve Bank of Philadelphia
is part of the Federal Reserve System —a




. . . Thrifts have impacted the implem enta­
tion of the MCA at the discount window
and in merger analysis.

System which includes twelve regional banks
located around the nation as well as the
Board of Governors in W ashington. The
Federal Reserve System w as established by
Congress in 1913 prim arily to manage the
nation’s m onetary affairs. Supporting func­
tions include clearing checks, providing coin
and currency to the banking system, acting
as banker for the Federal government, super­
vising commercial banks, and enforcing
consumer credit protection laws. In keeping
with the Federal Reserve Act, the System is
an agency of the Congress, independent
adm inistratively of the Executive Branch,
and insulated from partisan political pres­
sures. The Federal Reserve is self supporting
and regularly m akes paym ents to the United
States Treasury from its operating surpluses.

FEDERAL RESERVE BANK OF PHILADELPHIA

Interest Rates:
How Much
Does Expected Inflation Matter?
by Herbert Taylof
tion would decline from, say, 10 percent to 6
percent next year, interest rates on one-year
securities would drop by four percentage
points. But m any analysts suspect that the
relation of inflation expectations to interest
rates is not that simple. Some argue that any
change in the expected inflation rate works
through the Federal income tax structure to
change interest rates by even more. Others
m aintain that business taxes and other eco­
nomic forces blunt the impact of inflation
expectations on interest rates so that the
change in interest rates is smaller than the
change in the expected inflation rate.
Economists have examined the link be­
tween interest rates and expected future infla­
tion using many different methods, and their
estimates of interest rates’ responsiveness to
changes in the expected rate of inflation vary.
On balance, though, the evidence suggests
that interest rates rise and fall by somewhat
less than changes in the expected inflation
rate.

Many business analysts blame today’s high
interest rates on the public’s anticipation of
continued high inflation. Policymakers seem
to share this view. The Reagan Administration
contends that once people realize that its
programs will reduce inflation, interest rates
will drop. The Federal Reserve argues that its
restrictive m onetary policy will ultimately
lower interest rates by demonstrating the Fed’s
resolve to m aintain noninflationary money
growth in the future. W hat is the nature of
the link betw een interest rates and expected
inflation? Is a decline in the expected rate of
inflation likely to produce substantial reduc­
tions in interest rates?
According to one popular rule of thumb,
m arket interest rates respond point for point
to changes in the expected rate of inflation.
So if everyone became convinced that infla4

‘Herbert Taylor received his Ph.D. from Temple
University. He specializes in macroeconomic policy.




3

BUSINESS REVIEW

JULY/AUGUST 1982

INTEREST RATES HAVE BEEN RISING STEADILY . . .
Percent

1960

1970

1980

SOURCE: Average six-month-ahead CPI inflation forecast from the Livingston Surveys, compiled at the Federal
Reserve Bank of Philadelphia.

TIONS). The six-month Treasury bill rate
has been more volatile than Livingston’s ex­
pected inflation measure, but the two have
risen together over the last 20 years, i
The evidence suggests that changes in
inflation expectations are at least partly
responsible for movements in interest rates.
But economists have used the tools of eco­
nomic theory and statistical analysis to assess
this linkage more precisely. In doing so, they
have built upon the work of Irving Fisher, an
American economist of the early twentieth
century. Fisher clarified the basic link of
interest rates to inflation expectations by
distinguishing nom inal from real rates of
interest. 2

RECENT EXPERIENCE

Interest rates have been rising steadily since
the late 1950s. Though both long-term and
short-term rates have declined during reces­
sions (see INTEREST RATES . . .), each
subsequent expansion has carried them to
still higher levels. Economists have often
attributed the secular rise in interest rates to
rising inflation expectations. Confirming the
influence of inflation expectations on interest
rates is difficult because the public’s expecta­
tions are not directly observed. But available
data do support a direct relation between
interest rates and expected inflation: interest
rates have risen in tandem w ith m easures of
expected inflation.
One widely used m easure of the expected
rate of future inflation is provided by Joseph
A. Livingston, business columnist for the
Philadelphia Inquirer. Every June and
December, Livingston surveys a group of
about 50 economists for their forecasts of
inflation. The average of economists’ sixm onth-ahead inflation forecasts shows a
close correlation w ith the average interest
rate on six-month Treasury bills for the survey
month (see . . . INFLATION EXPECTA­




NOMINAL AND REAL RATES

Almost everybody borrows at one time or
another. W hen consumers buy new homes,
they borrow the money by taking mortgages.
-'■The simple correlation between the six-month
Treasury bill rate and Livingston’s six-month-ahead
inflation forecast is 0.9.
2This discussion of Fisher is based on his book, The
Theory o f Interest, New York: Macmillan, 1930.
4

FEDERAL RESERVE BANK OF PHILADELPHIA

. . . ALONG WITH INFLATION EXPECTATIONS*
Percent

‘ Shaded areas indicate recessions.

W hen a business decides to purchase more
modern equipment, it may issue notes or
bonds to raise the money. W hen the Federal
governm ent’s expenses outrun its tax reve­
nues, the Treasury obtains the funds by selling
securities.
Financial instrum ents such as Treasury
bonds, commercial paper, and home mort­
gages are evidences of loans to the issuers of
the securities. The borrower agrees to pay
specified amounts of money later in exchange
for use of the lender’s money today. The nomi­
nal, or m arket, interest rate on these instru­
ments states the rate at which the borrower
must pay future dollars to get the current
dollars. For instance, a corporation marketing
one-year notes w ith a 15-percent interest rate
is agreeing to pay $115 after one year for
every $100 that the note-buying public lends
it now.
But people are not as concerned about dol­
lars, present or future, as they are about the
goods and services those dollars command.
Inflation erodes the purchasing power of
money. Each percentage point of inflation
m eans one percentage point less in goods and
services that lenders will be able to purchase




when a loan bearing a particular nominal
interest rate matures. Consequently, lenders
consider not only an asset’s nominal rate of
interest, but also the rate of inflation likely to
prevail over the loan’s term to maturity.
Fisher put the m atter succinctly. He said
that, in evaluating a loan, people do not con­
sider the nominal rate of interest—the rate at
which current and future dollars are ex­
changed. They consider the expected real
rate of interest—the rate at which they expect
to exchange current for future goods and
services. The nominal rate of interest that an
asset promises can be decomposed into the
real rate of interest lenders expect plus an
adjustment for the rate of inflation they expect
over the asset’s term to maturity: 3
nominal
rate
of interest

=

expected
real rate
of interest

+

expected
future rate
of inflation

If, for example, everyone expects 10-percent
annual inflation, then the corporation’s 153This breakdown of an instrument’s nominal return
allows for the impact of inflation on the value of the
principal but not on the value of the interest. To be
5

BUSINESS REVIEW

JULY/AUGUST 1982

percent one-year notes carry an expected
real interest rate of 5 percent. Both the bor­
rowing business and the lending public view
the notes as offering roughly the same
opportunity to exchange present for future
goods as would notes with a 5-percent
nominal interest rate were no inflation
expected.

