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d a rn Jr: May 31,1974 The Treasury made news during May with a successful $4.1 billion financ ing to replace several issues of maturing notes and bonds, with a net paydown of $1.6 billion. The refunding package included two intermediate-maturity notes as well as a $300-million issue of 25-year bonds, which attracted a good re sponse from small investors with a $1,000 minimum and an enticing 81 per cent coupon rate. During /2 the refunding, the Federal Reserve followed its usual practice of main taining "even keel." simply debt-management objec tives. Prior to that date— especially during World War II— the Fed's primary function was to insure that the rapidly growing Government debt would be marketed at low cost and would find a good recep tion in the financial markets. In this environment, increased government debt led to increased Fed purchases of government securities, which in turn led to an inflationary increase in the money supply. The price paid was an aggravation of the inflation of the middle 1940's. The Fed's even-keel objective is to avoid overt actions that may under mine a Treasury financing. In par ticular, during even keel, the System avoids operating in the open market in a manner which the market might interpret as reflecting a change in monetary policy. At the same time, the Reserve Banks make no changes in discount rates, and the Board of Governors makes no change in reserve requirements. As one benefit of even keel, government securities dealers and trading banks— which, in effect, privately underwrite Treasury financings— encounter only normal financial risks, not sudden changes in interest rates due to a change in monetary policy. When the Korean War erupted in 1950, inflation became severe again in response to scare buying in this country as well as worldwide short ages of raw materials. Under these new circumstances, an independent monetary policy seemed essential, so that the Federal Reserve regained its freedom of action under the Accord. At the same time, the monetary authorities promised that when the Treasury went into the market, the Fed would not change monetary policy in such a way as to complicate the Treasury's ability to sell its securities. In this fashion, even keel was born. Birth of even keel The use of the even-keel concept dates back to the Treasury-Federal Reserve Accord of March 1951, which gave the Fed the freedom to conduct monetary policy primarily in accordance with economicstabilization objectives rather than 1 Digitized for FR A SER Use of even keel Even keel is not maintained on all Treasury financings. By and large, it is not considered to be necessary for small offerings or for most offer ings of bills and shorter-maturity notes. Instead, even keel has been limited principally to the large quarterly refundings and to a few other offerings involving longerdated coupon issues. (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. Coupon issues are treated differ ently from Treasury bills, since the longer maturity means that a rela tively small change in the yield is associated with a larger change in the price of the security and, there fore, a greater risk to the bond dealer. Moreover, these issues require several weeks to distribute completely, so that the dealer is exposed to a greater risk for a greater length of time. Also, when the Treasury issues securities on an announced-yield basis (the usual case until recent years) rather than an auction basis; any mistake in pricing the issue could lead dealers to ignore the issue and cause the refunding to fail. Normally, the time span of even keel includes the initial period of marketing and distribution of new issues by private underwriters— roughly from the announcement date until payment date or perhaps, on occasion, a little beyond. such direct support has been ruled out by the System since the early 1950's, except when considered absolutely necessary to head off the development of potential disorder in the market. No such direct sup port has, in fact, been undertaken since 1958. The System conducts its open market operations during even-keel periods through pur chases and sales of the outstanding stock of Treasury securities already in the marketplace. Consequence? In view of the central importance of monetary policy in the nation's economic stabilization efforts, some observers question whether even keel may not at times interfere with this more important Federal Reserve role. Especially when the Treasury raises new money, there is a net increase in demands for funds, which tends to raise interest rates. If the Fed attempted to dampen this increase in rates, the result could be an expansion in openmarket purchases of Treasury securi ties and ultimately in the money supply— an increase which may not be