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March 30, 1984 Endingthe lag Last month, the long-debated switch from lagged reserve accounting (LRR)to contemporaneous reserve accounting (CRR)took place. This arcane subject has been a major "bone" of contention among monetary economists and policymakers for the last fifteen years. One side has argued that implementing CRR is essential if the Federal Reserve is to have close control over the monetary aggregates, and that such control is necessary if monetary policies are to be effective. Others have asserted that this regulatory change would have little, if any, appreciable effect on monetary control, and that close short-run monetary control would be undesirable. The purpose of this Letter is to describe the main features of CRR and how the change in rules is likely to alterthe Federal Reserve's methods for controlling money in the short-run, and thereby affect interest rates and the economy. Regulations on reserves Under the Monetary Control Act of 1980 (MCA), all deposit-taking institutionscommercial and savings banks, savings and loan associations and credit unions-are required to hold reserves equal to specified proportions of certain categories of their outstanding deposits. When the M CA is fully phased in (the phase-in has been completed for all but nonmember institutions), most transaction (checkable) deposits in M 1 will carry reserve requirements of 12 percent, and the non-personal time, savings and money market deposit accounts in M2 and M3 will have 3 percent requirements. All other deposits in M2 and M3 are free of reserve requirements. Lagged reserve accounting was introduced in 1 968. In a given statement week, LRR meant that the level of reserveswhich an institution was required to hold depended on its deposits outstanding two weeks earlier. Underthe newCR R system, the statement period is lengthened from one week to two, and the lag between deposits and required reserves is reduced from two weeks to two days. Thus, during a given two-week "reserve maintenance period/" which begins on a Thursday and ends on the second Wednesday, a bank's required reserves will depend on its transaction deposits in the two-week "reserve computation period" which ended on the preceding Monday. The two systemsare shown in the chart. The new system applies only to the transaction (checkable) accounts in M 1: reserve requirements against non-transaction deposits will continue to be computed on a lagged basis. The new lagged system will differ from the old, however, in that the maintenance and computation periods are both two weeks in length, and the beginning of the maintenance period lags the end of the previous computation period by 17 days. This feature of the new reserve accounting rules, together with the features of the M CA discussed above, mean that the entire reserve accounting system is now set up to provide for a close link between M 1 and reserves, but only a weak link between the broader aggregatesand reserves. Operating procedures The significance of CRR for M 1 control wi II depend on the Fed's so-called short-run operating procedures. The Fed could minimize the importance of CRR by using the federal funds rate asa tool for controll ing M 1, as it did prior to October 1979. Under this procedure, if the Fed wished, for example, to lower M1 growth, itwould raise the federal funds rate in an attempt to reduce the public's demand to hold M1 and to induce banks to supply fewer deposits. This reduction in M1 would lead toa reduction in required reserves. Under LRR, reserves would fall with a lag of two weeks, whereas under CRR they would fall contemporaneously. However, this difference would have JF Ia&\I T'i\ C61ll Jk(G)if IF"fr celi :§')(CCQ) . Opinions expressed in Ihis newsletter do not necessarily renee! the views of the rnanagernent of the Federal [<eserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve Svstern. Fed hadtoinfi'uence the stock of money by varying the share of total reserves which it provided to banks through the discount window, that is, by altering the ratio of borrowed to non borrowed reserves. If the Fed wished to slow M 1 growth, it sold government securiti"es to reduce the supply of nonb Qrrowed reserves. With no change in the (predetermined) level of required reserves, this meant that borrowed reserves had to rise. Banks are reluctant to borrow from the discount window, however, since they are discouraged from doing so through adm ini strative pressures when other sou rces of funds are reasonably available. Thus, when the Fed reduced the supply of nonborrowed reserves, banks would first try to meet deficiencies through the federal funds market. The resultant increase inthe funds rate relative to the discount rate not only induced banks to borrow from the Fed but also slowed M1 growth, as the public's demand to hold M 1 decelerated. no significance for monetary control because changes in reserves would merely be incidental by-products of monetary control, not the causal factor. Alternatively, the Fed may choose to control M1 through a reserve aggregate. In this case, the choice between lagged and contemporaneous accounting could become an important monetary policy issue. The link between reserves and M 1 depends very much on reserve requirements. With a twelve percent reserve requirement, for example, every $1 00 change in deposits is associated with a $12 change in required reserves. Thus, if the Fed reduces the quantity of total reserves avai lable to the banking system; total bank deposits must fall. Since the link between required reserves and deposits is contemporaneous under CRR, the Fed can use total reserves as a means of controlling M1 . This is because, with CRR, banks as a group influence their current period's required reserves through changes in current deposits. Thus, the Fed can provide a fixed quantity of total reserves and force the banking system to adjust its current deposits and, thereby, required reserves, accordingly. Under LRR, this approach is not feasible because the link between current deposits and required reserves.is broken. Banks enter any given week with' a predetermined or unchangeable quantity of required reserves. Unless the Fed wanted to force the banking system into a deficiency, it had to provide the quantity of reserves demanded by the banking system. This meant