real rate at which the $400 billion will be
exchanged.
What happens when inflation expectations
change? Suppose that the public suddenly
anticipates a decline in the future rate of
inflation from 10 percent to 9 percent. If the
nominal rate stays at 15 percent, the expected
real rate of interest on loans jumps from 5
percent to 6 percent. At a 6-percent expected
real rate, lenders would w ant to lend more
than $400 billion, but borrowers would want
to take down less than they did at 5 percent.
The excess supply of loanable funds puts
downward pressure on the nominal rate of
interest. In order to make loans, some
potential lenders accepted lower interest rates
and nominal rates begin to slip below 15 per­
cent. If the change in inflation expectations
has not changed people’s willingness to bor­
row and lend $400 billion at the 5-percent ex­
pected real interest rate, then the nominal rate
settles at 14 percent. This restores the
expected real rate to 5 percent (14 percent
minus 9 percent) and eliminates the excess
supply of loanable funds. Generally, any
change in the expected rate of future infla­
tion would result in an equal change in the
current nominal interest rate, provided the

Fisher’s argum ent underlies the view that

nominal interest rates adjust point for point
to changes in the expected rate of inflation.
For when the public revises its inflation
expectations, only an identical revision in
prevailing nominal interest rates can pre­
serve the expected real interest rate. And
financial m arkets work to preserve the
expected real interest rate, provided that the
revised inflation expectations affect neither
the willingness to borrow nor the willingness
to lend at that expected real rate.
THE MARKET-CLEARING REAL RATE

The role of the financial m arkets is to settle
on the expected real rate of interest at which
the amount that savers are willing to lend is
exactly equal to the amount that investors
find worthwhile to borrow. Economists call
this rate the m arket-clearing expected real
rate of interest. The nom inal rate of interest
at which the loans are actually made, in turn,
reflects this m arket-clearing real rate and the
expected rate of inflation. For example,
suppose that at an expected real rate of 5
percent savers are willing to lend, and
investors are willing to borrow, $400 billion.
If inflation is expected to run at 10 percent,
the nominal interest rate will settle at 15 per­
cent. This establishes the 5-percent expected

market-clearing expected real interest rate

remains the same.
What complicates the relationship between
nominal interest rates and inflation expecta­
tions is that when inflation expectations
change, the m arket-clearing expected real
interest rate is not likely to remain un­
changed. People’s willingness to borrow and
lend at any particular expected real interest
rate depends on m any factors, such as savers’
income and wealth, the potential productivity
of investment projects, taxes, and uncertainty.
If a change in expected inflation were to alter
any of these factors, the expected real rate
which at first had equated the supply and
demand for loanable funds might no longer
do so. The expected real rate would have to
change in order to reestablish consistency
between the plans of borrowers and lenders.

precise, a $1 security bearing nominal rate n over a time
when the inflation rate is expected to be pe has an ex­
pected real return of re where
1 + r e =(1 +n)/(l + p e).
This can be rearranged to
n = r e +, p e +, r e p e.
Since the product of two rate terms is relatively small, re pe
is usually dropped.




6

FEDERAL RESERVE BANK OF PHILADELPHIA

Nominal interest rates would then have to
adjust both for the change in expected infla­
tion itself and for the movement in the marketclearing expected real rate that it induced. So
nom inal interest rates would no longer move
one for one w ith changes in the expected
inflation rate.
Since Fisher's early work, economists have
discerned several channels through which a
change in the expected rate of inflation affects
the m arket-clearing expected real rate of
interest. They have found that a change in
the expected rate of inflation alters economic
agents’ willingness to borrow and lend at the
original expected real rate, both because the
change in expectations leads to changes in
savers’ income and w ealth and because of tax
laws. 4
Changes in Income and Wealth. When
the public’s inflation expectations change,
economic factors other than interest rates
also adjust. Several economists have investi­
gated how these adjustments could ultimately
influence people’s income and wealth, there­

by affecting the expected real rate of interest. 5
They have shown that if a decrease in the
expected rate of inflation were to lower real
income or raise real (inflation-adjusted)
wealth, the m arket-clearing expected real
interest rate would rise. Nominal rates, there­
fore, would wind up falling by less than the
decrease in expected inflation.
How do these income and w ealth effects
arise? Initially, a percentage point decline in
the expected rate of inflation increases the
expected real rate of interest associated with
the original nominal rate. Savers are suddenly
willing to lend more funds than investors
w ant to borrow. In the financial market
example, the nom inal interest rate was the
only variable that changed. Thus, the
nominal interest rate had to decline by a full
percentage point to restore the original
m arket-clearing expected real rate and close
the gap betw een the amount of funds de­
manded and supplied. But a change in infla­
tion expectations also opens up a gap be­
tween the volume of goods and services
demanded and supplied at the original
interest rate. Depending on how the economy
adjusts to close this gap, there could be
changes in other determ inants of borrowing
and lending.
W hen anticipated inflation dips and the

i n this section, and throughout the article, the impact
of changes in the expected future rate of inflation is
discussed without any explanation of what changes
people’s inflation expectations. Two important issues
should be mentioned in this regard.
First, people consider a diverse set of factors when
they try to predict future inflation. Among these factors,
the expected future course of monetary and fiscal policy
is likely to play an important role in people’s forecasts.
The current stance of government economic policy, in
turn, is likely to provide them a strong signal about the
future direction of that policy. But the precise linkage
between current policy actions and expected future infla­
tion is not examined here.
Second, current policy actions do not affect current
interest rates only by affecting inflation expectations.
Shifts in policy can affect the market-clearing real inter­
est rate, too, by altering the desired amount of private
borrowing and lending at any particular real rate of
interest. A complete analysis of the impact of monetary
and fiscal policy on interest rates requires an analysis of
policies’ direct effects on interest rates as well as their
expectations-related effects. Only the expectationsrelated changes in nominal rates are discussed here.




5The possibility of a wealth effect on expected real
rates of interest was demonstrated by Robert A. Mundell,
“Inflation and Real Interest,” Journal of Political
Econom y 71 (June 1963), pp. 280-283. The conditions
under which an income effect could arise have been
clearly laid out by Thomas J. Sargent. See Thomas J.
Sargent, “Rational Expectations, the Real Rate of Inter­
est, and the Natural Rate of Unemployment,” Brookings
Papers on Economic Activity (1973:3), pp. 429-472,
especially pp. 430 and 437-438; and also see “Anticipated
Inflation and the Nominal Rate of Interest,” Quarterly
Journal of Economics86 (May 1972), pp. 212-225, espe­
cially pp. 220-225. The process of adjustment of the
economy to a change in expected inflation is also dis­
cussed in Martin J. Bailey, National Incom e and the
Price Level: A Study in M acrotheory, second edition
(New York: McGraw-Hill, 1971), especially pp. 74-82.
7

JULY/AUGUST 1982

BUSINESS REVIEW

quently, the expected real rate of interest
need not drop back to its original level in
order to choke off the excess supply of
loanable funds. A higher expected real rate
of interest now clears the m arket. Therefore,
nominal interest rates decline by less than the
drop in the expected inflation rate.
Of course, w hen faced w ith a drop in
demand for their products, businesses could
choose to m aintain their output of goods and
services by lowering prices or, at least, by
reducing the rate at which their prices
increase. Indeed, this is the response econo­
mists predict more businesses would make in
the long run, once they have had a chance to
adjust to a less inflationary environment. At
that point, the reduction in expected inflation
would leave real output, and hence real
income, relatively unchanged, so the income
effect would be smaller. But there could be a
wealth effect on interest rates associated with
the decline in actual inflation.
Lower prices for goods and services
increase the purchasing pow er of money
and, therefore, may make people already
holding money in their portfolios feel sub­
stantially wealthier. The greater an individ­
ual’s wealth, the less incentive he has to
accumulate still more by buying securities or
making loans. So increased wealth, like
decreased income, reduces the supply of
loanable funds at any expected real rate of
interest. And the reduced supply of funds
raises the m arket-clearing expected real
interest rate. If the wealth effect is significant,
a decline in the expected rate of inflation
would be associated with a rise in the prevailing
expected real rate of interest even if real
income did not change. So nominal rates still
would fall by less than the expected rate of
inflation does.
In sum, a decline in the expected rate of
inflation, to the extent that it reduces income
or raises real wealth, tends to increase the
market-clearing expected real rate of interest.
With the expected real interest rate rising as
the expected inflation rate falls, the nominal

