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IEbiB\Jilllk August 1, 1980 Two Weeks Can Be a l on g Time Lagged reserveaccounting is one of the most arcane, yet frequently debated monetarypol icy issuesof the past decade.On its face, this regulation-part of FederalReserveRegulation D -appears to be simple and innocuous. It statesthat, in any given week, Federal Reservemember banksmusthold reserves(in the form of depositsat a FederalReserveBank or vault cash) in prescribed percentagesof their various types of depositsoutstanding two weeksearlier.This rule hasbeen in effect since 1968, replacing the systemof contemporaneous reserveaccounting, which required banks to hold reservesbasedon their currentweek'sdeposits. times, depending on certain technical features of the Fed's efforts to control money. Specifically, lagged accounting createsa major problem onlywhen reservesborrowed from the Federal Reserveare nearly at zero levels, andwhen the Fedwishes to focus its monetary-control procedureson bank reserves.The problem is that the Fed may find it necessaryto control money by setting Federal-funds rate targets-the method it abandoned lastOctober in favor of a reserves method. Funds-rateoperating procedures The Fed can influence money growth in either of two basic ways-by targeting the quantity of reservesit supplies to the banking systemor by targeting the Federal-fundsrate, the interest rate at which banks borrow reservesfrom each other and from other institutions. Prior to October 6, 1979, the Fed used the latter method. When it wanted slower monetary growth, the Fed raised the funds rate, making reservesmore expensive for banks to obtain. Many observers,including Milton Friedman in his Newsweek column, are currently suggesting that the Fed should switch from the lagged systemback to the contemporaneous rule. They arguethatthis action would significantly improve Federal Reservecontrol over the monetary aggregates.Thesearguments took on new urgency this spring, when several key policy aggregatesdeclined at a time when the economy was moving into a recession. (The narrow M-1 B measure-currency plusbank demand depositsplus other checktype deposits-decl ined at a 7.7-percent rate over April and May.) The rule thus has become an important policy issue,in view of the argument that lagged accounting hampers efforts to push the monetary aggregates back up into their target ranges. Under lagged accounting, any increasesin depositsthis week forced banksto obtain more reservestwo weeks later. Furthermore, an increasein this week's funds rate often indicated that the funds rate two weeks later would be similarly high. The higher expected funds rate induced balance-sheetreactions of individual banks that led to slower growth in system-widedeposits, and thus in M-1 B. Demand-depositgrowth was also reduced as the funds-rate increasespreadto other money-market yields, reducing the public's demand for deposits. Sincethis process would have been virtually identical under contemporaneousaccounting, the choice of reserveaccounting rules was of little consequenceunderthe former funds-rate procedure. Is the choice between laggedand contemporaneous accounting,really all that important? After all, a matter'of only two weeks is involved. Indeed, some analystsmaintain that a two-week lag can only insignificantly influence the decisions of individual banks, which are basedupon longer-run considerations. In this view, the choice between reserve accounting rules plays only a minor role in how the money stock is determined. Our analysis suggests,however, that both sidesof this debate are correct at various Reservesoperating procedures On October 6, 1979, the Federal Reserve 1 §§ 1F @ill ]ED@iEldk §@i1l'0. 1FJJ'@ill'l1(\; li (\;CSJ) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco" nor 01 the Board of Governors of the Federal Reserve System, announCEidthat it wou Id place a greater emphasis in the day-to-day control of the monetary aggregates on the quantity of bank reserves, and allow greater short-run fluctuations in the funds rate (see the October 19, 1979 Weekly Letter-"The Fed Crosses the Rubicon"), The Fed took this action because the funds-rate approach to monetary control had not worked as well as was desirable or possible, But these efforts to tighten monetary control had another effect closer to the current discussion -the choice between lagged and contemporaneous accounting became an important monetary-policy issue, (even if that quantity is less than current requirements), and in effect, force the banking system to adjust its current deposits (and thus required reserves) accordingly, Under lagged accounting, 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 some individual banks into a deficiency, it must provide the quantity of reserves demanded by the banking system, Under lagged accounting, the Fed's supply of reserves must adjust to the banking system's demand, This is just the opposite to contemporaneous accounting, where banks adjust their demand for reserves (through deposit changes) to the Fed's fixed supply, To see this point, we must understand the basic elements of controlling money through reserves, As noted earlier, the Fed sets the dollar volume of reserve'requirements equal to fixed percentages of the various types of deposits issued by banks, Thus if the Fed fixes the quantity of total reserves available to the banking system, bank deposits can expand only by some fixed amount. Otherwise, total reserve requirements for the banking system would exceed the total quantity of reserves available to meetthose requirements, As a consequence, some individual banks would find themselves without enough reserves to meet their requirements, Discount window Does the Fed have any control over the monetary aggregates under a system of lagged accounting, where it must accommodate any quantity of reservesdemanded by banks?The answer is yes under certain circumstances, which depend on the level of reserves which banks borrow from the Fed, The Fed has two basic methods of supplying reserVes,Nonborrowed reserves are supplied when the Fed purchases a Treasury bill or other security directly or indirectly from a bank, paying for the security with reserves (in the form of a