that the Fed was effectively prevented from controlling the money stock by changing total reserves. This nonborrowed reserves method also could be applied under CRR. Even under this indirect approach, CRR has an advantage over the lagged rules. Under CRR, unexpected changes in the public's demand to hold M1 cause a quicker interest rate response, which helps bring Ml back to target more quickly. Assume for the moment that the public's demand for money increases. This causes an immediate increase in required reserves under CRR. Ifthe Fed holds nonborrowed reserves constant, the added demand for reserves causes an immediate and automatic rise in the funds rate so that the unexpected growth in M 1 is slowed more quickly. Under LRR, the funds rate increase took two weeks because required reserves lagged behind deposits by that length of time. The delay of any offsetting interest rate movements was a disadvantage because it allowed deviations of Ml from target to persist longer. A two week speed-up in response is important for close monthly control, but opinions differ as to its impor- Some critics of the Fed have argued that the inability to use total reserves was a major disadvantage of LRR. They asserted that if the Fed wanted to use reserves to control M 1, as it did after October 1 979, it had to do so through a less direct and inferior linkage. To use a reserves approach under LRR, the 2 Fed has given less policy weight to M 1 in favor of M2 and M3 as intermediate targets of monetary policy. The importance of the broader aggregates was confirmed in the Fed's recent Monetary Policy Report to Congress. tance for controlling M 1 on a quarterly or longer basis. Policydebate The ability afforded by CRR to use a total reserves operating procedure as well as CRR's faster interest rate responses are viewed as major advantages by some economists. They argue that volatility in the growth of the monetary aggregates has led to cyclical movements in the economy, and that the resu lting economic uncertainty has raised real (inflation-adjusted) interest rates. They see CRR as a way to lessen the disruptive influence of volatile money growth. The main concern of the Fed appears to be thatthe introduction of N OW and other new accounts in recent years may have changed the behavior of M1 significantly enough to make its relationship with G N P less reliable. than it once was. The Monetary Policy Report states that "while there is evidence of more normal and predictable patterns reappearing, the (Federal Open Market) Committee felt that more time would be required for assessing the impact of structural changes on public and institutional behavior before full or primary weight could be placed on Ml as a policy guide." Discussing CRR, the Report argued that the choice of operating procedures" ... does not depend on the technical characteristics of the reserve requirement system in place but rather on broader policy judgments about the relative weight to be given M1 as a target and the desirability of seeking close shortrun control of that aggregate." As a result, it decided not to make any substantial change in current operating procedures at this time. eRR th!JSwi II have little effect on monetary policy in the immediate future. Other economists disagree. They argue that close short-run M 1 control wou Id require extreme volatil ity in interest rates in the short-run, and thatthis would be detrimental to the performance of the economy because it would disrupt financial flows. They also argue that it makes I ittle sense to control money precisely because money's relationship with economic activity frequently changes (possibly because of financial innovation and deregulation). It appears unl ikely that the experience of the near future will resolve these arguments. The current contemporaneous reserve requirement rules may help the Fed to control M 1, but they provide no great advantage in controlling the broader aggregates. However, since October 1 982, the JohnP.Juddand Brian Motley Contemporaneous Reserve Accounting System'" Lagged Reserve Accounting· System Week 1 Week 2 Week 3 ,. .- - - - - - - - - - - . ' Week 1 T W Th F S Su M T W Th F S Su M T W Th F S Su M T W 1·week computation period Week 2 Week 3 T W Th F S Su M T W Th F S Su M T W Th F S Su M T W 1·week maintenance period 2·week computation period I 2·week maintenance period -Transaction Deposits Only 3 !IPMPH :. • 4Pln PIUJOj!IPJ • • PPPAilN • 04 PPI PUOZ!JV • P>jSPIV ell (G) BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT ( Dollar amounts in millions) Amount Outstanding 3/1 4/84 Selected Assetsand Liabilities large Commercial Banks Loans, Leases and Investments 1 2 Loans and Leases1 6 Commercial and Industrial Real estate Loans to Individuals Leases U.S. Treasury and Agency Securities2 Other Securities 2 Total Deposits Demand Deposits Demand Deposits Adjusted 3 Other Transaction Balances4 Total Non-Transaction Balanc;es6 Money Market Deposit Accounts-Total Time Deposits in Amounts of $100,000 or more Other Liabilities for Borrowed MoneyS Weekly Averages of Daily Figures ReservePosition, All Reporting Banks Excess Reserves (+ l/Deficiency Borrowings Net free reserves (+ l/Net borrowed (- 176,216 155,933 46,511 59,349 26,990 5,005 12,190 8,092 185,745 43,509 29,294 12,278 129,958 - 40,495 - 29 38,005 18,771 - 31 555 Weekended 3/14/84 1 Change from year_ago Dollar Percent Change from 3/7/84 - - - 475 465 104 72 42 5 5 15 83 181 228 189 91 - - 190 578 548 450 339 56 316 70 5,251 5,727 2,037 496 973 - 898 - - 159 4,235 Weekended 3/7/84 NA NA NA - NA NA NA .5 1.6 5.0 3.2 5.3 4.7 10.6 3.6 11.5 48.8 27.3 16.3 3.2 9.5 - 1.8 77.2 Comparable year-ago period NA NA NA 1 Includes loss reserves, unearned income, excludes interbank loans Excludes trading account securities Excludes U.S. government and depository institution deposits and cash items 4 ATS, N OW, Super N O W and savings accounts with telephone transfers 5 Includes borrowing via FRB, I T&L notes, Fed Funds, RPsand other sources 6 Includes items not shown separately 2 3 Editorial commentsmay be addressedto the editor (GregoryTong)or to the author ••.• Freecopiesof Federal Reservepublications can be obtained from the Public Information Section, FederalReserve Bank of San Francisco,P.O. Box 7702. SanFrancisco94120. Phone(415) 974-2246.
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