expected real rate rises at first, households
want to increase their net supply of loanable
funds; they would do that by economizing on
their own purchases of goods and services.
At the higher expected real interest rate,
businesses w ant to cut back on their demand
for funds, so they trim their expansion plans
and, likewise, purchase few er goods and
services. In short, when the expected inflation
rate falls, the excess supply of loanable
funds at current nom inal interest rates is
accompanied by an excess supply of both
consumption and investment items at current
levels of output. Just as the excess supply of
loanable funds puts dow nw ard pressure on
interest rates, the excess supply of goods and
services puts downward pressure on the out­
put and prices of those goods and services.
Suppliers of goods and services must choose
between selling less of their products and
lowering the prices they charge for them . 6
M any economists argue that, at least in the
short run, businesses tend to stand their
ground on prices and cut their output.
W orkers’ hours are shortened, overtime is
eliminated, and if sales decline enough, some
workers are laid off. Production facilities are
used less intensively as second or third shifts
are dropped, and perhaps some plants are
shut down completely. As a result, the
purchasing power that flows from businesses
to households in the form of wages, rents,
and profits falls. Faced w ith a reduction in
income and unwilling to reduce current con­
sumption by an equal amount, households
reduce saving. In other words, they make
smaller amounts of funds available for loans
at any expected real rate of interest. Conse®The precise combination in which nominal interest
rates, the prices of goods and services, and the output of
goods and services adjust to changes in the expected
inflation rate also depends on how economic agents
decide how much of their funds to hold in the form of
money. For either the income or wealth effects to occur,
the public’s demand for money must be sensitive to
nominal interest rates. We assume that this is the case
here.




8

FEDERAL RESERVE BANK OF PHILADELPHIA

interest rate—the sum of the tw o—winds up
declining less than point for point with
expected inflation.
The Tax Angle. In this era of supply-side
economics we routinely hear about the
complicated maze of economic incentives
and disincentives that the Federal tax code
creates. So it comes as little surprise that
changes in expected inflation work through
the tax structure to alter the decisions of bor­
rowers and lenders. But sorting out the role
of taxes is no simple task. Different provi­
sions of the tax system have contrary effects
on the relation of interest rates to expected
inflation. While Federal tax treatm ent of
interest income and expenses tends to amplify
the impact of changes in inflation expecta­
tions on nom inal interest rates, for example,
the tax treatm ent of depreciation on business
plant and equipm ent tends to dampen this
impact.
Because interest income is taxed, lenders
are concerned about the expected real rate of
interest after taxes.7 But when the expected
rate of inflation rises, an equal increase in
the nom inal rate preserves only the before­
tax expected real rate of interest. That
increase will not be sufficient to preserve the
expected real rate of interest after taxes
because part of the increase in the nominal
interest income will be taxed away. The
nom inal rate would have to rise by more than
any increase in expected inflation to keep the
after-tax real rate unchanged. Conversely,
w hen the expected rate of inflation falls, an
equal decrease in nominal rates would
preserve the lender’s expected real rate of
interest before taxes. Nominal rates would
have to fall by more than the drop in expected
inflation to keep the after-tax real rate un­
changed. In other words, lenders have to lose

in interest w hat they gain in smaller tax
liabilities if their expected after-tax real rate
is to rem ain the same w hen expected infla­
tions falls (see INFLATION AND THE
AFTER-TAX REAL RATE OF INTEREST
overleaf).
To summarize: taxes on lenders’ interest
incomes tend to amplify the size of changes
in nominal rates associated w ith changes in
expected inflation. 8
Other tax laws, particularly those con­
cerning depreciation, dampen nominal rates’
response to changes in expected inflation,
however. Historical cost depreciation rules
reduce businesses’ incentives to invest and,
hence, tend to depress expected real interest
rates when the expected rate of inflation
rises.
A profit-seeking business undertakes only
those investment projects where the after­
tax real returns are expected to exceed the
after-tax real rate of interest it must pay for
financing. Increases in the expected inflation
8Of course, what the expected real rate and the volume
of lending will be when expectations change also de­
pends on how borrowers are affected. But the income
tax effects on borrowers complement those on lenders.
The interest that lenders count as taxable income, bor­
rowers count as a tax-deductible expense. So if, for
example, borrowers and lenders are subject to the same
tax rate, the after-tax real rate of interest that lenders
earn is equal to the after-tax real interest rate that bor­
rowers pay. In that case, when the expected inflation
rate rises, borrowers are willing to pay the more than
proportionate increase in nominal rates that lenders
require to maintain their original level of lending. When
the expected rate of inflation falls, lenders are willing to
accept precisely the lower expected real rate that bor­
rowers require to maintain their original level of bor­
rowing. If borrowers and lenders are subject to different
tax rates, then, whatever the expected before-tax real
rate of interest, each faces a different expected after-tax
real rate. Nonetheless, the tax provisions for interest
income and expense allow borrowers to pay a higher real
rate of interest when expected inflation rises and allow
lenders to accept a lower real rate when expected infla­
tion declines.
For a detailed discussion, see Niels Christian Nielson,
“Inflation and Taxation,” Journal o f Mo netary Econom­
ics 7 (1981), pp. 261-270.

7The importance of the distinction between savers’
expected real rate of interest before and after taxes was
emphasized by Michael Darby, “The Financial and Tax
Effects of Monetary Policy on Interest Rates,” Economic
Inquiry85 (June 1975), pp. 266-276.




9

JULY/AUGUST 1982

BUSINESS REVIEW

rate work through depreciation laws to reduce
the after-tax real return expected on each
potential investm ent project (see INFLA­
TION AND DEPRECIATION]. That lower
expected after-tax return reduces the incen­
tive to finance the acquisition of new plant
and equipment by borrowing at any particu­
lar expected real rate of interest. And the
reduced willingness to borrow puts down­
ward pressure on the m arket-clearing
expected real rate of interest. With the
expected inflation rate higher but the pre­
vailing expected real rate lowered by the
decreased demand for funds, nominal interest

rates wind up rising by less than the expected
rate of inflation. Conversely, a decrease in
expected inflation raises the after-tax real
return on investments through this deprecia­
tion channel. This, in turn, increases busi­
nesses’ willingness to borrow and raises the
market-clearing real rate. As a result,
nominal interest rates fall by less than the
decline in the expected rate of inflation. 9
^Some of the ways in which inflation affects invest­
ment via tax rules are discussed by Richard W. Kopcke,
“Why Interest Rates Are So Low,” New England Eco­
nomic Review, July/August 1980, pp. 24-33.