deposit at the Fed), The Fed supplies borrowed reserves when it makes a loan to a bank at the discount rate, Banks are reluctant to borrow from the discount window, however, partly because the Fed has historically discouraged such loans except in emergencies, and partly because it imposes explicit restrictions on the quantity of reserves it will lend to anyone bank overtime, Thus, in view of banks' reluctance to borrow, the Fed can restrict money growth byproviding a larger proportion of banks' predetermined requirements through the discount window, These banks might respond by bidding for reserves in the funds market, causing the funds rate to rise, In fact, the funds rate would have to rise to the level at which system-wide deposits and reserve requirements fell enough to eliminate the aggregate reserve deficiency, Thus, the use of reserves to control money growth does not reduce the role of the funds rate in the control process, This approach instead makes the necessary fundsrate changes an automatic result of the Fed's reserves targets, Laggedreserve accounting With contemporaneous reserve accounting, banks as a whole influence their current week's required reserves through changes in current deposits, As a consequence, the Fed can provide a fixed quantity of total reserves For example, when the Fed wants to slow money growth, it reduces its provision of nonborrowed relative to borrowed reserves, 2 Funds Rate Demand Supply A - - - - Total Reserves Note: Below point A, borrowed reservesequal zero, and the funds rate is below the discount rate. Under laggedaccounting, this would not change banks' requirementsfor total reserves,which are basedon the level of depositstwo weeks earlier-but it would force some banks ultimately to borrow more of thosereserves·fromthe discount window. But since banksare reluctant to go to the window, they may first try to meetdeficiencies through the funds market, driving this rate up relative to the discount rate. With the increase in the relative cost of borrowing in the funds market, some bankswill be induced to make up their deficienciesat the discount window. But becauseof the rising funds rate, deposits will expand lessrapidly. funds rate could not be determined by nonFedparticipants in the reservesmarket becauseneither the demand for reservesnor the supply of reservesrespondto the funds ratesupply is unresponsivebecauseborrowed reservesare nearly zero, while lagged accounting makesreservesdemand unresponsive (seechart). Crux of problem To avoid such extreme funds-ratefluctuations, the Fed could buy the excessreserves from banks through open-market operations designedto set the funds rate at some desired level. But in that event, the Fedwould be following a funds-rateapproach to money control-the approach it abandoned last fall. Alternatively, the Fedcould maintain the discount ratelj"low thefunds'rilte,inducing a positive level of borrowed reservesat all times. But for a variety of reasons,the Fed historically hasnot changedthe discount rate actively enough to pursue such a policy. This procedure can provide for monetary control if banks' reluctance to borrow is predictable, andif the 'aggregatequantity of . discount-window borrowing is not close to zero. But what happenswhen borrowed reservesare close to zero (becausethe funds rate isbelow the discount rate) and when the Fed increasesnonborrowed reservesto stimulate money growth? Under these circumstances,bankswould find themselveswith excessreserves,which they would then lend to other banks in the funds market. This would make the funds rate fall as excessreserveswere transferredbetween banks. If borrowed reserveswere significantly positive, the funds rate would stop declining as bankswere induced to borrow fewer reserves from the Fed,thus absorbingthe excessreservesin the banking system.But with borrowed reservesalready nearly zero, banks could not be induced to lower that borrowing any further. Thus the excessreservesin the systemwould not be absorbeduntil the funds rate approachedzero. In technical terms, the This then is an important problem with lagged accounting: if the Fedneedsto reduce borrowed reservesto nearly zero, it must effectively return to the funds-rateoperating procedure. This can Occurwhenever the funds rate is below the discount rate,as has been the case in recent months. Thus, from a purely monetary-control standpoint,a switch to contemporaneous reserveaccounting appearsto be justified as a natural extensionof the Fed's October 6 actions,which involved a change to a reservesprocedure for controlling the monetary aggregates. JohnP.Judd 3 J.Sl:lI::l UOlSU!YSEM• 410'1(1 • uoSfUO ,. epeA.3N ,. OljEPI !!l?MEH • E!UJOj!le:> OIV<I 39V1S0<l 'S'O llVW SSVlJ 1SHI1 :If BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollar amounts in millions) loans(gross, adjusted) andinvestments* loans(gross, adjusted)- total# Commercial and industrial Realestate Loansto individuals Securitiesloans U.S.Treasury securities" Othersecurities" Demanddeposits- total# Demanddeposits-adjusted Savingsdeposits- total Time deposits - total# Individuals, part. & corp. (LargenegotiableCD's) WeeklyAverages of Daily Figures MemberBankReserve Position ExcessReselVes(+ )/Oefidency (-) Borrowings Net free reserves(+ lI Net oorrowed(-) E'UOZPV C\J) ·J!le::> IO:>SpUI!J:I UI! S 1:St 'ON 11WH3<1 SelectedAssetsandliabilities LargeCommercialBanks • Amount Outstanding 7/16/80 136,940 115,294 33,204 46,666 23,584 973 6,274 15,372 44,161 31,948 28,719 61,534 53,262 22,116 Weekended 7/16/80 - 65 47 111 Changefrom year ago Dollar Percent Change from 7/9/80 - - 300 190 106 111 19 28 2 112 403 191 143 81 15 113 - - Weekended 7/9/80 10 2 8 7,696 8,610 1,819 7,624 1,129 615 1,349 435 558 369 1,969 11,492 11,687 4,966 6.0 8.1 5.8 19.5 5.0 - 38.7 - 17.7 2.9 1.3 1.2 - 6.4 23.0 28.1 29.0 Comparable period 15 84 69 * Excludestradmg account securities. # Includes items not shown separately. Editorialcommentsmaybeaddressed to theeditor(WilliamBurke)or to theauthor••.. Freecopiesof this andotherFederalReserve publications canbeobtainedbycallingor writingthePublicInformationSection, FederalReserve Bankof SanFrandsco,P.O.Box7702,SanFrancisco 94120.Phone(415) • l?>jSl?I'v'
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