completely offset after the even-keel period. Two common misconceptions about even keel may be noted. First, even keel does not completely rule out a rise in interest rates during a Treasury financing. Such a rise may be brought about by forces external to the Federal Reserve. Moreover, Normally, this is not a major prob the current trend or posture of lem. Most increases in Treasury new monetary policy may be continued money demands occur during reces during even keel, even if that trend sion periods, when monetary policy happens to be one of tightening. tends to be easier in any event. But, Second, even keel does not require at times, even keel considerations the Fed to buy part of a Treasury may result in a faster expansion of offering in order to ensure the suc cess of the offering. On the contrary,2 the money supply than stabilization objectives might have dictated, 2 Digitized for FR A SER especially if the Fed is emphasizing interest rates— rather than monetary aggregates— as targets. Indeed, some critics argue that this happened several times during the 1967-68 period, when there was a heavy amount of war-related borrowing at a time of full employment. Possible changes One major debt-management change recently introduced has been the use of auctioning for Treasury notes and bonds, analo gous to the traditional way of handling Treasury bills. When mar ket participants bid, knowing the size of the issue, the chances of the issue being absorbed at that price are much greater than if the Treasury established a price ahead of time in the hopes the market would absorb the entire amount. Thus, the auction method tends to shorten the even-keel period, by making it less necessary to maintain even keel prior to the auction date. It has also been suggested that the Fed should completely abandon the observance of even keel. If the System should substantially tighten policy during Treasury financing periods, however, private under writers might well suffer heavy capital losses. Such an eventuality could have adverse consequences for the Federal Reserve. First, such losses might undermine the ability and willingness of the private market to underwrite future Treas ury financings, and there would be great pressure for the Federal 3 Digitized for FR A SER Reserve itself to perform this underwriting function. If the system were forced to acquire new Treasury issues, it might have to supply more in the way of reserves than it wished and it would run the risk, in particu lar, of losing control over the mone tary aggregates. Second, the gov ernment dealers “ make" the market in which the System carries out its open-market operations, and any substantial weakening of the dealer network could seriously hamper these operations. If the Fed withdrew from the evenkeel function, there would be a substantial increase in the risks of making a market in government securities. Some dealers may leave the business while others would strive for larger profit margins to cover the increased risks. Some ob servers consider it would be better to permit dealers a larger rate of return than to ease their plight by a more expansionary monetary policy than may be justified on domestic stabilization grounds. In any event, the importance of the System's even-keel commitment has diminished considerably over the last twenty years, due to the decline in the size of the outstanding Treasury debt relative to the overall size of U.S. financial markets. If this trend persists, the importance of even keel may well continue to decline— and with it any difficulties it may cause the Fed in implement ing monetary policy. Michael W. Reran l ------------3 uojSumsEM . qejn • uoSa-io • epeAaN • oqepi ne/wEH • eiuJop|E3 • suozuy • e> E v |S | BANKING DATA— TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) Weekly Averages of Daily Figures Amount Outstanding 5 /1 5 /7 4 82,573 64,280 1,251 23,063 19,112 9,231 5,132 13,161 78,496 21,867 736 54,650 17,860 26,919 7,222 13,824 Change from 5 /8 /7 4 - + + — + + — + — — + - + — + Week ended 5 /1 5 /7 4 Change from year ago Dollar Percent + 9,579 + 8,827 — 114 + 2,880 + 3,036 + 955 — 882 + 1,634 + 7,709 + 1,547 — 110 + 6,166 330 + 6,933 — 471 + 4,614 326 89 72 107 99 7 437 22 294 240 300 148 20 200 121 58 Week ended 5 /8 /7 4 + 13.12 + 15.92 — 8.35 + 14.27 + 18.89 + 11.54 — 14.67 + 14.18 + 10.89 + 7.61 — 13.00 + 12.72 1.81 + 34.69 — 6.12 + 50.10 Comparable year-ago period Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( - ) + + - 16 109 93 + + - 45 196 151 + 19 + 217 -1 9 8 + 872 + 886 + 449 + 300 + 308 + 103 Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases ( + ) / Net sales ( —) Transactions: U.S. securities dealers Net loans ( + ) / Net borrowings ( —) * Includes items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137. Digitized for FR A SER