INFLATION AND THE AFTER-TAX REAL RATE
OF INTEREST
Since nominal interest income is taxed, a lender’s expected real rate of interest after taxes is
roughly
expected
real rate
of interest
after taxes

=

(1 - tax rate]

X

nominal
rate of
interest

expected
rate of
inflation

where the tax rate is the percentage of his income that he would have to pay in taxes.* Consider the
individual earning 15-percent nominal interest on a loan and anticipating 10-percent inflation, so
that he expects to earn a 5-percent real rate before taxes. If he is in the 20-percent tax bracket, his
expected real return after taxes is 2 percent [=(1 - .2) x 15 percent - 1 0 percent].
Suppose that his view of the future changes and he expects 11-percent rather than 10-percent
inflation. Now a loan bearing a 16-percent nominal interest rate would offer him the same 5-percent
expected real rate before taxes but it would provide only 1.8-percent [= (1 - .2) x 16 percent - 11
percent] after taxes. In order to maintain his original 2-percent after-tax real return, the individual
would have to make a loan with a 16.25-percent nominal interest rate.
On the other hand, suppose that the individual’s inflation expectations fall and he anticipates 9percent rather than 10-percent inflation. A loan with a 14-percent nominal yield would offer him the
same 5-percent expected before-tax real return that a 15-percent nominal yield did previously, but it
would offer a higher real return after taxes at 2.2 percent [=(1 - .2] x 14 percent - 9 percent]. In fact,
this saver could settle for a loan bearing only a 13.75-percent nominal yield, and still maintain his
original expected after-tax real rate of interest at 2 percent [ = (1 - .2) x 13.75 percent - 9 percent].
In short, maintaining expected after-tax real interest rates in the face of changing inflation
expectations requires more than equal changes in nominal interest rates.
’When deciding on the purchase of an asset, the lender must consider his marginal tax rate, that is, the
additional tax liability as a percentage of the additional interest income. How much of his interest income a
taxpayer must surrender at the margin depends upon the precise source of the income and his overall income
level, among other factors. The present discussion assumes that the saver does not expect inflation to alter his
marginal tax rate. In reality, of course, higher inflation raises nominal income and hence pushes people into
higher tax brackets. Allowing for so-called bracket creep would only reinforce the argument presented here.




10

FEDERAL RESERVE BANK OF PHILADELPHIA

INFLATION
AND DEPRECIATION
The firm’s net return from an investment project is the increased sales revenue that it generates less
the increased production costs it creates. The net real revenues from the project would not be
affected by a general inflation; both sale and production costs would rise at the same rate. Theoreti­
cally, with a fixed tax rate, real net revenues after taxes would not be affected either; both the portion
of net revenue paid in taxes and the portion left after taxes would grow at the rate of inflation. But, in
fact, inflation does reduce real net revenues after taxes because the depreciation laws preclude the
firm from fully adjusting its production costs for inflation when computing its tax bill.
As a piece of capital— such as a new machine, a new truck, a new plant— is being used, its ability to
produce is being run down (depreciated) and, ultimately, will be exhausted. The cost to the firm of
using up the capital’s stream of productive services is the price it will have to pay to replace the
capital when it has worn out completely. But in computing its taxable income, the business is
allowed to deduct an amount based on the original purchase price of the capital. If inflation is high over
the course of the capital’s useful life, its replacement cost will be high relative to its original or
historical purchase price, so the taxable income from the project will be overstated and the project’s
after-tax real return will be cut. If inflation is low, capital’s replacement cost will be closer to its
historical purchase price and depreciation rules will not distort after-tax real return as much. So, the
higher the rate of inflation a business expects, the lower the after-tax real rate of return it expects on
any particular project, and, consequently, the lower the expected after-tax real rate of interest it is
willing to pay for financing.

most empirical studies, the latter set of forces
dominates.
Economists have made m any attempts to
estimate just how much of an impact changes
in the expected inflation rate have on interest
rates. Some investigators have found that
inflation expectations have a substantial im­
pact. For example, a 1979 study by John
Carlson suggests that each percentage point
change in the expected rate of inflation alters
nominal interest rates by as much as 1.3
percentage points. In a 1975 study, Eugene
Fama found that nom inal rates respond point
for point to changes in inflation expectations.
Most often, though, analysts have found that
nominal interest rates respond less than point
for point to changes in the expected rate of
inflation. According to investigations by Tanzi,
by Yohe and Karnosky, and by Anderson and
others, for example, each percentage-point
change in the expected inflation rate gener­
ates a change in nom inal rates between .8
and .9 of a percentage point. Benjamin
Friedman reports in a 1980 study that a
percentage-point change in expected inflation

In short, historical cost depreciation rules
for tax computations tend to push expected
inflation and the m arket-clearing expected
interest rate in opposite directions. So depre­
ciation rules, by themselves, imply less than
a point-for-point adjustment of nominal rates
to changes in expected inflation. On balance,
the tax system may, as some argue, foster a
more than point-for-point response of
nominal rates to changes in expected infla­
tion. Because of depreciation rules, however,
the response is not as great as the income tax
rules alone imply.
HOW MUCH INFLUENCE
DO INFLATION EXPECTATIONS
HAVE ON INTEREST RATES?

W hen the public expects a decline in the
future rate of inflation, Federal income tax
provisions work toward a more than equal
reduction in nom inal rates. On the other
hand, income and w ealth effects and the tax
laws concerning depreciation work toward
less than equal reduction in nominal interest
rates. W hat is the net result? According to




li

JULY/AUGUST 1982

BUSINESS REVIEW

produces as little as a .65 percentage-point
change in nom inal interest rates. 10
These findings support the view that when
the expected rate of inflation changes, the
income, wealth, and depreciation effects of
the change dominate the income tax effects,
and, as a result, the expected real rate of
interest changes in the opposite direction. So
when the expected rate of inflation falls, the
expected real rate of interest rises at least for
a while. The nom inal rate, the sum of the
expected real interest rate and the expected
inflation rate, falls, but not by as much as
expected inflation.

inflation have been building up for 20 years
and may not change quickly. Moreover, policy
actions do not affect interest rates only by
affecting inflation expectations. M onetary
and fiscal policy can directly affect the
market-clearing real interest rate, too. In fact,
many argue that the current mix of fiscal and
m onetary policies, while intended to lower
inflation and inflation expectations over the
long run, has driven up m arket-clearing real
interest rates, at least in the short run.
Nonetheless, both economic theory and
statistical evidence give reason to believe
that interest rates are closely related to infla­
tion expectations. W hen the expected rate of
inflation is revised downward by a percentage
point, interest rates should fall by nearly a
percentage point. So if the public comes to
expect inflation of 5 percent instead of 10
percent—and if other factors do not drive up
real interest rates—nominal interest rates
should decline by about 4 or 41/2 percentage
points. Compared to the level of interest rates
in 1981 and early 1982, that would be a
welcome change.

CONCLUSION

Everyone would like to see lower interest
rates. Both the A dm inistration and the Fed­
eral Reserve have attem pted to formulate
policies which will reduce current inflation
and hence people’s expectations about future
inflation. Lower inflation expectations, it is
hoped, will m ean lower interest rates.
The path to lower interest rates is not neces­
sarily short or direct. Expectations of high

Benjamin M. Friedman, “Price Inflation, Portfolio
Choice, and Nominal Interest Rates,” American Eco­
nomic Review70 (March 1980), pp. 32-48.
Vito Tanzi, “Inflationary Expectations, Economic
Activity, Taxes and Interest Rates,” American Econom­
ic Review70 (March 1980), pp. 12-21.
William P. Yohe and Denis S. Karnosky, “Interest
Rates and Price Level Changes, 1952-1969,” Review,
Federal Reserve Bank of St. Louis, December 1969, pp.
18-39.

^References in this section are to:
Paul A. Anderson, Thomas Sargent, and Carol
Thistlethwaite, “The Response of Interest Rates to
Expected Inflation in the MPS Model,” Journal o f Mone­
tary Econom ics 1 (1975), pp. 111-115.
John A. Carlson, “Expected Inflation and Interest
Rates,” Econom ic Inquiry 89 (October 1979), pp. 597608.
Eugene F. Fama, "Short-Term Interest Rates as Pre­
dictions of Inflation,” American Econom ic Review 65
(June 1975), pp. 269-282.




12

FEDERAL RESERVE BANK OF PHILADELPHIA

Implementing
the Monetary Control Act
in a Troubled Environment for Thrifts
by Janice M. Moulton*
passed by Congress in M arch 1980. This
legislation had several broad objectives,
which included improving the Fed’s monetary
control procedures, expanding thrift institu­
tion powers, and opening the financial
markets to more competition. The latter two
considerations, in particular, have raised
some interesting im plem entation issues.
The MCA became law during a period of
sustained high interest rates and fast­
changing financial markets. These develop­
ments were quite troublesome for thrift
institutions, especially savings and loan
associations and m utual savings banks.
Indeed, the plight of the thrifts has had a
noticeable impact on the Fed’s implementa­
tion of certain aspects of the MCA.
There are two broad areas—discount
window access and mergers among financial

Since the Federal Reserve was created in
1913, it has been a major regulatory and
supervisory body of the banking system. In
this role, the Fed has helped to assure the
safety and soundness of the banking system
by lending to institutions with liquidity needs
and by regulating merger activity in banking
markets.
The Fed’s traditional role in lending and
regulation has been altered, however, by the
Depository Institutions Deregulation and
M onetary Control Act (MCA) which was
*IaniceM. Moulton, who formerly wrote as Janice M.
Westerfield, is a Research Officer and Economist in the
Philadelphia Fed’s Department of Research, where she
heads the Banking and Financial Markets section. She
received her Ph.D. from the University of
Pennsylvania.




13

JULY/AUGUST 1982

BUSINESS REVIEW

tion in which transactions accounts or nonpersonal time deposits are held shall be
entitled to the same discount and borrowing
privileges as member banks.” Moreover, the
Fed is to “take into consideration the special
needs of savings and other depository institu­
tions for access to discount and borrowing
privileges consistent w ith their long-term
asset portfolios and the sensitivity of such
institutions to trends in the national money
m arkets.” In other words, the Fed is directed
to open its discount window to nonmember
depository institutions on the same basis as
to member banks.23Further, the thrifts appear
to be singled out by the language of MCA as
eligible for longer term borrowing from the
Fed.
Current Status Report. The Fed has refor­
mulated discount window guidelines to allow
thrift access to its various programs: adjust­
ment credit, seasonal credit, and other ex­
tended credit (including special assistance).
To date, most thrift borrowing has been
focused in the last program. 3
Short-term credit (adjustment credit) has
traditionally encompassed the bulk of dis­
count window borrowing. The district
Reserve banks can grant adjustment credit at
their discretion to a bank or thrift which tem­
porarily does not have access to its usual
source of funds. 4 In the August-March period,

institutions—where the problems of the
thrifts have been particularly relevant to the
Fed’s post-MCA decisions, i The MCA
opened the discount w indow to all deposi­
tory institutions—commercial banks, savings
and loans, m utual savings banks, and credit
unions—that m aintain reserves at the Fed,
and the Fed has established a new extended
credit program for longer term loans to
financially troubled institutions. The finan­
cial weakness of the thrifts has raised some
tough issues concerning the administration
of the Fed’s lending program. In the merger
area, the Fed has been forced to rethink the
question of the extent of competition between
banks and thrifts. The MCA allowed ex­
panded powers for the thrifts, making them
more like commercial banks. At the same
time, the financial problems of the thrifts
have resulted in a spate of thrift mergers.
While the question of bank holding company
acquisition of thrifts would have inevitably
surfaced in light of the MCA, the sense of
urgency surrounding the difficulties in the
thrift industry forced the Fed to face the
bank-thrift merger question in short order.
AN EXPANDED
LENDING RELATIONSHIP
AT THE DISCOUNT WINDOW

The Federal Reserve has a long history of
lending to member commercial banks. The
Fed extends assistance, possibly for an
extended period of time, w hen a commercial
bank finds that its usual sources of funds are
not available. Under the MCA, borrowing
privileges have been extended as well to nonmember commercial banks (CBs), savings
and loans (S&Ls), m utual savings banks
(MSBs), and credit unions (CUs). The relevant
provision states that “any depository institu-

2 See page 1 of “The Federal Reserve Discount
Window,” published by the Board of Governors of the
Federal Reserve System in October 1980.1would like to
thank Bill Stone, Vice President and Lending Officer,
and Bernie Beck, Manager, Credit, at the Philadelphia
Fed for helpful discussions on the discount window.
3The official language used in the pamphlet “The
Federal Reserve Discount Window” labels the programs
as follows: (a) short-term adjustment credit and (b) ex­
tended credit, including (lj seasonal credit and (2) other
extended credit (special assistance to a particular
depository institution and “other extended credit” to a
class of institutions).
^Guidelines for adjustment credit state that appropriate
reasons for borrowing include an unexpected loss of
deposits, a surge of credit demands, or a shortfall in

1Another major area of the MCA—Fed pricing and
provision of services—was less affected by the troubled
financial environment and is not covered in this
article.




14

FEDERAL RESERVE BANK OF PHILADELPHIA

Home Loan Bank in Pittsburgh before
approaching the Philadelphia Fed’s discount
window. But if the S&L needs funds on short
notice and cannot gain access to the FHLB in
timely fashion, the Fed may grant credit on a
tem porary basis. The Fed would expect to be
repaid the next business day once the institu­
tion again has access to its usual sources of
funds. Thus, effectively, most nonbank de­
pository institutions are limited to overnight
loans from the discount window for adjust­
ment credit.
Although adjustment credit accounts his­
torically for the great bulk of discount window
borrowing, extended or longer term credit
has increased significantly since thrifts have
gained access to the discount window. Three
types of extended (longer term) credit are
granted by the Fed—seasonal credit, special
assistance credit, and w hat the Fed calls
“other extended credit.” Seasonal credit is
available to institutions w ith earnings that
vary at different times of the year, such as
banks at the seashore or in agricultural areas.
These institutions often experience large
seasonal fluctuations in flows of funds that
they can’t deal with in another way. To date,
thrifts have not used seasonal credit. The
seasonal credit program is available, how­
ever, should they qualify. Special assistance
credit is available to an individual bank or
thrift institution in exceptional circumstances.
Commercial banks have been the only bor­
rowers under special assistance to date, but
this program is also available to thrifts with
problems unique to a particular institution.
The other extended credit program, in
contrast, is targeted toward a class of institu­
tions affected by a general situation, such as
changing money-market conditions or de­
posit disintermediation. This program was
implemented by the Fed in August 1981 when
many thrifts appeared to be facing serious
financial problems. Though, in principle,
other extended credit is available to banks,
the Fed contended that S&Ls and MSBs faced
special difficulties as a class of institutions

short-term borrowing from the Fed (about 70
percent of total borrowing] has averaged
about $850 million nationwide and $50 million
for the Third District. Commercial banks
have accounted for nearly all of the adjust­
ment borrowing; short-term borrowing in the
system by thrifts has averaged less than 1
percent. Although short-term borrowing in
the Third District has been modest, several
local MSBs, S&Ls, and CUs have completed
the necessary paperw ork and could borrow
on short notice.
One of the more difficult aspects of dis­
count window policy under MCA has been
deciding w hat the Act means by the “same”
borrowing privileges for nonmember institu­
tions. It has long been a basic tenet of adjust­
ment discount policy that a borrower normally
should seek other reasonably available
sources of funds before turning to the w in­
dow for assistance. In the case of S&Ls,
MSBs, and CUs, the Fed has interpreted the
available sources of funds to include credit
from special industry lenders, such as the
Federal Home Loan Bank System, credit
union centrals, or the Central Liquidity
Facility of the National Credit Union Admin­
istration (NCUA).*5 An S&L in Philadelphia
that is a mem ber of the Federal Home Loan
Bank System, for example, would be expected
to seek assistance from its regional Federal
reserve requirements. Reasons not considered appropri­
ate include supporting a program of aggressive loan
expansion or taking advantage of a differential between
the discount rate and other rates for alternative sources
of funds. Nor is it considered appropriate to substitute
discount borrowing for other short-term liabilities that
are sensitive to interest rate changes, such as moneymarket certificates.
5S&Ls and MSBs that are members of the Federal
Home Loan Bank System are eligible to borrow from one
of their regional banks, such as the Federal Home Loan
Bank in Pittsburgh. S&Ls and MSBs that are not members
of the Federal Home Loan Bank System now have the
Fed as their primary industry lender. Credit unions have
access to the Central Liquidity Facility or to credit union
centrals, which serve a similar function and have been
formed recently in many areas of the country.




15

JULY/AUGUST 1982

BUSINESS REVIEW

repay. Typically the Fed will share the loan
on, say, a 50-50 basis w ith the FHLB. But if a
check with the FHLB shows that the thrift is
close to insolvency, the Fed may be reluctant
to participate and may suggest that the FHLB
take full responsibility for the loan. Thus far,
the individual Reserve banks appear to be
administering the other extended credit
program on a flexible case-by-case basis.
What Comes Next? As the Fed tries to
further implement the provisions of the
MCA and to anticipate thrift borrowing
needs, it will face a range of issues that will
require ongoing consultation with other
regulatory bodies.6 One such issue is the
extent of Fed lending under the other ex­
tended credit program: will this lending grow
or shrink? Fed lending to thrifts thus far is
small compared to the volume that thrifts
may w ant should their condition continue to
worsen. W eekly thrift borrowing at the dis­
count window amounted to $450 million at its
peak, most of it to MSBs. This amount is a
little smaller than the $630 million weekly
average in short-term funds (one year or less)
lent by the FHLBs during their peak month to
the S&Ls. Over the August-M arch period,
these FHLB short-term advances to members
totaled about $12 billion, nearly twice the $7
billion the Fed lent to thrifts. The limits of the
Fed’s commitment to lend to troubled thrift
institutions will depend partially upon the

because of their long-term asset portfolios
and their sensitivity to yield trends in national
money markets. Since the program has been
inaugurated, thrift borrowings from the Fed
under the other extended credit program have
fluctuated considerably, from a high of
around $450 million to a low of about $60
million (see WEEKLY THRIFT BORROW­
INGS . .
MSBs have borrowed more than
S&Ls. Thrift institutions in the Third District
have borrowed a substantial portion (about
20 percent) of this long-term credit.
The protocol for borrowing under extended
credit is similar to that for adjustment credit:
nonbank depository institutions are expected
to make a reasonable effort to seek alternative
sources of funds before coming to the dis­
count window. W hen the Fed considers such
applications, it consults w ith the appropriate
regulatory agency—say, the regional FHLB.
The thrift institution is evaluated in term s of
its particular circum stances and ability to

WEEKLY THRIFT
BORROWINGS
OF
EXTENDED CREDIT
FROM THE FED
VARY WIDELY
Millions of Dollars

®The Fed also communicates directly with thrifts via
advisory boards. Each district Reserve bank already has
a nine-person Board of Directors—three bankers elected
by member banks, three business people also elected by
members, and three nonbankers appointed by the Board
of Governors to represent the public interest. These
district boards vote on discount rate changes and over­
see the district Reserve banks’ activities. But in addition,
the district Reserve banks have established their own
communication networks with thrifts. The Philadelphia
Fed has established four Advisory Boards—one for non­
member commercial banks, one for S&Ls, one for MSBs,
and one for credit unions—to enhance communication
and feedback between the Philadelphia Fed and each
group.

0 u _____ i_____ i_____ i_____ i_____ i_____ i_____ i .......i .........J--------

A S

O N D J
1981

F M A M J
1982

SOURCE: Board of Governors, System “Weekly
report of discount window borrowing.”




16

FEDERAL RESERVE BANK OF PHILADELPHIA

have not resulted as yet in massive borrow­
ings. Nor are large borrowings likely to occur,
because the Fed is concerned that its moneygrowth targets not be jeopardized. Large bor­
rowings could create money-supply control
problems that would conflict w ith the Fed’s
m onetary policy. Still, the Fed is ready to
cooperate with other primary industry lenders
and has established a continuing basis on
which to work tow ard resolving differences
among the regulatory agencies. These rela­
tionships should prove useful as financial
institutions and markets become more closely
integrated.

availability of funds from other prim ary in­
dustry lenders. In this regard, the FHLBB
and the Fed have established a basis for con­
sultation, albeit an evolving one. As yet, the
Fed and the Central Liquidity Fund—the
prim ary industry lender for national credit
unions—have not established a formal con­
sulting relationship. But even if credit unions
should become active borrowers, they prob­
ably would account for only a small portion
of long-term borrowings because of their
smaller average size.
A nother lending issue concerns the poten­
tial conflicts that might arise from the differ­
ent lending rates and policies of the prim ary
lenders. S&Ls consider the Fed to be a more
restrictive lender than the FHLB; the Fed
lends prim arily for tem porary liquidity pur­
poses w hereas the FHLB lends for loanexpansion purposes as well. Despite the
restrictions, however, thrifts at times will
have a strong incentive to borrow from the
Fed. The Fed’s discount rate moves up and
down, but it is not tied in any m echanical way
to a m arket rate. Overall considerations of
m onetary policy play the fundam ental role.
Especially during periods of high interest
rates, the Fed’s discount rate often is below
m arket (but on some occasions the discount
rate has been above the m arket rate). In con­
trast, the district FHLBs sell bonds and borrow
in the m arket at close to a competitive rate and
then advance the monies with a 1/4-percent
premium or so to the S&Ls. Thus if the Fed
frequently m aintains the discount rate well
below m arket rates, thrifts will argue for
relaxing Fed guidelines to allow them greater
borrowings.
In sum, the Fed has made substantial pro­
gress in implementing access to the discount
window for all depository institutions. Guide­
lines have been established for the other ex­
tended credit program, and the Fed has devel­
oped a consulting relationship with the FHLBs.
The program is basically in place. The diffi­
culties of the thrift industry, although the
catalyst for the extended credit program,




THRIFT PROBLEM PROMPTS
A QUICK RECONSIDERATION
OF MERGER QUESTIONS

By opening the discount window to thrifts,
the MCA acknowledged that these institu­
tions have become more like commercial
banks. But the Act w ent considerably further
in this regard. Thrifts received expanded
asset powers; they also faced a dismantling of
their regulation-preserved ability to pay
higher rates on deposits than banks. These
provisions of the MCA clearly set in motion
forces that increased financial integration.
Eventually, all these factors would have
forced the Fed to face up to a host of new
regulatory issues. But once again the plight
of the thrifts forced the Fed’s hand in these
matters.
One major way that the Fed is involved in
regulation of financial institutions is through
its role in the merger process. The Fed has
responsibility for approving bank mergers in
which the surviving bank is a state member
bank, for approving bank holding company
formations and the acquisition of banks by
holding companies, and for approving non­
bank activities of bank holding companies.
Prior to MCA, the Fed for the most part deemphasized the presence of thrift institutions
in reaching these decisions. But now there
are two kinds of mergers in which the Fed
might need to take account of thrifts and their
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JULY/AUGUST 1982

BUSINESS REVIEW

and Urban Affairs Committee, and released
a staff report which suggested that “in gen­
eral, policy and economic considerations that
have been the basis for precluding bank
holding companies from acquiring thrifts
have diminished or are relatively insignifi­
cant.” 8 More recently, the Comptroller and
FDIC submitted studies favoring cross­
industry acquisitions. At this point, however,
the Board’s policy does not favor acquisitions
of thrifts except under restricted circum­
stances. 9
This issue of bank-thrift mergers has
surfaced in one form or another in practically
every piece of recent U.S. banking legisla­
tion. In testimony so far the Fed has tried to
make a distinction betw een emergency
circumstances and normal times. Because of
the distressed condition of the thrifts (and
some banks), the Fed did support the cross­
industry acquisition of thrifts under emer­
gency circumstances. If the emergency
should recede, however, the issue of bankthrift mergers will still be with us. The Fed is
reluctant to address this issue on its own and
is looking to Congress for guidance and clari­
fication. M any pieces of legislation have
been proposed, both at national and state
levels, to relax the branching constraints of
the M cFadden Act or the product constraints
of the Glass-Steagall Act (see LEGISLATIVE
INITIATIVES).89

new powers: bank-thrift mergers and bankbank mergers.
Bank-Thrift Mergers. Both the expanded
asset powers of the thrifts and their generally
troubled financial state have created new
incentives for mergers of banks with thrifts.
These mergers can be accom plished when
banks or bank holding companies acquire
thrifts or w hen savings and loan holding
companies acquire banks. Currently, feder­
ally chartered S&Ls can branch statewide in
all states. State chartered S&Ls can branch
according to state law, which allows state­
wide branching in most cases, such as
Pennsylvania. M oreover, they may merge
across state lines under emergency conditions.
Several mergers among S&Ls spanning large
geographical areas have taken place. 7
The Fed began to reconsider bank-thrift
mergers when the thrift industry became
distressed. As the regulator of bank holding
companies, the Fed has statutory authority
under the 1970 Am endm ents to the Bank
Holding Company Act of 1956 to permit
bank holding companies to acquire thrifts.
Fed policy to date, however, states that the
operation of a thrift, while an activity closely
related to banking, is not an activity that is a
proper incident to banking. Thus the Fed has
not listed acquisitions of thrifts among the
permissible activities of bank holding
companies. In April 1981 the Fed asked for
comment on w hether savings and loan
activities might be considered a proper
incident to banking. The response from the
Justice Departm ent stated that the activities
of thrifts are indeed closely related to
banking. They also supported bank purchases
of thrifts in localities other than a bank’s
home state. The Fed studied the m atter
further at the request of Senator Garn,
Chairman of the Senate Banking, Housing,

8Cover letter from Paul Volcker to Chairman Garn,
September 21, 1981. The study, titled “Bank Holding
Company Acquisition of Thrift Institutions,” was
written by Eisenbeis, Cleaver, Bleier, Savage, and
others on the staff of the Board of Governors.
9On April 5,1982 the Federal Reserve Board approved
the emergency merger of Scioto Savings Association,
Columbus, Ohio, and Interstate Financial Corporation,
owner of the Third National Bank and Trust Company,
Dayton, Ohio. The merger was approved under Section
4(c)(8) of the Bank Holding Company Act, which allows
bank holding companies to operate nonbank subsidi­
aries. Scioto will continue to operate as an S&L, except
for some restrictions, such as adherence to Ohio bank
branching laws.

7For example, Citizen Savings and Loan of San
Francisco, a subsidiary of National Steel Corporation,
acquired an S&L in New York City and an S&L in Miami
Beach.




18

FEDERAL RESERVE BANK OF PHILADELPHIA

LEGISLATIVE INITIATIVES
The Fed has a strong interest in legislation that affects its policies, and the Chairman testifies
frequently before Congress on such legislation. The Fed also consults with other regulatory authorities
on different legislative approaches. On the national level the Fed supported the so-called Regulators’
bill. This bill had provisions to facilitate mergers of troubled S&Ls across state lines and across
industries, including bank acquisitions of thrifts in emergencies, provided a particular sequence is
followed. Other provisions authorized the FDIC and FSLIC to aid a broader class of distressed
institutions, increased the drawing authority of these insurance funds from the Treasury, and
required both FSLIC and Reserve Board approval of a bank holding company acquisition of an S&L.
The Regulators’ bill has met with considerable opposition from various industry groups.
An alternative approach under consideration by Congress is embodied in the Gam bill (Restructuring
bill]. This broader, more comprehensive bill evolved from two major perspectives. The first was the
FHLBB’s desire, backed by the Administration, to provide thrift institutions with full banking
powers. The second was to give more powers to banks to enable them to compete better with
nonbanks. The Garn bill is wide ranging: it permits bank acquisitions of distressed thrifts; it allows
banks and S&Ls to operate mutual funds and grants federally chartered thrifts the power to make
commercial loans and buy commercial paper; it preempts state consumer usury ceilings and state
due-on-sale clauses; it increases the insurance on IRA/Keogh accounts. Before this bill makes much
progress, however, there will have to be many compromises made on all sides.
The Fed also is watching closely the Bank Holding Company Deregulation Act of 1982, introduced
by the Administration. This bill expands the powers of banks and securities firms to enter each
others’ traditional lines of business. Bank holding companies could enter the securities business
through securities affiliates subject to the same regulations as other participants in those markets.
Hearings on this blockbuster bill will encompass all the issues of Glass-Steagall.
On a statewide basis, changes are also occurring on the legislative front in the Third District. The
Pennsylvania legislature has just passed a bill relaxing the state’s one-bank holding company and
contiguous-county branching laws. The new bill permits bicontiguous county branching and allows
multibank holding companies statewide.* The holding company provision is phased in. It allows
bank holding companies to control up to four banks within the first four years and to acquire up to
four banks in the second four-year period, with unrestricted acquisition thereafter. Home office
protection is accorded some banks in small towns. In New Jersey, which permits statewide branching,
multibank holding companies already exist. In Delaware, the Financial Center Development Act,
passed in early 1981, allows out-of-state bank holding companies to enter de novo as brand new
institutions. New banks created by out-of-state holding companies must meet certain requirements
and not compete directly in the local retail banking markets. The attraction to Delaware stems from
the elimination of all usury ceilings and a graduated tax system which favors larger banks. So far,
several institutions based outside Delaware, including several large New York banks, have estab­
lished operations in Delaware or have announced plans to move there.
‘Contiguous county branching allows a bank headquartered in a given county to branch into all adjacent
counties. Bicontiguous county branching would extend branching to the next adjacent county as well.

both bound by legislation and constrained by
court precedent. Banks are formally subject
to state branching laws under the M cFadden
Act and require the approval of the proper
regulatory authority, Federal and state, to
merge within a state. The existing court

Bank-Bank Mergers. Even in cases of
bank or bank holding company mergers,
thrifts and their expanded powers under the
MCA have influenced Fed merger policy.
W hen the Fed considers the regulatory
approval of bank merger applications, it is




19

JULY/AUGUST 1982

BUSINESS REVIEW

cases address im portant concepts, such as
potential competition, and sometimes raise
questions about the rationale for the existing
institutional restrictions. 10 To date, how­
ever, the courts have not fully reflected the
rapid changes in the financial scene; concepts
like banking as a separate line of commerce
still are upheld by the courts and thus may
constrain the F ed.11*134 The line of commerce
definition was enunciated in the United
States versus Philadelphia National Bank
decision in 1963, w hen the Court ruled that
commercial banking is sufficiently distinct
that other financial institutions are not able
to compete with banks in the same markets.
Thus in the past, consideration of the com­
petitive effects of a bank acquisition has
focused primarily on the relevant commercial
bank m arket data, w ith m arket shares of
deposits used as m easures of concentration.
Other institutions, financial or otherwise,
have not been considered to be significant
bank competitors. The courts have been
moving somewhat in the direction of
including thrifts as competitors. In the
Connecticut National Bank case of 1974, for
example, the Connecticut court specified the
terms on which thrifts might be included in
the regulatory decision process, tz But the

courts have not set a strong or systematic
precedent for explicitly considering the
importance of thrifts in the relevant market.
Few recent cases have addressed directly the
presence of thrift competition in banking
markets, but the issue is sure to come up
again.
Although the absence of definitive court
cases since 1974 has increased uncertainty
over how to assess thrift competition with
banks, the regulatory authorities have felt
compelled to move ahead on their own. The
Fed has considered several alternative ways
to include competition from thrifts in the
market analysis. One approach taken was to
include thrifts in the m arkets w hen thrifts are
substantial competitors in certain product
lines or for particular custom er classes. !3
The Fed also has begun to make subjective
judgments to identify some m arkets where
thrifts should be included in market-share
data, citing the size and deposit-taking role of
thrifts as well as their expanded powers. i4

U.S. 656 (1974), the Supreme Court acknowledged that
savings banks were “fierce competitors” of commercial
banks in some markets. Yet it overturned a lower court
ruling that thrifts should be included in the line of com­
merce. The Court reaffirmed that commercial banks
offer a unique cluster of services and that banks and
mutual savings banks do not compete significantly for
commercial accounts. The Court also stated, however,
that it may be “unrealistic to distinguish them from com­
mercial banks for purposes of the Clayton Act” at a later
stage when "savings banks become significant partici­
pants in the marketing of bank services to commercial
enterprises.” For further discussion on the general topic
of thrift competition see Michael Trebing, “The New
Bank-Thrift Competition: Will It Affect Bank Acquisition
and Merger Analysis?” Review, Federal Reserve Bank
of St. Louis, February 1981, and the April 1982 Economic
Review, Federal Reserve Bank of Atlanta.
13Bank Holding Company Letter #198, issued by the
Board of Governors in June 1980, states the Board’s
position on consideration of thrifts in competitive
analysis.
14The difficulty with including thrifts in market share
data is that concentration of total deposits would remain
the key competitive factor in considering whether
mergers of any two banks would restrain trade. This

10Fed guidelines for bank acquisitions, for example,
are being reevaluated to streamline the applications pro­
cess. A market extension acquisition (acquisition of a
bank in a market in which the acquiring firm is not
already represented) would be subject to intensive scrutiny
when all of the following circumstances are met: (1) the
three-firm deposit concentration ratio is 75 percent or
higher in the market of the firm to be acquired; (2) there
are six or fewer probable future entrants into the market;
(3) the market of the firm to be acquired is in an SMSA
and is attractive for entry; (4) the firm to be acquired is
one of the three largest in the market and has 10 percent
or more of deposits. New Justice Department merger
guidelines will be a factor in this reevaluation.
•^For further discussion, see Robert A. Eisenbeis,
“Regulatory Agencies’ Approaches to the ‘Line of
Commerce’,” Economic Review, Federal Reserve Bank
of Atlanta, April 1982.
12In United States v. Connecticut National Bank, 418




20

FEDERAL RESERVE BANK OF PHILADELPHIA

Essentially the Fed has taken the first step in
recognizing that commercial banks may
respond to the w ay thrifts price their product
lines and in assessing the significance of
alternative suppliers of financial services.15
Thus the Fed is reconsidering its position
on mergers of bank holding companies with
thrifts or banks and it is attempting to develop
new analytical tools and concepts of compe­
tition in m arket analysis. 16

credit program of the discount window
probably will be operating for some time.
The extent of the Fed’s involvement still
remains to be w orked out, but the basic com­
mitment to all depository institutions has
been established.
In assessing mergers, the Fed has moved to
include consideration of bank competitors,
particularly thrifts, in banking m arkets. The
implications of cross-industry mergers are
being explored. The evolution of the different
regulatory approaches and the issue of how
to treat thrift competition also may be shaped
by the courts. And the Fed is working closely
with other regulatory agencies and with
Congress. M any different legislative and
regulatory approaches have been suggested,
and it will take time to sort them all through.
With continued change expected in financial
institutions and the m arkets they serve, one
thing is certain—life at the Fed won’t be
dull.

CONCLUSION

Financial institutions and m arkets have
changed so fast that the Fed has faced many
difficult questions when implementing the
provisions of the MCA and responding to
today’s financial environment.
The S&Ls, MSBs, CUs, and nonmember
commercial banks that make up the Fed’s
expanded constituency have been given
access to the discount window. Given the
recent high inflation rates and the difficulties
of the thrift institutions, the other extended

S&Ls, MSBs, and CUs, contributed significantly as a
determinant of bank performance. See Timothy Hannan,
“Competition Between Commercial Banks and Thrift
Institutions: An Empirical Examination,” Research
Paper No. 70, Federal Reserve Bank of Philadelphia,
April 1981. Contradictory evidence is provided in a more
recent study by William N. Cox and Joel R. Parker, “Do
Banks Price as if Thrifts Matter?” Econom ic Review,
Federal Reserve Bank of Atlanta, April 1982. They found
that banks in the Sixth Federal Reserve District did not
respond to thrift NOW account pricing.
■^The far-reaching implications for the Fed of bankthrift mergers and increasing financial integration have
still to unfold. The Fed and the other regulatory authori­
ties were established when each type of institution had
its own niche in the financial markets. Now that finan­
cial services overlap to a great extent and nonbanking
conglomerates are becoming strong competitors, the
lines previously drawn between different types of insti­
tutions have become fuzzy. When carried to its conclu­
sion, this argument states that it is no longer useful to
separate the different regulatory authorities. The Fed,
FHLBB, FDIC, Comptroller, and FSLIC, so the argument
goes, could be consolidated and grouped according to
function. One agency would be responsible for insurance,
one would group together the supervision and regulatory
functions, and one would handle the money supply
control function.

approach implicitly lumps all the product lines of banks
and thrifts into a single aggregate deposit measure of
market share. A second approach under consideration
would be to include thrifts, and possibly other competi­
tors, and to disaggregate the product lines. For example,
in addition to demand deposits and savings deposits,
there might be consumer loans, commercial loans,
NOW accounts, trusts, and other product lines in which
banks compete. Although the unbundling of products
inherent in this second approach may be more accurate
in looking at banks and thrifts as multiproduct institu­
tions, an overall assessment of competition could be
difficult. Weights would have to be given to the different
product lines; how restrictive the regulatory stance is
would depend partially on the weights chosen. This
procedure has the merit of considering several different
types of participants in a given market.
The Justice Department divided the line of commerce
into retail (including thrifts) and wholesale banking
(excluding thrifts) in its complaint filed February 28,
1982 in the U.S. v. Virginia National Bankshares case.
*5Evidence from a study in Pennsylvania supports the
hypothesis that, even before the MCA, substantial
competition between banks and thrifts existed for certain
product lines, such as passbook savings. Measures of
market structure, as defined by an index covering CBs,




21

FROM THE PHILADELPHIA FED




•

•

•

This new pamphlet compares
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This new pamphlet presents
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